Monetary

Highlights A first Fed funds rate hike by early 2023 is cloud cuckoo land – because it will take years to meet the Fed’s pre-condition of full employment. More likely, the first rate hike will happen after mid-2024, and even this is a coin toss which assumes no further shock(s). Buy the March 2024 US interest rate future contract. An alternative expression is to buy the 5-year T-bond, or to go long the 5-year T-bond versus the 5-year German bund. For equity investors, the current overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Bitcoin has support at $32500, and then at $22750. The latest correction in cryptocurrencies is a good entry point into a diversified basket that includes ‘proof of stake’ coins, such as ethereum. Fragile iron ore prices confirm the onset of a commodity correction. Feature Chart of the WeekAfter A Recession, It Takes Many Years To Reabsorb The Unemployed After A Recession, It Takes Many Years To Reabsorb The Unemployed After A Recession, It Takes Many Years To Reabsorb The Unemployed After a recession, an economy takes years to reabsorb the unemployed. Here’s how long it took in the US after each of the last five recessions.1 1974-75 recession: 4 years Early-1980s recession: 6 years Early-1990s recession: 5 years Dot com bust: 3 years Global financial crisis: 8 years After the pandemic recession, reabsorbing the unemployed (that are not just on ‘temporary layoff’) will also take many years (Chart I-1). Full Employment Is Many Years Away There is a remarkable consistency in employment recoveries. The last five recessions were different in their severities and durations, and therefore in their peak unemployment rates. Yet in the recoveries that followed each of the last five recessions, the unemployment rate declined at a consistent pace of 0.4-0.5 percent per year. After the mild recessions of the early-1990s and the dot com bust, the pace of recovery in the unemployment rate was at the lower end of 0.4 percent per year. Whereas after the global financial crisis and its surge in permanent unemployment, the pace of recovery was at the upper end of 0.5 percent per year. But the difference in the pace of the five employment recovery was marginal (Table I-1). Table 1After Every Recession, The Pace Of Recovery In The Jobs Market Is Near-Identical A Fed Rate Hike By Early 2023 Is Pie In The Sky A Fed Rate Hike By Early 2023 Is Pie In The Sky Another near-constant through the past fifty years is the definition of ‘full employment’. It is achieved when the (permanent) unemployment rate reaches 1.5 percent. Combining the latest (permanent) unemployment rate of 2.7 percent, the unemployment rate at full employment, and the remarkably consistent recovery paces, we can deduce that: The US economy will reach full employment between September 2023 and June 2024. The Federal Reserve has promised that it will not raise the Fed funds rate until the economy has reached full employment. Based on the remarkably consistent pace of the past five employment recoveries, it means September 2023 at the earliest, but more likely closer to June 2024. Yet US interest rate futures are pricing the first Fed funds rate hike through December 2022-March 2023 (Chart I-2). Chart I-2Cloud Cuckoo Land: A First Rate Hike In Dec 22-Mar 23 Cloud Cuckoo Land: A First Rate Hike In Dec 22-Mar 23 Cloud Cuckoo Land: A First Rate Hike In Dec 22-Mar 23 This makes US interest rate future contracts from December 2022 to June 2024 a compelling buy (Chart I-3). Chart I-3Cloud Cuckoo Land: 4 Rate Hikes By June 24 Cloud Cuckoo Land: 4 Rate Hikes By June 24 Cloud Cuckoo Land: 4 Rate Hikes By June 24 Buy The March 2024 US Interest Rate Future The post-pandemic jobs market recovery will likely be at the lower end of its 0.4-0.5 percent a year pace, for two reasons. First, reducing the unemployment rate doesn’t only mean creating jobs for the currently unemployed. It also means creating jobs for those that have left the labour force but plan on re-joining. When these so-called ‘inactive’ people re-join the labour force they add to the number that are counted as unemployed. As the millions of inactives re-join the labour market, it will weigh on the pace of the recovery in the unemployment rate. During the pandemic, the number of inactive people surged by an unprecedented 8 million. Even now, the excess inactive stands at 5 million (Chart I-4). As these millions gradually re-join the labour market, it will weigh on the pace of the recovery in the unemployment rate. Chart I-4Massive Slack In The US Labour Market Massive Slack In The US Labour Market Massive Slack In The US Labour Market Second, after every recession, there is a surge in productivity (Chart I-5). This is because the period immediately after a recession is when the economy experiences the most intensive clearing out of dead wood, restructuring of capital and labour, and absorption of new technologies and ways of working. Chart I-5The Post-Pandemic Productivity Boom Will Be A Super-Boom The Post-Pandemic Productivity Boom Will Be A Super-Boom The Post-Pandemic Productivity Boom Will Be A Super-Boom If anything, the post-pandemic productivity boom will be even larger than normal. Whereas most recessions upend one or two sectors of the economy, the pandemic has forced all of us to adopt new technologies and ways of working and living. The unfortunate corollary of this post-pandemic productivity super-boom is that the pace of absorption of the excess unemployed and inactive will be slower. Moreover, even achieving full employment by June 2024 assumes blue skies through the next few years, which is to say no further shocks. Yet as we explained in The Shock Theory Of Bond Yields, deflationary shocks tend to come once every three years, meaning there is an evens chance that dark clouds ruin the blue skies. One complication is that the Fed will start tapering its asset purchases much sooner, and that this will be interpreted as the precursor of a rate hike. However, in the last cycle the taper of asset purchases in early 2014 preceded the first rate hike by two years (Chart I-6). On a similar timeframe, a taper at the end of 2021 would imply the first rate hike at the end of 2023, and not the start of 2023 as is implied by the interest rate futures. Chart I-6The First Rate Hike Came Two Years After The Taper The First Rate Hike Came Two Years After The Taper The First Rate Hike Came Two Years After The Taper Pulling all of this together, a first Fed funds rate hike by early 2023 is cloud cuckoo land. More likely it will happen after mid-2024, and even this is a coin toss which assumes no further shock(s) in the interim. The investment conclusion is to buy any of the US interest rate futures that expire from December 2022 out to June 2024. The earlier contracts have the higher probabilities of expiring in profit while the later contracts have the greater upside if the Fed stays pat. Our choice is the March 2024 contract. An alternative expression is to buy the 5-year T-bond, or to go long the 5-year T-bond versus the 5-year German bund. For equity investors, the current overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. The 419th Time That Cryptos Have ‘Died’ Rumours of crypto’s death have been greatly exaggerated. Apparently, last week was the 419th time that cryptocurrencies have died. Get used to it. As we pointed out in Why Cryptocurrencies Are Here To Stay… cryptocurrencies can suffer deep corrections from which they fully resurrect. Since 2013, the bitcoin price has suffered 17 drawdowns of more than 50 percent and an additional 11 drawdowns of 25-50 percent.2  Rumours of crypto’s death have been greatly exaggerated. We will not repeat the arguments why cryptos are here to stay, which were detailed in our Special Report, but we will discuss the recent price action. Why did cryptos correct? The simple answer is that their fractal structure had become extremely fragile, making the price extremely vulnerable to the slightest negative catalyst (Chart I-7). Chart I-7The Fractal Structure Of Cryptos Had Become Very Fragile The Fractal Structure Of Cryptos Had Become Very Fragile The Fractal Structure Of Cryptos Had Become Very Fragile A fragile fractal structure signifies that longer-term investors have disappeared from the price setting process. This means that price evolution is the result of more and more short-term traders joining the trend. Eventually though, there are no more short-term traders left to buy at the current price. So, when somebody wants to sell – perhaps on some negative news – a longer-term investor must step in as the buyer. But the longer-term investor will only buy at a much lower price, meaning that the price suffers a deep correction. Empirically and theoretically, the price correction meets support at successive Fibonacci retracements of the preceding momentum-fuelled rally, because a new cohort of buyers enters at each retracement level. Hence, the key support levels in the current correction are the 23.6 percent and 38.2 percent retracements of the preceding rally. In the case of bitcoin, this equates to support at $32500 and $22750. Which of these support level will prevail? Our bias is the higher level, because successive crypto corrections are becoming less and less extreme – possibly because more and more institutional investors are now involved in the asset class (Chart I-8). Chart I-8Crypto Corrections Are Becoming Less Extreme Crypto Corrections Are Becoming Less Extreme Crypto Corrections Are Becoming Less Extreme Hence, the latest correction in cryptos offers a good entry point. Albeit it is important to own a diversified basket that includes ‘proof of stake’ coins, such as ethereum. The Onset Of A Commodity Correction Finally this week, we highlight that iron ore prices are at the same level of fractal fragility that has marked previous major turning points in 2015 and 2019 (Chart I-9). Chart I-9Iron Ore Is Very Fragile Iron Ore Is Very Fragile Iron Ore Is Very Fragile Combined with the fragility we have recently highlighted in lumber, agricultural commodities, industrial metals, and DRAM prices, it confirms the onset of a commodity correction. We have already discussed this theme in Don’t Panic About US Inflation and are exposed to it through short positions in PKB, CAD, and inflation expectations. Hence, there are no new trades this week.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Throughout this analysis, the unemployment rate is based on the unemployed that are ‘not on temporary layoff’. Full employment is defined as this unemployment rate reaching 1.5 percent, or the cycle low, whichever is the higher. 2 The drawdown is calculated versus the highest price in the preceding 6 months. 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Highlights Monetary Policy: The Fed will not immediately change its policy stance in response to rising inflation and inflation expectations. Rather, it will follow its current forward guidance and only lift rates off zero once the labor market has reached “maximum employment”. However, once the first rate hike has occurred, the Fed will shift its focus toward inflation and inflation expectations. Duration: The overnight index swap curve is priced for a total of 77 bps of rate hikes by the end of 2023. We see strong odds that more hikes will be delivered and therefore continue to recommend a below-benchmark portfolio duration stance. Corporate Bonds: High and rising inflation expectations will eventually pose a risk to credit spreads, but only once the Fed tightens policy in response. For now, we remain overweight spread product versus Treasuries, though we maintain a preference for high-yield corporates, USD-denominated EM Sovereigns and municipal bonds over investment grade corporate bonds. Feature Recent inflationary trends are making the Fed’s job more difficult. Not only was April’s increase in core CPI the largest since 1981, but measures of long-term inflation expectations have also jumped. The 5-year/5-year TIPS breakeven inflation rate has quickly risen to levels that are consistent with the Fed’s 2% inflation target (Chart 1). What’s more, survey measures of inflation expectations have also moved up, in many cases to uncomfortably high levels (Chart 2). Chart 1Back To Target Back To Target Back To Target Chart 2Inflation Expectations Have Jumped Inflation Expectations Have Jumped Inflation Expectations Have Jumped All of this makes the Fed’s zero-lower-bound interest rate policy look increasingly untenable. Can the Fed really just sit on the sidelines as inflation and inflation expectations rise to above-target levels? Our expectation is that the Fed will ignore rising inflation until the labor market is fully recovered, but it may then need to move quickly to contain inflationary pressures. The result could very well be a rate hike cycle that takes a long time to start, but then proceeds at a rapid pace. The Fed’s Liftoff Criteria Are Different Than Its Criteria For Pace A crucial point about the Fed’s forward guidance is that the criteria that will determine the timing of the first rate hike are different than the criteria that will determine the post-liftoff pace of rate hikes. Liftoff Criteria Table 1A Checklist For Liftoff Lower For Longer, Then Faster Than You Think Lower For Longer, Then Faster Than You Think For liftoff, the Fed has been very explicit that three conditions must be met before it will raise rates off the zero bound (Table 1). Of the three conditions listed in Table 1, the timing of when the labor market will reach “maximum employment” is the most uncertain. We have written extensively about how the Fed defines “maximum employment” and about the pace of employment growth that’s necessary to achieve that goal by specific future dates.1 To summarize, we calculate that average monthly nonfarm payroll growth of at least 698k is required to reach “maximum employment” by the end of this year and average monthly payroll growth of at least 412k is required to hit that target by the end of 2022 (Chart 3). Chart 3Employment Growth Employment Growth Employment Growth Chart 4Labor Demand Is Strong Labor Demand Is Strong Labor Demand Is Strong Our assessment is that “maximum employment” will be achieved in time for the Fed to lift rates in 2022, largely because employment growth must rise quickly in order to catch up with skyrocketing indicators of labor demand (Chart 4). The risk, of course, is that inflation continues to run hot as the Fed waits for its “maximum employment” condition to be met. If this occurs, we believe that the Fed will stick to its current forward guidance. It will ignore rising inflation until its liftoff criteria are met. Only then, will Fed policy turn toward containing inflation. Pace Criteria In a recent speech, Fed Vice-Chair Richard Clarida laid out three indicators that he will track to guide the pace of policy tightening post Fed liftoff.2 First, he pointed to inflation expectations. In particular, the Fed’s index of Common Inflation Expectations (CIE):3 Other things being equal, my desired pace of policy normalization post-liftoff to return inflation to 2 percent […] would be somewhat slower than otherwise if the CIE index is, at time of liftoff, below the pre-ELB level. [ELB = effective lower bound]. Chart 2 shows that the CIE index has already broken above its 2018 peak. It stands to reason that, all else equal, an elevated CIE index would speed up the post-liftoff pace of rate hikes. Chart 5Inflation Since August 2020 Inflation Since August 2020 Inflation Since August 2020 Second, Clarida noted that: Another factor I will consider in calibrating the pace of policy normalization post-liftoff is the average rate of PCE inflation since the new framework was adopted in August 2020. The annualized rate of change in core PCE since August 2020 is almost at the Fed’s 2% target already, and it will certainly rise to above-target levels when the April data are released, as was the case with core CPI (Chart 5). Finally, Clarida offered up a detailed Taylor-type monetary policy rule that he says he will consult once the conditions for liftoff are met: Consistent with our new framework, the relevant policy rule benchmark I will consult once the conditions for liftoff have been met is an inertial Taylor-type rule with a coefficient of zero on the unemployment gap, a coefficient of 1.5 on the gap between core PCE inflation and the 2 percent longer-run goal, and a neutral real policy rate equal to my SEP forecast of long-run r*. Chart 6Balanced Approach (Shortfalls) Rule* Recommendations Lower For Longer, Then Faster Than You Think Lower For Longer, Then Faster Than You Think Chart 6 shows the results of a very similar policy rule using median FOMC estimates for r*, NAIRU and the path of inflation. We use a slightly more pessimistic forecast for the unemployment rate and assume that it reaches 4.5% by the end of 2022 and 4% by the end of 2023. Even with those conservative assumptions, the rule still recommends a policy rate of 1.5% by the end of 2022 and 2.65% by the end of 2023. This is not to say that the Fed will immediately lift rates to those levels once it is ready to hike, only that the Fed will have a strong incentive to pursue a rapid pace of rate hikes once it finally lifts rates off the zero bound. Investment Implications For investors, the bottom line is that the Fed will not immediately change its policy stance in response to rising inflation and inflation expectations. Rather, it will follow its current forward guidance and only lift rates off zero once the labor market has reached “maximum employment”. However, once the first rate hike has occurred, the Fed will shift its focus toward inflation and inflation expectations. If inflation and inflation expectations rise further, or even remain sticky near current levels, the Fed will lift rates more quickly than many anticipate. At present, the overnight index swap curve is priced for a total of 77 bps of rate hikes by the end of 2023. We see strong odds that more hikes will be delivered and therefore continue to recommend a below-benchmark portfolio duration stance. Is Inflation A Risk For Spread Product? Yes it is, but not just yet. In past reports, we’ve often pointed to 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5% as a reason to turn more cautious on spread product (see Chart 1), and the recent rise in inflation expectations certainly does set off some alarm bells. High inflation expectations pose a risk to credit spreads because of what they signal about the future course of Fed policy. If the Fed responds to high inflation expectations by tightening policy into restrictive territory, then economic growth and credit spreads are at risk. All this remains true, but the Fed’s willingness to ignore rising inflation expectations – at least until “maximum employment” and fed funds liftoff are achieved – gives spread product a little more runway than usual. One way to illustrate this dynamic is with the slope of the yield curve (Chart 7). Historically, corporate bond (both investment grade and junk) excess returns are strong at least until the 3-year/10-year Treasury slope flattens to below 50 bps (Table 2). Currently, the 3-year/10-year Treasury slope is well above 100 bps and has shown few signs of rolling over. If the Fed was still following its old forward-looking policy framework, then the yield curve would likely be much flatter today. That is, the curve would be pricing-in some policy tightening in response to high and rising inflation expectations. However, as discussed above, inflation expectations are not currently the Fed’s primary concern and they will only become the Fed’s primary concern once “maximum employment” has been achieved and the funds rate has been lifted off the zero bound. Chart 7Spread Product Returns Are Strong When The Curve Is Steep Spread Product Returns Are Strong When The Curve Is Steep Spread Product Returns Are Strong When The Curve Is Steep Table 2Corporate Bond Performance In Different Phases Of The Cycle Lower For Longer, Then Faster Than You Think Lower For Longer, Then Faster Than You Think All in all, we are concerned that, if inflation expectations remain elevated, the Fed may quickly ramp up its post-liftoff pace of rate hikes, sending credit spreads wider. But we are reluctant to position for that outcome when we are still many months away from Fed liftoff and the slope of the yield curve remains so steep. Chart 8Low Expected Returns In IG Low Expected Returns in IG Low Expected Returns in IG Another factor to consider is that value in spread product is extremely tight. In fact, our measure of the 12-month breakeven spread for the quality-adjusted investment grade corporate bond index is almost at its most expensive level since 1995 (Chart 8). This doesn’t change our assessment of when restrictive Fed policy will cause spreads to widen, but it does reduce our return expectations in the interim. All else equal, since the rewards from being overweight spread product versus Treasuries are low, we will be quicker to reduce our recommended spread product allocation when our indicators start to point toward the end of the credit cycle. Though, at the very least, we will still want to see the 3-year/10-year Treasury slope start to flatten and approach 50 bps before we get too pessimistic on spread product. The bottom line is that high and rising inflation expectations will eventually pose a risk to credit spreads, but only once the Fed tightens policy in response. For now, we remain overweight spread product versus Treasuries, though we maintain a preference for high-yield corporates, USD-denominated EM Sovereigns and municipal bonds over investment grade corporate bonds.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Overshoot Territory”, dated April 13, 2021. 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm 3 The CIE is a composite measure of different market-based and survey-based indicators of inflation expectations. https://www.federalreserve.gov/econres/notes/feds-notes/index-of-common-inflation-expectations-20200902.htm  Fixed Income Sector Performance Recommended Portfolio Specification

Highlights ECB Tapering?: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. Euro Area Bond Strategy: We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. We also suggest a new tactical trade to fade the current market pricing of ECB rate hikes by going long the December 2023 euribor interest rate futures contract. Feature Dear Client, Next week, we will be jointly publishing a Special Report, discussing the investment implications of the current global housing boom, with our colleagues at the monthly Bank Credit Analyst. You will be receiving that report on Friday, May 28. We will return to regular weekly publishing schedule on Tuesday, June 1. - Rob Robis Chart of the WeekAn Underwhelming Rise In European Bond Yields An Underwhelming Rise In European Bond Yields An Underwhelming Rise In European Bond Yields For next month’s monetary policy meeting, European Central Bank (ECB) President Christine Lagarde reportedly plans to invite the Governing Council members to meet in person for the first time since the start of the pandemic. That provides an interesting subtext to a meeting that will surely involve a debate over how much monetary support is still necessary for an increasingly vaccinated Europe that is emerging from the depths of COVID-19. Some ECB officials have already noted that the risks to economic growth and inflation expectations were now “tilted to the upside”, according to the minutes of the last ECB meeting in April. With European economic confidence improving, European bond yields have moved higher in response (Chart of the Week). The benchmark 10-year German bund yield now sits at -0.11%, up 46bps year-to-date but with half of that move occurring over the past month. The pickup up in yields has not been contained to the core countries of Germany and France – the 10-year Italian government bond yield is now up to 1.11%, over twice the level that began 2021 (0.52%). Inflation expectations have picked up sharply, with the 5-year/5-year forward euro CPI swap now up to 1.63%, a level last seen in December 2018. These yield increases have lagged the big moves seen in other countries; 10-year government bond yields in the US and Canada have seen year-to-date increases of 72bps and 90bps, respectively. In those countries, yields have surged because of rising inflation expectations and worries about a tapering of central bank bond buying – concerns that turned out to be accurate in the case of Canada, where the Bank of Canada did indeed announce a slower pace of bond buying last month. In our view, it is still too soon for the ECB to contemplate such a shift to a less dovish policy stance. This message is corroborated by our ECB Monitor that has risen but is still not signaling a need for tighter monetary policy. The bond selloff in Europe looks like a case of "too much, too fast". The ECB Now Has A Lot To Think About Recent euro area economic data has not only caught up to the earlier strength visible in the US, but in some cases is back to levels not seen for many years. The expectations component of the German ZEW survey surged nearly 14 points in May and is now up to levels last seen in 2000. The Markit PMI for manufacturing reached an all-time high of 62.9 in April. The European Commission’s consumer confidence index for the euro area is nearly back to pre-pandemic levels (Chart 2), which bodes well for a continued recovery of the Markit PMI for services. More positive news on the pandemic is driving the surge in growth expectations. The pace of new COVID-19 cases has fallen steadily, with Italy – one of the hardest-stricken regions during the initial months of the pandemic – now seeing the lowest rate of new cases since October (on a rolling 7-day basis). Meanwhile, the pace of vaccinations has accelerated after a slow initial rollout; the number of daily jabs administered (per 100 people) is now greater in Germany, France and Italy than in the US (Chart 3). Chart 2European Growth Is Recovering European Growth Is Recovering European Growth Is Recovering Chart 3Inoculation Acceleration In Europe Inoculation Acceleration In Europe Inoculation Acceleration In Europe Chart 4How Much Spare Capacity Is There In Europe? How Much Spare Capacity Is There In Europe? How Much Spare Capacity Is There In Europe? The rapid increase in inoculations is setting Europe up for a solid recovery from the lockdown-driven double-dip recession of Q4/2020 and Q1/2021. The European Commission upgraded its growth forecasts for the euro area last week, with real GDP now expected to expand by 4.3% in 2021 and 4.4% in 2022, compared with previous forecasts of 3.8% in both years. All euro area countries are now expected to see a return to the pre-pandemic level of economic output by the end of 2022 – a number boosted by a pickup in public investment through the Next Generation EU (NGEU) package, which is expected to begin paying out funds later this summer. The ECB will surely raise its own forecasts at the June meeting, both for economic growth and inflation. The outlook for the latter will likely turn into the biggest source of debate within the ECB Governing Council. Despite the fairly coordinated recovery of survey-based data like the manufacturing PMIs, there remains a wide divergence of unemployment rates - and measures of spare capacity, more generally - within the euro area (Chart 4). This will make it difficult for the ECB to determine if the current surge in realized inflation, which has pushed the annual growth of headline HICP inflation towards the 2% level in many euro zone nations, can persist with countries like Italy and Spain still suffering from very high unemployment. The wide dispersion of unemployment rates within the euro zone also suggests that the current level of policy rates (at or below 0%) is appropriate. One simple metric to measure the “breadth” of European labor market strength is to look at the percentage of euro area countries that have an unemployment rate below the OECD’s estimate of the full employment NAIRU.1 That metric correlates well with an estimate of the appropriate level of euro area short-term interest rates generated by a basic Taylor Rule. Currently, only 43% of euro zone countries are beyond full employment, which is consistent with an ECB policy rate round 0% (Chart 5). Chart 5Policy Rates Near 0% Are Still Appropriate Policy Rates Near 0% Are Still Appropriate Policy Rates Near 0% Are Still Appropriate A slightly larger share of countries (47%) is witnessing an acceleration in wage growth (bottom panel). This could mean that some of the NAIRU estimates for the individual countries are too low, which would fit with the acceleration in overall euro area wage growth seen since 2015. With so many euro area countries still working off the rise in unemployment generated by the pandemic, however, it will take some time for the ECB to get a clear enough read on labor market dynamics to determine if any necessary monetary policy adjustments should be made. The “breadth” of data trends do not only correlate to theoretical interest rate measures like the Taylor Rule. Actual ECB policy decisions are motivated by the degree to which higher growth and inflation is evident across the euro area. In Chart 6, we show a similar metric to the labor market breadth measures from Chart 5, but using other economic and inflation data. Specifically, we show the percentage of euro area countries that are seeing: Chart 6ECB Typically Tightens When Growth AND Inflation Are Broad Based ECB Typically Tightens When Growth AND Inflation Are Broad Based ECB Typically Tightens When Growth AND Inflation Are Broad Based a) Accelerating growth momentum, indicated by an OECD leading economic indicator that is higher than the level of one year earlier; b) Accelerating inflation momentum, comparing the latest reading on headline HICP inflation to that of one year earlier; c) Relatively high inflation, measured by headline HICP inflation being above the ECB’s “just below 2%” target. Looking at all previous periods of ECB monetary tightening since the inception of the euro in 1998 – taking the form of actual policy rate hikes or a flat-to-declining trend in the ECB’s balance sheet – it is clear that the ECB does not tighten without at least 75% of euro area countries seeing both economic growth and inflation accelerate. Actual rate hikes occur when at least 75% of countries had inflation above 2%, as occurred during the hiking cycles of 2000, 2005-2007 and 2011. More recently, the ECB paused the expansion of its balance sheet in 2017 when growth and inflation accelerated, but did not make any policy rate adjustments as only 50% of countries had inflation above 2%. Today, essentially all euro area countries are seeing accelerating growth momentum compared to the pandemic-depressed levels of a year ago. 59% of the euro area is seeing faster inflation, a number that is likely to move higher as more of Europe reopens from lockdown amid a surge in global commodity prices. Yet only 12% of euro area countries have headline inflation above 2%, suggesting that realized inflation is not yet strong enough to trigger even an ECB balance sheet adjustment, based on the 2017 experience. Don’t Bet On A June ECB Taper So judging by past ECB behavior, an announcement to taper bond buying at the June policy meeting would be highly premature. A more likely scenario is that an upgrade of the ECB’s growth and inflation forecast prompts a discussion of what to do with all the varying parts of the ECB’s monetary stimulus – quantitative easing, bank funding programs like TLTROs, as well as policy interest rates. Yet it will be impossible for the ECB Governing Council to reach any conclusions on their next step(s) at the June meeting because the very nature of the ECB's inflation target might soon change. The ECB is currently conducting a review of its monetary policy strategy – the first since 2003 – that is scheduled for completion later this year. Some adjustment to the ECB inflation target is expected to allow more flexibility, but it is not yet clear what that change will look like. Could the ECB follow the lead of the Federal Reserve and move to an “average inflation target” regime, tolerating overshoots of the inflation target after periods of below-target inflation? ECB Chief Economist Philip Lane noted back in March that “there was a very strong logic” to the Fed’s new approach. He also said that the “very different histories of inflation” in some European countries may make it difficult to reach an agreement on any system that allows even temporary periods of higher inflation.2 More recently, Bank of Finland Governor Olli Rehn – a moderate member of the Governing Council who was considered a candidate for the current ECB presidency – came out in favor of the ECB shifting to a Fed-like average inflation target for Europe in a recent Financial Times interview.3 Rehn noted that a Fed-like focus on aiming for maximum unemployment “makes sense in the current context of a lower natural rate of interest.” Rehn went on to describe the ECB’s current wording of its inflation target as having “generated a perception of asymmetry” such that “2 per cent is perceived as a ceiling and that is dampening inflation expectations.” We imagine that Jens Weidmann from the Bundesbank would vehemently oppose any move to change the ECB inflation target to tolerate even a temporary period of inflation above 2%. German headline HICP inflation already reached 2.1% in April, with more increases likely as the German economy reopens from extended pandemic lockdowns. Yet even if Weidmann were to not dig in his heels against any “loosening” of the ECB inflation target, the looming conclusion of the ECB strategy review makes it highly unlikely that any change in policy – like tapering – could credibly be announced before then. If higher inflation will be tolerated, then why bother to taper at all? Looking beyond the inflation strategy review, there are other factors that could weigh on the ECB in its deliberations on the next monetary policy move: China policy tightening: China – Europe’s largest trading partner – has seen its policymakers begin to rein in credit growth, and fiscal spending, after allowing a surge in borrowing in 2020 to help boost growth during the pandemic. Our measure of the China credit impulse leads the annual growth rate of European exports to China by around nine months (Chart 7), and is flagging a dramatic slowing of exports in the latter half of this year. This represents a downside risk to euro area growth, particularly in countries that export more heavily to China like Germany. Slowing loan growth: The annual growth rate of overall euro area bank lending peaked at 12.2% back in February and is now down to 10.9% (Chart 8). Much of the softening has occurred in Germany and France – countries that had seen a big take-up of subsidized bank funding through the ECB’s TLTROs. The pricing incentives set up by the ECB for the latest TLTRO program were highly attractive, and it appears that German and French banks took advantage of the cheap funding to ramp up lending activity. This makes the economic interpretation of the bank lending data more challenging for the ECB, especially with Italian loan growth – and TLTRO usage – now accelerating. Chart 7Warning Signs For European Export Demand Warning Signs For European Export Demand Warning Signs For European Export Demand Chart 8ECB LTROs Are Becoming Italy-Focused ECB LTROs Are Becoming Italy-Focused ECB LTROs Are Becoming Italy-Focused NGEU spending: As mentioned earlier, disbursements from the €750bn NGEU (a.k.a. “recovery fund”) are expected to begin later this year, pending EU approval of government investment proposals. NGEU funds are intended to finance initiatives that can boost future economic growth, like investments in digital and green programs. Most euro area countries have already submitted their proposals, led by Italy’s request for €192bn. Chart 9NGEU Will Give A Big Boost To European Growth Over The Next Five Years ECB Outlook: Walking On Eggshells ECB Outlook: Walking On Eggshells Chart 10NGEU Impact Will Be Front Loaded NGEU Impact Will Be Front Loaded NGEU Impact Will Be Front Loaded A recent study by S&P Global concluded that NGEU investments could boost overall euro area growth by between 1.3 and 3.9 percentage points, cumulatively, between 2021 and 2026 (Chart 9).4 That same study also noted that the impacts of the spending will be front-loaded over the next two years (Chart 10). The Italian government believes that NGEU investment could double Italy’s anemic trend growth rate to 1.5%. Many ECB officials have noted that NGEU is the kind of structural fiscal stimulus that makes it less necessary to maintain highly accommodative monetary policy. Until the NGEU proposals are finalized and the final approved amounts are dispersed, however, the ECB will be unable to adjust its economic forecasts to account for more government investment. Given all of these immediate uncertainties, including how successfully Europe can reopen from pandemic lockdowns, we do not see a plausible scenario where the ECB Governing Council could conclude at the June policy meeting that an immediate change in the current monetary policy tools and guidance was needed. Bottom Line: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. Likely ECB Next Moves & Investment Implications While a June taper announcement from the ECB is unlikely, a hint towards a future move is quite possible. The ECB is notorious for preparing markets well in advance of any policy shifts, thus the official statement following the June meeting – as well as ECB President Lagarde’s press conference – could contain clues as to what the ECB will do next. Chart 11ECB Easing Takes Many Forms ECB Easing Takes Many Forms ECB Easing Takes Many Forms A discussion of what will happen with the Pandemic Emergency Purchase Program (PEPP) – which is scheduled to end next March – could come up in June. We deem it more likely that the topic will be raised at the September policy meeting when there will be more clarity on the success of the reopening of Europe’s economy, and to the final approved size of the NGEU funds, which will determine the need to maintain an asset purchase program introduced because of the COVID-19 shock. There are certainly many policy options available for the ECB to choose from when they do decide to dial back accommodation. There are several policy interest rates that could be adjusted. Although it is likely that when the ECB next tries to hike interest rates, the first rate to move will be the overnight deposit rate which is currently at -0.5% and represents the “floor” for short-term interest rates in Europe (Chart 11). Rate hikes will not occur before the balance sheet tools are reduced or unwound, however, which means asset purchases will be dialed back first. Market participants are well aware of that order of policy choices, as a very flat path for short-term interest rates is currently discounted in the European overnight index swap (OIS) curve. The spread between forward rates in the OIS and CPI swap curves can be used as a proxy for the market forward pricing of real interest rates. Currently, the market-implied real ECB policy rate is expected to stay between -2% and -1% over the next decade (Chart 12). Put another way, the markets are pricing in a very flat path for ECB policy rates that will stay below expected inflation over the next ten years. While the natural real rate of interest in Europe is likely very low given low trend growth, a real rate as low as -2% discounts a lot of bad structural news for the European economy. By comparison, the NY Fed’s last estimate of the natural real rate (r-star) for Europe – calculated in Q2/2020 before the economic volatility surrounding the pandemic made r-star estimation more unreliable – was positive at +0.6%. The prolonged path of negative expected real interest rates in Europe goes a long way in explaining the persistence of negative real bond yields in the benchmark German government yield curve. Simply put, there is little belief that the ECB will ever be able to engineer a full-blown rate hike cycle – an outcome that Japanese fixed income investors are quite familiar with. Given the ECB’s constant worry about the level of the euro, and its role in impacting European growth and inflation expectations, markets are correct in thinking that it will be difficult for the ECB to lift rates much without triggering unwanted currency appreciation. It is no coincidence that the euro has been consistently undervalued on a purchasing power parity (PPP) basis ever since the ECB moved to a negative interest rate policy back in 2014 (Chart 13). Chart 12Markets Expect Negative European Real Rates For The Next Decade Markets Expect Negative European Real Rates For The Next Decade Markets Expect Negative European Real Rates For The Next Decade Looking ahead, the ECB will need to be careful about signaling any changes in monetary policy, including tapering, that would force markets to revise up the future path of European interest rates and give the euro a large boost. Chart 13Low ECB Rates Keeping The Euro Undervalued Low ECB Rates Keeping The Euro Undervalued Low ECB Rates Keeping The Euro Undervalued That means that European real bond yields are likely to stay deeply negative over at least the latter half of 2021, with any additional nominal yield increases coming from higher inflation expectations (Chart 14). This will limit how much more European bond yields can rise from current levels. Chart 14European Bond Strategy Summary European Bond Strategy Summary European Bond Strategy Summary We continue to believe that core European bond yields will trade with a “low yield beta” to US Treasury yields over at least the second half of 2021 and likely into 2022 when we expect the Fed to begin tapering its bond buying. Thus, we are sticking with our strategic recommendation to overweight core European government bonds versus US Treasuries in global bond portfolios. We simply see greater odds of a taper occurring in the US than in Europe, with the Fed more likely to deliver subsequent post-taper rate hikes than the ECB. We still recommend a moderately below-benchmark duration stance within dedicated European bond portfolios, although if the 10-year German bund yield rises significantly into positive territory, we would likely look to raise our suggested European duration exposure. We are also maintaining our recommended overweight on European inflation-linked bonds, as breakeven spreads in Germany, France and Italy are the only ones that remain below fair value in our suite of global valuation models. On European credit, we continue to recommend overweighting spread product versus sovereign bonds. That includes Italian and Spanish government bonds, as well as both investment grade and high-yield corporate debt. The time to turn more bearish on those markets will be when the ECB does begin to taper its asset purchases, as credit spreads have tended to widen during periods when the growth of the ECB’s balance sheet has been decelerating (Chart 15). We expect that when the ECB does finally decide to taper, the net amount of TLTROs will likely be maintained near current levels (by introducing new TLTROs to replace expiring ones). This will ensure that borrowing costs in the more fragile countries like Italy do not spike higher from the double-whammy of reduced ECB buying of Italian bonds and diminished access to cheap ECB bank funding. One final note – we are introducing a new trade in our Tactical Overlay portfolio on page 19 this week, as a way to fade the markets pricing in a more hawkish ECB outlook. A 10bp rate hike – the most likely size of any first attempt for the ECB to lift rates – is now priced in the OIS curve around mid-2023. By the end of 2023, nearly 25bps of hikes are discounted in forward rate curves. We do not expect the ECB to lift rates at all in 2023, but even if rates were increased, a cumulative 25bps of hikes within six months is unlikely to be delivered. Thus, we recommend going long the December 2023 3-month Euribor interest rate futures contract at an entry price of 100.27 (Chart 16). Chart 15ECB Tapering Would Be Bad News For European Credit ECB Tapering Would Be Bad News For European Credit ECB Tapering Would Be Bad News For European Credit Chart 16Go Long Dec/2023 Euribor Futures Go Long Dec/2023 Euribor Futures Go Long Dec/2023 Euribor Futures Bottom Line: The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 NAIRU is an acronym for the Non-Accelerating Inflation Rate of Unemployment. 2 Lane’s comments came from a wide-ranging interview with the Financial Times published on March 16, 2021, which can be found here: https://www.ft.com/content/2aa6750d-48b7-441e-9e84-7cb6467c5366 3 Rehn’s comments were published earlier this month on May 9 and can be found here: https://www.ft.com/content/05a12645-ceb2-4cd5-938e-974b778e16e0 4 The S&P Global report, titled “Next Generation EU Will Shift European Growth Into A Higher Gear”, can be found here: https://www.spglobal.com/ratings/en/research/articles/210427-next-generation-eu-will-shift-european-growth-into-a-higher-gear-1192994 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ECB Outlook: Walking On Eggshells ECB Outlook: Walking On Eggshells Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 19 at 10:00 AM EDT, 3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Highlights Global currencies are at a critical level versus the dollar. From a positioning standpoint today, a break below 89-90 on the DXY index will be extremely bearish, while a bounce from current levels should be capped in the 3-4% range. Two key factors have pushed the dollar down: lower real rates in the US and recovering economic momentum outside the US. There could be some seasonal strength in the dollar as equity markets churn in May. However, this will provide an opportunity for fresh short positions. The Federal Reserve will maintain its resolve to view the current inflation overshoot as transitory, while it will still focus on the labor market. This will keep real rates in the US depressed relative to other countries. New trade idea: Go long CHF/NZD as a play on rising currency volatility. Also sell USD/JPY if it touches 110. Feature Chart I-1The Dollar Is At A Critical Juncture The Dollar Is At A Critical Juncture The Dollar Is At A Critical Juncture After a brief rally from January to March, the dollar is once again on the verge of a technical breakdown. Both the DXY index, the Federal Reserve trade-weighted dollar and EM currency benchmarks are sitting at critical levels (Chart I-1). A breakdown will confirm that the dollar bear market that began in March 2020 remains intact. It will also trigger a flurry of speculative outflows from the dollar. In our December FX outlook,1 our view was that the DXY was headed towards 80 on a cyclical (12-18- month horizon). However, we also predicted the DXY index would hit 94-95 in the first quarter, a view we have reinforced multiple times since then. With the DXY index having peaked at 93.5, it is now instructive to explore the most likely next move. To do this, we will revisit what has changed and what has remained the same since our December piece.  Gauging Investor Positioning Chart I-2Dollar Bulls Are Capitulating Dollar Bulls Are Capitulating Dollar Bulls Are Capitulating Going into 2021, selling the dollar was a consensus trade and the currency was very much oversold. For contrarians, it paid to be bullish (Chart I-2). Since then, investors have closed their short positions on the dollar, shifting their focus to JPY- and CHF-funded carry trades. Speculators are still long the euro, but the magnitude of this bet has declined from a net 30% of open interest to around 10% today. Positioning in GBP and CAD are still elevated, which suggests that these currencies remain vulnerable to a technical pullback.  Interestingly, the Citigroup sentiment indicator for the USD is close to its January nadir. From the vantage point of this gauge, there has been an accumulation of dollar short positions in recent weeks. This helps explain recent dollar weakness. Going forward, positioning will not be particularly useful in dictating the next move in the dollar since it only works well at extremes. Even then, it is only useful for gauging countertrend moves. For much of the early 2000s, sentiment on the dollar was bearish yet rallies were capped at 4-6%. During last decade’s dollar bull market, sentiment remained mostly in bullish territory, but the dollar achieved escape velocity (Chart I-3). Chart I-3The Dollar And Regime Shifts The Dollar And Regime Shifts The Dollar And Regime Shifts From today’s positioning standpoint, a break below 89-90 on the DXY index will be an extremely bearish sign, while a bounce from current levels should be capped in the 3-4% range. This puts the greenback at a critical crossroad in technical terms. The Federal Reserve, Inflation And Interest Rates At the start of 2021, interest rates were moving in favor of the dollar, which continued a trend that has been in place since the middle of last year. The gap between the US and German 10-year yields rose from a low of around 100 basis points last year to a high of over 200 basis points in March. More recently, interest rate differentials have started to move against the dollar, explaining the broad reversal in dollar indices since March. The US-German 10-year spread now sits at 180 basis points. Exchange rates tend to reflect real interest rate differentials, since inflation erodes the purchasing power of a currency. As such, it is important to gauge not only what is happening to nominal rates, but also to underlying inflation trends. This complicates matters because inflation is often a lagging variable, so getting a sense of where inflation is headed can be greatly useful for currency strategy. As a starting point, the US does not rank well when it comes to real interest rates. Chart I-4 shows the broad correlation between real interest rates and the dollar. For low interest rate countries such as Switzerland, Sweden and the euro area, the peak in US real rates also coincided with a cyclical rebound in these currencies. Even for a currency such as the Japanese yen, real rates are favorable compared to the US. Nominal 10-year rates are 10bps and inflation swaps at the 10-year tenor are 23bps. This pins Japanese real rates almost 100bps above rates in the US. Chart I-4AInterest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Chart I-4BInterest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Chart I-4CInterest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Of course, with inflation surprising to the upside in the US, the Fed could taper sooner than they have communicated and/or raise interest rates faster than the market expects. This will not be surprising given other central banks such as the Bank of Canada and the Bank of England have already telegraphed reduced asset purchases. However, even if the Fed does decide to taper its asset purchases, the impact on the dollar will not be as straightforward as some market participants expect. To understand why, consider Chart I-5, which shows that relative to other central banks, the Fed’s balance sheet impulse is already shrinking by approximately 13% of GDP. In essence, the Fed has already been "stealthily" tapering asset purchases compared to other G10 central banks. This action supported the dollar this year. It has also pushed market pricing of the Fed funds rate well above the median dots of the FOMC in 2 years (Chart I-6). Thus the prospect of the Fed tapering asset purchases might already be embedded in the price of assets. Chart I-5Stealth Tapering By The Fed? Stealth Tapering By The Fed? Stealth Tapering By The Fed? Chart I-6Markets Have Already Priced A Hawkish Fed Markets Have Already Priced A Hawkish Fed Markets Have Already Priced A Hawkish Fed Going forward, our Global Fixed Income colleagues have noted that the Fed is already moving down the ladder in terms of who is expected to taper next.2 The Bank of Japan and the European Central Bank have barely tapered their asset purchases. They might not announce anything significant in their June 10 and June 18 meetings respectively, but markets will still be squarely focused on any change in language. Chart I-7A Profligate US Government Has Historically Been Dollar Bearish A Profligate US Government Has Historically Been Dollar Bearish A Profligate US Government Has Historically Been Dollar Bearish If investors decide to take the Fed’s messaging at face value, which suggests that the FOMC will look through any upside surprises in inflation, then real rates will remain depressed in the US—which will pressure the dollar lower. We have little conviction about whether US inflation is transient or more permanent. However, we do know that the US economy is more inflationary than most other developed markets because the US is stimulating domestic demand by much more than is required to close the output gap. Historically, this is a bearish development for the US dollar (Chart I-7). Economic Momentum As A Catalyst To the extent that monetary policy is tailored to suit domestic economic conditions, growth momentum is clearly rotating from the US to other countries. This suggests that the case for other central banks, such as the ECB or the RBA, to follow the steps of the BoE or BoC is rising at the margin. Manufacturing PMIs around the world have overtaken US levels, and it is only a matter of time before the services PMIs catchup. Chart I-8 shows that euro area data continues to surprise to the upside, with the economic surprise index between the euro area and the US at a decade high. This has historically been synonymous with modestly higher Eurozone bond yields relative to the US, which has also provided some support for the currency. The expectations component of both the ZEW and the Sentix surveys came out stronger this month, which confirms that both European and German growth should remain healthy over the summer (Chart I-9). Chart I-8Small Window For European Yields To Rise Small Window For European Yields To Rise Small Window For European Yields To Rise Chart I-9Euro Area Data To Stay Strong Euro Area Data To Stay Strong Euro Area Data To Stay Strong As for the slowdown in Chinese stimulus, we agree it is a risk to global growth as our China Strategists highlight, but two opposing  factors are also at play: Chinese stimulus leads the economy by a long lag. Last cycle, the apex of Chinese credit was in 2016, but it took until 2018 for global trade to slow down (Chart I-10). This partly explains why commodity prices have not relapsed, despite slowing credit creation from their largest buyer. An economy cannot rely on credit formation alone. At some point, the baton has to be passed to the forces of animal spirits. The velocity of money, or how many units of GDP are created for every unit of money creation, is one of these forces. Chart I-11 shows that the velocity of money has been rising faster outside the US, led by China. Chart I-10Chinese Credit Impulse Works With A Lag Chinese Credit Impulse Works With A Lag Chinese Credit Impulse Works With A Lag Chart I-11Money Velocity Versus The US Money Velocity Versus The US Money Velocity Versus The US The above trends give us conviction that any strength in the dollar is a countertrend move that should be faded until the Federal Reserve does a volte face and tightens monetary policy faster than they have telegraphed. A period of weak global growth would constitute another risk to our view. Interestingly, the Chinese RMB has hit new cyclical lows, despite a narrowing of interest rate differentials between the US and China. We suggested in our February Special Report that USD/CNY was headed for 6.2, even if interest rate differentials between the US and China narrowed. If Chinese economic activity is able to stay relatively robust despite slowing credit formation, then USD/CNY will decline further. Chart I-12EM Growth Remains Weak EM Growth Remains Weak EM Growth Remains Weak A break lower in USD/CNY is a necessary but not a sufficient condition for EM currencies to outperform. Relative to the US, EM growth remains worse than at the depths of the COVID-19 recession last year (Chart I-12). Our Emerging Market Strategists reckon a change in economic conditions will be necessary for EM currencies to outperform on a sustained basis. A broadening of the vaccination campaign toward EM countries is likely to hold the key to this change. The Real Risk To Dollar Short Positions The risk from shorting the dollar at current levels comes from the equity market. Developed market currencies have run ahead of the relative performance of their domestic bourses. This is a departure from historical correlations (Chart I-13). A reset in equity markets that favors defensive equities will lead to inflows into the US equity and bond markets, which will hurt DM currencies and buffet the dollar. It is worrisome that this earnings season, the US enjoyed stronger positive earnings revisions. Correspondingly, the US put/call ratio remains very depressed, with complacency reigning across most equity bourses (Chart I-14). Chart I-13ACurrencies Have Ran Ahead Of Equity Outperformance Currencies Have Ran Ahead Of Equity Outperformance Currencies Have Ran Ahead Of Equity Outperformance Chart I-13BCurrencies Have Ran Ahead Of Equity Outperformance Currencies Have Ran Ahead Of Equity Outperformance Currencies Have Ran Ahead Of Equity Outperformance Chart I-14Lots Of Exuberance In US Stocks Lots Of Exuberance In US Stocks Lots Of Exuberance In US Stocks Chart I-15Equities And The Dollar Have Diverged Equities And The Dollar Have Diverged Equities And The Dollar Have Diverged The nature of a potential market reset is important to consider. For example: Global equities correct, but technology and healthcare lead the drop. In this scenario, the dollar underperforms, as is happening now (Chart I-15) because the US has a heavy weighting in these defensive sectors. The reverse will happen if value stocks or cyclicals lead the drop in global equities. Global equities correct, but bond yields drop as well. The initial reaction will be a stronger dollar as US inflows accelerate, but this will also curb the appeal of the US dollar since Treasury yields will converge towards those of Bunds or JGBs. Moreover, US real rates will collapse even further. We will be sellers of the dollar on strength in this scenario. Global equities correct as yields increase. If US yields lead this rise, the dollar will rally at first, but outflows from the US equity market will also accelerate. If this rotation is durable, the dollar will eventually depreciate, because foreign bourses are highly levered to rising yields. In a nutshell, the US bond market offers attractive yields and the US stock market could behave defensively (as has historically been the case) in a market correction. This creates a risk to shorting the dollar today. Currency Strategy Currency markets are at a critical juncture (Chart I-1) where either a breakdown in the dollar or a countertrend reversal is imminent. Our strategy remains the same it has been so far in 2021. Continue to short the USD against a basket of the most attractive currencies. On this basis, we are already long the Scandinavian currencies. Go short USD/JPY given lopsided positioning. We are placing a limit sell on USD/JPY today at 110. We are also raising our limit buy on the euro to 1.18. It is interesting that the EUR/JPY cross broke out from a multi-year downtrend. This cross has an inverse correlation with the dollar. Buy CHF/NZD today as a play on rising currency volatility. This is a good bet as markets grapple with the next central bank taper policy (Fed versus other DM economies) (Chart I-16). Wait for the equity market correction to play out, after which a green light to short the dollar outright will once again emerge. Historically, May is a good month for the dollar and a volatile one for equities (Chart I-17). That said, dollar bear markets often run in long cycles. Chart I-16Buy CHF/NZD As Insurance Buy CHF/NZD As Insurance Buy CHF/NZD As Insurance Chart I-17The Dollar And Seasonality The Dollar And Seasonality The Dollar And Seasonality   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2021 Key Views: Tradeable Themes," dated December 4, 2020. 2Please see Global Fixed Income Strategy Special Report, "Who Tapers Next?," dated December 04, 2020. Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The recent data out of the US have been mixed: Average hourly earnings improved by 0.7% in April versus March, beating the expected 0.1% increase. Non-farm payrolls increased by 266K in April, far below the expected 978K and 770K in March. The unemployment rate worsened slightly from 6% in March to 6.1% in April, versus an expected improvement to 5.8%.  The NFIB Small Business Optimism survey edged higher to 99.8 in April from 98.2 the prior month. CPI came in at 4.2% year on year in April, outpacing expectations of a 3.6% rise. Month on month, CPI grew by 0.8% in April, crushing the 0.2% consensus. Core CPI came in at 3% year on year in April, beating the expected 2.3%. PPI also surprised to the upside, clocking in at 6.2% year on year in April, versus an expected rise of 5.8%. The US dollar DXY index dropped by 1.3% this week. While CPI surged ahead, employment severely lagged expectations. The Fed’s “maximum employment” target, a gateway to any asset purchase tapering, is unlikely to be reached when the market expects it. This combination of persistent Fed dovishness and potential sizable inflation is bearish for the dollar.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been strong: March German imports strengthened by 6.5% month on month, crushing the expected 0.7%. German ZEW current condition registered at -40.1 in May, far ahead of the -48.8 in April. German ZEW economic sentiment also surprised to the upside in May at 84.4 versus the anticipated 72.  For the entire euro area, the ZEW economic sentiment increased to 84 in May from 66 in April. Sentix investor confidence improved to 21 in May from 13.1 in April, beating the expected 14. Sentix investor expectations climbed to an all-time high of 36.8. The current situation crossed into positive territory for the first time since February 2020. March industrial production was up by 0.1% month on month, lower than the expected 0.7%. The euro strengthened by 1.3% this week against the USD. The uplifting ZEW survey results reinforce our expectation of a global growth rotation in favor of the euro area. While the ECB may not taper asset purchases, a forceful vaccination campaign should lead to further upside data surprises, especially in services. The Euro Area Economic Surprise Index (ESI) remains elevated in contrast with the US ESI, which has declined sharply from its July 2020 peak.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 There was scant data out of Japan this week: Household spending strengthened by 7.2% in March versus February, comfortably beating the expected 2.1% increase. The Japanese current account weakened to JPY 2.65tn in March from JPY 2.9tn in February. The Eco Watchers Survey disappointed in April, with current conditions declining from 49 to 39.1 and the expectations component falling from 49.8 to 41.7. The yen was up by 0.5% against the USD this week. The recent extension of the already months-long state of emergency will put downward pressure on the yen in the near term. However, with Japanese equities and the currency in oversold conditions, we are cautiously optimistic on the yen further along in the year.   Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020   British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data out of the UK have been weak: Construction PMI remained mostly unchanged at 61.6 in April. GDP weakened, quarter on quarter, by 1.5% in Q1. More disappointing was business investment that dropped in Q1 by 11.9% quarter on quarter and 18.1% year on year. March GDP strengthened by 2.1% month on month, suggesting the pullback in the first quarter was mostly due to lockdowns. Manufacturing production was up by 2.1% in March versus February, beating the 1% consensus. The trade deficit narrowed to GBP11.71B in March.  The pound was up by 1.7% this week against the USD. The soft Q1 output data, primarily a result of the winter lockdown, mask improvements in March. With restrictions being lifted, services output and household consumption (induced by excess savings) should quickly catch up with the recent bounce in manufacturing. However, markets may have priced in too much of the UK’s vaccination outperformance as is reflected in the overpriced small-cap equities.   Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The recent data out of Australia have been positive: The NAB Business confidence increased to 26 in April from 17 the prior month. The NAB business survey index also edged higher to 32 in April from 25 in March. Retail sales increased by 1.3% in March month on month, slightly below the expected 1.4%. Quarter on quarter, Q1 retail sales weakened by 0.5% versus the estimated drop of 0.4%. Q1 CPI came in below expectations at 0.6% quarter on quarter and 1.1% year on year. The AUD was up by 1.2% this week against the USD. While the NAB business confidence and conditions indices came in at record highs, the price pressures remain weak in Australia and vaccination progress continues to lag. That said, leading indicators such as capex intentions and forward orders are improving. We are short AUD/MXN mainly to capitalize on Mexico’s proximity to the rebounding US.   Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The recent data out of New Zealand have been scant: Electronic card retail sales increased by 4% month on month in April after a 0.8% drop in March. The food price index came in at 1.1% month on month in April, compared to 0% in March. The NZD was up by 0.8% this week against the dollar. With positive data coming out of New Zealand recently, our Global Fixed Income Strategy colleagues judge the RBNZ to be the next central bank most likely to taper sometime in the second half of 2021. However, with Q2 inflation expectations that remain soft and the tourism sector still held back by broad border shutdowns, we remain cautious on the kiwi.   Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data out of Canada have been mildly disappointing: The employment report was disheartening. Canada lost 207.1K jobs in April, and the participation rate dropped from 65.2% to 64.9%. The unemployment rate also weakened from 7.5% to 8.1% in April, higher than expected.  The Ivey PMI dropped to 60.6 in April from 72.9 in March, in line with expectations. The CAD was up by 1.35% against the USD this week. Despite the already months-long rallying of the loonie and the housing prices, the CAD is still cheap by its real effective exchange rate. Strengthening oil prices should continue to support the currency. A potential extension to the current COVID-19 lockdown and lagging vaccination progress remain downside risks.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020   Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The recent Swiss data have been neutral: Unemployment rate remained relatively unchanged at 3.3% in April, in line with expectations. The Swiss franc was up by 1% this week against the USD. The franc is cheap with a real effective exchange rate that is at one standard deviation below fair value. Should the pickup in global trade continue, this will buffet the franc. However, our bias is that the SNB will continue to fight excessive franc strength, especially against the euro. So we think the franc will lag the euro over the longer term. We are also going long CHF/NZD today should currency volatility pick up.    Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020   Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The recent data out of Norway have been mixed: CPI came in at 3% in April, in line with expectations. PPI growth registered at 22.5% in April, year on year. GDP dropped by 0.6% in Q1 quarter on quarter, a disappointment given an estimated 0.4% decrease. Mainland GDP also undershot expectations, decreasing by 1% in Q1 quarter on quarter. The NOK was up by 1% this week against the dollar. The soft Q1 data may hold back the NOK in the very near term, especially considering its remarkable performance since its March 2020 lows. That said, the rally in oil prices will continue to provide support to the NOK. Vaccination progress, on par with that of the euro area, should also benefit the currency.    Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020   Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent Swedish data have been mildly positive: The unemployment rate came down from 8.4% in March to 8.2% in April. CPI came in at 2.2% year on year and 0.2% month on month in April, in line with expectations. CPIF registered at 2.5% year on year and 0.3% month on month in April, both beating the consensus. The SEK was up by 2% this week against the USD. Vaccination progress in Sweden is only notches below that of the euro area. A potential shift of sentiment out of the crowded commodity-driven trades could also lend support to the export-driven SEK, on the back of a recovery in Europe in the near term.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019   Footnotes 1     Please see Foreign Exchange Strategy Special Report, "2021 Key Views: Tradeable Themes," dated December 4, 2020. 2     Please see Global Fixed Income Strategy Special Report, "Who Tapers Next?," dated December 04, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global stocks are very vulnerable to a correction. But cyclically the Fed is committed to an inflation overshoot and the global economy is recovering. China’s fiscal-and-credit impulse fell sharply, which leaves global cyclical stocks and commodities exposed to a pullback. Beyond the near term, China’s need for political stability should prevent excessive policy tightening. The risk is frontloaded. China’s population census underscores one of our mega-themes: China’s domestic politics are unstable and can bring negative surprises. India’s state elections, held amid a massive COVID-19 wave, suggest that the ruling party is still favored in 2024. This implies policy continuity. Stick with a bullish cyclical bias but be prepared to shift if China commits a policy mistake. Feature Chart 1Inflation Rears Its Head Inflation Rears Its Head Inflation Rears Its Head Global markets shuddered this week in the face of a strong core inflation print in the US as well as broader fears as inflation rears its head after a long slumber (Chart 1). Cyclically we still expect investors to rotate away from US stocks into international stocks and for the US dollar to fall as the global economy recovers (Chart 2). However, this view also entails that emerging market stocks should start outperforming their developed market peers, which has not panned out so far this year. Emerging markets are not only technology-heavy and vulnerable to rising US bond yields but also further challenged now by China’s stimulus having peaked. Chart 2Equity Market Trembles Equity Market Trembles Equity Market Trembles Chart 3Global Economy And Sentiment Recovering Global Economy And Sentiment Recovering Global Economy And Sentiment Recovering Chart 4Global Cyclicals Versus Defensives Wavering Global Cyclicals Versus Defensives Wavering Global Cyclicals Versus Defensives Wavering The one thing we can rely on is that the COVID-19 vaccine rollout will continue to enable a global growth recovery (Chart 3). The US dollar is signaling as much. The greenback bounced in the first quarter on US relative growth outperformance but it has since fallen back. A falling dollar is positive for cyclical stocks relative to defensives, although cyclicals are flagging that the reflation trade is overdone in the near term (Chart 4). China’s growth now becomes the critical focal point. A policy mistake in China would upset the bullish cyclical view. China’s tightening of monetary and fiscal policy is a major global policy risk that we have highlighted this year and it is now materializing. However, we have also highlighted the constraints to tightening. At present China is standing right on the threshold of overtightening according to our benchmarks. If China tightens further, we will take a fundamentally more defensive view. Also in this report we will review the results of China’s population census and the implications of India’s recent state elections in the face of the latest big wave of COVID-19 infections. We are not making any changes to our bullish view on India yet but we are putting it on watch. China: The Overtightening Risk China’s troubles stem from the ongoing change of its economic model from reliance on foreign trade to reliance on domestic demand. This was a strategic decision that the Communist Party made prior to the rise of President Xi Jinping. Xi also has come to embody it and reinforce it through his strategic vision and confrontation with the United States. Beijing’s goal was to manage a smooth and stable transition. The financial turmoil of 2015 and the trade war of 2018-19 jeopardized that goal but policymakers ultimately prevailed. Then COVID-19 broke out and caused the first real economic contraction since the 1970s. While China contained the virus and bounced back with another massive round of stimulus (13.8% of GDP from the onset of the trade war to the 2021 peak), it now faces an even more difficult transition. Chart 5China's Rising Propensity To Save China's Rising Propensity To Save China's Rising Propensity To Save The need to improve quality of life is more urgent given that potential GDP has slowed. The need to contain systemic financial risk is more urgent given the big new increase in debt. And the need to diversify the economy is more urgent given that the US is now creating a coalition of democracies to confront China over a range of policies. The spike in the “marginal propensity to save” among Chinese people and corporations – as measured by the ratio of long-term cash deposits to short-term deposits – is an indication that the country is beset by troubles and animal spirits are depressed (Chart 5). China’s fiscal-and-credit impulse is turning down after the large expansion in 2018-21. Policymakers have signaled since last year that they would withdraw emergency stimulus and now the impact is apparent in the hard data. China’s money, credit, and combined credit-and-fiscal impulses all correlate with economic growth after a six-to-nine-month lag. This is true regardless of which indicators one uses for China’s money and credit cycles and economic activity (Charts 6A and 6B). China’s economic momentum is peaking and will become a headwind for the global economy later this year and in 2022, even though the world is otherwise enjoying the tailwinds of vaccination and economic reopening. Chart 6AChina’s Fiscal-And-Credit Impulse Falls Sharply … China's Fiscal-And-Credit Impulse Falls Sharply... China's Fiscal-And-Credit Impulse Falls Sharply... Chart 6B… As Do Money-And-Credit Impulses ... As Do Money-And-Credit Impulses ... As Do Money-And-Credit Impulses The downshift in the fiscal-and-credit impulse portends a slowdown in demand for commodities, materials, and other goods that China imports, especially for domestic consumption. (Chinese imports of parts and inputs that go into its manufacturing exports to the rest of the world look healthier as the rest of the world recovers.) This shift will make it hard for high-flying metals prices and other China plays, such as Swedish stocks, to continue rising without a correction (Chart 7). Speculative positioning is heavily in favor of commodities at the moment. The divergence between China and the metals markets that it dominates looks untenable in the short run (Chart 8). Chart 7China Reflation Trades Near Peaks China Reflation Trades Near Peaks China Reflation Trades Near Peaks Chart 8Money Cycle And Commodity Prices Clash Money Cycle And Commodity Prices Clash Money Cycle And Commodity Prices Clash The global shift to green or renewable energy systems (i.e. de-carbonization) is bullish for metals, especially copper, but will not be able to make up for the fall in Chinese demand in the short run, as our Emerging Markets Strategy has shown. China’s domestic uses of copper for construction and industry make up about 56.5% of global copper demand while the green energy race – namely the production of solar panels, windmills, electric cars – makes up only about 3.5% of global demand. This number somewhat understates the green program since re-gearing and retrofitting existing systems and structures is also projected, such as with electricity grids. But the point is that a drop in China’s copper consumption will work against the big increase in American and European consumption – especially given that the US infrastructure program will not kick in until 2022 at the earliest. Hence global copper demand will slow over the next 12 months in response to China even though the rest of the world’s demand is rising. Chinese policymakers have not yet signaled that they are worried about overtightening policy or that they will ease policy anew. The Politburo meeting at the end of April did not contain a major policy change from the Central Economic Work Conference in December or the Government Work Report in March (Table 1). But if there was a significant difference, it lay in reducing last year’s sense of emergency further while projecting some kind of scheme to hold local government officials accountable for hidden debt. The implication is continued tight policy – and hence the risk of overtightening remains substantial. Table 1China’s Recent Macroeconomic Policy Statements: Removing Stimulus China Verges On Overtightening China Verges On Overtightening Chart 9Benchmarks For China's Policy Tightening Benchmarks For China's Policy Tightening Benchmarks For China's Policy Tightening True, the tea leaves of the April meeting can be read in various ways. The April statement left out phrases about “maintaining necessary policy support” from the overarching macroeconomic policy guidance, which would imply less support for the economy. But it also left out the goal of keeping money supply (M2) and credit growth (total social financing) in line with nominal GDP growth, which could be seen as enabling a new uptick in credit growth. However, the People’s Bank of China did maintain this credit goal in its first quarter monetary policy report, so one cannot be sure. Notice that according to this rubric, China is right on the threshold of “overtightening” policy that we have utilized to measure the risk (Chart 9). Based on Chinese policymaking over the past two decades, we would expect any major inflection point to be announced at the July Politburo meeting, not the April one. We do not consider April a major change from the preceding meetings – nor does our China Investment Strategy. Therefore excessive policy tightening remains a genuine risk for the Chinese and global economy over the next 12 months. Our checklist for excessive tightening underscores this point (Table 2). Table 2Checklist For Chinese Policy Tightening China Verges On Overtightening China Verges On Overtightening China’s fiscal-and-credit downshift is occurring in advance of the twentieth national party congress, which will take place throughout 2022 and culminate with the rotation of the top leadership (the Politburo Standing Committee) in the autumn. The economy is sufficiently stimulated for the Communist Party’s hundredth birthday on July 1 of this year, so policymakers are focused on preventing excesses. Financial risk prevention, anti-monopoly regulation, and tamping down on the property bubble are the orders of the day. The increase in corporate and government bond defaults and bankruptcies underscore the leadership’s willingness to push forward with economic restructuring and reform, which is well-attested in recent years (Chart 10). Chart 10Creative Destruction In China China Verges On Overtightening China Verges On Overtightening Investors cannot assume that the party congress in 2022 is a reason for the leadership to ease policy. The contrary occurred in the lead-up to the 2017 party congress. However, investors also cannot assume that China will overtighten and sink its own economy ahead of such an important event. Stability will be the goal – as was the case in 2017 and previous party congresses – and this means that policy easing will occur at some point if the current round of tightening becomes too painful financially and economically. China-linked assets are vulnerable in the short run until policymakers reach their inflection point. Incidentally, the approach of the twentieth national party congress will be a magnet for political intrigue and shocking events. The top leader normally sacks a prominent rival ahead of a party congress as a show of force in the process of promoting his faction. The government also tightens media controls and cracks down on dissidents, who may speak up or protest around the event. But in 2022 the stakes are higher. President Xi was originally expected to step down in 2022 but now he will not, which will arouse at least some opposition. Moreover, under Xi, China has undertaken three historic policy revolutions: it is adopting a strongman leadership model, to the detriment of the collective leadership model under the two previous presidents; it is emphasizing economic self-sufficiency, at the expense of liberalization and openness; and it is emphasizing great power status, at the expense of cooperation with the United States and its allies. Bottom Line: Global equities, commodities, and “China plays” stand at risk of a substantial correction as a result of China’s policy tightening. Our base case is that China will avoid overtightening but the latest money and credit numbers run up against our threshold for changing that view. Another sharp drop in these indicators will necessitate a change. China’s Disappearing Workforce Ultimately one of the constraints on overtightening policy is the decline in China’s potential GDP growth as a result of its shrinking working-age population. China’s seventh population census came out this week and underscored the deep structural changes affecting the country and its economy. Population growth over the past ten years slowed to 5.4%, the lowest rate since the first census in 1953. The fertility rate fell to 1.3 in 2020, lower than the 2.1 replacement rate and the 1.8 target set when Chinese authorities relaxed the one-child policy in 2016. The fertility rate is also lower than the World Bank’s estimates (1.7 in 2019) and even Japan’s rate. The birthrate (births per 1,000 people) also fell, with the number of newborns in 2020 at the lowest point since 1961, the year of the Great Famine. The birth rate has converged to that of high-income countries, implying that economic development is having the same effect of discouraging childbearing in China, although China is less developed than these countries. Chart 11China’s Working Population Falling Faster Than Japan’s In 1990s China Verges On Overtightening China Verges On Overtightening The youngest cohort rose from 16.6% to 17.95% of the population, the oldest cohort rose 8.9% in 2010 to 13.5% today, while the working-age cohort fell from 75.3% to 68.6%. The working-age population peaked in 2010 and fell by 6.79 percentage points over the past ten years. By contrast, Japan’s working-age population peaked in 1992 and fell 2.18 percentage points in the subsequent decade (Chart 11). In other words China is experiencing the demographic transition that hit Japan in the early 1990s – but China’s working-age population might fall even faster. The country is experiencing this tectonic socioeconomic shift at a lower level of per capita wealth than Japan had attained. The demographic challenge will put pressure on China’s socioeconomic and political system. The China miracle, like other Asian miracles, was premised on the use of export-manufacturing to generate large piles of savings that could be repurposed for national development. The decline in China’s working-age population coincides with economic development and a likely decline in the saving rate over the long run. This is shown in Chart 12, which shows two different pictures of China’s working population alongside the gross national saving rate. As China’s dependency ratio rises the saving rate will fall and fewer funds will be available for repurposing. The cost of capital will rise and economic restructuring will accelerate. In the case of Japan, the demographic shift coincided with the 1990 financial crisis and then a nationwide shift in economic behavior. The saving rate fell as the economy evolved but the savings that were generated still exceeded investment due to the shortfall in private demand and the pressure of large debt burdens. Companies focused on paying down debt rather than expanding investment and production (Chart 13). All of this occurred when the external environment was benign, whereas China faces a similar demographic challenge in the context of rising economic pressure due to geopolitical tensions. Chart 12Chinese Workers Getting Scarcer Chinese Workers Getting Scarcer Chinese Workers Getting Scarcer Chart 13High Savings Enable Debt Splurge Until Debt Overwhelms High Savings Enable Debt Splurge Until Debt Overwhelms High Savings Enable Debt Splurge Until Debt Overwhelms China has so far avoided a debilitating financial crisis and collapse in real estate prices that would saddle the country with a traumatizing liquidity trap. The Chinese authorities are painfully aware of the danger of the property bubble and are therefore eager to prevent financial excesses and curb bubble-like activity. This is what makes the risk of overtightening significant. But a mistake in either direction can lead to a slide into deflation. The Xi administration has stimulated the economy whenever activity slowed too much or financial instability threatened to get out of hand, as noted above, but this is a difficult balancing act, which is why we monitor the risk of excessive tightening so closely. A few other notable takeaways from China’s population census include: The two-child policy is not succeeding so far. COVID-19 might have had a negative effect on fertility but it could not have affected births very much due to the timing. So the trends cannot be distorted too much by the pandemic. Rapid urbanization continues, with the rate hitting 64% of the population, up 14 percentage points from 2010. Policy discussions are emphasizing lifting the retirement age; providing financial incentives for having babies; a range of price controls to make it more affordable to have babies, most notably by suppressing the property bubble; and measures to ensure that property prices do not fall too rapidly in smaller cities as migration from the country continues. China’s ethnic minority population, which consists of 9% of the total population, grew much faster (10% rate) over the past decade than the Han majority, which makes up 91% of the population (growing at a 5% rate). Minorities are exempt from the one-child (and two-child) policy. Yet ethnic tensions have arisen, particularly in autonomous regions like Xinjiang, prompting greater international scrutiny of China’s policies toward minorities. China’s demographic challenge is widely known but the latest census reinforces the magnitude of the challenge. China’s potential growth is falling while the rising dependency ratio underscores social changes that will make greater demands of government. Greater fiscal and social spending needs will require difficult economic tradeoffs and unpopular political decisions. Economic change and the movement of people will also deepen regional and wealth disparities. All of these points underscore one of our consistent Geopolitical Strategy mega-themes: China’s domestic political risks are underrated. Bottom Line: China’s 2020 census reinforces the demographic decline that lies at the root of China’s rising socioeconomic and political challenges. While China has a strong central government with power consolidated under a single ruling party, and a track record of managing its various challenges successfully in recent decades, nevertheless the magnitude of the changes happening are overwhelming and will bring negative economic and political surprises. India: State Elections Not A Turning Point Against Modi At the height of the second COVID-19 wave in India, elections were held in five Indian states. Results for the state of West Bengal were most important. West Bengal is a large state, accounting for nearly a-tenth of legislators at India’s national assembly, and the ruling Bharatiya Janata Party (BJP) of Prime Minister Narendra Modi had declared that it would win nearly 70% of the 294 seats there. In the event West Bengal delivered a landslide victory for the All India Trinamool Congress (AITMC), a regional party. Despite the fact that the AITMC was facing a two term anti-incumbency, the AITMC seat count hit an all-time high. Few had seen this coming as evinced by the fact that AITMC’s performance exceeded forecasts made by most pollsters. What should investors make of the BJP’s loss in this key state? Was it a backlash against Modi’s handling of the pandemic? Does it portend a change of government and national policy in the general elections in 2024? Not really. Here we highlight three key takeaways: Takeaway #1: The BJP’s performance was noteworthy Chart 14India: BJP Gets Foot In Door In West Bengal China Verges On Overtightening China Verges On Overtightening Whilst the BJP fell short of its goals in West Bengal, the state is not a BJP stronghold. The BJP is known to have natural traction in Hindi-speaking regions of India and West Bengal is a non-Hindi speaking state where the BJP was traditionally seen as an outsider. Also, this state is known to be unusually unwilling to accept change. For instance, before AITMC, the Left was in power for a record spell of 34 years in this state. In such a setting, the BJP’s performance in 2021 in West Bengal is noteworthy: the party increased its seat count to 77 seats, compared to only 3 seats in 2016 (Chart 14). This performance now catapults the BJP into becoming the key opposition party in West Bengal. It also indicates that the BJP may take time but has what it takes to build traction in states that are not traditional strongholds. Given that it achieved this feat in a state where it has little historic strength, its performance is noteworthy as a sign that the BJP remains a force to be reckoned with. Takeaway #2: The BJP’s popularity slipped but it is still favored to retain power in 2024 Whilst discontent against the BJP is rising on account of its poor handling of COVID-19 and the accompanying economic distress, there remains no viable alternative to the BJP at the national level. The recent state elections, not only in West Bengal, confirm that the opposition Indian National Congress (INC) is yet to get its act in order. The Congress party collapsed from 44 seats in Bengal to 0 seats. More importantly, the Congress is yet to resolve two critical issues, i.e. the need to appoint or elect an internal leader with mass appeal, and the need to develop an identifiable policy agenda. The weakness of the Congress means that while the BJP’s seat count could diminish as against its 2019 peak performance, nevertheless our base-case scenario for 2024 remains that of a BJP-led government maintaining power in India. Policy continuity and the chance of some structural reform are still the base case. Takeaway #3: The rise and rise of India’s regional parties The rise of the BJP over the last decade has coincided with losses in seats by both the Congress party and India’s regional parties. However, the most recent round of state elections signals that the BJP cannot compress regional parties’ seat share drastically. For instance, in West Bengal, it managed to win 77 seats by itself but this was not at the expense of the AITMC, which is the dominant player in this state. In another large state where elections were held earlier this month, i.e. Tamil Nadu, control continues to fluctuate between two well-entrenched regional parties. Chart 15India: BJP Peaked In 2019 But Still Favored 2024 China Verges On Overtightening China Verges On Overtightening The 2019 general elections saw the share of regional parties (defined as all parties excluding the BJP and Congress) fall to 35% from the near 40% levels seen at the general elections of 2014 (Chart 15). The 2024 elections could in fact see regional parties’ seat share move up a notch as the BJP’s peak seat count could diminish from the highs of 2019. The coming rise of India’s regional parties is a trend rooted in a simple dynamic. With the BJP as a two-term incumbent in the 2024 elections, voters could choose to gratify regional parties at the margin, in the absence of any alternative to the BJP at the national level. The BJP remains in a position to be the single largest party in India in 2024 with a seat count in excess of the half-way mark. But could a situation arise where the ruling party pulls in a regional party to stay ahead of the half-way mark with a large buffer? Absolutely. But of course 2024 is a long way away. Managing COVID-19 and its economic fallout will make it harder than otherwise for the BJP to beat its 2019 performance. The next bout of key state elections in India are due in February 2022 and India’s largest state, Uttar Pradesh, will see elections. With the BJP currently in power in this Hindi-speaking state, the February 2022 elections will shed more light on BJP’s ability to mitigate the anti-incumbency effect of the pandemic and economic shock. Bottom-Line: BJP’s popularity in India has been shaken but not dramatically so. The BJP remains firmly in a position to be the single largest party in India with a seat count that should cross the half-way mark in 2024. So government stability is not a concern in this emerging market for now. In light of China’s domestic political risks, and India’s political continuity, we will maintain our India trades for the time being (Charts 16A and 16B). However, we are undertaking a review of India as a whole and will update clients with our conclusions in a forthcoming special report. Chart 16AStay Long Indian Bonds Versus EM Stay Long Indian Bonds Versus EM Stay Long Indian Bonds Versus EM Chart 16BStick To Long India / Short China Stick To Long India / Short China Stick To Long India / Short China Investment Takeaways Maintain near-term safe-haven trades. Close long natural gas futures for a 19.8% gain. Maintain cyclical (12-month) bullish positioning with a preference for value over growth stocks. Maintain long positions in commodities, including rare earth metals, and emerging markets. But be prepared to cut these trades if China overtightens policy according to our benchmarks. For now, continue to overweight Indian local currency bonds relative to emerging market peers and Indian stocks relative to Chinese stocks. But we are reviewing our bullish stance on India. Chart 17Cyber Security Stocks Perk Up Amid Tech Rout Cyber Security Stocks Perk Up Amid Tech Rout Cyber Security Stocks Perk Up Amid Tech Rout Stay long cyber security stocks – though continue to prefer aerospace and defense over cyber security as a geopolitical “back to work” trade. Cyber security stocks perked up relative to the tech sector during the general tech selloff over the past week. The large-scale Colonial Pipeline ransomware cyber attack in the US temporarily shuttered a major network that supplies about 45% of the East Coast’s fuel (Chart 17). Nevertheless the attack on critical infrastructure highlights that cyber security is a secular theme and investors should maintain exposure. Cyber stocks have outperformed tech in general since the vaccine discovery (Chart 18). Chart 18Cyber Security Is A Secular Theme Cyber Security Is A Secular Theme Cyber Security Is A Secular Theme Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com

Highlights The US is only one deflationary shock away from a European level of bond yields. On a multi-year horizon, a deflationary shock is a near-certainty. The shock will be deflationary, because even if it starts inflationary, it will quickly morph into deflationary. The reason is that the sharp backup in bond yields resulting from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. Hence, the US 30-year bond will ultimately deliver an absolute return approaching 100 percent, in absolute terms… …and relative to core European and Japanese bonds. Fractal trade shortlist: Stocks to consolidate versus bonds; Commodities look dangerously frothy; Buy USD/CAD. Feature Chart of The WeekThe Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks The Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks The Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks Ten years ago, 30-year bond yields in the US, UK and Germany stood at near-identical levels, around 3 percent. Today though, those yields are widely dispersed: the US at 2.3 percent, the UK at 1.3 percent, and Germany at 0.3 percent. What happened? In 2012, the German bond yield decoupled from the UK and the US, because the deflationary shock from the euro debt crisis was focussed in the euro area. Then, in 2016, the UK bond yield decoupled from the US, because the deflationary shock from Brexit was focussed in the UK and EU27 (Chart Of The Week). The ‘Shock Theory’ Of Bond Yields Welcome to a new concept – the ‘shock theory’ of bond yields. According to this theory, the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that the economy has suffered. Each successive deflationary shock takes the bond yield to a lower structural level until it can go no lower (Chart I-2). Chart I-2Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Since 2011, US, UK and German bond yields have decoupled because the US has suffered the legacies of one fewer deflationary shock than the UK, and two fewer deflationary shocks than Germany. But the important corollary is that the US is only one deflationary shock away from a European level of bond yields. When that deflationary shock arrives and the US 30-year bond yield reaches the recent low achieved in the UK, it will equate to a price gain of over 50 percent. And if the yield reaches the recent low achieved in Germany, it will equate to a price gain of well over 100 percent. Many people say that such gains are impossible. Yet ten years ago these same people were saying that UK and German long-duration bonds could never reach near-zero yields, and look what happened! Our high-conviction view is that the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. The simple reason is that another deflationary shock is just a matter of time away. Long-Term Investors Must Always Plan For A Shock Most strategists and investors claim that shocks, such as the pandemic, are inherently unpredictable, and therefore that you cannot plan for them. We disagree. Yes, the timing and nature of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the statistical distribution of shocks is highly predictable. What constitutes a shock? There is no established definition, so our definition is any event that causes the long-duration bond price in a major economy to rally or slump by at least 25 percent.1 (Chart I-3) Using this definition through the last 50 years, we can say that the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the statistical distribution of the time between shocks is Exponential (3.33). Chart I-3A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years It follows that in any ten-year period, the likelihood of suffering a shock is a near-certain 96 percent (Chart I-4). And even in any five-year period, the likelihood of a shock is an extremely high 81 percent. Chart I-4On A Multi-Year Horizon, A Shock Is A Near-Certainty The 'Shock Theory' Of Bond Yields The 'Shock Theory' Of Bond Yields For many people, this creates a cognitive dissonance. Even though a shock is a near-certainty, they cannot visualise its exact nature or timing, so they resist planning for it. Yet long-term investors must always plan for shocks. Not to do so is unforgiveable. An Inflationary Shock Will Quickly Morph Into A Deflationary Shock The crucial question is, will the next shock be deflationary, or inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if the shock starts as inflationary, it will quickly morph into deflationary. The simple reason is that the sharp backup in bond yields that would come from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. The 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. As prices doubled almost everywhere, the value of global real estate surged by $150 trillion (Chart I-5), of which $75 trillion was due to the valuation uplift from lower bond yields (Chart I-6). To put this into context, lower bond yields have boosted the value of global real estate by the equivalent of world GDP! Chart I-5In The 2010s Housing Boom, The Value Of Global Real Estate Surged By $150 Trillion… In The 2010s Housing Boom, The Value Of Global Real Estate Has Surged By $150 Trillion... In The 2010s Housing Boom, The Value Of Global Real Estate Has Surged By $150 Trillion... Chart I-6…Of Which $75 Trillion Was Due To Lower Bond Yields ...Of Which $75 Trillion Is Due To Lower Bond Yields ...Of Which $75 Trillion Is Due To Lower Bond Yields Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. The starting valuation needed to generate a given real return during an inflationary shock is much lower than during price stability. For example, for equities in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But in the inflation shock of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to halve to 7 (Chart I-7). Chart I-7In The 1970s Inflationary Shock, Valuations Collapsed In The 1970s Inflationary Shock, Valuations Collapsed In The 1970s Inflationary Shock, Valuations Collapsed How much can bond yields rise before undermining the value of global real estate? Over the past decade the global rental yield has not been able to deviate from the global long-duration bond yield by more than 100 bps.2 Given that the bond yield is already around 25 bps above the rental yield, we deduce that the long-duration bond yield can rise by no more than 75 bps before global real estate prices start getting hurt (Chart I-8).  Chart I-8The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt To repeat our key structural recommendation, the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. Candidates For Countertrend Reversal This week we note that the rally in stocks versus bonds (MSCI All Country World versus 30-year T-bond) is likely to consolidate in the coming months – given the fragility in the 260-day fractal structure similar to previous turning points in 2008, 2010, 2013, and 2020 (Chart I-9). Chart I-9The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months We also repeat our warning to steer clear of commodities. The rally in all commodities is becoming dangerously frothy, displaying the extremes of fractal fragility seen in 2008. (Chart I-10and Chart I-11). Chart I-10The Rally In Commodities Is Becoming Dangerously Frothy... The Rally In Commodities Is Becoming Dangerously Frothy... The Rally In Commodities Is Becoming Dangerously Frothy... Chart I-11...Displaying The Extremes Of Fractal Fragility Seen In 2008 ...Displaying The Extremes Of Fractal Fragility Seen In 2008 ...Displaying The Extremes Of Fractal Fragility Seen In 2008 A good trade right now is to short the Canadian dollar. Based on the loonie’s composite fractal structure, a lot of good news is already priced in, including the dangerously frothy commodity markets and the Bank of Canada’s (hawkish) taper of asset purchases. As such we expect the Canadian dollar to reverse in the coming months (Chart I-12). Chart I-12Short The Canadian Dollar Short The Canadian Dollar Short The Canadian Dollar Go long USD/CAD, setting a profit-target and symmetrical stop-loss at 3.7 percent. Dhaval Joshi Chief Strategist Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 Here, the global long-duration bond yield is defined as the average of the 30-year yields in the US and China. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Highlights Global Tapering: The Bank of England has joined the Bank of Canada as central banks tapering the pace of bond buying. Markets are now trying to sort out who is next and concluding that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. US Treasury Curve: We are adding a new recommended US butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell using US Treasury futures. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime. Feature Heading into 2021, one of our key investment themes for the year was that no major central bank would shift to a less dovish monetary policy stance before the Fed. Not even five months into the year, our theme has already been proven incorrect. Last week, the Bank of England (BoE) announced a slower pace of its asset purchases, following a similar tapering decision by the Bank of Canada (BoC) last month. Chart of the WeekUS Jobs Recovery Lagging, Despite Vaccine Success Who Tapers Next? Who Tapers Next? We had assumed that no central bank could tolerate the currency strength that would inevitably occur by tapering ahead of the Fed. That was clearly not the case in Canada, and the Canadian dollar has already appreciated 4.6% versus the greenback since the BoC taper announcement April 21. The British pound also rallied solidly against both the US dollar and euro immediately after the BoE taper announcement last week. Markets are beginning to speculate on future taper candidates, like the Reserve Bank of New Zealand (RBNZ), with the New Zealand dollar being one of the strongest currencies in the G10 versus the US dollar since the end of March (+4.4%). Investors had been debating the possibility that the Fed could begin tapering sometime in the second half of 2020, largely based on what has to date been a successful US vaccination campaign. Yet while that led to optimism that the US economy can quickly reopen and return to normal, the fact remains that the recovery in US employment from the COVID shock has lagged other major economies (Chart of the Week). The big downside miss on the April US payrolls report highlights how the Fed can be patient before joining the tapering club. US Treasury yields are likely to continue trading sideways, and the US dollar will trade soft, until markets can sort out the true state of US labor demand versus supply. Which Central Bank Could Follow The BoC And BoE? Back in March, we published a report that discussed what we called the “pecking order of global liftoff”.1 We looked at how interest rate markets were pricing in an increasingly diverse path out of the coordinated global monetary easing enacted last year during the COVID recession (Chart 2). We looked at both the timing of “liftoff” (the first rate hike) and the pace of hikes afterward to the end of 2024. We then ranked the countries by the market-implied timing of liftoff. Chart 2Sorting Out The Relative Hawks & Doves Among Global CBs Sorting Out The Relative Hawks & Doves Among Global CBs Sorting Out The Relative Hawks & Doves Among Global CBs At the time, overnight index swap (OIS) curves were discounting the earliest liftoff from the RBNZ (June 2022) and BoC (August 2022). The Fed was expected to hike in January 2023, followed by the BoE in June 2023 and Reserve Bank of Australia (RBA) in July 2023. The European Central Bank (ECB) and Bank of Japan (BoJ) were the laggards, with no rate hiked discounted until September 2023 and February 2025, respectively. In terms of the pace of rate hikes after liftoff through 2024, our list was broken into two groups. The more aggressive central banks were expected to be the BoC (+175bps), RBA (+156bps), RBNZ (+140bps) and the Fed (+139bps). Much smaller amounts of rate hikes were anticipated from the BoE (+63bps), ECB (+25bps) and BoJ (+9bps). In the two months since our March report, the market timing of liftoff, and the pace of subsequent hikes, has shifted for all those countries (Table 1). The BoC is now expected to move in September 2022, ahead of the RBNZ (October 2022). In 2023, the Fed is now priced for liftoff in March 2023, followed by the BoE and RBA (both in July 2023). The ECB liftoff date is little changed (now August 2023), while the market has dramatically pushed out the timing of any BoJ hike (now November 2025). The cumulative rate hikes through 2024 are moderately lower for all countries except Australia (a reduction in total tightening of 56bps). Table 1The Fed Is Sliding Down The “Pecking Order Of Liftoff” List Who Tapers Next? Who Tapers Next? What is interesting about these changes is that the market has pulled forward the timing of liftoff for the BoE and RBA, while pushing it out for the BoC, RBNZ, BoJ and, most importantly, the Fed. The Fed is now drifting down the “pecking order” for liftoff, expected to lift rates only a couple of months before the BoE or RBA. This is a major change from previous monetary policy cycles, when the Fed would typically be a first mover when it comes to tightening policy. Chart 3The Momentum Of Global QE Has Already Been Slowing The Momentum Of Global QE Has Already Been Slowing The Momentum Of Global QE Has Already Been Slowing While the BoC and BoE decisions to taper quantitative easing (QE) have garnered the headlines, the pace of global central bank balance sheet expansion had already peaked at the start of 2021 (Chart 3). The pace has slowed most dramatically in Canada and the US, but this was a result of certain emergency programs expiring – most notably the Fed’s corporate bond buying vehicles late last year and the BoC’s short-term repo facilities more recently. Greater financial market stability was the reason cited to end those programs, while still leaving government bond QE buying in place unchanged. The year-over-year pace of global QE was set to slow, simply from less favorable comparisons to 2020 after the surge in central bank balance sheet expansion last year. Yet now we are starting to see actual tapering of government bond purchases from some central banks. Is such “early tightening” warranted? Back in that same March report where we discussed the order of global liftoff, we gave our assessment of the most important factors that could drive central banks to consider a shift to a less dovish stance (like tapering). For the BoC, we cited booming house prices and robust business confidence as reasons the BoC could turn less dovish sooner (Chart 4). For the BoE, we noted a sharper-than-expected recovery in domestic investment and consumer spending, as the locked-down UK economy reopens, as reasons why the BoE could begin to tweak its policy settings. For both central banks, all those indicators were mentioned as factors leading to their decision to taper. For the Fed, we determined that rising inflation expectations and increasing labor market tightness would both be required for the Fed to turn less dovish. Only inflation expectations have reached that goal, with the US Employment/Population ratio still well below the pre-pandemic peak (Chart 5). For the RBA, we looked solely at realized inflation measures, as the RBA has explicitly noted that Australian wage growth must rise sustainably towards 3% - nearly double current levels - before realized CPI inflation could return to the 2-3% target range. For both the Fed and RBA, the necessary conditions for a change in current policy settings have not yet been met. Chart 4What The More Hawkish CBs Are Watching What The More Hawkish CBs Are Watching What The More Hawkish CBs Are Watching Chart 5What The More Dovish CBs Are Watching What The More Dovish CBs Are Watching What The More Dovish CBs Are Watching For the ECB, we noted that realized inflation (and the ECB’s inflation forecasts), along with the Italy-Germany government bond spread as a measure of financial conditions, were the most important indicators to watch before the ECB could consider any move to taper its QE programs (Chart 6). Italian spreads have widened a bit in recent months, while the latest set of ECB economic forecasts still call for headline euro area inflation to remain well south of the 2% target out to 2023. For the BoJ, we simply cited a rise in realized inflation as the only possible development that could lead to a BoJ taper. The BoJ now forecasts that Japanese inflation will not reach the 2% central bank target until at least 2024. So for both the ECB and BoJ, the conditions do not warrant any imminent tapering of bond buying. Chart 6What The Most Dovish CBs Are Watching What The Most Dovish CBs Are Watching What The Most Dovish CBs Are Watching As another way to determine who could taper next, we turn to our Central Bank Monitors, which are designed to measure the pressure on policymakers to ease or tighten monetary setting. All the Monitors have responded to the recovery in global growth and inflation, along with the easing of financial conditions implied by booming markets, over the past year. Yet only the RBA Monitor is calling for tightening (Chart 7), indicating that the RBA’s current focus on only wages and realized inflation is a departure from their behavior in the past. The Fed and BoE Monitors have risen to the zero line, suggesting no further pressure to ease policy but no tightening is needed either. The ECB, BoJ and RBNZ Monitors are all close, but just below, the zero line, suggesting diminishing need for more monetary stimulus (Chart 8). Chart 7Bond Yields Have Moved Ahead Of Our CB Monitors Bond Yields Have Moved Ahead Of Our CB Monitors Bond Yields Have Moved Ahead Of Our CB Monitors Chart 8Yields Overshooting Tightening Pressures Here Too Yields Overshooting Tightening Pressures Here Too Yields Overshooting Tightening Pressures Here Too Based on our assessment of the above indicators, we judge the RBNZ to be the next central bank most likely to taper, sometime in the 2nd half of 2021. We still see the Fed starting to signal tapering later this year, but with actual slowing of US Treasury (and Agency MBS) purchases not occurring until early 2022. The year-over-year momentum of bond yields correlates strongly with the Central Bank Monitors. The rise in global bond yields seen over the past year has exceeded the pace implied by the Monitors. This is unsurprising given how rapidly the global economy has recovered from pandemic-fueled recession in 2020. Supply chain disruptions and surging commodity prices have also given a lift to bond yields via rising inflation expectations, even as central banks have promised to keep rates on hold for at least the next couple of years. Yet purely from a monetary policy perspective, the surge in global bond yields looks to have gone a bit too far, too fast. Bottom Line: Markets are now trying to sort out who will taper next after the BoC and BoE, and have concluded that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. Bond yields in other developed markets appear to have overshot economic momentum, and a period of consolidation is needed before yields can begin moving higher again. US Treasury Curve: How Much Steepening Left? Chart 9A Pause In The UST Bear-Steepening Trend A Pause In The UST Bear-Steepening Trend A Pause In The UST Bear-Steepening Trend For most of the past year, the primary trend in the US Treasury curve has been one of bear steepening. Longer maturity yields have borne the brunt of the upward pressure stemming from the rapid recovery in US (and global) economic growth from the depths of the 2020 COVID-19 recession. In recent weeks, however, the surge in longer-maturity Treasury yields has stalled, as have the immediate steepening pressures (Chart 9). Purely from a fundamental economic perspective, a steepening Treasury curve is an expected result of the reflationary mix of growth, inflation and monetary policy currently at work in the US. For example, since the 2020 lows, 5-year/5-year forward inflation expectations from the TIPS market have risen 143bps while the ISM manufacturing index surged from a low of 41 to a high of 65 in March of this year (Chart 10). Combine that with the Fed cutting rates to 0% last year, while promising to keep rates unchanged through 2023 and reinforcing that commitment through QE, and it is no surprise to see a steeper US Treasury curve. Chart 10UST Curve Steepening Has Been Driven By Reflation UST Curve Steepening Has Been Driven By Reflation UST Curve Steepening Has Been Driven By Reflation Yet even despite these obvious steepening pressures, the pace of the Treasury curve steepening does seem to be a bit rapid compared to history. In Chart 11, we show a “cycle-on-cycle” analysis, comparing the slope of various US Treasury curve segments (2-year versus 5-year, 5-year versus 10-year, 10-year versus 30-year) to the average of the previous five US business cycles, dating back to the 1970s. The curves are lined up to the start date of the previous recession, with the vertical line in the chart representing that date. Thus, this chart allows us to see how the Treasury curve evolved heading into, and coming out of, economic downturns. Chart 11 shows that the current 2-year/5-year curve, with a steepness of 63bps, is in line with past steepening moves coming out of recession. For the curve segments at longer maturities, the pace of steepening has been much more rapid than in the past. In fact, the current 5-year/10-year slope of 82bps is already above the average past peak level, as is the 10-year/30-year curve of 72bps. If we do the same cycle-on-cycle analysis for the three previous US recessions dating back to 1990, the current curve slopes are more in line with levels seen one year into the economic expansion (Chart 12). During those previous cycles, the curve steepening trend ended around two years into the expansion. This suggests that the current curve steepening could continue into 2022, except for one major difference – the Fed cut rates to 0% very rapidly last year, far faster than in the previous easing cycles. This suggests that additional curve steepening from current levels can only occur through a surge in US inflation. Chart 11Current UST Steepening Has Moved Fast Compared To Past Cycles Current UST Steepening Has Moved Fast Compared To Past Cycles Current UST Steepening Has Moved Fast Compared To Past Cycles Chart 12Can More UST Curve Steepening Occur With A 0% Funds Rate? Can More UST Curve Steepening Occur With A 0% Funds Rate? Can More UST Curve Steepening Occur With A 0% Funds Rate? The slope of the Treasury curve is typically correlated to the level of the nominal fed funds rate, but is even more strongly correlated to the funds rate minus actual inflation, or the real fed funds rate. When the real funds rate is below the natural real rate of interest, a.k.a. r-star, the Treasury curve has historically exhibited its strongest steepening trend. That can be seen in Chart 13, where we show the real fed funds rate (adjusted by US core CPI inflation) compared to the New York Fed’s estimate of r-star. The gap between the two series is shown in the bottom panel, correlating very strongly to the 2-year/30-year Treasury curve slope. Chart 13Curve Steepening Results When Real Rates Are Below R* Curve Steepening Results When Real Rates Are Below R* Curve Steepening Results When Real Rates Are Below R* With the nominal funds rate at zero, that gap between r-star and the real fed funds rate can only widen in a fashion that would support more curve steepening if a) realized US inflation moves higher or b) r-star moves higher. Both outcomes are possible as the US economic recovery, fueled by expanding vaccinations and fiscal stimulus. Both real rates and r-star are much lower in the current cycle than in previous economic recoveries, although the r-star/real funds rate gap appears to be following a more typical path that suggests potential additional steepening pressure (Chart 14). The wild card in this analysis is the Fed itself. If US economic growth and inflation evolve in way that makes it more likely the Fed would have to begin tapering QE and, eventually, signal future rate hikes, the Treasury curve may shift to a more typical bear-flattening trend seen during tightening cycles. We saw an example of that after the release of the March US employment report, where over a million jobs were created in a single month, causing 5-year Treasury yields to jump higher than longer-maturity Treasuries (i.e. curve flattening). Looking ahead, it appears that the US yield curve is more likely to slowly transition to a bear-flattening/bull-steepening regime than continue the bear-steepening/bull-flattening: trend of the past twelve months. One way to position for this is to enter into butterfly curve trades that offer attractive carry or valuation. For that, we turn to our Treasury curve valuation models. We have been recommending a Treasury yield curve trade in our Tactical Overlay portfolio on page 19, going long a 7-year bullet versus going short a 5-year/10-year barbell (Chart 15). This barbell is now very cheap on our models, which measure value by regressing the butterfly spread on the underlying slope of the curve. In this case, the spread between the 5/7/10 butterfly is unusually wide compared to the slope of the 5/10 Treasury curve. According to our model, this butterfly spread discounts nearly 100bps of additional 5/10 steepening, an excessive amount compared to past cycles. Chart 14R* - Real Funds Rate Gap Below Previous Cyclical Peaks R* - Real Funds Rate Gap Below Previous Cyclical Peaks R* - Real Funds Rate Gap Below Previous Cyclical Peaks Chart 15Maintain Our Current 5/7/10 UST Butterfly Trade Maintain Our Current 5/7/10 UST Butterfly Trade Maintain Our Current 5/7/10 UST Butterfly Trade While the valuation is attractive on the 5/7/10 butterfly (Table 2), the carry on this position is a modest 12bps. A butterfly with more attractive carry is the 2/5/30 butterfly. Table 2US Butterfly Strategy Valuation: Standardized Residuals Who Tapers Next? Who Tapers Next? Table 3US Butterfly Strategies: Carry Who Tapers Next? Who Tapers Next? Chart 16Enter A New 2/5/30 UST Butterfly Trade Enter A New 2/5/30 UST Butterfly Trade Enter A New 2/5/30 UST Butterfly Trade This butterfly has a neutral valuation (Chart 16) on our model, but offers 35bps of carry - the most attractive among all butterflies involving a 5-year bullet (Table 3). With US Treasury yields, and the Treasury curve slope, likely to remain rangebound for the next few months, going for higher carry trades is an attractive strategy – particularly if used in conjunction with a below-benchmark duration stance, which we still advocate. The 2/5/30 butterfly represents an attractive near-term hedge to that more defensive duration posture. Bottom Line: We are adding a new recommended US Treasury butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Who Tapers Next? Who Tapers Next? ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis.  Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Climbing Swiss Peaks Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone A Good Sign For The Eurozone A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Sweden Leads The Eurozone Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Accelerating Vaccinations Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus A Surprising Dance A Surprising Dance Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Ample European Pent-up Demand Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount The Service Sector Recovery Is Paramount The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises Decomposing The Surprises Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns A Surprising Dance A Surprising Dance The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks A Surprising Dance A Surprising Dance Table 3A Bullish Backdrop For EUR/USD A Surprising Dance A Surprising Dance The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Rising German Yields? Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9).  Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February.  The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth Support For Household Net Worth Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More UK Consumption Will Rise More UK Consumption Will Rise More Chart 12Accelerating UK Inflation Accelerating UK Inflation Accelerating UK Inflation   Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains.  It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Cable Is Ripe For Some Near-Term Profit Taking Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable UK Small-Cap Stocks Are Technically Vulnerable UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Deteriorating Profit Performance Deteriorating Profit Performance Chart 16Quite The Valuation Premium Quite The Valuation Premium Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead Lower EUR/GBP Ahead Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Currency Performance A Surprising Dance A Surprising Dance Fixed Income Performance Government Bonds A Surprising Dance A Surprising Dance Corporate Bonds A Surprising Dance A Surprising Dance Equity Performance Major Stock Indices A Surprising Dance A Surprising Dance Geographic Performance A Surprising Dance A Surprising Dance Sector Performance A Surprising Dance A Surprising Dance ​​​​​​​ Closed Trades