Munis/S&L tax exempt

Highlights Spread Product: TIPS breakeven inflation rates are holding firm despite the correction in equity markets. Remain overweight spread product versus Treasuries for now, but be prepared to reduce exposure once long-maturity TIPS breakevens reach our target range of 2.4% to 2.5%. Volatility: While implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. Municipal Bonds: After-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. MBS: The option-adjusted spread offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to an investment grade corporate bond. Feature Chart 1Corporate Spreads Are Stoic Corporate Spreads Are Stoic Corporate Spreads Are Stoic The stock market is down and volatility is up dramatically. At least so far the pass through to credit spreads has been relatively mild (Chart 1), but this does not make us more optimistic. Rather, our sense is that last week's market action is yet another sign that we are approaching the end of the credit cycle. Same Loop, Different Day Last week's equity sell off is best viewed through the lens of the Fed Policy Loop that we introduced in 2015 (Chart 2).1 The Fed Policy Loop is a framework for understanding the interplay between monetary policy and risk assets. Its recent dynamics can be summarized as follows: The perception of easy Fed policy fuels the outperformance of risk assets, and seven months of falling inflation between last January and August kept that perception in place for all of 2017. The end result is that financial conditions eased dramatically - stock prices soared and credit spreads tightened. But easing financial conditions also sow the seeds of their own destruction. Easier financial conditions eventually beget stronger growth and stronger growth eventually begets higher inflation (Chart 3). Last week the market finally caught a whiff of inflation and started to price-in a more hawkish Fed reaction function. Chart 2The Fed Policy Loop On The MOVE On The MOVE Chart 3Financial Conditions Lead Growth And Growth Leads Inflation Financial Conditions Lead Growth And Growth Leads Inflation Financial Conditions Lead Growth And Growth Leads Inflation On a positive note, the Loop framework also tells us that the Fed will eventually ease policy in response to tighter financial conditions and this will allow the risk-on rally to resume. While this is undoubtedly true, the Fed's breaking point is also a lot higher when inflationary pressures are more pronounced. This is why we have repeatedly stressed that our cyclical call on spread product hinges on the path of long-dated TIPS breakeven inflation rates.2 Chart 4No Correction Here No Correction Here No Correction Here Last year, when the 10-year TIPS breakeven inflation rate was down around 1.6% - well below the 2.4% to 2.5% range that is consistent with inflation anchored around the Fed's target - the market understood that the Fed's tolerance for tighter financial conditions was quite low. This made it very difficult for risk assets to sell off meaningfully. But now, with the 10-year TIPS breakeven rate at 2.05% and the 5-year/5-year forward breakeven rate at 2.27%, the Fed can clearly tolerate more market pain. The bad news from a cyclical perspective is that, despite the equity correction, the market's assessment of inflationary pressure in the economy has barely budged. Long-maturity TIPS breakeven inflation rates are holding firm, as are the prices of crude oil and other commodities - prices that tend to correlate with TIPS breakeven rates (Chart 4).3 In other words, last week's correction didn't give our overweight spread product position any further room to run. While it may take a few more sessions, our sense is that the market and the Fed will hash out a new equilibrium in the near-term and that the true bear market in risk assets won't occur until inflationary pressures are even more pronounced. We continue to look for a range of 2.4% to 2.5% on long-maturity TIPS breakeven inflation rates before we scale back our cyclical overweight exposure to spread product. The inflation data take on extra significance between now and then, as each incoming report will help confirm or deny the message priced into TIPS breakevens. Every weak inflation print buys the credit cycle more time, every strong print hastens its demise. Next up: tomorrow morning's CPI. Don't Fear Rising Rate Vol The return of volatility was the other big story last week. The VIX index of implied equity volatility was as low as 9 in early January, but stood at 33 as of last Friday's market close. With rising inflation starting to weaken the "Fed put" in risk assets we think it is unlikely that equity volatility will return to its previous cycle lows.4 But what about the volatility in rates markets? The MOVE index of implied interest rate volatility also jumped last week, and its path going forward is of critical importance for Treasury yields. Chart 5 shows that the Kim & Wright estimate of the term premium embedded in the 10-year Treasury yield is highly correlated with the MOVE index, while the expectations component implied by that term premium is the mirror image of the fed funds rate. It follows that a surge in rate volatility would lead to much higher Treasury yields, particularly if the Fed continues to hike. However, it would be quite unusual for the MOVE index to increase significantly while the Fed is lifting rates. To see this we can simply observe the tight correlation between the MOVE index and the slope of the yield curve (Chart 6). The crucial question then becomes: Does the slope of the yield curve drive volatility or does volatility drive the slope of the curve? Chart 5Volatility And The Term Premium Volatility And The Term Premium Volatility And The Term Premium Chart 6Volatility And The Yield Curve Volatility And The Yield Curve Volatility And The Yield Curve Like most things in economics, the answer is a little bit of both. Chart 7Forecasters In Agreement Forecasters In Agreement Forecasters In Agreement It is relatively straightforward to see why higher rate volatility might lead to a steeper yield curve. To the extent that the slope of the yield curve reflects a term premium to compensate investors for the extra price risk in a long-dated bond, then investors should demand greater compensation to bear that extra risk when rate volatility is elevated. But that analysis ignores the other reason why the yield curve might be steep. Namely, the yield curve might be steep because the market expects the Fed to hike rates substantially. It would seem logical to expect that investors would be more uncertain about a forecast that calls for many rate hikes than they would be about a forecast that calls for only a few rate hikes. It therefore follows that an environment where the market expects a large change in the fed funds would also be an environment of elevated rate volatility. The two-way causation between rate volatility and the slope of the yield curve is reinforced by the fact that both trends also correlate with forecaster uncertainty about the macro environment. Chart 7 shows that the dispersion of individual forecasts for the 3-month T-bill rate and GDP growth correlate with both the MOVE volatility index and the slope of the yield curve. At the moment, disagreement amongst professional forecasters remains low relative to history. All in all, our sense is that once long-maturity TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5% they are unlikely to move much higher. Fed hawkishness will ramp up considerably and the yield curve will be much more likely to flatten. This means that while implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. We are not overly concerned about a huge spike in rate volatility leading to a blow-out in bonds. Two Attractive Ways To De-Risk As stated in the first section of this report, the higher that TIPS breakeven inflation rates rise the closer we get to calling the end of the credit cycle. If current trends continue, then it is likely we will begin to de-risk the spread product side of our recommended portfolio in the not-too-distant future. With that in mind, we have identified two lower risk spread sectors that are starting to look attractive. 1) Municipal Bonds Like all spread sectors, at first blush municipal bonds appear quite expensive relative to Treasuries. Chart 8 shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, relative to equivalent-maturity Treasury yields. The message is quite clear. Municipal bonds offer far less excess compensation relative to Treasuries than has been typical in the past. However, the valuation picture changes completely when we consider municipal bonds versus investment grade corporates. Chart 9 once again shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, but this time relative to equivalent-duration corporate bonds. We do not attempt to match credit quality in Chart 9, so Aaa-rated municipal bonds are being compared to the corporate bond index which has an average credit rating of A3/Baa1. Chart 8Munis Expensive Versus Treasuries Munis Expensive Versus Treasuries Munis Expensive Versus Treasuries Chart 9Munis Cheap Versus Corporates Munis Cheap Versus Corporates Munis Cheap Versus Corporates Chart 9 shows that after-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. In fact, a 10-year Aaa-rated municipal bond currently offers only 13 bps less yield than an equivalent duration A3/Baa1-rated corporate bond. In addition, whenever the after-tax yield on a 10-year Aaa-rated municipal bond has exceeded the yield on a 10-year corporate bond in the past, it has been a fairly good signal that investment grade corporates are too expensive and due for a correction. Not only did municipal bonds look more attractive than corporates before the crisis in 2007, but also before corporates sold off in 2011 and 2014 (Chart 9, bottom panel). Agency MBS Chart 10An Opportunity In MBS? An Opportunity In MBS? An Opportunity In MBS? As with munis, the option-adjusted spread (OAS) offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to investment grade corporate bonds (Chart 10). Further, in a rising rate environment the risk of a large increase in mortgage refinancings is low and this should keep MBS spreads well contained. The biggest potential risk for MBS spreads is that a large spike in Treasury yields causes MBS duration to extend, and sparks a spread widening. In our report from two weeks ago we introduced a model for excess MBS returns in an attempt to quantify what sort of increase in Treasury yields would be necessary to make duration extension a meaningful risk for MBS.5 We modeled monthly excess returns for conventional 30-year MBS relative to duration-matched Treasuries using the following equation: Formula On The MOVE On The MOVE The monthly change in Treasury yields enters the equation with a positive sign because it proxies for refinancing risk. Higher yields lead to lower refis, and lower refis lead to MBS outperformance. The squared change in yields enters the equation with a negative sign because it proxies for extension risk. If yields rise too much during the month, then MBS duration will extend and the sector will underperform. Chart 11Refi Risk Is Low Refi Risk Is Low Refi Risk Is Low From that equation we calculated that, holding the change in OAS flat, it would take a monthly increase in yields of at least 72 bps to lead to negative monthly excess returns. However, in January this appeared not to work very well. The duration-matched Treasury yield in our equation increased only 38 bps in January and the OAS was virtually flat, but MBS still managed to underperform Treasuries by 16 bps on the month. Upon further investigation, the reason our model failed in January is that mortgage refinancings actually increased on the month even though Treasury yields rose (Chart 11). This behavior is unusual and we would not expect it to persist going forward. However, we also made one modification to our model that we expect will lead to more accurate results on a real-time basis. Specifically, we removed the intercept term from the prior model and replaced it with a 1-month lag of the average index OAS. The rationale is that since the intercept term is in the equation to capture the carry return in an MBS trade, we should use a more accurate measure of MBS carry rather than relying on the regression to calculate the historical carry. Our new equation is as follows: Formula On The MOVE On The MOVE Chart 12 On The MOVE On The MOVE Interestingly, using our new equation we find that the monthly increase in Treasury yields required to spark MBS underperformance is now a function of the current average OAS of the MBS index. This would seem to make sense. If the carry buffer is higher, then it should take a greater duration extension for capital losses to overcome the carry and lead to negative excess returns. The relationship between the required monthly increase in yields and the index OAS is illustrated in Chart 12. At the current average index OAS of 31 bps, our equation suggests that a monthly increase in Treasury yields of 58 bps or higher is required for extension risk to become meaningful. Bottom Line: Both municipal bonds and Agency MBS are starting to look attractive relative to investment grade corporate bonds. We stand ready to upgrade these sectors at the expense of investment grade corporate bonds when the time comes to de-risk our spread product portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 For further details on the correlation between TIPS breakevens and commodity prices please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 4 Please see BCA Research Special Report, "The Return Of Vol", dated February 6, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Waiting For A Signal Waiting For A Signal Waiting For A Signal TIPS breakeven inflation rates are fast approaching our end-of-cycle targets (Chart 1). The 10-year and 5-year/5-year rates are currently 2.14% and 2.36% respectively, only slightly below our target range of 2.4% to 2.5%. If this trend continues it is highly likely that we will start to slowly reduce the credit risk in our portfolio in the coming weeks. Already, we find that some lower risk spread products (Foreign Agency bonds and Munis) are attractively valued relative to corporates. But there are also risks to exiting credit too early. First and foremost is that the recent widening in TIPS breakevens might reverse before it bleeds into higher core inflation. As we noted in last week's report, the St. Louis Fed's Price Pressures Measure is still supportive of an overweight allocation to corporate bonds (Chart 1, bottom panel) and core PCE inflation has only just risen to 1.5% year-over-year.1 Investors should maintain below-benchmark duration and an overweight allocation to corporate bonds for now, but be wary that the time to make end-of-cycle preparations is drawing nearer. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 72 basis points in January. The average index option-adjusted spread tightened 7 bps on the month, and currently sits at 85 bps. Investment grade corporate bond spreads continue to tighten, and with each additional basis point the evidence of extreme overvaluation grows. As of today, the 12-month breakeven spread for an A-rated corporate bond has only been tighter 3% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 4% of the time (panel 3). Further, the average spread on the Foreign Agency bond index is now 3 bps greater than the average spread of an equivalent-duration corporate bond, despite having an average credit rating that is three notches higher (Aa2/Aa3 versus A3/Baa1). Even a 10-year Aaa-rated Municipal bond now offers 7 bps greater after-tax yield than a duration-equivalent corporate bond for investors in the top marginal tax bracket (see page 9). The bottom line is that with such poor value in investment grade corporate spreads, we only need to see a stronger signal from our inflation indicators before reducing exposure.2 Depending on how inflation (and TIPS breakevens) evolve, that time could come relatively soon. The Federal Reserve's Senior Loan Officer Survey, released yesterday, showed that lending standards for commerical & industrial (C&I) loans eased somewhat in the fourth quarter of 2017, and also noted that banks expect to ease standards further on C&I loans to large and middle-market firms in 2018. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Warning Signs Warning Signs Table 3BCorporate Sector Risk Vs. Reward* Warning Signs Warning Signs High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 149 basis points in January. The average index option-adjusted spread tightened 24 bps on the month, and currently sits at 324 bps. Last week's equity sell-off and spike in the VIX suggest that some near-term junk spread widening could be in the cards (Chart 3). However, we expect it is still a bit too soon to move out of junk bonds for the cycle. That decision will be made based on whether our inflation indicators continue to rise in the coming weeks and/or months, suggesting that the monetary policy back-drop is becoming less accommodative. In terms of value, high-yield corporates offer better risk-adjusted value than their investment grade brethren. The 12-month breakeven spread for a Ba-rated high-yield bond has currently been tighter than it is today 14% of the time since 1995. The same figure comes in at 25% for a B-rated bond and 31% for a Caa-rated bond. Similar measures for investment grade corporates are significantly lower (see page 3). Further, assuming a default rate of 2.35% for the next 12 months and a recovery rate of 51%, we calculate that a position in high-yield bonds will return 209 bps in excess of Treasuries if spreads stay flat at current levels. Another 100 bps of spread tightening would imply an excess return of just over 6%, but this would bring junk spreads to all-time tight valuations and is probably too optimistic. Remain overweight high-yield for now. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in January. The conventional 30-year zero-volatility MBS spread narrowed 2 bps on the month, all concentrated in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) was flat on the month, and currently sits at 29 bps. After having widened for most of last year, the OAS for a conventional 30-year mortgage bond is now more attractive relative to an equivalent-duration investment grade corporate bond than at any time since 2014 (Chart 4). This makes MBS a reasonably attractive sector for investors looking to shift away from corporate bonds and de-risk their spread product portfolios. Further, there would appear to be very little risk of spread widening in the MBS sector. First, the schedule of run-off from the Fed's mortgage portfolio is already well known, and likely in the price. Second, mortgage refinancings are likely to stay contained in a rising interest rate environment (bottom panel). Finally, the risk of duration extension in MBS only becomes material when Treasury yields spike higher very quickly - on the order of 72 bps or more in a month - as we showed in last week's report.3 Investors should stay at neutral on MBS for now, but stand ready to increase exposure when the time comes to move out of corporate bonds for the cycle. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in January. Sovereign bonds outperformed by 118 bps, Local Authorities by 67 bps, Foreign Agencies by 54 bps, Domestic Agencies by 8 bps and Surpranationals by 3 bps. USD-denominated Sovereign bonds continue to look expensive compared to Baa-rated U.S. Credit (Chart 5), yet they still managed to deliver almost identical excess returns during the past 12 months because of the U.S. dollar's large depreciation. Going forward, with the dollar's rapid decline unlikely to accelerate, we would avoid Sovereign bonds in favor of U.S. corporates. Valuation is more attractive elsewhere in the Government-Related index. Foreign Agency bonds now offer greater spreads than equivalent-duration U.S. corporate bonds, despite benefitting from higher credit quality (panel 4). Local Authority spreads also look attractive compared to recent history (bottom panel). We continue to recommend overweight allocations to both sectors. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 12 bps and 16 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 29 bps and 40 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 53 basis points in January (before adjusting for the tax advantage). The average AAA-rated Municipal / Treasury (M/T) yield ratio was flat on the month. Two market technicals spurred Muni outperformance in January. First, supply plunged after many advance refunding issues were pulled forward in anticipation of the U.S. tax bill (Chart 6). Second, the repeal of the state and local tax deduction led to increased demand for Munis, as evidenced by the recent jump in fund inflows (panel 3). In terms of credit quality, state and local government net borrowing as a percent of GDP likely fell to 0.9% in 2017 Q4 - assuming that corporate tax revenues are held constant. This is consistent with current low yield ratios (panel 4). Meanwhile, tax revenue growth should stay strong in the coming quarters due to recent increases in property prices and retail sales. While M/T yield ratios remain low compared to history, excessive valuations in investment grade corporate bonds mean that Munis are starting to look attractive by comparison. For example, for investors in the top marginal tax bracket, we calculate that the after-tax yield on a Aaa-rated municipal bond is 7 bps higher than the duration-equivalent yield offered by the investment grade corporate bond index, even though the corporate bond index offers an average credit rating of only A3/Baa1. While the bottom panel shows that this yield differential has been higher in the past, it is nevertheless an indication that we are approaching the end of the credit cycle. Stay underweight Munis for now, though an upgrade is likely when it comes time to exit our corporate bond overweights. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear steepened out to the 10-year maturity point in January, as bond markets started to price-in a rebound in inflation. The 2/10 slope steepened 7 basis points on the month and the 5/30 slope flattened 11 bps. The 2/10 slope steepened even further in the first five days of February and currently sits at 69 bps, up from its recent low of 50 bps. More near-term curve steepening is possible if long-maturity TIPS breakeven inflation rates continue to widen, especially since the Fed's median projected rate hike path for the next 12 months is already fully discounted (Chart 7). However, the yield curve is much more likely to be flatter by the end of the year than it is today. In large part because the upside in long-maturity yields will be limited once TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5%. In terms of positioning, we continue to advocate a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell. The 5-year continues to look very cheap on the curve (panel 3), or put differently, our model suggests that the 2/5/10 butterfly spread is currently priced for 29 bps of 2/10 curve flattening during the next six months (panel 4).4 This seems excessive for the time being. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate increased 15 bps on the month. At 2.14% and 2.36%, respectively, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are still below our target range of 2.4% to 2.5%, but only modestly so. The big run-up in TIPS breakeven rates coincided with a jump in oil prices and, as we discussed in a recent report, this is no coincidence (Chart 8).5 The Fed has an asymmetric ability to influence inflation - it has an unlimited ability to tighten policy but its ability to ease policy is restricted by the zero-lower bound on interest rates. It is for this reason that when TIPS breakeven inflation rates become un-anchored to the downside, they also become much more sensitive to swings in commodity prices. In these environments the market sees inflation as increasingly determined by price pressures in the economy and not by the Fed's reaction function. The logical conclusion is that we should expect the tight correlation between oil prices and long-maturity TIPS breakeven rates to persist until breakevens reach our target fair value range of 2.4% to 2.5%. At that point, it is unlikely that further increases in commodity prices would filter through to long-maturity breakevens, because the market would anticipate a tightening response from the Fed. Stay overweight TIPS versus nominal Treasury securities for now. We will reduce exposure when our fair value target of 2.4% to 2.5% is achieved. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in January. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 2 bps on the month and now stands at 33 bps, only 6 bps above its all-time low (Chart 9). All in all, a 33 bps spread is still reasonably attractive for a sector that is Aaa rated with an average duration of 2. By way of comparison, the intermediate maturity Aaa Credit index offers an OAS of only 17 bps and has an average duration above 3. However, credit trends are clearly shifting against the Consumer ABS sector. The consumer credit delinquency rate has put in a bottom, albeit from a very healthy level, and the trend in the household debt service ratio suggests that delinquencies will continue to rise (panel 3). Further, the Federal Reserve's Senior Loan Officer Survey shows that lending standards on auto loans have tightened on net in each of the past 7 quarters, while credit card lending standards have tightened for 3 consecutive quarters. Even though lending standards on both auto loans and credit cards moved slightly closer to net easing territory in the fourth quarter of 2017, the reading from lending standards is still consistent with a rising delinquency rate (bottom panel). We retain a neutral allocation to consumer ABS due to still attractive spreads for a low-duration, high credit quality sector. However, if the uptrend in consumer delinquencies is sustained then our next move will probably be to reduce allocation to this sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 7 bps on the month and currently sits at 59 bps. The spread is now only 8 bps above the lowest level seen since the inception of the index in 2000 (Chart 10). Much like in the Consumer ABS sector, historically low CMBS spreads are observed at a time when lending standards are tightening in the commercial real estate (CRE) sector. The Federal Reserve's most recent Senior Loan Officer Survey shows that lending standards for nonfarm nonresidential CRE loans have tightened for 10 consecutive quarters, though they have been tightening less aggressively of late (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in January. The index option-adjusted spread narrowed 1 bp on the month and currently sits at 40 bps. With an average spread of 40 bps and an average duration of around 5, this sector is not quite as attractive as Consumer ABS on a spread per unit of duration basis. However, it still offers greater expected compensation than a position in Conventional 30-year residential MBS which has an option-adjusted spread of 29 bps and a similar duration. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 3.01% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 3.06%. The Global PMI actually ticked down in January, but only slightly from 54.5 to 54.4. This small decline was more than offset in our model by the large drop in dollar sentiment, which just moved into "net bearish" territory (bottom panel). Of the four major economic blocs, PMIs increased in the U.S. and Japan, ticked down from an extremely high level in the Eurozone and held steady in China. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.84%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 4 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 1Bond Bear On Pause? Bond Bear On Pause? Bond Bear On Pause? The start of a new year often brings optimism and nowhere is this more evident than in economic projections. In three of the past four years (2017 being the exception) Bloomberg consensus GDP growth expectations ended the year lower than where they began. A related pattern played itself out in the Treasury market. At the turn of each of the past four years the average yield on the Bloomberg Barclays Treasury Index increased in December only to fall back in January. In two of those instances the January decline exceeded the December increase. Should we expect a similar January bond rally this year? Our favorite short-term indicators are not sending a strong signal (Chart 1). Net speculative futures positions weakly suggest that the 10-year yield will be lower in three months, but our auto regressive model suggests the Economic Surprise Index will still be in positive territory at the end of the month. In a recent report we showed that yields tend to rise in months where the Surprise Index is above zero.1 Perhaps most importantly, our 2-factor Treasury model shows that yields are significantly lower than is suggested by global economic fundamentals. Maintain below-benchmark duration. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 49 basis points in December and by 335 bps in 2017. At 94 bps, the average index spread is 28 bps tighter than at the beginning of 2017 and investment grade corporate spreads are extremely expensive compared to history (Chart 2). After adjusting for changes in the average duration of the index over time, we calculate that A-rated corporate spreads have only been tighter 5% of the time since 1989 (panel 2), and Baa-rated spreads have only been tighter 7% of the time (panel 3). Essentially, at this stage of the credit cycle we should expect excess returns no greater than carry. As for the credit cycle itself, we noted in our last report that with corporate balance sheets deteriorating, low inflation and still-accommodative monetary policy are the sole supports for corporate spreads.2 We expect spreads will start to widen later this year once inflation rises and policy becomes more restrictive. With excess returns likely to be lower in 2018 than in 2017, we should also expect a lower marginal return from increasing the riskiness within credit portfolios.3 For investors looking to scale back on credit risk, our model shows that Financials and Technology are the most attractive low-risk sectors. Energy, Basic Industry and Communications are all attractive high-risk sectors (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* January Effect January Effect Table 3BCorporate Sector Risk Vs. Reward* January Effect January Effect High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 23 basis points in December and by 602 bps in 2017. The average index option-adjusted spread tightened 1 bp on the month and 66 bps in 2017. Though spreads appear somewhat more attractive than for investment grade corporates, there is still not much room for spread compression in high-yield. In fact, we calculate that if the high-yield index spread tightens another 117 bps, junk bonds will be the most expensive they have been since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Given trends in corporate leverage, another 100 bps of spread tightening should be viewed as unlikely. More realistically, we expect excess returns in the range of 200 bps to 500 bps (annualized) between now and the end of the credit cycle (Chart 3). Given our forecast for default losses, flat spreads translate to a 12-month excess return of 213 bps. An additional warning sign for junk spreads is that the slope of the 2/10 Treasury curve is hovering around 50 bps. We showed in a recent report that when the 2/10 slope is between 0 bps and 50 bps, junk bonds underperform Treasuries in 48% of months, and average monthly excess returns (though still positive) are much lower than when the curve is steeper.4 MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in December and by 51 bps in 2017. The conventional 30-year zero-volatility MBS spread narrowed 2 bps in December, the combination of a flat option-adjusted spread (OAS) and a 2 bps decline in the compensation for prepayment risk (option cost). The Z-spread widened 2 bps in 2017, as an 8 bps OAS widening was offset by a decline of 6 bps in the compensation for prepayment risk. The substantial OAS widening in early 2017 was almost certainly caused by investors pricing-in the eventual run-off of the securities on the Fed's balance sheet. Now that run-off has begun we see no obvious catalyst for further OAS widening in the months ahead. Turning to the compensation for prepayment risk, with Treasury yields biased higher as the Fed continues to lift rates, we see little risk of a material increase in refinancing activity. This will ensure that overall MBS spreads stay capped near historically low levels (Chart 4). All in all, with MBS OAS looking more attractive relative to Aaa-rated credit than at any time since 2015 (panel 3), we think this is an opportune time for investors looking to de-risk their portfolios to shift some of their spread product allocation away from corporate bonds and into MBS. We already upgraded our recommended allocation to MBS from underweight to neutral in October, and will likely further increase exposure as we advance toward the end of the credit cycle. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 5 basis points in December, but outperformed by 216 bps in 2017. Sovereign bonds underperformed the Treasury benchmark by 36 bps in December, Foreign Agencies and Domestic Agencies underperformed by 8 bps and 1 bp, respectively. Local Authorities outperformed the benchmark by 17 bps, and Supranationals underperformed by 1 bp. Sovereign bonds were the best performers within the Government-Related index in 2017, delivering excess returns of 538 bps relative to duration-matched U.S. Treasuries. This outperformance was concentrated early in the year and was driven by the sharp depreciation of the U.S. dollar (Chart 5). With the market still priced for a relatively modest 63 bps of Fed rate hikes during the next 12 months, further sharp dollar depreciation appears unlikely. We recommend an underweight allocation to Sovereign debt. We remain overweight Local Authority and Foreign Agency bonds, sectors that delivered excess returns of 420 bps and 248 bps, respectively in 2017. Despite the outperformance, both of these sectors still offer attractive spreads after adjusting for credit rating and duration. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 15 bps and 17 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 28 bps and 42 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 99 bps in December and by 332 bps in 2017 (before adjusting for the tax advantage). The average Aaa Municipal / Treasury (M/T) yield ratio fell 5% in December, and is 12% below where it began 2017 (Chart 6). The recent decline follows a sharp increase that was driven by fluctuating supply trends related to the passage of U.S. tax legislation. The final tax bill ends the practice of advance refunding municipal bonds. As a result, December set a new high of $55.6 billion for municipal issuance as issuers rushed to get their advance refunding deals to market before the bill was passed (panel 3). Now that the bill has passed, visible supply has evaporated and the average M/T yield ratio has fallen back to one standard deviation below its post-crisis mean. The absence of advance refunding will bias municipal bond issuance lower in 2018, thus removing one potential risk for yield ratios. The M/T yield ratio for short maturity debt has risen considerably relative to the yield ratio for long maturity debt in recent months (panel 2), and the risk/reward trade-off now appears more balanced. We close our recommendation to favor long maturities versus short maturities on the Aaa Muni curve. The third quarter update of our Muni Health Monitor showed a slight improvement (panel 5), but still no clear reversal of trend. Although health remains supportive for now - and consistent with municipal upgrades outpacing downgrades - with yield ratios close to their lows we maintain an underweight allocation to Municipal bonds.  Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in December. The 2/10 Treasury slope flattened 13 bps on the month, and the 5/30 Treasury slope flattened 15 bps. The evolution of the Treasury curve in 2018 will come down to a trade-off between how quickly inflation rises versus how quickly the Fed lifts rates. For example, in a recent report we showed that the 10-year Treasury yield will likely settle into a range between 2.80% and 3.25% by the time that core PCE inflation reaches the Fed's 2% target.5 That same report shows that if that adjustment occurs relatively quickly, and the Fed has only lifted rates once or twice between now and then, then the 2/10 Treasury slope is much more likely to steepen than to flatten. Conversely, if the Fed lifts rates three or four more times between now and the time that inflation returns to target, then the curve is more likely to flatten. For our part, we think it is wise to maintain a position long the 5-year bullet and short a duration-neutral 2/10 barbell. Such a position profits from a steeper curve, and our model shows that the butterfly spread is currently priced for significant curve flattening (Chart 7). According to our model, the 2/5/10 butterfly spread is discounting 27 bps of 2/10 flattening during the next six months.6 In other words, if the 2/10 slope steepens or flattens by less than 27 bps, then our recommended position will profit. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 41 basis points in December, but underperformed by 43 bps in 2017. The 10-year TIPS breakeven inflation rate went on a wild ride last year. It started 2017 at 1.95% and, driven by strong inflation prints and continued post-election euphoria, reached as high as 2.09% in January. The breakeven dropped to a low of 1.66% in June, as inflation started to disappoint in the second quarter, but has rebounded during the past couple of months and just recently broke back above 2%. The 10-year TIPS breakeven rate is currently 2.02%, above where it began 2017. According to our TIPS Financial Model, the recent widening in breakevens is in line with the message from other related financial market instruments (Chart 8). Specifically, oil prices, the trade-weighted dollar and the stock-to-bond total return ratio. Further, measures of pipeline inflation pressure continue to signal an increase in inflationary pressures (panels 3 and 4), and the trimmed mean PCE shows that the realized inflation data are forming a tentative bottom (bottom panel). The annualized 6-month rate of change in the trimmed mean PCE ticked up to 1.68% in November, higher than the 12-month rate of change (1.67%). The 1-month rate of change is higher still at 2.19%, annualized. We continue to see signs that inflation will start to rebound in the coming months, and this will cause long-maturity TIPS breakeven inflation rates to reach a range between 2.4% and 2.5% by the time that inflation returns to the Fed's target. Remain overweight TIPS versus nominal Treasury securities. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities performed in line with the duration-equivalent Treasury index in December and outperformed by 92 basis points in 2017. In 2017, Aaa-rated ABS outperformed the Treasury benchmark by 79 bps and non-Aaa ABS outperformed by 217 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp in December, but tightened 21 bps in 2017. It now sits at 31 bps, only 4 bps above its all-time low (Chart 9). At 31 bps, Aaa-rated ABS now offer only a 3 bps spread advantage over Agency-backed MBS, and offer 11 bps less spread than Agency-backed CMBS. With consumer lending standards tightening and delinquency rates rising, we view no more than a neutral allocation to ABS as appropriate. On lending standards, the Fed's October Senior Loan Officer's Survey showed a continued tightening in lending standards on both credit cards and auto loans (panel 4), and also that demand for credit card and auto loans was essentially unchanged from the prior quarter. It also included a set of special questions regarding the reasons for changes in the supply and demand for consumer credit. Banks cited a less favorable or more uncertain economic outlook, a deterioration in existing loan quality and a general reduced risk tolerance as reasons for tightening the supply of credit. The hard data confirm that banks are seeing a deterioration in the quality of their consumer loan books (bottom panel). Although delinquencies remain depressed compared to history, with ABS spreads near all-time tights, rising delinquencies and tightening lending standards make for a poor risk/reward trade-off in the sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in December and by 201 bps in 2017. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps in December and 13 bps in 2017. At its current level of 64 bps, the index spread is about one standard deviation below its pre-crisis mean, and only 13 bps above its all-time low reached in 2004 (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in December and by 133 bps in 2017. The index option-adjusted spread for Agency CMBS tightened 3 bps in December and 13 bps in 2017. At its current level of 42 bps, the sector offers greater option-adjusted compensation than a position in Agency-backed MBS (28 bps) and Aaa-rated consumer ABS (31 bps). Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing.   Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.94% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.92%. PMIs across the world continue to surge. December PMI data show increases in the four largest economic blocs (U.S., Eurozone, China, Japan), and more broadly show that 86% of the 36 countries with available data currently have PMIs above the 50 boom/bust line. Meanwhile, bullish sentiment toward the U.S. dollar continues to trend lower in response to strong growth in the rest of the world (bottom panel). This is also a bearish development for U.S. bonds. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.48%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 12017 Bond Returns 2017 Bond Returns 2017 Bond Returns Treasuries sold off for the third consecutive month in November (Chart 1), and with Congress about to deliver tax cuts and core inflation showing signs of bottoming, the bond bear market is poised to shift into a higher gear. At the moment, the biggest upside risk for bonds is that the Fed continues its hawkish posturing but inflation refuses to comply. That combination would put downward pressure on TIPS breakeven inflation rates and cause the yield curve to flatten further. A flat yield curve increases the odds of a risk-off episode in equities and credit spreads, with a consequent flight into the safety of Treasuries. We do not think the Fed will get it wrong and expect TIPS breakevens to widen alongside rising inflation, easing the flattening pressure on the yield curve. Investors should maintain a below-benchmark duration stance and an overweight allocation to spread product on a 6-12 month investment horizon.   Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 3 basis points in November, dragging year-to-date excess returns down to 285 bps. The average index option-adjusted spread widened 2 bps on the month and now sits at 97 bps. Spreads gapped wider early in the month but then reversed course, ending November not far from where they began. In other words, investment grade corporate bonds remain extremely expensive. We calculate that Baa-rated spreads can only tighten another 39 bps before reaching the most expensive levels since 1989. This represents 3 months of historical average spread tightening. Corporate bonds are essentially a carry trade at this stage of the cycle, but should continue to deliver positive excess returns to Treasuries until inflation pressures mount and the credit cycle comes to an end. We expect the credit cycle will end sometime in 2018.1 Last week's profit data showed that our measure of EBITD increased at an annualized rate of 4% in Q3 (Chart 2), solidly above zero but significantly slower than the 12% registered in Q2. If corporate debt grows by more than 4% in the third quarter, our measure of gross leverage will tick higher (panel 4). As we have shown in prior reports, this would bring the end of the credit cycle closer.2 Quarterly corporate debt growth has averaged just under 6% (annualized) since 2012, so higher leverage in Q3 is likely (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* A Higher Gear A Higher Gear Table 3BCorporate Sector Risk Vs. Reward* A Higher Gear A Higher Gear High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 2 basis points in November, dragging year-to-date excess returns down to 578 bps. The index option-adjusted spread widened 6 bps on the month, and currently sits at 349 bps. Excess returns were negative in November for only the fourth month since spreads peaked in February 2016. In a recent Special Report we argued that last month's sell-off would prove fleeting, but also cautioned that excess returns are likely to be low between now and the end of the credit cycle.3 The report flagged five reasons why investors might be nervous about their high-yield allocations. The two most important being that spreads are very tight and the yield curve is very flat. Tight spreads imply that investors should not expect much in the way of further capital gains, insofar as much further spread tightening would lead to historically expensive valuations. In a baseline scenario where spreads remain flat, we forecast excess returns to junk of 246 bps (annualized) (Chart 3). An inverted yield curve signals that investors believe the Fed will be forced to cut rates in the future. This makes it an excellent indicator for the end of the credit cycle. When the yield curve is very flat investors are more inclined to view any negative development as a signal that the cycle is about to turn. This leads to more frequent sell-offs. A period of curve steepening led by higher inflation would mitigate the risk. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in November, bringing year-to-date excess returns up to 35 bps. The conventional 30-year zero-volatility MBS spread was flat on the month, as a 2 bps widening in the option-adjusted spread (OAS) was offset by a 2 bps decline in the compensation for prepayment risk (option cost). Agency MBS OAS continue to look reasonably attractive, especially relative to Aaa-rated credit. And with the pace of run-off from the Fed's balance sheet already well telegraphed, there is no obvious catalyst for further OAS widening. In addition, mortgage refinancings are unlikely to spike any time soon. This will ensure that nominal MBS spreads remain capped at a low level (Chart 4). If bond yields rise during the next 6-12 months, as we expect, then higher mortgage rates will be a drag on refinancings. However, as we showed in a recent report, even if rates move lower, the coupon and age distribution of outstanding mortgages has made refi activity much less sensitive to rates than in the past.4 All in all, with OAS more attractive than they have been for several years, Agency MBS are an alluring alternative for investors looking to scale back exposure to corporate bonds. We anticipate shifting some of our recommended spread product allocation out of corporate bonds and into MBS once we are closer to the end of the credit cycle, likely sometime in 2018. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 28 basis points in November, bringing year-to-date excess returns up to 221 bps. Foreign Agencies and Local Authorities outperformed the Treasury benchmark by 39 bps and 34 bps, respectively. Meanwhile, Sovereign bonds delivered a stellar 93 bps of outperformance. Domestic Agency bonds outperformed by 4 bps, while Supranationals underperformed by 1 bp. We continue to hold a negative view of USD-denominated Sovereign debt. Not only is valuation unattractive compared to similarly-rated U.S. corporate bonds (Chart 5), but historically, periods of sovereign bond outperformance have coincided with falling U.S. rate hike expectations.5 Our Global Fixed Income Strategy team flagged similar concerns in a recent Special Report on the merits of USD-denominated EM debt (both corporate and sovereign).6 The recent moderation in Chinese money and credit growth also heightens the risk of near-term Sovereign underperformance.7 We remain overweight Local Authorities and Foreign Agencies. Year-to-date, those sectors have delivered 256 bps and 402 bps of excess return, respectively, and continue to offer attractive spreads after adjusting for credit rating, duration and spread volatility. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 19 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio moved sharply higher in November, with short maturities bearing the brunt of the sell-off. But even after November's weakness, the average M/T yield ratio remains below its average post-crisis level, and long maturities continue to offer a significant yield advantage over short maturities. Both the Senate and House have already passed their own versions of a tax bill, which now just need to be reconciled before new tax legislation is signed into law. Judging from the two versions of the bill, the following will likely occur: The Muni tax exemption will be maintained, the top marginal tax rate will remain close to its current level, the corporate tax rate will be reduced substantially, the state & local income tax deduction will be at least partially eliminated, the tax exemption for private activity bonds might be removed, and advance refunding of municipal bonds will be outlawed or severely restricted. Last month's poor Muni performance was driven by a surge in supply (Chart 6), almost certainly issuers trying to get their advance refundings done before the passage of the final bill. Given that the other provisions in the bill should not have a major impact on yield ratios (any negative impact from lower corporate tax rates should be mitigated by stronger household demand stemming from the removal of the state & local tax deduction), this back-up in yield ratios could present a tactical buying opportunity in Munis once the bill is passed. Stay tuned.   Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in November, as investors significantly bid up the expected pace of Fed rate hikes but did not correspondingly increase their long-dated inflation expectations. The sharp upward adjustment in rate hike expectations means that investors are now positioned for 69 bps of rate hikes during the next 12 months (Chart 7). Similarly, the July 2018 fed funds futures contract is now priced for 52 bps of rate hikes between now and next July. Even if the Fed lifts rates in line with its dots, we would only see 75 bps of rate hikes between now and next July. Since there are strong odds that the Fed will proceed more gradually, this week we close our short July 2018 fed funds futures position for an un-levered profit of 21 bps. In a Special Report published last week, we presented several scenarios for the slope of the 2/10 yield curve based on different combinations of Fed rate hikes and future rate hike expectations.8 We also noted that the positive correlation between long-maturity TIPS breakeven inflation rates and the slope of the nominal 2/10 yield curve has remained intact this cycle. We conclude that the 2/10 slope will steepen modestly in the first half of 2018, before transitioning to flattening once TIPS breakevens level-off at a higher level. With the 2/5/10 butterfly spread now discounting some mild curve flattening (panel 4), investors should remain long the 5-year bullet versus the duration-matched 2/10 barbell.   TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 15 basis points in November, bringing year-to-date excess returns up to -84 bps. The 10-year TIPS breakeven inflation rate fell 2 bps on the month and, at 1.86%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. As was detailed in last week's Special Report, one of our key views for 2018 is that core inflation will resume its gradual cyclical uptrend, causing long-maturity TIPS breakeven inflation rates to return to their pre-crisis trading range between 2.4% and 2.5%.9 A wide range of indicators, such as our own Pipeline Inflation Indicator and the New York Fed's Underlying Inflation Gauge, already suggest that TIPS breakevens are biased wider (Chart 8). Even more encouragingly, both year-over-year core CPI and core PCE inflation have printed higher in each of the last two months. But even if inflation remains stubbornly low, we think any downside in long-maturity breakevens will prove fleeting. We are quickly approaching an inflection point where if inflation does not rise, the Fed will have to adopt a more dovish policy stance. A sufficiently dovish policy response would limit any downside in breakevens. According to our model, the 10-year TIPS breakeven inflation rate is currently trading in-line with other financial market variables - oil, the trade-weighted dollar and the stock-to-bond total return ratio (panel 2). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in November, bringing year-to-date excess returns up to 92 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps and non-Aaa ABS outperformed by 30 bps. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 3 bps on the month and, at 31 bps, it remains well below its average pre-crisis trading range. The value proposition in Aaa-rated ABS is not what it once was. At 31 bps, the average index OAS is only 1 bp greater than the average OAS for a conventional 30-year Agency MBS. Agency CMBS are even more attractive, offering an index OAS of 44 bps. Further, the credit cycle is slowly turning against consumer debt. Delinquency rates are rising, albeit off a very low base, but this has caused banks to start tightening lending standards on consumer credit (Chart 9). Tight bank lending standards typically coincide with wider spreads. Importantly, while lending standards are tightening they are not yet very restrictive in absolute terms. In response to a special question from the July 2017 Fed Senior Loan Officer's Survey, banks reported (on net) that lending standards are tighter than the midpoint since 2005 for subprime auto and credit card loans, but are still easier than the midpoint since 2005 for credit card and auto loans to prime borrowers. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in November, dragging year-to-date excess returns down to 180 bps. The index option-adjusted spread (OAS) for non-agency Aaa-rated CMBS widened 3 bps in November, but is still about one standard deviation below its pre-crisis average (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as quite unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 15 basis points in November, bringing year-to-date excess returns up to 112 bps. The index OAS for Agency CMBS tightened 2 bps on the month but, at 44 bps, the sector continues to offer an attractive spread pick-up relative to other low-risk spread product. The Aaa-rated consumer ABS OAS is only 31 bps, and the OAS on conventional 30-year Agency MBS is a mere 30 bps. Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.81% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.79%. The Global Manufacturing PMI edged higher once more in November, up to 54 from 53.5 in October. It is now at its highest level since March 2011. Meanwhile, sentiment toward the dollar remains significantly less bullish than it was in 2015 and 2016 (bottom panel). A higher PMI reading and less bullish dollar sentiment both lead to a higher fair value in our model. At the country level, both the Eurozone and Japanese PMIs ticked higher in November. The Eurozone PMI broke above 60 for the first time since April 2000. The U.S. and Chinese PMIs both moved modestly lower. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.39%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Update", dated October 10, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 6 Please see Global Fixed Income Strategy Special Report, "Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios", dated October 31, 2017, available at gfis.bcaresearch.com 7 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 1Fed Must Fall Behind The Curve Fed Must Fall Behind The Curve Fed Must Fall Behind The Curve Jerome Powell will assume the Fed Chairmanship at a critical juncture for monetary policy. Core PCE inflation is still well below the Fed's 2% target, and yet, the slope of the 2/10 Treasury curve is a mere 71 bps (Chart 1). Such a flat yield curve alongside such low inflation suggests that the market believes the Fed will tighten the yield curve into inversion before inflation even regains the Fed's target. That would be an unprecedented policy mistake that the new Chairman will seek to avoid at all costs. This means either inflation will soon rise, justifying the FOMC's median rate hike projections, or inflation will stay low and the Fed will be forced to take a dovish turn. Either way the Fed must "fall behind the curve" and start chasing inflation higher. The act of falling behind the inflation curve means that long-maturity TIPS breakevens are likely to widen, the yield curve will steepen and the policy back-drop will stay accommodative for spread product. We recommend positioning for all three of these outcomes. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in October, bringing year-to-date excess returns up to 288 bps. The average index option-adjusted spread tightened 6 bps on the month, and now sits at 97 bps. Two weeks ago we noted that there is simply not much room for investment grade corporate spreads to tighten.1 Looking at 12-month breakeven spreads shown as a percentile rank relative to history, we see that A-rated paper has only been more expensive than it is today 7% of the time. Baa-rated paper has been more expensive only 9% of the time (Chart 2).2 Further, we calculate that at current duration levels Baa-rated option-adjusted spreads can only tighten another 36 bps before the sector is more expensive than it has ever been. Similarly, A-rated spreads can tighten another 14 bps, Aa-rated spreads another 17 bps and Aaa-rated spreads another 7 bps. All this to say that corporate bonds are essentially a carry trade at this stage of the cycle. The important question is how much longer we can pick up the carry before a period of significant spread widening. With low inflation keeping monetary policy accommodative and accelerating profit growth putting downward pressure on leverage (bottom 2 panels), the carry trade appears safe for now (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Into The Fire Into The Fire Table 3B Corporate Sector Risk Vs. Reward* Into The Fire Into The Fire High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 51 basis points in October, bringing year-to-date excess returns up to 580 bps. The index option-adjusted spread (OAS) tightened 9 bps on the month, and currently sits at 339 bps. Based on our current forecast for default losses we calculate that, if junk spreads remain flat, high-yield excess returns will be 230 bps for the next 12 months. If spreads tighten by 100 bps we should expect excess returns of 606 bps, and if spreads widen by 100 bps we should expect excess returns of -145 bps (Chart 3). Given that the OAS for the high-yield index can only tighten another 139 bps before it reaches all-time expensive valuations, 606 bps is a fairly optimistic excess return projection. But equally, with inflation pressures still muted and monetary policy still accommodative, more than 100 bps of spread widening is also unlikely. Our base case forecast is that high-yield excess returns will be between 2% and 5% (annualized) on a 6-12 month investment horizon.3 In a recent report we noted that high-yield generally looks more attractive than investment grade after adjusting for differences in spread volatility between the two sectors.4 Specifically, we calculate that it will take 39 days of average spread tightening before B-rated bonds reach all-time expensive levels. The same calculation shows it will take 19 days for A-rated debt. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in October, bringing year-to-date excess returns up to 31 bps. The conventional 30-year zero-volatility MBS spread was roughly flat on the month, as was the option-adjusted spread (OAS) and the compensation for prepayment risk (option cost). Last month we upgraded Agency MBS from underweight to neutral, noting that OAS have become significantly more attractive during the past year, particularly relative to corporate credit (Chart 4). The spread widening likely resulted from the market pricing-in the impact of the Fed's balance sheet run-off. Now that the run-off has begun, and its future pace has been well telegraphed, its impact has probably also been fully priced. While OAS is the correct measure of MBS carry because it adjusts for expected losses due to prepayments, it is the change in the nominal spread that determines capital gains and losses. With that in mind, it is difficult to see a catalyst for significantly wider nominal MBS spreads on a 6-12 month horizon. The two factors that correlate most closely with nominal MBS spreads - credit spreads and mortgage refinancings - are likely to stay depressed (bottom panel). Higher mortgage rates would obviously prevent refinancings from rising. But we showed in a recent report that even if rates move lower the coupon and age distribution of outstanding mortgages has made refi activity much less sensitive to rates than in the past.5 Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to 193 bps. Sovereign bonds underperformed the Treasury benchmark by 5 bps on the month. Foreign and Domestic Agency bonds outperformed by 2 bps and 9 bps, respectively. Supranationals outperformed by 4 bps. The underperformance in Sovereigns was concentrated in Mexican debt, which sold off as the White House took a hard line on NAFTA negotiations. Local Authority bonds outperformed by 62 bps in October, bringing year-to-date excess returns up to 367 bps (Chart 5). Excess returns for Local Authority debt - mostly taxable municipal debt and USD-denominated Canadian provincial debt - have exceeded excess returns from Baa-rated corporate debt so far this year, despite the sector's average credit rating of Aa3/A1. In a recent report we looked at whether USD-denominated Emerging Market Sovereign debt is an attractive alternative to U.S. high-yield corporates.6 We observed that hard currency EM sovereigns and similarly rated U.S. corporate bonds offer almost exactly the same breakeven spread, and also that EM Sovereigns have been getting comparatively cheaper since early last year. Further, we observed that periods when EM Sovereigns outperform U.S. corporates tend to coincide with falling U.S. rate hike expectations, as measured by our 24-month fed funds discounter. At present, our 24-month discounter is at 74 bps, meaning the market expects less than three Fed hikes during the next two years. We anticipate a better opportunity to move into EM Sovereigns once U.S. rate hike expectations have adjusted higher. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in October (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 251 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged down in October and currently sits at 87%, still extremely tight relative to its post-crisis trading range. M/T yield ratios look much more attractive at the long-end of the curve (Chart 6), and we continue to recommend that investors extend maturity within their municipal bond allocations. Congress released its first draft of proposed tax legislation last week, and while it will certainly undergo some changes in the coming months, it appears as though it will not be very negative for municipal bondholders. Crucially, the top marginal personal tax rate remains unchanged at 39.6% and demand for munis should benefit from the removal of other deductions. A reduction of the corporate tax rate to 20% remains a risk, but that will likely be revised higher as the bill is re-written. Fundamentally, state & local government health improved sharply in Q3, with net borrowing likely falling to $157 billion from $211 billion in Q2, assuming that corporate tax revenues are unchanged (Chart 6).7 The rate of growth in state & local tax revenues now exceeds expenditures and that should put further downward pressure on borrowing in the coming quarters. However, a decline in state & local government borrowing is already reflected in historically tight M/T yield ratios. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in October alongside a sharp move higher in the expected pace of Fed rate hikes (Chart 7). The 2/10 Treasury slope flattened 8 bps and the 5/30 slope flattened 7 bps. The upward adjustment in rate hike expectations benefited our recommendation to short the July 2018 fed funds futures contract. That trade is now 13 bps in the money since it was initiated on July 10. Further, the July 2018 contract is still discounting fewer than two rate hikes between now and next July. If two more hikes are delivered by July our trade will earn an additional 5 bps. If three more hikes are delivered it will earn an additional 31 bps. In a recent report we discussed why the Fed must soon "fall behind the curve" on inflation and allow the yield curve to steepen.8 Essentially, unless the Fed starts to chase inflation higher it will soon invert the yield curve without having met its inflation goal. That would be a severe policy mistake. This means that either inflation must start to rise, or the Fed must slow its pace of rate hikes. Both scenarios lead to a steeper yield curve. We continue to position for a steeper curve via a long position in the 5-year bullet versus a short position in the 2/10 barbell. At the moment our model shows the 5-year bullet trading roughly in-line with its fair value, or alternatively that the 2/5/10 butterfly spread is priced for an unchanged 2/10 slope on a 6-month horizon.9 TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 33 basis points in October, bringing year-to-date excess returns up to -99 bps. The 10-year TIPS breakeven inflation rate rose 4 bps on the month but, at 1.86%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. As was pointed out on the front page of this report, the Fed must "fall behind the curve" on inflation if it wants to avoid a policy mistake. Our expectation is that this will occur because inflation will move higher in the coming months. The 6-month rate of change in trimmed mean PCE has already bounced off its lows (Chart 8) and pipeline measures of inflation are soaring (panels 3 & 4). However, even if inflation remains stubbornly low, we think any downside in long-maturity TIPS breakeven rates will prove fleeting. We are approaching an inflection point where if inflation does not rise the Fed will have to adopt a much more dovish policy stance. This should limit any downside in long-dated breakevens. As long as the Fed can maintain interest rates low enough for realized inflation to eventually recover to its target, then we anticipate that long-maturity TIPS breakeven rates will settle into a range between 2.4% and 2.5% by the time that occurs. According to our model, the 10-year TIPS breakeven inflation rate is currently trading in-line with other financial market variables - oil, the trade-weighted dollar and the stock-to-bond total return ratio (panel 2). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in October, bringing year-to-date excess returns up to 81 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps on the month, bringing year-to-date excess returns up to 71 bps. Non-Aaa ABS outperformed the benchmark by 32 bps, bringing year-to-date excess returns up to 176 bps. The index option-adjusted spread for Aaa-rated ABS tightened 5 bps in October and, at 33 bps, it remains well below its average pre-crisis trading range. We continue to favor credit cards over auto loans within Aaa-rated ABS, despite the modest additional spread pick-up available in autos (Chart 9). The main reason is that auto loan net losses have been trending steadily higher for several years while credit card charge-offs are still depressed (panel 4). However, even the credit card space is starting to see rising delinquency rates, albeit off a low base, and banks are tightening lending standards on both auto loans and cards (bottom panel). We expect that tight labor markets and solid income growth will prevent a surge in consumer delinquencies, but these are nonetheless troubling signals that bear monitoring. From a valuation perspective, with the 33 bps OAS offered from Aaa-rated Consumer ABS now only slightly higher than the 29 bps offered by Agency Residential MBS, we advocate a neutral allocation to consumer ABS. Further increases in delinquencies could warrant an eventual downgrade, stay tuned. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 71 basis points in October, bringing year-to-date excess returns up to 182 bps. The index option-adjusted spread (OAS) for non-agency Aaa-rated CMBS tightened sharply in October, from 74 bps to 65 bps. At current levels it is now one standard deviation below its pre-crisis average (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we view the risk/reward trade-off in non-Agency CMBS as quite unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 34 basis points in October, bringing year-to-date excess returns up to 96 bps. The index OAS for Agency CMBS tightened 6 bps on the month but, at 46 bps, the sector continues to offer an attractive spread pick-up relative to other low-risk spread product. The Aaa-rated consumer ABS OAS is only 33 bps, and the OAS on conventional 30-year Agency MBS is a mere 29 bps. Such an attractive spread pick-up in a sector that benefits from Agency backing is probably worth grabbing. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.69% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.67%. The Global Manufacturing PMI increased to 53.5 in October, its highest level in six-and-a-half years. Bullish sentiment toward the dollar also edged higher, but not by enough to prevent the fair value reading from our 2-factor Treasury model from climbing. Last month's fair value reading was 2.65%. The U.S. and Eurozone PMIs continued to trend up, while the Chinese PMI held flat. The Japanese PMI ticked down from 52.9 to 52.8. Most importantly, of the 36 countries we track 34 now have PMIs above the 50 boom/bust line. The global economic recovery has become incredibly broad based, a bearish development for U.S. Treasury yields. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 2 We use breakeven spreads to adjust for the changing duration of the index over time. We calculate the 12-month breakeven spread as option-adjusted spread divided by duration. We ignore the impact of convexity. 3 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Update", dated October 10, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 9 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Duration: Treasury yields likely have another 50-60 basis points of upside during this cycle, and at least for now their uptrend should not be constrained by unreasonably elevated economic expectations. Stay at below-benchmark duration. Economy & Inflation: GDP growth remains firmly entrenched above levels necessary to ensure that the unemployment rate continues to fall and inflation is pressured higher. Weakness in residential investment presents a risk to the view that above-trend growth will persist, but leading housing indicators suggest it will bounce back in the coming quarters. Municipal Bonds: State & Local government net borrowing declined in the third quarter, but the improvement is already reflected in historically tight Muni / Treasury yield ratios. Remain underweight municipal bonds. Feature Chart 1Discounting An Inflation Rebound Discounting An Inflation Rebound Discounting An Inflation Rebound In last week's report we pointed out that a flat yield curve is incompatible with core inflation so far below the Fed's target and that the bond market is fast approaching a day of reckoning where either inflation will rise quickly enough to justify the Fed's rate hike expectations, or those expectations will be revised lower.1 Meantime, the Treasury curve has been bear-steepening since early September, and the 37 basis point increase in the 10-year yield has been driven both by higher real yields and a higher cost of inflation compensation (Chart 1). This suggests that the market is pricing-in a rebound in inflation rather than a capitulation from the Fed. Yesterday's PCE inflation report didn't do much to justify those expectations, coming in at only 1.33% year-over-year, not far above the 1.30% reading from August. However, we have previously noted mounting evidence that we are past the worst of the inflation downtrend.2 This raises the question of how much higher Treasury yields can rise, and this is the question we tackle in this week's report. Data Surprises & Playing The Odds Longer run, the 10-year cost of inflation compensation (currently 1.88%) will likely settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's 2% target. Assuming that inflationary pressures are sufficiently strong for that outcome to be achieved with the Fed lifting rates at a pace of about 50 bps per year, then long-dated real yields should stay roughly flat. This means that the nominal 10-year Treasury yield can move another 50-60 bps higher before the end of the cycle. But in the meantime, depending on swings in the macroeconomic data, bonds could experience several playable rallies and sell-offs. Is there a way for us to get a handle on when those might occur? One way might be to examine the economic surprise index (ESI). This index tracks whether economic data are over- or under-shooting consensus expectations. In this way it is very much like a financial market price. It moves higher when the incoming data suggest a rosier outlook than is currently anticipated, but then falls once expectations become so bullish they can no longer be surpassed. This is exactly what happened at the beginning of the year when the 10-year Treasury yield peaked at 2.62% following an extended period of elevated data surprises (Chart 2). Chart 2Economic Surprises Are Mean Reverting Economic Surprises Are Mean Reverting Economic Surprises Are Mean Reverting More specifically, we observe that when the ESI ends a month above (below) the zero line, it is very likely that the 10-year Treasury yield increased (decreased) during that month (Chart 3). The same is also true for 3-month and 6-month investment horizons, although the correlation is less robust, particularly for values close to zero (Charts 4 & 5). It follows that if we know whether the economic data will surprise on the upside or on the downside in a given month, then we can predict whether Treasury yields will rise or fall. Chart 3Economic Surprise Index & ##br##1-Month Change In Yields How Much Higher For Yields? How Much Higher For Yields? Chart 4Economic Surprise Index & ##br##3-Month Change In Yields How Much Higher For Yields? How Much Higher For Yields? Chart 5Economic Surprise Index & ##br##6-Month Change In Yields How Much Higher For Yields? How Much Higher For Yields? Unfortunately that is not a very profound statement. It is similarly easy to decide how much to bet on a hand of blackjack if you already know what cards will be dealt. But while it is obviously impossible to predict whether data surprises will be positive or negative in a given month, much like a card counter in blackjack, a study of events that have just occurred can help us make inferences that tilt the odds in our favor. In other words, we know that the ESI is mean reverting. A long sequence of elevated readings means it is more likely to fall, and a long sequence of depressed readings means it is more likely to rise. We can even use an AR(3) model to quantify the extent of mean reversion in the index. Using monthly data we run a regression of the ESI on its three most recent lags and get the following result which explains 55% of the variation since 2003: How Much Higher For Yields? How Much Higher For Yields? Notice that the index is positively correlated to its reading from the prior month, but negatively correlated with its readings from two and three months ago. Let's now consider that the most recent reading from the ESI is 38.2. One month ago it was -7.9 and two months ago it was -23.1. Using our formula, our best prediction for where the surprise index will be next month is 39. This is still deep in positive territory, meaning that if the model is correct, Treasury yields will remain under upward pressure. More decisively, we conclude from our model that it is unlikely that investor expectations have become so elevated that markets are set up for disappointment. The Appendix to this report provides a reference table for different ranges of the surprise index based on the above formula. It can be used as a quick reference guide for predicting where the ESI is likely to fall next month based on its readings from the prior three months. Bottom Line: Treasury yields likely have another 50-60 basis points of upside during this cycle, and at least for now their uptrend should not be constrained by unreasonably elevated economic expectations. Stay at below-benchmark duration. Economy & Inflation No Signs Of A Slowdown Last week we learned that GDP grew at an annualized rate of 3.0% in the third quarter, well above the Fed's 1.8% estimate of trend. The number was boosted by strong contributions from inventory accumulation (+0.73%) and net exports (+0.41%), but even stripping out those more volatile components to focus on real final sales to domestic purchasers reveals that growth is firmly above trend (Chart 6). Above-trend GDP growth will ensure that the unemployment rate continues to decline, which in turn will ensure that inflation moves higher. The unemployment rate had come close to flattening off late last year as growth decelerated toward 1.8%, but has since started to fall more rapidly alongside the re-acceleration in GDP (Chart 6, bottom panel). In fact, we attribute this year's decline in inflation to last year's growth deceleration and expect inflation will soon follow GDP growth higher (Chart 7). Chart 6Growth Is Steady, And Well Above Trend Growth Is Steady, And Well Above Trend Growth Is Steady, And Well Above Trend Chart 7Inflation Lags Growth Inflation Lags Growth Inflation Lags Growth Considering the contributions from the more stable sources of growth, we observe the following (Chart 8): Consumer spending remains firm, still above its post-2010 average. Nonresidential investment is accelerating back toward its post-2010 average, following a period of weakness that was driven by the mid-2014 commodity price collapse. Leading capex indicators, such as new orders surveys, suggest the acceleration will continue. Residential investment is a source of concern. It had already decelerated to well below its post-2010 average even prior to the hurricanes that depressed its contribution to growth in Q3. We are not yet concerned that the weakness in residential investment will morph into a broader slowdown. In fact, it appears quite likely that residential investment will bounce back in the coming quarters. Growth in residential investment is correlated with changes in the inventory of outstanding homes (Chart 9). Typically, large slowdowns in residential investment are preceded by a big run-up in supply. But at the moment, supply continues to contract, whether or not we include the shadow inventory from properties that were foreclosed upon during the housing bust. This shadow inventory has mostly evaporated in any case (Chart 9, panel 3). Chart 8Housing Not Keeping Pace Housing Not Keeping Pace Housing Not Keeping Pace Chart 9Inventories Still Falling Inventories Still Falling Inventories Still Falling Further support for residential investment comes from homebuilder sentiment which remains very strong (Chart 9, bottom panel). Bottom Line: GDP growth remains firmly entrenched above levels necessary to ensure that the unemployment rate continues to fall and inflation is pressured higher. Weakness in residential investment presents a risk to the view that above-trend growth will persist, but leading housing indicators suggest it will bounce back in the coming quarters. An Improvement In State & Local Government Balance Sheets Assuming that corporate tax revenues were the same in Q3 as in Q2, we can estimate that state & local government net borrowing declined to $163 billion in the third quarter. This represents a substantial improvement from prior quarters, but one that has already been discounted in Municipal / Treasury (M/T) yield ratios (Chart 10). M/T yield ratios are extremely tight, even compared to average pre-crisis levels (Chart 11), and the unattractive valuation underscores our negative stance on the sector. However, at least for now, there are no signs of an imminent surge in state & local government net borrowing that could cause a credit premium to get priced into muni yields. Chart 10Less Borrowing Is In The Price Less Borrowing Is In The Price Less Borrowing Is In The Price Chart 11Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Until last quarter, growth in state & local current expenditures had been running consistently above growth in current revenues (Chart 12). However, the weakness in current revenues was mostly attributable to a slowdown in transfers from the federal government. When we look at growth in state & local government tax revenues only, we find that it is substantially outpacing expenditure growth (Chart 12, panel 2). Chart 12Tax Revenue Growth Greater Than Expenditure Growth Tax Revenue Growth Greater Than Expenditure Growth Tax Revenue Growth Greater Than Expenditure Growth The acceleration in transfers from the federal government that started in mid-2014 reflected the expansion of Medicaid under the Affordable Care Act. Now that most eligible individuals have signed up, we would expect growth in federal transfer payments to level-off. Unless legislation is passed to further curb transfers from the federal government, state & local borrowing should continue its decline in the coming quarters. Bottom Line: State & Local government net borrowing declined in the third quarter, but the improvement is already reflected in historically tight Muni / Treasury yield ratios. Remain underweight municipal bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Must Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com. Appendix Table 1 How Much Higher For Yields? How Much Higher For Yields? Table 2 How Much Higher For Yields? How Much Higher For Yields? Table 3 How Much Higher For Yields? How Much Higher For Yields? Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Tax Reform Is A Bear-Steepener Tax Reform Is A Bear-Steepener Tax Reform Is A Bear-Steepener The federal government provided some details about its tax reform proposal last week. Markets reacted immediately, once again starting to price-in the possibility of lower tax rates. A basket of high tax-rate stocks outperformed the S&P 500, although the relative price remains well below the highs reached in the immediate aftermath of the election (Chart 1). Bond markets have also been influenced by the "will they, won't they" tax reform drama. Since tax cuts at this relatively late stage of the economic cycle are widely expected to be inflationary, the slope of the yield curve steepens and long-dated TIPS breakevens widen whenever the passage of a tax bill seems more likely. Our political strategists expect that a tax bill will be passed by the end of Q1 2008, or by early Q2 at the latest.1 All else equal, this will bias TIPS breakevens wider and cause the Treasury curve to steepen. Even in the absence of significant tax legislation we think that TIPS breakevens will widen and the yield curve will steepen as inflation starts to pick up during the next few months. But any fiscal stimulus related to tax reform would certainly expedite the process. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 87 basis points in September, bringing year-to-date excess returns up to 234 bps. The average index option-adjusted spread tightened 9 bps on the month to reach 101 bps. Valuation looks increasingly stretched across much of the corporate bond universe. The 12-month breakeven spread for A-rated corporate bonds has dipped well below its mid-2014 trough and is approaching the minimum value witnessed in the early stages of prior Fed tightening cycles. The same measure for Baa-rated credits fell to 17 bps last month, almost exactly equal to its mid-2014 low. While spreads are somewhat expensive, recent data on profit and debt growth have been positive. We noted in last week's report2 that net leverage declined in the second quarter, breaking a streak of two consecutive increases (Chart 2). In addition, other credit cycle indicators such as the slope of the yield curve and C&I bank lending standards do not yet signal wider spreads. Further declines in leverage will depend on whether profit growth can sustain its recent strength (bottom panel). While some moderation is likely, as of now, our leading profit indicators - particularly the weak dollar and surging manufacturing PMI - suggest that growth will stay firm for the remainder of the year (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Return Of The Trump Trade Return Of The Trump Trade Table 3BCorporate Sector Risk Vs. Reward* Return Of The Trump Trade Return Of The Trump Trade High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 143 basis points in September, bringing year-to-date excess returns up to 526 bps. The index option-adjusted spread tightened 31 bps to end the month at 347 bps, 24 bps above the mid-2014 cycle low. After adjusting for expected default losses, we calculate that the junk index currently offers an excess spread of 213 bps. We would expect a default-adjusted spread at this level to translate into low, but positive, excess returns during the next year. A simple linear regression suggests those excess returns will be on the order of 100 to 200 bps (Chart 3), but with a fairly wide margin for error. The default-adjusted spread incorporates our estimate of default losses for the next 12 months. This estimate currently sits at 1.3%. The estimate is derived from the Moody's baseline forecast of a 2.7% default rate and our own estimate of a 51% recovery rate (bottom panel). The relatively benign default outlook is reinforced by the persistent environment of steady growth and low inflation. Last week's third estimate showed that second quarter GDP growth was 3.1%, well above most estimates of trend. Meanwhile, the St. Louis Fed Price Pressures Measure predicts only a 2% chance that inflation will rise above 2.5% during the next year (panel 3). This combo of steady growth and low inflation will ensure that Fed policy remains sufficiently accommodative to support high-yield bond returns. MBS: Upgrade To Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 35 basis points in September, bringing year-to-date excess returns up to 26 bps. The conventional 30-year MBS yield rose 10 bps in September, driven by a 19 bps increase in the rate component. This was partially offset by an 8 bps tightening of the option-adjusted spread (OAS), while the compensation for prepayment risk (option cost) narrowed 1 bp. OAS have widened considerably during the past few months. In all likelihood this has been in anticipation of the Fed starting to unwind its MBS portfolio. The result is that MBS no longer look expensive compared to Aaa-rated credit (Chart 4). With more attractive valuations and the Fed's schedule for balance sheet runoff now well known, we think the time is right to edge MBS exposure higher. After having sold the rumor of Fed balance sheet runoff, it is time to buy the news. Arbitrage between MBS and credit should limit how much MBS OAS can widen during the next 6-12 months, even in the face of higher MBS supply. Further, recent spread widening has been helped along by falling mortgage rates and rising refinancings. With Treasury yields and mortgage rates now poised to put in a bottom, refis will also roll over and lend support to the MBS trade (bottom panel). Government-Related: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to 181 bps. Sovereign bonds outperformed the Treasury benchmark by 93 bps on the month. Foreign Agencies and Local Authority bonds outperformed by 25 bps and 46 bps, respectively. Domestic Agency bonds outperformed by 1 bp and Supranationals outperformed by 3 bps. Year-to-date Sovereign bond outperformance has been spurred by dollar weakness, even though spread differentials are tilted firmly in favor of domestic U.S. credit (Chart 5). But with U.S. economic data just now starting to surprise to the upside, we think the tailwind from a weakening dollar is about to fade. Mexico is the single largest issuer in the Sovereign index, and appreciation in the peso versus the U.S. dollar has been a particularly important driver of Sovereign outperformance this year. However, our Emerging Markets Strategy team now believes that peso appreciation is overdone.3 Mexican growth has been supported by strong exports and a weak currency while domestic demand has been soft. Without a solid foundation from domestic demand, this year's currency appreciation will soon cause inflation to roll over and Mexican interest rates to fall. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 62 basis points in September (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 207 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged up from 84% to 86% in September, but it remains extremely tight relative to its post-crisis trading range (Chart 6). State & local government budgets dodged a bullet when the Graham-Cassidy healthcare reform bill was defeated last month. The bill included a block-grant provision for Medicaid that would have reduced federal government transfer payments, a significant source of state & local government revenue. Last week we also learned more specifics about the federal government's proposed tax reform legislation. While the lower tax rates in the proposal are obviously negative for M/T yield ratios, the impact should be somewhat offset by the elimination of tax deductions, the state & local income tax deduction in particular. Eliminating deductions makes the tax advantage in municipal bonds appear more attractive, irrespective of the tax rate. Most importantly, the municipal bond tax exemption itself appears safe. Of course, it will still be some time before we know the final details of tax reform, which our political strategists expect will be passed by the end of Q1 2018. With the plan still not finalized, M/T yield ratios near post-crisis lows look too complacent. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted higher in September and steepened out to the 5-year maturity point. The 2/10 Treasury slope steepened 7 bps and the 5/30 slope flattened 9 bps. The market brought a December rate hike back into focus last month following a somewhat stronger CPI inflation report and Fed Chair Janet Yellen's insistence that low inflation will prove transitory. Our 12-month fed funds discounter, which shows the market's expected change in the fed funds rate during the next 12 months, moved up to 40 bps from 19 bps. As discussed in last week's report,4 we tend to agree with Chair Yellen that inflation will soon follow growth indicators higher. The market implication of this thesis is that wider TIPS breakevens will lead to one last bout of curve steepening this cycle. We continue to position for curve steepening via a trade long the 5-year bullet and short a duration-matched 2/10 barbell. This trade has returned 16 bps since inception last December. At present, our fair value model shows that the 5-year bullet is slightly expensive on the curve (Chart 7). Or put differently, that the 2/5/10 butterfly spread is fairly priced for 2 bps of 2/10 curve steepening during the next 6 months.5 We think curve steepening will easily surpass this threshold and maintain our long 5-year, short 2/10 position. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in September, bringing year-to-date excess returns up to -131 bps. The 10-year TIPS breakeven inflation rate rose 8 bps on the month but, at 1.84%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. CPI beat expectations in August for the first time in several months and, as was discussed in a recent report,6 the bond market was quick to react to even a tentative sign that inflation might have troughed. The market's sensitivity should not be surprising. Leading pipeline indicators of inflation, such as the prices paid and supplier deliveries components of the ISM manufacturing index, suggest that inflation and TIPS breakevens are biased higher (Chart 8). Counter-acting some of the optimism on inflation was the slightly weaker-than-expected August PCE report. While trimmed mean PCE inflation did perk up on a month-over-month basis, the 6-month and 12-month rates of change continue to fall (bottom panel). The 2% inflation target is of utmost importance to the Fed. In our base case scenario there is sufficient inflationary pressure for this target to be achieved with a pace of rate hikes similar to the Fed's median projection. But if that turns out not to be the case, then the Fed will respond with a slower pace of hikes. Either way, long-maturity TIPS breakevens must move higher before the end of the cycle or the Fed will have failed. ABS: Cut To Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in September, dragging year-to-date excess returns down to 68 bps. Credit card and auto loan ABS both underperformed the duration-equivalent Treasury benchmark by 2 bps in September, pulling year-to-date excess returns down to 67 bps and 69 bps, respectively. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month to reach 39 bps. It remains well below its average pre-crisis level (Chart 9). At 39 bps, the Aaa-rated ABS spread is still 11 bps wider than the average option-adjusted spread for conventional 30-year agency MBS. However, as we observed in last week's report,7 delinquency rates for consumer credit (credit cards, auto loans and student loans) are rising, while mortgage delinquency rates continue to fall. This squares with the message from the Fed's Senior Loan Officer Survey which shows that lending standards are tightening for both credit cards and auto loans (bottom panel). While delinquencies appear to have bottomed, the charge-off rate in credit card ABS collateral pools remains near all-time lows. Meanwhile, net losses in auto loan ABS collateral pools are in a clear uptrend. We continue to prefer Aaa-rated credit card ABS over Aaa-rated auto loan ABS, but are wary that credit card charge-offs will also start to increase in the near future, albeit from very low levels. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in September, dragging year-to-date excess returns down to 110 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, but it remains well below its average pre-crisis level. Fundamentally, the commercial real estate space continues to be characterized by tightening lending standards and falling demand (Chart 10) and, outside of the multi-family sector, CMBS delinquencies are trending higher (panel 5). Against this back-drop, spreads are not wide enough to entice us. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to 62 bps. The average index option-adjusted spread for the Agency CMBS index widened 3 bps on the month to reach 51 bps. This compares favorably to the 39 bps offered by Aaa-rated consumer ABS and the 28 bps offered by conventional 30-year Agency MBS. Especially since multi-family delinquency rates remain very low. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.65% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.62%. The Global Manufacturing PMI held flat at 53.2 in September, while bullish sentiment toward the dollar crept higher. This caused our model's fair value to edge lower to 2.65% from 2.67%. The U.S., Eurozone and Japan all saw stronger PMIs in September. While China's PMI dipped slightly (from 51.6 to 51), it remains firmly above the 50 boom/bust line. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?", dated September 20, 2017, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, avail-able at usbs.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017, available at ems.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For further details on our fair value model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 1"Trump Trade" Progress Report "Trump Trade" Progress Report "Trump Trade" Progress Report One of our seven investment themes for 2017, published in a Special Report last December, is that the combination of strong U.S. growth and accommodative Fed policy creates a cyclical sweet spot in which risk assets will outperform. After last week's GDP revisions we now know that real growth averaged 2.1% in the first half of the year, solidly above the Fed's 1.8% estimate of trend. Meanwhile, weak inflation has caused markets to discount an exceptionally shallow path for Fed rate hikes - only 19 bps of rate hikes are priced for the next 12 months. This divergence between growth and inflation is reflected in Treasury yields. The real 10-year yield is 24 bps above its pre-election level, while the compensation for inflation protection is only 5 bps higher (Chart 1). Not surprisingly, the cyclical sweet spot has led corporate bonds to outperform duration-matched Treasuries by 296 bps since the election. The persistence of the cyclical sweet spot leads us to believe that last month's politically-driven spread widening should be seen as an opportunity to increase exposure to corporate bonds. Remain at below-benchmark duration and overweight spread product in U.S. fixed income portfolios. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in August, dragging year-to-date excess returns down to 146 bps. The average index option-adjusted spread widened 8 bps on the month to reach 110 bps. In last week's report,1 we demonstrated that to properly assess corporate bond valuations it is not sufficient to simply look at the average index spread. We need to adjust for the fact that both the average credit rating and duration of the index change over time. We also need to consider corporate spreads relative to other similar stages of the economic cycle, not relative to long-run averages. In this respect, considering the breakeven spread2 for each credit tier relative to where it traded in the early stages of prior Fed tightening cycles gives us the best sense of the value proposition in corporate bonds. At present, this analysis shows that while Aaa corporate spreads are expensive, the other investment grade credit tiers all appear fairly valued (Chart 2). Corporate profit data for the second quarter was released last week and showed a big jump in our measure of EBITD (panel 4). This makes it extremely likely that net corporate leverage declined in Q2. All else equal, this lengthens the window for corporate bond outperformance Table 3.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Cyclical Sweet Spot Rolls On The Cyclical Sweet Spot Rolls On Table 3BCorporate Sector Risk Vs. Reward* The Cyclical Sweet Spot Rolls On The Cyclical Sweet Spot Rolls On High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 67 basis points in August, dragging year-to-date excess returns down to 378 bps. The index option adjusted spread widened 26 bps to end the month at 378 bps, 55 bps above the mid-2014 cycle low. Back in March4 we tested a strategy of buying the High-Yield index relative to Treasuries whenever spreads widened by more than 20 bps in a single month, and then holding the trade for a period of one, two or three months. We found that this "buy the dips" strategy works very well when inflationary pressures are low, but performs poorly when inflation is high and rising. When inflation is low the Fed needs to support the recovery by adopting a more dovish posture whenever financial conditions tighten. With the St. Louis Fed Price Pressures Measure5 at only 6% (Chart 3), we expect a "buy the dips" strategy will continue to work for some time. In terms of valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6%, and an expected recovery rate of 49%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -9 bps. The conventional 30-year MBS yield fell 13 bps in August, driven by an 18 bps decline in the rate component. This was partially offset by a 4 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening of the option-adjusted spread (OAS). The Fed is likely to announce the run-off of its balance sheet when it meets later this month. For its part, the market has been pricing-in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments (Chart 4). In this sense, the Fed's commitment to proceed with balance sheet normalization no matter the outlook for the future pace of rate hikes is doubly negative for MBS spreads. OAS are biased wider as Fed buying exits the market, while low rates encourage faster prepayments and a higher option cost component of spreads. Going forward, the option cost component of spreads will decline as mortgage rates cease their downtrend, but OAS still appear too tight relative to trends in net issuance. Despite robust issuance so far this year and the Fed backing away as a buyer, the conventional 30-year MBS OAS remains well below its pre-crisis mean (panel 2). While MBS are starting to look more attractive, especially relative to Aaa credit (panel 3), we think it is still too soon to buy. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to 154 bps. The Foreign Agency and Local Authority sectors drove the index outperformance in August. Both beat the duration-matched Treasury benchmark by 12 bps. Sovereigns outperformed the benchmark by 3 bps, Supranationals outperformed by 1 bp, and Domestic Agency bonds underperformed by 2 bps. We took a detailed look at the Sovereign index in a recent report,6 both at the aggregate and individual country levels. At the aggregate level, the two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the U.S. dollar (Chart 5). At present, relative valuation is skewed heavily in favor of domestic U.S. credit (panel 2). Added to that, given downbeat Fed rate hike expectations, we view further dollar weakness as unlikely on a 6-12 month horizon. Taken together, we continue to favor U.S. credit over USD-denominated Sovereign debt. At the country level, we identified several countries where USD-backed debt appears attractive. We found that Finland, Mexico and Colombia all offer attractive spreads. However, the spread pick-up available in Mexican and Colombian debt is compensation for heightened exchange rate volatility. Finnish debt appears the most attractive on a risk/reward basis. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 40 basis points in August (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 144 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio held flat in August, and it remains extremely tight relative to its post-crisis trading range (Chart 6). The M/T yield ratio remains very low despite the fact that state & local government net borrowing continues to rise. Net borrowing increased to $209 billion in Q2, the highest level since the second quarter of last year. Further, the Trump administration appears to be finally tackling the issue of tax reform. While comprehensive tax reform is probably too ambitious, some form of corporate and personal tax cuts seems likely, probably in the first half of next year. Lower tax rates are obviously a negative for municipal bonds, but some of the negative impact could be offset if current tax deductions (such as the deduction of state & local income tax) are removed. All else equal, fewer available tax deductions elsewhere makes the tax exemption of municipal bonds look more attractive. Of course, the municipal bond tax exemption itself could also be threatened, but at least so far this appears less likely. The bottom line is that current M/T yield ratios are far too low given the looming risks of rising state & local government borrowing and looming federal tax cuts. Remain underweight. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull flattened in August. The 2/10 slope flattened 17 bps and the 5/30 slope flattened 2 bps. The market moved to discount an even shallower path for Fed rate hikes in August. At the end of July the market had expected 27 bps of rate hikes during the next 12 months, and that number has now fallen to 19 bps (Chart 7). Consequently, our recommendation to short the July 2018 fed funds futures contract has suffered. The position is now 17 bps in the red, but we continue to believe that the market's expected rate hike path is too benign. From current levels, a position short the July 2018 fed funds futures contract will return 35 bps if there are two hikes between now and next July and 61 bps if there are 3 hikes. We also continue to recommend a position long the 5-year bullet versus a duration-matched 2/10 barbell on the view that the Treasury curve will steepen as inflation and TIPS breakevens move higher. This position has earned 28 bps since initiation last December, but valuation is starting to look less attractive. Our butterfly spread model7 suggests that the 5-year bullet is now slightly expensive compared to the 2/10 barbell (panel 3). Or put differently, that the 2/10 Treasury slope will have to steepen by more than 20 bps during the next 6 months for our trade to earn a positive return. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 36 basis points in August, dragging year-to-date excess returns down to -169 bps. The 10-year TIPS breakeven inflation rate fell 6 bps on the month and, at 1.76%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Despite robust growth, extremely weak realized inflation has caused breakevens to tighten this year. Last week's July PCE release was yet another disappointment. The year-over-year core inflation rate fell from 1.51% to 1.41% and the year-over-year trimmed mean rate fell from 1.68% to 1.64% (Chart 8). However, measures of pipeline inflation pressure such as the supplier deliveries and prices paid components of the ISM Manufacturing survey point towards higher inflation. The supplier deliveries component increased from 55.4 to 57.1 in August (panel 4) while the prices paid component held firm at an elevated 62 (panel 3). Adding it all up, and incorporating the fact that employment growth should stay strong enough to maintain downward pressure on the unemployment rate, we think it is very likely that core inflation will soon reverse course and resume the steady uptrend that began in early 2015. TIPS breakevens will widen alongside. At present, our TIPS Financial model suggests that breakevens are trading in line with other financial market instruments (panel 2). In other words, there is no apparent mis-valuation in breakevens relative to other financial markets, and higher realized inflation is likely required before breakevens move sustainably wider. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in August, bringing year-to-date excess returns up to 71 bps. Aaa-rated ABS outperformed the benchmark by 10 bps in August, bringing year-to-date excess returns up to 63 bps. Meanwhile, non-Aaa ABS outperformed by 26 bps in August, bringing year-to-date excess returns up to 147 bps. Credit card ABS outperformed the Treasury benchmark by 10 bps in August, bringing year-to-date excess returns up to 69 bps. Auto loan ABS outperformed by 12 bps, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month, and remains well below its average pre-crisis level (Chart 9). At 36 bps, the option-adjusted spread for Aaa-rated ABS is now the same as the option-adjusted spread for conventional 30-year Agency MBS. Meanwhile, lending standards are now tightening for both auto loans and credit cards. Further, the New York Fed's Household Debt and Credit Report for the second quarter revealed that "flows of credit card balances into both early and serious delinquencies climbed for the third straight quarter - a trend not seen since 2009."8 While overall credit card charge-offs in ABS collateral pools remain low (panel 4), it is clear that the cyclical winds are shifting against consumer ABS. If the trends of tightening lending standards and rising delinquencies continue, then it will soon be time to reduce consumer ABS exposure, possibly shifting into Agency MBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in August, bringing year-to-date excess returns up to 116 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month, and is approaching one standard deviation below its average pre-crisis level (Chart 10). The combination of tightening lending standards and weaker demand for commercial real estate (CRE) loans (as evidenced by the Fed's Senior Loan Officer Survey) suggests that credit concerns are starting to mount in the CRE space. Meanwhile, CMBS delinquency rates have leveled-off during the past few months and remain much lower in the multi-family space (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to 79 bps. The average index option-adjusted spread for the Agency CMBS index held flat at 48 bps on the month. This compares favorably to the 36 bps offered by both Aaa-rated consumer ABS and conventional 30-year Agency MBS. Not only does the Agency CMBS sector continue to offer an attractive spread relative to both consumer ABS and Agency MBS, but its agency guarantee and concentration in the multi-family space (where delinquencies are still low) makes it look particularly attractive. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.67% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.68%. The Global Manufacturing PMI rose to 53.1 in August, from 52.7 in July, reaching a 75-month high (panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (bottom panel). Taken together, these two factors suggest that not only is global growth accelerating but that the global economic recovery is increasingly broad based. This is an extremely bond-bearish development. A broad based global recovery means that when U.S. data finally start surprising positively, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.16%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Policy Reflections", dated August 29, 2017, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the basis point widening required over a 12-month period before a corporate bond delivers losses relative to a duration-matched Treasury security. We assume no impact from convexity and calculate the breakeven spread as OAS divided by duration. 3 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 The Price Pressures Measure is a composite indicator which shows the percent chance that PCE inflation will exceed 2.5% during the next 12 months. 6 Please see U.S. Bond Strategy Weekly Report, "The Upside Of A Weaker Dollar", dated August 15, 2017, available at usbs.bcaresearch.com 7 For further details on our models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 8 https://www.newyorkfed.org/microeconomics/hhdc Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 1Too Close For Comfort Too Close For Comfort Too Close For Comfort The Fed is in the midst of tightening policy, but with inflation still below target it wants to ensure that overall policy settings remain accommodative. In the language of central bankers, the Fed wants to keep the real fed funds rate below its equilibrium level, the level that applies neither upward nor downward pressure to price growth. The equilibrium fed funds rate cannot be calculated with precision, but one popular estimate shows that policy settings are dangerously close to turning restrictive (Chart 1). While an announcement of balance sheet reduction is almost certain to occur next month, with the real fed funds rate so close to neutral, rate hikes are probably on hold until the gap widens. Higher inflation will widen the gap by causing the real fed funds rate to fall, and we are confident that core inflation will rise in the coming months (see page 11 for further details). This will permit the Fed to deliver more than the currently discounted 28 bps of rate increases during the next 12 months. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in July, bringing year-to-date excess returns up to 209 bps. The financial press is littered with stories highlighting extremely unattractive corporate bond valuations, but we think this storyline is exaggerated. In fact, the average spread on the Bloomberg Barclays corporate bond index is somewhat wider than is typically observed in the early stages of a Fed tightening cycle (Chart 2). We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 86 bps and traded in a range between 66 bps and 104 bps.1 Viewed in this context, the current spread of 102 bps looks somewhat cheap. That being said, corporate balance sheet health is worse than is typically seen during the early stages of a tightening cycle and this will limit spread compression from current levels. But all in all, excess returns to corporate bonds should be consistent with carry during the next 6-12 months, with higher inflation and tighter Fed policy being pre-conditions for material spread widening. In a recent report2 we showed that bank bonds (both senior and subordinate) still offer a spread advantage compared to other similarly risky sectors (Table 3). Banks also continue to make progress shoring up their balance sheets and the outlook for bank profits is starting to brighten. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* On Hold, But Not For Long On Hold, But Not For Long Table 3BCorporate Sector Risk Vs. Reward* On Hold, But Not For Long On Hold, But Not For Long High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in July, bringing year-to-date excess returns up to 448 bps. The index option-adjusted spread tightened 12 bps to end the month at 352 bps, 8 bps above the 2017 low. We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread almost in line with the average witnessed during other similar monetary environments. In contrast, the VIX index, which co-moves with junk spreads (Chart 3), is well below levels seen during the early stages of the prior two tightening cycles. The VIX currently sits at 10, and its historical range in similar monetary environments is between 11 and 17, with an average of 13.3 In this way, there would appear to be more room for investment grade corporate bond spreads to tighten than junk spreads, especially on a volatility-adjusted basis. Despite somewhat more stretched valuations than in investment grade, high-yield still offers reasonable compensation relative to expected defaults. At present, our estimated default-adjusted spread is 206 bps, only slightly below its historical average (panel 3). This is based on an expected default rate of 2.8% during the next 12 months and an expected recovery rate of 48% (bottom panel). MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in July, bringing year-to-date excess returns up to 4 bps. The conventional 30-year MBS yield declined 3 bps in July, as a small 1 bp increase in the rate component was offset by a 4 bps tightening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. Index OAS has been in a widening trend since bottoming at 15 bps last September (Chart 4). Since then, MBS have returned 43 bps less than duration-equivalent Treasury securities. The Bloomberg Barclays Aaa-rated Credit index has outperformed Treasuries by 71 bps during that same timeframe. The back-up in OAS reflects, in large part, the market pricing in the upcoming wind-down of the Fed's balance sheet, set to be announced next month. However, we think OAS still have further to widen to catch up with the rising trend in net issuance. According to Flow of Funds data, net MBS issuance totaled $83 billion in the first quarter. If that pace continues for the rest of the year, then 2017 will be the strongest year for MBS issuance since 2009. While higher mortgage rates since the end of 2016 present a drag, at least so far, home sales have not shown much weakness (bottom panel). This is unlike the 2013 taper tantrum when home sales fell sharply following the surge in rates. We are underweight MBS on the expectation that the housing market will remain resilient in the face of higher rates, allowing issuance to continue its uptrend. However, we are closely tracking the spread advantage in MBS compared to Aaa-rated credit which is finally starting to look attractive (panel 3). Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to 149 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 81 bps and 112 bps, respectively. The low-beta Supranational and Domestic Agency sectors each outperformed by 5 bps. The Foreign Agency sector outperformed the duration-matched Treasury index by 56 bps. USD-denominated sovereign bonds have underperformed the Baa-rated U.S. Corporate index (their closest comparable in terms of risk) during the past three months even though the U.S. dollar has continued its trend lower (Chart 5). But despite this recent underperformance, the Sovereign index still does not offer a spread advantage over the Baa-rated U.S. Corporate index (panel 3). Further, while our Emerging Markets Strategy service still looks favorably upon the Mexican peso relative to other emerging market currencies, it does not expect the peso to continue its recent appreciation versus the U.S. dollar.4 We share this opinion, and expect the broad trade-weighted dollar to appreciate as U.S. growth rebounds in the back-half of the year.5 In our cross-sectional model, which adjusts spreads for credit rating and duration. Local Authorities and Foreign Agencies continue to look attractive compared to most U.S. corporate sectors. In contrast, the Sovereign and Supranational sectors appear expensive. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 38 basis points in July (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 186 bps year-to-date. The average Municipal / Treasury (M/T) yield ratio fell 2% in July, breaking below 85%. The average yield ratio remains extremely tight relative to its post-crisis trading range (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. Our early estimate, based on the recently released second quarter National Accounts data, shows that state & local government net borrowing probably moved higher in Q2 (panel 3), making the recent decline in yield ratios appear even more tenuous. The increase in net borrowing stems largely from a $21 billion drop in income tax revenues and a $20 billion decline in transfer receipts from the federal government. Income tax revenue should recover in the next two quarters,6 and we expect net borrowing will also start to decline. However, it is unlikely that net borrowing will fall by enough to justify current muni valuations. On July 6, the state House of Illinois overrode Governor Bruce Rauner's veto to finally pass a $36 billion budget. The move was sufficient for Moody's and S&P to both subsequently affirm the state's investment grade rating. The 10-year Illinois General Obligation bond yield declined 102 bps on the month, despite only a 1 bp drop in the 10-year Treasury yield. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull steepened in July. The 2/10 slope steepened 3 bps and the 5/30 slope steepened 10 bps. We currently recommend two tactical trades designed to profit from movements in the Treasury curve. First, we have been recommending a short position in the July 2018 fed funds futures contract since July 11.7 From current levels, we calculate this trade will deliver an un-levered return of 28 bps if there are two hikes between now and then, and 53 bps if there are three hikes. Our second recommendation is a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell, a trade designed to profit from a steepening of the 2/10 yield curve. It remains our view that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve. We expect the 2/10 slope to steepen as inflation rebounds during the next few months. Two weeks ago we published a Special Report 8 that explained our rationale for taking views on the slope of the curve using butterfly trades. It also explained our butterfly spread valuation model, and how we use that model to determine how much steepening/flattening is currently discounted in the yield curve. According to our model, the curve is priced for 9 bps of 2/10 steepening during the next six months (Chart 7). Our recommended butterfly trade will earn positive returns if the curve steepens by more than that. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in July. The 10-year TIPS breakeven inflation rate rose 9 bps on the month and, at 1.8%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Core inflation has moved sharply lower since February, but the fact that our Phillips Curve model of core inflation has not rolled over makes us inclined to view the downtrend as transitory. Also, during the past few weeks we have seen some preliminary signs that inflation is on the cusp of rebounding. Year-over-year core PCE inflation ticked higher in June for the first time since January. The PCE diffusion index, which has a good track record capturing near-term swings in core PCE, moved sharply higher (Chart 8). The prices paid components of the ISM manufacturing and non-manufacturing surveys increased from 55 to 62 and from 52.1 to 52.7, respectively, in July. We expect stronger realized inflation will lead TIPS breakevens higher during the next few months. However, even in a scenario where core inflation fails to rebound, the downside in breakevens from current levels is limited. The reason is that if inflation remains very low, the Fed will most likely refrain from hiking rates in December. Such a dovish capitulation from the Fed would put upward pressure on breakevens at the long-end of the curve. We discussed this possible scenario in more detail in a recent report.9 ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in July, bringing year-to-date excess returns up to 59 bps. The index option-adjusted spread for Aaa-rated ABS held flat on the month, and remains well below its average pre-crisis level. The Federal Reserve released its Q2 Senior Loan Officer Survey last week. It showed that credit card lending standards moved back into "net tightening" territory after having eased the previous quarter (Chart 9). Auto loan lending standards tightened on net for the fifth consecutive quarter. Tightening lending standards are usually a response to deteriorating credit quality, and thus tend to correlate with higher losses and wider spreads. In that regard, net loss rates for auto loans continue to trend higher, and Moody's data show that the cumulative loss rate for prime auto loans originated in 2017 is worse than for any vintage since 2009, for loans with the same age. Conversely, the mild tightening in credit card lending standards has so far not translated into rising charge-offs (Chart 9), but the situation bears close monitoring. For now, we are content to remain overweight ABS given the attractive spread pick-up compared to other similarly risky sectors. However, we also recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans, even though auto loans now once again offer an attractive spread differential, after adjusting for differences in duration and spread volatility (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 39 basis points in July, bringing year-to-date excess returns up to 96 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month, and remains below its average pre-crisis level. The Fed's Q2 Senior Loan Officer Survey showed that lending standards for all classes of commercial real estate (CRE) loans tightened, on net, for the eighth consecutive quarter. The survey also reported that demand for CRE loans is on the decline (Chart 10). The combination of tighter lending standards and weak loan demand suggests that credit concerns continue to mount in the private CMBS space. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 11 basis points in July, bringing year-to-date excess returns up to 65 bps. The average option-adjusted spread for the Agency CMBS index held flat on the month but, at 49 bps, the sector continues to look attractive compared to other similarly risky alternatives.10 Not only does the sector offer attractive spreads, but the agency guarantee and the lower delinquency rate in multi-family loans compared to other CRE loans (panel 5) makes its risk/reward profile particularly appealing. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.62% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.63%. The U.S. PMI bounced back in July, after having trended lower for most of this year. The Chinese PMI also increased last month, while the Eurozone reading moderated somewhat from a very high level (panel 4). Overall, the Global PMI came in at 52.7 in July, up from 52.6 in June. Bullish sentiment toward the U.S. dollar has also fallen sharply in recent weeks (bottom panel). Bearish dollar sentiment in an environment of expanding global growth sends a very bond-bearish signal. It means that the entire world is participating in the global expansion and any increase in Treasury yields is less likely to be met with an influx of foreign buying. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.26%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Range calculated using monthly data, specifically the final day of each month. 2 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 3 Ranges for junk spread and VIX calculated using monthly data, specifically the final day of each month. 4 Please see Emerging Markets Strategy Weekly Report, "The Case For A Major Top In EM", dated July 12, 2017, available at ems.bcaresearch.com 5 Mexico carries the largest weight in the Sovereign index, accounting for 23% of market cap. 6 Please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 1Too Pessimistic On Growth Too Pessimistic On Growth Too Pessimistic On Growth Treasury yields bounced sharply last week and the yield curve steepened. As a result the Bloomberg Barclays Treasury index posted a negative return in June, only the second month of negative Treasury returns so far in 2017. Last week's increase in yields could signal that growth expectations have finally become overly pessimistic. Our U.S. Investment Strategy service has calculated that after the U.S. Economic Surprise Index rises above 40, its average peak to trough decline lasts 90 days. Given that the surprise index peaked above 40 in mid-March, a bottoming-out in the coming weeks would be right on schedule (Chart 1). Net speculative positioning in the futures market has also capitulated, swinging sharply from net short to net long. In recent years, extreme net long positioning has led to higher Treasury yields during the following three months (bottom panel). Our assessment is that U.S. growth will remain above trend for the remainder of the year, and the Treasury curve will continue to bear-steepen as the economic data start to outperform downbeat expectations. Stay at below-benchmark duration, in curve steepeners, overweight spread product versus Treasuries, and overweight TIPS versus nominals. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 50 basis points in June. The index option-adjusted spread tightened 4 bps to end the month at 109 bps. Though below its historical mean, the investment grade spread is actually somewhat elevated compared to the early stages of prior Fed tightening cycles (Chart 2). We calculate that in the early stages of the past two tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 90 bps and traded in a range between 66 bps and 107 bps. While spreads are currently more attractive than is typical for this stage of the cycle, there is good reason for investors to demand some extra risk premium. In a recent report1 we observed that non-financial corporate debt as a percent of GDP is already as high as it was during the past two recessions. Further, the majority of this debt has been issued to finance direct payments to shareholders (dividends & buybacks) as opposed to capital investment. This unfavorable shift in corporate capital structures means that bond investors should demand somewhat greater compensation. All in all, we do not see potential for much spread tightening from current levels. However, a large spread widening would be equally unlikely given the favorable back-drop of steady growth and muted inflation. Small positive excess returns, consistent with carry, remains the most likely scenario. Energy debt underperformed duration-matched Treasuries by 12 bps in June. The sector still looks cheap after adjusting for credit rating and duration (Table 3), and our commodity strategists remain bullish on oil. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Inflection Point? Inflection Point? Table 3BCorporate Sector Risk Vs. Reward* Inflection Point? Inflection Point? High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 35 basis points in June. The index option-adjusted spread widened 1 bp to end the month at 364 bps, 20 bps above its 2017 low. Energy sector spreads widened sharply in June, alongside falling oil prices, once again de-coupling from the overall index spread (Chart 3). Junk-rated energy credits underperformed the duration-equivalent Treasury index by 190 bps in June, while the High-Yield index excluding energy outperformed by 70 bps. In a report published today,2 our Energy Sector Strategy service takes a detailed look at credit risk among high-yield energy issuers, concluding that while the worst of the energy bankruptcy cycle is behind us, $23 billion of high-yield energy debt remains in distress. 91% of that distressed debt is in the Exploration & Production and Offshore Drilling & Transportation sectors. The continued moderation in energy sector defaults will ensure that the overall speculative grade default rate trends lower for the rest of the year, probably settling below 3% (bottom panel). The decline in defaults means that the current compensation offered by junk spreads in excess of expected default losses stands at 221 bps, right in line with its historical average (panel 3). In last week's report,3 we showed that a default-adjusted spread of 221 bps is consistent with excess returns close to 150 bps during the next 12 months. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 20 basis points in June, dragging year-to-date excess returns down to -20 bps. The conventional 30-year MBS yield rose 11 bps on the month, driven by a 7 bps increase in the rate component and a 6 bps widening of the option-adjusted spread (OAS). This was partially offset by a 2 bps decline in the compensation for prepayment risk (option cost). In last week's report,4 we examined the risk/reward trade-off in different Aaa-rated spread products. We found that despite some recent widening in MBS OAS, you still need to move into 4% coupons or higher to find competitive spreads relative to Aaa-rated corporates, consumer ABS, agency CMBS and non-agency CMBS. Further, MBS OAS are still too tight compared to the trend in net issuance (Chart 4), and even though depressed refi activity will continue to hold down the option cost component of spreads, it is unlikely that a lower option cost will be able to completely offset wider OAS during the next 12 months. The Fed released more details about its balance sheet run-off plan at the June FOMC meeting. We now know that the Fed will start by allowing only $4 billion of MBS per month to run off its balance sheet, but this cap will increase by $4 billion every 3 months until it reaches $20 billion per month. This means that even if the Fed starts to wind down its balance sheet following the September meeting, which is our base case expectation, then it will still be some time before a significant amount of extra supply shifts into the private market. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 21 basis points in June, bringing year-to-date excess returns up to +107 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 65 bps and 73 bps, respectively. The low-beta Supranational and Domestic Agency sectors outperformed by 2 bps and 10 bps, respectively. The Foreign Agency sector underperformed duration-matched Treasuries by 4 bps, alongside the dip in oil prices. A weakening U.S. dollar has led to the outperformance of USD-denominated sovereign debt so far this year. Year-to-date, the Sovereign index has outperformed the duration-equivalent Treasury index by 300 bps. This is better than the equivalently-rated Baa U.S. Corporate index, which has outperformed by 195 bps year-to-date. However, there are already signs that the trade-weighted dollar is starting to moderate its downtrend (Chart 5), and we expect the trade-weighted dollar will strengthen as the economic data surprise to the upside in the back half of the year, as discussed on the first page of this report. Granted, the Mexican peso continues to strengthen versus the dollar (panel 3) and this currency pair is particularly important since Mexico is the largest issuer in the Sovereign index. On the heels of its recent outperformance, the Sovereign sector once again looks expensive compared to U.S. corporate sectors, after adjusting for credit rating and duration. Meanwhile, the Local Authority and Foreign Agency sectors continue to look cheap. Supranationals and Domestic Agencies offer very little additional compensation relative to Treasuries, and as we discussed last week,5 there are better options available for investors in need of high-quality spread product. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 18 basis points in June (before adjusting for the tax advantage). Last month we observed that Municipal / Treasury (M/T) yield ratios had become very tight, and we advised reducing municipal bond exposure to underweight. The average M/T yield ratio ticked higher in June, but at 85%, it remains more than one standard deviation below its post-crisis average (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. The National Association of State Budget Officers recently released its Fiscal Survey of the States and it showed that overall general fund expenditures are expected to increase by only 1% in the 2018 fiscal year, the slowest rate of growth since 2009/10. Meanwhile, 23 states have already enacted mid-year budget cuts in 2017. Budget cutting measures are clearly a response to disappointing tax revenues, which should bounce back somewhat in fiscal year 2018.6 This will help reduce net borrowing, though probably not by enough to justify current municipal bond valuations (panel 3). The state of Illinois avoided a ratings downgrade to junk this week, as the State House of Representatives voted to approve an income tax increase. This measure will keep the rating agencies at bay for now, but a downgrade is still possible in the coming months if the state fails to pass a budget for fiscal year 2018. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened for most of June, before suddenly reversing course and bear-steepening late in the month. The 2/10 slope flattened 15 basis points between the end of May and June 26, and then steepened 15 bps between June 26 and the end of the month. All told, the 2/10 slope was unchanged in June, while the 5/30 slope flattened 17 bps. The abrupt transition from bull-flattening to bear-steepening was prompted by comments from European Central Bank (ECB) President Mario Draghi that suggested a much more hawkish bias from the ECB. Higher rate expectations in the rest of the world should put downward pressure on the U.S. dollar, and historically, bearish sentiment toward the U.S. dollar has led to a steeper U.S. yield curve (Chart 7, bottom panel). This correlation has not held up so far this year, and we suspect this is because a weaker dollar has not translated into higher U.S. inflation and inflation expectations, as it usually does. We have previously made the case that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve (panel 4).7 As such, we attribute the bulk of this year's curve flattening to disappointing core inflation which has dragged TIPS breakevens lower. This should reverse in the coming months.8 Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 86 basis points in June. The 10-year TIPS breakeven rate fell 8 bps on the month and, at 1.75%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. In a recent report9 we outlined three possible scenarios for Treasury yields between now and the end of the year based on the interaction between incoming inflation data and Fed policy. In our base case scenario inflation will start to rebound in the coming months, heeding the message from our Phillips Curve model (Chart 8), leading to wider TIPS breakevens and keeping the Fed on its current tightening path. Even if realized inflation remains depressed, the next most likely scenario is that the Fed will capitulate later this year and adopt a shallower expected rate hike path. Such a dovish reaction from the Fed would lend support to long-maturity breakeven wideners, even though real yields would decline. The least likely scenario, in our view, is one where realized inflation remains low but the Fed sticks to its hawkish rhetoric. This is also the scenario that would lead to the most downside in the cost of inflation protection. May PCE inflation data were released last Friday, with year-over-year core PCE decelerating from 1.50% to 1.39%, and trimmed mean PCE decelerating from 1.70% to 1.66% (panel 4). One bright spot is that our PCE Diffusion Index swung sharply into positive territory. Historically, this index has a strong track record signaling turning points in core inflation (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in June, bringing year-to-date excess returns up to +54 bps. The index option-adjusted spread for Aaa-rated ABS tightened 2 bps on the month, and remains well below its average pre-crisis level. Despite low spreads relative to history, in a recent report10 we showed that Aaa-rated ABS appear quite attractive compared to other Aaa-rated spread product. Specifically, Aaa consumer ABS offer greater compensation per unit of duration than Agency bonds, agency MBS and Aaa Credit. They offer similar compensation per unit of duration to Agency CMBS, but less than non-Agency Aaa CMBS. Within consumer ABS, auto loan-backed securitizations offer slightly greater compensation than the credit card-backed variety (Chart 9). However, we still prefer credit card ABS over auto loan ABS. While credit card charge-offs remain historically low, auto net loss rates are rising. Auto lending standards also moved deeper into "net tightening" territory in the first quarter, according to the Fed's Senior Loan Officer Survey, while credit card lending standards dipped back into "net easing" territory (bottom panel). We continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans within an overall overweight allocation to consumer ABS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to +57 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 1 bp on the month, and remains below its average pre-crisis level (Chart 10). In last week's report,11 we showed that non-agency CMBS offer by far the most compensation per unit of duration of any Aaa-rated spread sector. However, we are concerned that non-agency CMBS spreads will widen on a 6-12 month horizon. Commercial real estate lending standards are tightening and property prices are decelerating. Both of these developments tend to correlate with wider spreads. Despite lower spreads, we are much more comfortable in the Agency CMBS market. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 4 basis points in June, bringing year-to-date excess returns up to +54 bps. Agency CMBS offer somewhat lower spreads than their non-agency counterparts, but this sector should be more insulated from spread widening in the months ahead. Not only do these securities benefit from agency backing, but they also mostly comprise multi-family loans. Multi-family property prices have been stronger than those in the retail and office sectors, and delinquencies have been lower (bottom 2 panels). Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.52% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.45%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound. The U.S. PMI has dipped lower in recent months, but remains firmly entrenched above the 50 boom/bust line. Meanwhile, the Eurozone PMI continues to surge ahead. China's PMI sent a worrying signal when it dipped below 50 in May, but it bounced back to 50.4 last month (bottom panel). Overall, the Global PMI came in at 52.6 in June, no change from the prior month. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.35%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 2 Please see Energy Sector Strategy Weekly Report, "HY Debt Update: Offshore Drilling & Transportation Getting Left Behind", dated July 5, 2017, available at nrg.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 For further details please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)