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Highlights Global: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US: The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out.  Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. Canada: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves.  Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. Feature After knocking on the door several times in recent weeks, global equity markets are finally enjoying a true breakout.  In the U.S., the S&P 500 is setting new all-time highs on a daily basis, while equities in Europe and emerging markets (EM) are also registering solid gains. There is no conflicting signal from global corporate credit markets where spreads remain stable, or from the volatility space with measures like the US VIX index hovering near the 2019 lows. Chart Of The WeekThings Are Looking Up Things Are Looking Up Things Are Looking Up Despite this positive price action, many remain skeptical that this “risk rally” is sustainable.  Just last week, a headline in the Financial Times declared that the “U.S. stock market’s new highs baffles investors”. We find that reluctance to accept the equity market strength to be even more baffling, as the current macro backdrop is a perfect “sweet spot” for risk assets to do well.  Global economic momentum is bottoming out, with improving leading indicators suggesting better days lie ahead for growth.  A majority of central banks worldwide have eased monetary policy over the past several months, providing a more supportive liquidity backdrop for financial markets.  The world’s most important central bank, the Federal Reserve, has delivered a cumulative -75bps of rate cuts since July, helping to cool off the US dollar, which is now flat on a year-over-year basis in trade-weighted terms (Chart Of The Week).  A softening dollar is also often a signal that global growth is improving, as it indicates a shift in capital flows into more economically-sensitive non-U.S. markets like Europe and EM.  Thus, a weaker greenback combined with better global growth prospects should help lift global bond yields by raising depressed inflation expectations (middle panel).  The “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. Yet with policymakers worldwide still playing the stimulus game, fearful of persistent negative impacts on growth from the U.S.-China trade dispute and other political uncertainties, it will take a large and sustained increase in inflation expectations before there is any shift to a more hawkish global policy bias.  This is critical for bond markets, as a much bigger move higher in global bond yields would require not just a pricing out of rate cut expectations, but the pricing in of future rate hikes. Such a repricing will not occur before there is clear evidence that global growth, broadly speaking, is accelerating for a sustained period and not just stabilizing in a few countries. The earliest we can envision such a hawkish shift for global monetary policy would be late in 2020, led by the Fed signaling a removal of some of the “insurance” rate cuts of 2019.  Until that happens, the “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. The Art Of Analyzing Economic Data At Turning Points Typically, at turning points in the global growth cycle, there are always data available to support the arguments of both optimists and pessimists. That is certainly the case today, where so-called “hard” economic data that is reported with a lag (i.e. exports, durable goods orders) remains weak, but leading indicators are starting to improve. For example, the global manufacturing PMI data for October released last week shows the following (Chart 2): strong pickup in China, with the Caixin manufacturing PMI now up to 51.7; slight improvement in the US ISM manufacturing index, which rose from 47.8 to 48.3 in the month but remains below the 50 boom/bust line; bounce in the U.K. Markit manufacturing PMI index, rising from 48.3 to 49.6; the slightest of increases in the overall euro area Markit manufacturing PMI, from 45.7 to 45.9, still below the 50 line but showing marginal improvement in the critical German PMI; Continued weakness in the Japanese Markit manufacturing PMI, which fell to 48.4. The relative message from the PMIs fits with the signals sent from the OECD leading economic indicators (LEI) for those same countries, with the China LEI strengthening the most and the LEIs in Europe and Japan still struggling. The US is a mixed bag, with the ISM ticking up but the LEI languishing. There is, however, a sign of optimism in the export sub-index of the ISM manufacturing data. That measure surged nine points in October from 41.0 to 50.4, signaling a potential bottoming of the overall ISM index within the next three months (Chart 3).  While the ISM exports index is volatile, the modest improvement seen in the export order series from the China manufacturing PMI over the past few months (bottom panel) suggests that there may be a more significant improvement in global trade activity brewing – as signaled by the improvement in our global LEI index. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Chart 2Global PMIs Are A Mixed Bag Global PMIs Are A Mixed Bag Global PMIs Are A Mixed Bag Chart 3Momentum Turning For The Trade Warriors? Momentum Turning For The Trade Warriors? Momentum Turning For The Trade Warriors? Bottom Line: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US Capital Spending Slowdown:  Only A Cautious Pause Chart 4Rising Uncertainty? Or Just Slowing Profit Growth? Rising Uncertainty? Or Just Slowing Profit Growth? Rising Uncertainty? Or Just Slowing Profit Growth? For growth pessimists in the US, a modest boost to “soft” data like the ISM does not allay their concerns about a broadening US economic slowdown. The trade war with China and the global manufacturing recession have had a clear negative impact on business confidence when looking at measures like the Conference Board CEO survey.  At the same time, US capital spending has contracted in real terms during the 2nd and 3rd quarter of 2019.  A logical inference would be to say that uncertainty over the trade war has led to a reduction in capex. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Like the fading impact of the 2018 U.S. corporate tax cuts (that helped trigger a surge in after-tax earnings growth) and the squeeze on profit margins from higher labor costs. On a year-over-year basis, US profit growth has slowed from nearly 25% in 2018 to 1.8% in the 3rd quarter (a projection based on the 76% of S&P 500 companies that have already reported).  The real non-residential investment spending category from the US GDP accounts has slowed alongside profits, from 6.8% to 1.3% on a year-over-year basis (Chart 4). At the same time, annual growth in US non-farm payrolls has slowed only modestly from 1.91% to 1.4%, with average hourly earnings growth falling from a 2019 peak of 3.4% to 3.0% in October. Given the tightness of the US labor market, with firms continuing to report difficulties in finding quality labor, it should come as no surprise that employment and wages have not slowed as much as capital spending, despite the sharp downturn in profit growth.  Businesses that see their earnings getting squeezed will seek to protect profits by cutting back on investment and hiring activity. With a tight labor market, however, cutting capital spending is an easier and less costly decision than laying off workers, as it may be even harder to re-hire those employees if the economy starts to improve once again. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer. That can also be seen when breaking down the US non-residential investment data into its broad sub-components (Chart 5).  On a contribution-to-growth basis, the only part of US investment spending that is outright contracting year-over-year is Structures. There is still modest positive annual growth in Equipment investment, although that did contract on a quarter-on-quarter basis in Q3/2019. The Intellectual Property Products category (which includes Software, in addition to Research & Development) continues to expand at a steady pace. Chart 5Slowing US Capex Focused On Structures How Sweet It Is How Sweet It Is Chart 6The Fed Has Dis-Inverted The UST Curve The Fed Has Dis-Inverted The UST Curve The Fed Has Dis-Inverted The UST Curve So similar to signals from global PMIs and LEIs, the U.S. capital spending and employment data are sending a mixed message about U.S. growth. Yes, capital spending has slowed but the bulk of the deceleration has come in the component where canceling or delaying investment plans is easiest – buildings and construction. It is not necessarily an indication that a deeper economic downturn is unfolding. Similar cutbacks in Structures investment, without a broader decline in overall capital spending, occurred in 2013 and 2015/16.  During the past two U.S. recessions in 2001 and 2008, however, all categories of capital spending contracted. If we look at the breakdown of the contribution to US investment spending today, the backdrop looks more like those non-recessionary years. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer (Chart 6).  The trade détente between the US and China will help boost depressed business confidence, especially with global growth already showing signs of bottoming out. This, along with a softer US dollar and some easing of wage pressures, will help put a floor underneath US corporate profit growth. Treasury yields have more upside from here, as markets are still priced for -25bps of Fed rate cuts over the next year that is unlikely to happen if the US economy rebounds, as we expect.  Bottom Line:  The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out.  Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. The Bank Of Canada’s Newfound Caution Is Unwarranted Chart 7Canada Is A High-Beta Bond Market Canada Is A High-Beta Bond Market Canada Is A High-Beta Bond Market The Bank of Canada (BoC) has been one of the few central banks to resist the shift towards easier global monetary policy in 2019.  This has resulted in Canadian government bonds trading at relatively wide yield spreads to other countries in the developed world, even as global growth has slowed in 2019 (Chart 7).  With global growth now set to improve over the next 6-12 months, Canada’s historic status as a “high yield beta” bond market during periods of rising global yields suggests that Canadian government bonds should underperform in 2020. However, in the press conference following last week’s policy meeting, BoC Governor Stephen Poloz noted that the BoC was “mindful that the resilience of Canada’s economy will be increasingly tested as trade conflicts and uncertainty persist.” Poloz even revealed that an “insurance” rate cut was discussed at the policy meeting, although the BoC Governing Council decided against it.  This is similar language to that parroted by the more dovish global central bankers over the past several months, raising the risk that Canada could be a lower-beta bond market if the Canadian economy falters. That outcome seems unlikely, given the indications of improving growth momentum, occurring alongside tight labor markets and stable inflation: The RBC/Markit Canadian manufacturing PMI has climbed from a trough of 49 in May to 51 in October, indicating that real GDP growth accelerated in Q3 (Chart 8, top panel); The BoC’s Autumn 2019 Business Outlook Survey (BoS) showed that an increasing share of firms are reporting labor shortages, coinciding with a sharp pickup in the annual growth rate of average weekly earnings to just over 4% (middle panel); Core inflation measures remain right at the midpoint of the BoC’s 1-3% target range, although breakeven inflation rates from Canadian Real Return Bonds remain closer to the bottom end of that range (bottom panel); After a long period of adjustment, house prices and housing activity are showing some signs of recovery in response to easier financial conditions, rising household incomes and improved affordability (Chart 9); Chart 8Resilience In Canadian Growth & Inflation Resilience In Canadian Growth & Inflation Resilience In Canadian Growth & Inflation Chart 9Canadian Housing Showing Improvement Canadian Housing Showing Improvement Canadian Housing Showing Improvement Canadian investment spending is set to pick up, as the Autumn 2019 BoS reported a modest improvement in overall business sentiment and an increase in capital spending plans with a growing number of firms facing capacity pressures (Chart 10). Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Chart 10Signs Of Life For Canadian Capex? Signs Of Life For Canadian Capex? Signs Of Life For Canadian Capex? Looking forward, reduced U.S.-China trade tensions should provide a boost to Canadian capex. Firms that had previously held off in the past few months due to the slowdown in the economy, caused partially by worries over global trade, will start to invest again. The BoC’s updated forecasts in the latest Monetary Policy Report released last week showed that the central bank expects Canadian exports to resume their expansion in 2020 – despite Governor Poloz’s stated concerns over global growth. Oil and gas exports are expected to improve as pipeline and rail capacity gradually expand, while consumer goods excluding automobiles should remain strong. Improvement in Chinese economic activity would provide a meaningful lift to Canadian exports, as Chinese imports from Canada are still contracting at a double-digit rate (Chart 11).  More importantly, Canadian exports to the country’s largest trade partner, the US, have already stabilized and should accelerate as the US economy gains momentum in the next 6-12 months. As Governor Poloz mentioned during the press conference, the BoC's decisions are not going to be directly influenced by political events such as Prime Minister Justin Trudeau’s recent re-election. Yet the odds of Canadian fiscal stimulus have shot up after Trudeau could only secure a minority government in the Canadian Parliament. Any fiscal stimulus is starting from a healthier place with the budget deficit currently at only -1% of GDP and the net government debt-to-GDP ratio falling towards a low 40% level (Chart 12).  Expected fiscal stimulus will provide an incremental boost to Canadian growth in 2020. Chart 11The Global Trade Slump Has Hurt Canada The Global Trade Slump Has Hurt Canada The Global Trade Slump Has Hurt Canada Chart 12Canada Can Afford A Fiscal Stimulus Canada Can Afford A Fiscal Stimulus Canada Can Afford A Fiscal Stimulus Net-net, the Canadian economy appears to be in good shape, with momentum starting to improve.  Inflation remains close to the BoC target, with rising pressures stemming from a tight labor market. This is not a backdrop that would be conducive to an “insurance” rate cut in December or even in early 2020.  Only -18bps of rate cuts over the next twelve months are discounted in the Canadian Overnight Index Swap (OIS) curve. Yet there is only a 16% chance of a -25bp cut expected at the December 2019 meeting, according to Bloomberg.  In other words, the markets are not taking the threat of a BoC rate cut seriously – a view that we agree with. Chart 13Stay Neutral On Canadian Government Bonds Stay Neutral On Canadian Government Bonds Stay Neutral On Canadian Government Bonds We suspect that Governor Poloz’s comments about a potential BoC policy ease were more designed to take some steam out of the strengthening Canadian dollar (Chart 13), which was threatening a major breakout going into last week’s BoC meeting.  We would be surprised if a rate cut was delivered at the December 2019 BoC meeting, but the dovish message sent last week does raise the possibility that the BoC could shock us. For now, we are choosing to stick with our neutral recommendation on Canadian government bonds, but we will re-evaluate after the December 4 BoC meeting. Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Bottom Line: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves.  Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. A Brief Follow Up To Our US MBS Versus IG Corporates Recommendation Chart 14Spread Targets Reached - Downgrade US IG To Neutral Spread Targets Reached - Downgrade US IG To Neutral Spread Targets Reached - Downgrade US IG To Neutral In last week’s report, we made the case for raising allocations to US Agency MBS while reducing exposure to higher-quality US investment grade (IG) corporate credit.1 We implemented the trade in our model bond portfolio, lowering our recommended allocation to US IG and increasing the weighting to US Agency MBS.  We now see a case for shifting to a formal strategic recommendation, upgrading US Agency MBS to overweight (a ranking of 4 out of 5 in the tables on page 14) and downgrading US IG to neutral (3 out of 5).  The rationale for the shift is based on valuation. Our colleagues at BCA Research US Bond Strategy calculate spread targets for each credit tier within US IG (Aaa, Aa, A and Baa). The targets are determined using a methodology that ranks the option-adjusted spread (OAS) of the Bloomberg Barclays index for each credit tier relative to its history, while controlling for the “phase” of the economic cycle as determined by the slope of the US Treasury yield curve.2 The latest rally in IG has driven the OAS for all tiers below those targets, with the Baa tier looking less expensive than the others (Chart 14).  As a result, we now advise only a neutral allocation to US IG corporates, with a preference for the Baa credit tier. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1Please see BCA Research Global Fixed Income Strategy Weekly Report, “Big Mo(mentum) Is Turning Positive”, dated Oct 29, 2019, available at gfis.bcaresearch.com 2For details on how those spread targets are determined, please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index How Sweet It Is How Sweet It Is Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1The Fed Must Remain Dovish The Fed Must Remain Dovish The Fed Must Remain Dovish Many were quick to label last week’s FOMC decision a “hawkish cut”. This is somewhat true in the near-term. The Fed lowered rates by 25 basis points while signaling that it doesn’t expect to have to cut more. But this focus on the near-term rate path misses the big picture. In the post-meeting press conference, Chairman Powell mentioned inflation expectations several different times. At one point, he called them “central” to the Fed’s framework and said “we need them to be anchored at a level that’s consistent with our symmetric 2 percent inflation goal.” As of today, the 5-year/5-year forward TIPS breakeven inflation rate is 1.69%, well short of the 2.3%-2.5% range that is consistent with the Fed’s goal (Chart 1). The Fed will take care to maintain an accommodative policy stance until inflation expectations are re-anchored. This will provide strong support for risk assets, and we recommend overweight positions in spread product versus Treasuries. We also expect that global growth will improve enough in the coming months for the Fed to keep its promise to stand pat. With the market still priced for 29 bps of cuts during the next 12 months, investors should keep portfolio duration low. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in October, bringing year-to-date excess returns up to +429 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is elevated and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The Fed’s Senior Loan Officer survey shows that C&I lending standards tightened in Q3 (bottom panel). We expect the Fed’s accommodative stance to push standards back into “net easing” territory in Q4. But if standards continue to tighten, it could indicate that monetary conditions are not as accommodative as we think. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are now below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Fed Will Stay Supportive The Fed Will Stay Supportive Table 3BCorporate Sector Risk Vs. Reward* The Fed Will Stay Supportive The Fed Will Stay Supportive High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield performed in line with the duration-equivalent Treasury index in October, keeping year-to-date excess returns steady at +621 bps. The junk index’s option-adjusted spread (OAS) has been fairly stable for most of the year, but the sector has become increasingly attractive from a risk/reward perspective.3 This is because the index’s negatively convex nature has caused its average duration to fall alongside declining Treasury yields. Chart 3 shows that while the index OAS has been rangebound, the 12-month breakeven spread has widened considerably.4 In other words, while junk expected returns have been stable, those expected returns now come with considerably less risk. As a result, the junk index OAS looks increasingly attractive relative to our spread target.5 Specifically, we now view the junk index OAS as 141 bps cheap (panel 3). Falling index duration also explains the divergence between quality spreads and the index OAS. Many have observed that the spread differential between Caa and Ba-rated junk bonds has widened in recent months, while the overall index OAS has been stable (panel 4). However, the divergence evaporates when we look at 12-month breakeven spreads instead of OAS (bottom panel). MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +3 bps. The conventional 30-year zero-volatility spread widened 4 bps on the month, as a 5 bps widening of the option-adjusted spread (OAS) was partially offset by a 1 bp decline in option cost (i.e. the expected losses from prepayments). This week we recommend upgrading Agency MBS from neutral to overweight, and in particular, we recommend favoring Agency MBS over corporate bonds rated A or higher. We have three main reasons for this recommendation.6 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 53 bps. This is above its pre-crisis average (Chart 4), and only 4 bps below the spread offered by a Aa-rated corporate bond. All investment grade corporate bond credit tiers also look expensive relative to our spread targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most people have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). 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 20 basis points in October, bringing year-to-date excess returns up to +183 bps. Sovereign debt outperformed duration-equivalent Treasuries by 38 bps on the month, bringing year-to-date excess returns up to +475 bps. Local Authorities outperformed the Treasury benchmark by 9 bps, bringing year-to-date excess returns up to +220 bps. Meanwhile, Foreign Agencies outperformed by 63 bps, bringing year-to-date excess returns up to +261 bps. Domestic Agencies underperformed by 2 bps in October, dragging year-to-date excess returns down to +40 bps. Supranationals underperformed by 8 bps on the month, dragging year-to-date excess returns down to +31 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to U.S. corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.7 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).8  Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 7 basis points in October, dragging year-to-date excess returns down to -64 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell almost 2% in October, and currently sits at 85% (Chart 6). We recently upgraded municipal bonds from neutral to overweight.9 The decision was based on the fact that yield ratios had jumped significantly. Yield ratios continue to look attractive relative to average pre-crisis levels, especially at the long-end of the Aaa curve (panel 2). Specifically, 2-year and 5-year M/T yield ratios are close to average pre-crisis levels at 73% and 77%, respectively. Meanwhile, M/T yield ratios for longer maturities are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 86%, 94% and 97%, respectively.   Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve steepened considerably in October, as short-dated yields came under downward pressure even as long-maturity yields edged higher. The 2/10 Treasury slope steepened 12 bps on the month, and currently sits at 17 bps. The 5/30 slope steepened 9 bps on the month, and currently sits at 66 bps (Chart 7). Last week’s report discussed the outlook for the 2/10 Treasury slope on a 6-12 month horizon.10 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 27 basis points in October, bringing year-to-date excess returns up to -64 bps. The 10-year TIPS breakeven inflation rate rose 1 bp on the month, and currently sits at 1.60%. The 5-year/5-year forward TIPS breakeven inflation rate fell 8 bps on the month, and currently sits at 1.69%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations is becoming increasingly stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.11 That being said, the 10-year TIPS breakeven rate is currently 32 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in October, dragging year-to-date excess returns down to +67 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month. It currently sits at 39 bps, 5 bps above its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive U.S. spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The same is true for the household interest expense ratio (panel 3). Senior loan officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in October, bringing year-to-date excess returns up to +233 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS was flat on the month. It currently sits at 73 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in October, bringing year-to-date excess returns up to +100 bps. The index option-adjusted spread was flat on the month, and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 29 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. The Fed Will Stay Supportive The Fed Will Stay Supportive The Fed Will Stay Supportive The Fed Will Stay Supportive Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuations: Raw Residuals In Basis Points (As Of November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 48 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 48 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Fed Will Stay Supportive The Fed Will Stay Supportive Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 4 The 12-month breakeven spread is the spread widening required to break even with a duration-matched position in Treasuries on a 12-month horizon. It can be approximated by OAS divided by duration. 5 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Two Themes and Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Equities & Bonds: The accelerating upward momentum of global equities – the ultimate “leading economic indicator” – suggests that the current rise in global bond yields can continue. Maintain below-benchmark overall duration exposure, while staying overweight global corporate credit versus government bonds. U.S. Agency MBS: U.S. agency MBS spreads are now attractive relative to high-quality U.S. corporate bonds, both in absolute terms and on a risk-adjusted basis. Increase allocations to agency MBS, while reducing exposure to Aaa-, Aa- and A-rated U.S. corporates. Feature The U.S. Federal Reserve and European Central Bank (ECB) are both set to ease monetary policy this week. The Fed is almost certain to deliver a third consecutive 25bp rate cut at tomorrow’s FOMC meeting, while the ECB will restart its bond buying program on Friday. Yet government bond yields around the world continue to drift higher, as markets reduce expectations of incremental rate cuts moving forward. Equity prices are an excellent leading indicator of global growth, while bond yields typically reflect current economic conditions. Thus, equity prices should be considered a leading indicator of bond yields. Chart of the WeekMore Upside For Global Bond Yields More Upside For Global Bond Yields More Upside For Global Bond Yields Yields are finally responding to the evidence that global growth is troughing - a dynamic that we have been telegraphing in recent weeks. Global equity markets are rallying, with the U.S. S&P 500 hitting a new all-time high yesterday. The year-over-year increase in global equities, using the MSCI World Index, is now at +10%, the fastest pace of upward acceleration seen since January 2017. Some of that rally in U.S. stock markets can be chalked up to 3rd quarter earnings beating depressed expectations. Yet there is also a forward-looking component of the rally that bond markets are starting to notice. Equity prices are an excellent leading indicator of global growth, while bond yields typically reflect current economic conditions. Thus, equity prices should be considered a leading indicator of bond yields. We see no reason to discount the positive message on growth from rallying equity markets, especially when confirmed by an improvement in our global leading economic indicator (LEI), led by the more cyclical emerging market (EM) countries (Chart of the Week). Falling stock prices in 2018 accurately heralded the global growth slowdown of 2019 which triggered the huge decline in bond yields. Why should rising stock prices not be interpreted in the same light, predicting better global growth – and higher bond yields – over the next 6-12 months? Multiple Signals Point To Higher Bond Yields The more optimistic message on growth is not only confined to developed market (DM) stock prices. EM equities and currencies have begun to perk up, with EM corporate credit spreads remaining stable, as well, mimicking the moves seen in U.S. credit markets. Bond volatility measures like the U.S. MOVE index of Treasury options are retreating to the lower levels implied by equity volatility indices like the U.S. VIX index, which is now just above the 2019 low (Chart 2). Markets are clearly pricing out some of the more negative tail-risk outcomes that prevailed through much of 2019. Some of that reduction in volatility can be attributed to the recent de-escalation of U.S.-China trade tensions and U.K. Brexit risks, both important developments that can help lift depressed global business confidence. A reduction in trade/political uncertainty should help fortify the transmission mechanism between easing global financial conditions and economic activity – an outcome that could extend the rise in yields given stretched bond-bullish duration positioning (Chart 3). Chart 2A More Pro-Risk Global Market Backdrop A More Pro-Risk Global Market Backdrop A More Pro-Risk Global Market Backdrop Chart 3Less Uncertainty = Higher Yields Less Uncertainty = Higher Yields Less Uncertainty = Higher Yields The improving global growth story remains the bigger factor pushing bond yields higher, though. While the manufacturing PMI data within the DM world remain weak, the downward momentum is starting to bottom out on a rate-of-change basis (Chart 4). The EM aggregate PMI index is showing even more improvement, sitting at 51 and above the year-ago level, helping confirm the pickup in EM equity market momentum (bottom panel). Importantly, if this is indeed the trough in the EM PMI, the index would have bottomed above the 2015 trough of 48.5. Given the improvement seen in “Big Mo” for global equities and global LEIs and PMIs, we remain comfortable with our current below-benchmark stance on global interest rate duration exposure.  Given the improvement seen in “Big Mo” for global equities and global LEIs and PMIs, we remain comfortable with our current below-benchmark stance on global interest rate duration exposure. How high could yields rise in the near term? Looking at yields on a country-by-country level, a reasonable initial target for yields would be a return to the medium-term trend as defined by the 200-day moving average (MA). For benchmark 10-year DM government yields, those targets are: U.S. Treasuries: the 200-day MA is 2.18%, +23bps above the current level German Bunds: the 200-day MA is -0.22%, +11bps above the current level U.K. Gilts: the 200-day MA is 0.89%, +17bps above the current level Japanese government bonds (JGBs): the 200-day MA is -0.10%, +2bps above the current level Canadian government bonds: the 200-day MA is 1.59%, -2bps below the current level Australian government bonds: the 200-day MA is 1.53%, +43bps above the current level Among those markets, the U.S. is likely to reach the level implied by the 200-day MA, led by the market pricing out the -53bps of rate cuts over the next twelve months discounted in the U.S. Overnight Index Swap curve (Chart 5) – a number that includes the likely -25bp cut tomorrow. A move beyond that 200-day MA may take longer to develop, as it would require markets to begin pricing in some reversal of the Fed’s “mid-cycle cuts” of 2019. That outcome would first require a pickup in TIPS breakevens. The Fed would not feel justified in risking a tightening of financial conditions by signaling rate hikes without the catalyst of higher inflation expectations. Chart 4EM Growth Leading The Way? EM Growth Leading The Way? EM Growth Leading The Way? Chart 5UST Yields Have More Upside UST Yields Have More Upside UST Yields Have More Upside German Bund yields are even closer to that 200-day MA than Treasuries but, as in the U.S., a sustained move beyond that level would require an increase in bombed-out inflation expectations, with the 10-year EUR CPI swap rate now sitting at only 1.05% (Chart 6). As for other markets, the likelihood of reaching, or breaching, the 200-day MA is more varied (Chart 7). Chart 6Bund Yield Upside Limited By Inflation Bund Yield Upside Limited By Inflation Bund Yield Upside Limited By Inflation The move in the Canadian 10-year yield to just above its 200-day MA fits with Canada’s status as a “high-beta” bond market, as we discussed in last week’s report.1 Chart 7Which Yields Will Test The 200-day MA? Which Yields Will Test The 200-day MA? Which Yields Will Test The 200-day MA? The Bank of Canada also meets this week and, while no change in policy is expected, the central bank will be publishing a new Monetary Policy Report that will update their current line of thinking about the Canadian economy and inflation. U.K. Gilts should easily blow through the 200-day MA if and when a final Brexit deal is signed, as the Bank of England remains highly reluctant to consider any policy easing even as political uncertainty weighs on economic growth. With the European Union now agreeing to an extension of the Brexit deadline to January 31, and with U.K. prime minister Boris Johnson now pursuing an early election in December, the political risk premium in Gilts will persist. Thus, Gilt yields will likely lag the move higher seen in higher-beta markets like the U.S. and Canada. JGBs remain the ultimate low-beta bond market with the Bank of Japan continuing to anchor the 10-yield around 0%, making Japan a good overweight candidate in an environment of rising global bond yields. Australian bond yields have the largest distance to the 200-day MA, but the Reserve Bank of Australia is giving little indication that it is ready to shift away from its dovish bias anytime soon, while inflation remains subdued. We do not expect a rapid jump in yields back towards the medium-term trend in the near term, and Australian yields will continue to lag the pace of the uptrend in the higher-beta global bond markets. Net-net, a climb in yields over the next 3-6 months to (or beyond) the 200-day MA is most likely in the U.S. and Canada, and least likely in Japan, Germany and Australia (and the U.K. until the Brexit uncertainty is finally sorted out). Bottom Line: The accelerating momentum of global equities – the ultimate “leading economic indicator” – is suggesting that the current rise in global bond yields can continue. Maintain below-benchmark overall duration exposure, while staying overweight global corporate credit versus government bonds. Raise Allocations To U.S. Agency MBS Out Of Higher Quality Corporate Credit Chart 8U.S. MBS More Attractive Than High-Rated U.S. Corporates U.S. MBS More Attractive Than High-Rated U.S. Corporates U.S. MBS More Attractive Than High-Rated U.S. Corporates Our colleagues at our sister service, BCA Research U.S. Bond Strategy, recently initiated a recommendation to favor U.S. agency MBS versus high-rated (Aaa, Aa, A) U.S. corporate bonds.2 This week, we are adding this position to the BCA Research Global Fixed Income Strategy recommended model bond portfolio. There are three factors supporting this recommendation: 1) The absolute level of MBS spreads is competitive The average option-adjusted spread (OAS) for conventional 30-year U.S. agency MBS – rated Aaa and with the backing of U.S. government housing agencies - is currently 57bps. That is only 3bps below the spread on Aa-rated corporates and 26bps below that of A-rated credit. (Chart 8). 2) Risk-adjusted MBS spreads look very attractive Agency MBS exhibit negative convexity, with an interest rate duration that declines when yields fall. The opposite is true for positively convex investment grade corporate bonds, where the duration rises as yields decrease. This makes agency MBS look attractive on a risk-adjusted basis after the kind of big decline in bond yields seen in 2019. The average duration of the Bloomberg Barclays U.S. agency MBS index is now only 3.4 compared to 7.9 for an A-rated corporate bond. Both of those durations were around similar levels at the 2018 peak in U.S. bond yields, but now the gap between them is large. With those new durations, it would take a 17bp widening of the agency MBS spread for an investor to see losses versus duration-matched U.S. Treasuries, compared to only an 11bp widening of the A-rated corporate spread (bottom panel). This is a big change in the relative risk profile of agency MBS versus high-rated U.S. corporates compared to a year ago, making the former look relatively more attractive. That was not the case the last time agency MBS duration fell so sharply in 2015/16, since corporate bond spreads were widening (getting cheaper) at that time. Today, corporate bond spreads have been stable as corporate duration has increased and agency MBS duration has plunged, making risk-adjusted MBS spreads more attractive. Given our view that U.S. Treasury yields will continue to grind higher, favoring lower duration assets like agency MBS over higher duration investment grade corporates makes sense. Given our view that U.S. Treasury yields will continue to grind higher, favoring lower duration assets like agency MBS over higher duration investment grade corporates makes sense. 3) Macro risks are reduced Mortgage refinancing activity remains the biggest macro driver of MBS spreads, particularly in an environment when mortgage rates are falling and prepayments are accelerating. There was a pickup in refinancing activity over the past year as mortgage rates fell, but the increase has been small relative to similar-sized rate declines in the past (Chart 9). We interpret this as an indication that, after the sustained period of low mortgage rates seen in the decade since the Great Financial Crisis, most homeowners have already had an opportunity to refinance. In other words, the so-called “refi burnout“ is now quite high. Chart 9Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Beyond refinancing, the other macro risks for agency MBS are subdued. The credit quality of outstanding U.S. mortgages remains solid. The median credit (FICO) score for newly-issued mortgages remains high and stable near the post-2008 crisis highs, while mortgage lending standards have mostly been easing over that same period according to the Federal Reserve Senior Loan Officers Survey. In addition, U.S. housing activity remains solid, with the most reliable indicators like single-family new home sales and the National Association of Home Builders activity surveys all up solidly following this year’s sharp drop in mortgage rates (Chart 10). This makes MBS less risky for two reasons: a) stronger housing activity typically leads to higher mortgage rates, which limits future refi activity; and b) more robust housing demand will boost home prices, the value of the underlying collateral for MBS securities. Chart 10U.S. Housing Activity Hooking Up U.S. Housing Activity Hooking Up U.S. Housing Activity Hooking Up Chart 11Relative Value Favoring U.S. MBS Over U.S. Corporates Relative Value Favoring U.S. MBS Over U.S. Corporates Relative Value Favoring U.S. MBS Over U.S. Corporates Given the improved risk-reward balance of agency MBS versus higher-quality U.S. corporates, we recommend that dedicated fixed income investors make this shift within bond portfolios, reducing allocations to Aaa-rated, Aa-rated and A-rated corporates while increasing exposure to agency MBS. Agency MBS is part of the investment universe of our model bond portfolio. Thus, we are increasing the recommended weighting of agency MBS while reducing the exposure to U.S. investment grade corporates in the portfolio. The changes can be seen in the table on Page 11. We do not split out the investment grade exposure by credit tier in the portfolio, as we prefer to allocate by broad sector groupings (Financials, Industrials, Utilities). So we cannot implement the precise “MBS for high-rated corporates” switch in the model portfolio. There is still a case for reducing overall investment grade exposure and adding to MBS weightings, however. The relative option-adjusted spread of agency MBS and investment grade corporates typically leads the relative excess returns (over duration-matched U.S. Treasuries) between the two by around one year (Chart 11). Thus, the compression of the spread differential between MBS and corporates over the past year is signaling that agency MBS should be expected to outperform the broad U.S. investment grade universe over the next twelve months. Bottom Line: U.S. agency MBS spreads are now attractive relative to high-quality U.S. corporate bonds, both in absolute terms and on a risk-adjusted basis. Increase allocations to agency MBS, while reducing exposure to Aaa-, Aa- and A-rated U.S. corporates. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “Cracks Are Forming In The Bond-Bullish Narrative”, dated October 23, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresarch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Big Mo(mentum) Is Turning Positive Big Mo(mentum) Is Turning Positive Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. Fed: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. Negative Convexity: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Feature Chart 1Positive Surprises Driven By The Hard Data Positive Surprises Driven By The Hard Data Positive Surprises Driven By The Hard Data The next two months are crucial for the U.S economy. Measures of sentiment, on both the business and consumer side, are sending recessionary signals. However, measures of actual economic activity paint a more benign picture (Chart 1). This divergence between the “hard” and “soft” data will likely resolve itself within the next couple of months, and the outcome of U.S./China trade negotiations will play a major part in determining whether that resolution is positive or negative. On the “Hard” And “Soft” Data There is a ton of economic data available to investors these days, but all of it can generally be classified as either “soft” or “hard”. We call measures of actual economic activity, such as housing starts or retail sales, “hard” data. These are the sorts of measures used to calculate a nation’s GDP. Alternatively, we use the term “soft” data to describe survey measures where firms or consumers are asked to describe whether activity is improving or deteriorating, or whether they are becoming more or less optimistic about the future. Some examples of soft data are PMI surveys and measures of consumer confidence. Both sorts of measures have value. Soft data are usually timelier and often lead the hard data. However, they are also more prone to whipsaws. The hard data tend to be more reliable, but don’t always provide enough lead time to be actionable. The soft and hard data are sending very different signals. At present, the soft and hard data are sending very different signals. On the consumer side, core retail sales are growing at the robust year-over-year pace of 4.8%, even though consumer confidence has declined during the past year (Chart 2). On the business side, the ISM manufacturing PMI survey came in at 47.8 in September, the lowest print since 2009. However, industrial production has fallen by only 0.1% during the past year. Industrial production growth got as low as -4% during the 2015/16 period, when the ISM was at a higher level (Chart 3). Similarly, actual orders for core durable goods have barely contracted, even though CEO confidence is at recessionary levels (Chart 3, panel 2). Capacity utilization also remains fairly strong, well above its 2016 low (Chart 3, bottom panel) Chart 2Hard Vs. Soft Data: On The Consumer Side Hard Vs. Soft Data: On The Consumer Side Hard Vs. Soft Data: On The Consumer Side Chart 3Hard Vs. Soft Data: On The Business Side Hard Vs. Soft Data: On The Business Side Hard Vs. Soft Data: On The Business Side Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. All measures of housing activity are growing strongly, a rapid snapback following last year’s weakness (Chart 4). Chart 4Housing Activity Summary Housing Activity Summary Housing Activity Summary Trade Negotiations Are Pivotal The soft data started to lag the hard data at around the same time as the Global Economic Policy Uncertainty index shot higher last year (Chart 5). This leads us to conclude that worries about the trade war’s negative consequences have caused sharp declines in measures of sentiment and confidence, even though the trade war’s actual impact on the hard data has been minor. This is what makes the outcome of November’s U.S./China trade talks so important. If an agreement is reached that makes it clear that no new tariffs will be implemented, we expect that would remove enough uncertainty for the soft data to improve, converging with the hard data. However, if things fall apart, then we would expect the negative survey data to eventually drag the hard data lower. Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. Our sense at the moment is that the looming 2020 U.S. election provides enough incentive for both sides to strike a deal, but the outcome could still go either way. Last Friday’s report from our Global Investment Strategy service discussed the outlook for trade negotiations in more detail.1 For bond investors, we are confident that a removal of trade uncertainty would lead to a rebound in important soft data measures such as the ISM manufacturing PMI and the CRB Raw Industrials index. Any increase in those measures would also send bond yields sharply higher. The ratio between the CRB Raw Industrials index and Gold continues to track the 10-year Treasury yield closely (Chart 6). Chart 5Trade War Worries Affecting ##br##Sentiment Trade War Worries Affecting Sentiment Trade War Worries Affecting Sentiment Chart 6Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bottom Line: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. The Fed Next Week The dichotomy between hard and soft data fits nicely with how the Fed has been describing the economic outlook for most of the year. That is, an economy who’s baseline outlook is favorable but that faces some downside risks. While that outlook doesn’t immediately suggest a policy response, low inflation expectations make it pretty clear what the Fed’s course of action will be during the next few months. The 5-year/5-year forward TIPS breakeven inflation rate is currently 1.68%, well below the 2.3%-2.5% range that is consistent with the Fed’s inflation target (Chart 7). What’s more, the median 3-year inflation forecast from the New York Fed’s Survey of Consumer Expectations just hit an all-time low (Chart 7, bottom panel). The Fed must take appropriate action to drive inflation expectations higher. At present, this means that it must ensure that financial conditions stay accommodative so that the economic recovery can continue. Eventually, continued economic recovery will lead to higher realized inflation (Chart 7, panel 2), and inflation expectations will follow realized inflation higher. Chart 7Low Inflation Expectations Equals Accommodative Fed Low Inflation Expectations Equals Accommodative Fed Low Inflation Expectations Equals Accommodative Fed In order to keep financial conditions accommodative, the Fed must at least match the market’s current rate cut expectations. An October rate cut is more or less fully priced, and it is therefore highly likely that the Fed will cut rates next week. After that, the market is pricing in roughly 50/50 odds of a fourth rate cut in December. But those expectations will certainly change as we learn the outcome of November’s trade talks and as the economic data roll in. Ultimately, we expect that enough good news will hit the wire between now and December that a fourth rate cut will be unnecessary. But the more important message is that, as long as inflation expectations are low, the Fed will not risk upsetting market expectations. Balance Sheet Update The Fed decided not to wait until next week to unveil its revamped balance sheet policy. It didn’t really have the luxury of time, given the turmoil in money markets that we discussed in a recent report.2 The main conclusion from our report is that the Fed must inject more bank reserves into the economy if it wants to maintain control of interest rates. This is exactly what the Fed will do going forward. It announced that it will purchase Treasury bills at least until the second quarter of 2020, starting at an initial pace of $60 billion per month. It will also continue to reinvest the proceeds from maturing Treasury notes/bonds and MBS into newly issued Treasury notes/bonds. Continued economic recovery will lead to higher realized inflation. Assuming the pace of $60 billion per month stays constant, and making some other assumptions about the growth rates of non-reserve liabilities, we project that the Fed’s actions will cause the supply of reserves to rise from $1.53 to $1.63 trillion by next June, and that its securities holdings will rise from $3.59  to $4.05 trillion (see Chart 8 and Table 1). Chart 8The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time Table 1Fed's Balance Sheet: Projections Crisis Of Confidence Crisis Of Confidence As we have argued in the past, now that the link between the Fed’s balance sheet and its interest rate policy has been severed, we see no investment implications from the Fed’s new balance sheet strategy. As per our Golden Rule of Bond Investing, changes in the fed funds rate relative to expectations will continue to drive bond yields.3 Since the Fed’s balance sheet strategy tells us nothing about its future interest rate plans, it should mostly be ignored. Bottom Line: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. A Good Time To Buy Negative Convexity We have repeatedly mentioned the attractiveness of high-yield bonds and Agency MBS during the past few weeks. The one thing those sectors have in common is that they are negatively convex. That is, unlike most fixed income instruments, their durations are positively correlated with yields. As a result, this year’s big drop in yields has led to large declines in duration for both high-yield and agency MBS (Chart 9). But despite this lower duration, junk spreads have remained relatively flat while MBS spreads have actually widened. In other words, expected return has not fallen even as the risk embedded in negatively convex securities has declined markedly. Chart 9Negatively Convex Products Are Attractive Negatively Convex Products Are Attractive Negatively Convex Products Are Attractive Last week we unveiled a new way of measuring risk for U.S. spread products.4 The Risk Of Losing 100 bps can be thought of as the number of standard deviations of annual spread change necessary for a sector to underperform duration-matched Treasuries by more than 100 basis points. A higher value means the sector is at a lower risk of losing 100 bps, and vice-versa. Chart 10 shows our new risk measure plotted against expected return for the investment grade and high-yield credit tiers, as well as for conventional 30-year Agency MBS. The y-axis shows each sector’s 12-month expected excess return, which we calculate as OAS less an adjustment for expected default losses. The x-axis shows the Risk Of Losing 100 bps. To put recent market moves in context, we show how each sector has moved within Chart 10 since spreads last troughed, about one year ago. Notice that last October, Ba and B rated junk bonds offered more expected return than Baa-rated corporates, with similar risk. Now, Ba and B offer a similar return advantage, but with much less risk. Caa-rated junk now strictly dominates the Baa sector in terms of risk and reward. Chart 10Risk-Reward Tradeoff Favors Negatively Convex Securities Crisis Of Confidence Crisis Of Confidence Turning to Agency MBS, we see again that the large fall in duration has led to a substantial risk reduction since last October. This is why we recently recommended upgrading Agency MBS at the expense of Aaa, Aa, and A corporates.5 Bottom Line: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Kumbaya”, dated October 18, 2019, available at gis.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Contagion? Contagion? Contagion? Until last week, global growth weakness had been wholly confined to the manufacturing sector. But the drop to 52.6 in September’s Non-Manufacturing PMI (from 56.4 in August) raises the specter of contagion from manufacturing into the broader U.S. economy. A further drop would be consistent with an economy headed toward recession, and run contrary to the 2015/16 roadmap that has been our base case (Chart 1). We think it is still premature to abandon the 2015/16 episode as an appropriate comparable for the current period. For one thing, the hard economic data paint a rosier picture than the PMI surveys. Industrial production and core durable goods new orders are up 2.5% and 2.3% (annualized), respectively, during the past 3 months. These data have helped drive the economic surprise index above zero, an event that usually coincides with rising yields (bottom panel). The divergence between soft and hard data makes it clear that trade uncertainties are so far having a greater impact on business sentiment than on actual production, but history tells us that these divergences don’t last long. Some positive news on the trade front will be required during the next few months to raise business sentiment and push bond yields higher. Stay tuned. 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 42 basis points in September, before giving back 37 bps in the first week of October. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions, and (iii) valuation. At present, the chief conundrum for investors is that while corporate balance sheet health is weak, the monetary environment is extraordinarily accommodative.1 On balance sheets, our top-down measure of gross leverage is elevated and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still very low, the Fed can maintain its “easy money” policy for some time yet. This will ensure that interest coverage stays solid and that bank lending standards continue to ease (bottom panel). This is an environment where corporate bond spreads should tighten. How low can spreads go? Our assessment of reasonable spread targets for the current environment suggests that Aaa, Aa and A-rated spreads are already fully valued, while Baa-rated spreads are 13 bps cheap (panels 2 & 3).2 We recommend focusing investment grade corporate bond exposure on the Baa credit tier, and subbing some Agency MBS into your portfolio in place of corporate bonds rated A or higher. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Crunch Time Crunch Time Table 3BCorporate Sector Risk Vs. Reward* Crunch Time Crunch Time High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in September, before giving back 117 bps in the first week of October. The junk index’s option-adjusted spread (OAS) has been fairly stable for most of the year, but the sector has become increasingly attractive from a risk/reward perspective.3 This is because the index’s negatively convex nature has caused its average duration to fall alongside declining Treasury yields. Chart 3 shows that while the index OAS has been rangebound, the 12-month breakeven spread has widened considerably.4 In other words, while junk expected returns have been stable, those expected returns now come with considerably less risk. As a result, the junk index OAS looks increasingly attractive relative to our spread target.5 Specifically, we now view the junk index OAS as 171 bps cheap (panel 3). Falling index duration also explains the divergence between quality spreads and the index OAS. Many have observed that the spread differential between Caa and Ba-rated junk bonds has widened in recent months, while the overall index OAS has been stable (panel 4). However, the divergence evaporates when we look at 12-month breakeven spreads instead of OAS (bottom panel). MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in September, before giving back 25 bps in the first week of October. MBS have underperformed Treasuries by 31 bps, year-to-date. The conventional 30-year zero volatility spread held flat at 82 bps in September, as a 3 bps increase in expected prepayment losses (option cost) was offset by a 3 bps tightening in the option-adjusted spread (OAS). In last week’s report, we recommended favoring Agency MBS over Aaa, Aa and A-rated corporate bonds.6 We have three main reasons for this recommendation. First, expected compensation is competitive. The conventional 30-year MBS OAS is now 57 bps. This is above the pre-crisis average (Chart 4), and only 4 bps below the spread offered by a Aa-rated corporate bond. Aaa, Aa and A-rated corporate bond spreads also all look expensive relative to our targets. Second, risk-adjusted compensation heavily favors MBS. The 12-month breakeven spread for a conventional 30-year MBS is 21 bps. This compares to 6 bps, 8 bps and 12 bps for Aaa, Aa and A-rated corporates, respectively. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most people have already had at least one opportunity to refinance their mortgage. This burnout will keep refi activity low, and MBS spreads tight (panel 2), going forward. 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 10 basis points in September, bringing year-to-date excess returns up to +163 bps. September returns were concentrated in the Foreign Agency sub-sector. These securities outperformed the Treasury benchmark by 55 bps on the month, bringing year-to-date excess returns up to +197 bps. Sovereign bonds underperformed duration-equivalent Treasuries by 6 bps in September, dragging year-to-date excess returns down to +436 bps. Local Authority and Domestic Agency debt underperformed by 1 bp and 2 bps on the month, respectively. Meanwhile, Supranationals bested the Treasury benchmark by a single basis point. Sovereign debt remains very expensive relative to equivalently-rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would also perform well in such an environment. Given the much more attractive starting point for U.S. corporate bond spreads, we find it difficult to recommend sovereign debt as an alternative. While sovereign debt in general looks expensive. USD-denominated Mexican sovereign bonds continue to look attractive relative to U.S. corporates (bottom panel). Investors should favor Mexican sovereigns within an otherwise underweight allocation to the sector as a whole. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 10 basis points in September, dragging year-to-date excess returns down to -57 bps (before adjusting for the tax advantage). We recommended upgrading municipal bonds from neutral to overweight in last week’s report.7  We based the decision on the increasing attractiveness of yield ratios, despite an underlying credit environment that remains supportive for munis. Municipal bond yields failed to keep pace with falling Treasury yields in recent months, and now look quite attractive as a result (Chart 6). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 4% in September and is now back above 90%. This is well above the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. In fact, Aaa M/T yield ratios for every maturity are now above average pre-crisis levels. Though yield ratios still look best at the long-end of the Aaa curve (panel 2), we now recommend owning munis in place of Treasuries across the entire maturity spectrum. Fundamentally, state & local government balance sheets remain solid. We showed in last week’s report that our Municipal Health Monitor is in “improving health” territory, and noted that state & local government interest coverage is positive (bottom panel). Both of those trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in September, and then bull-steepened sharply last week. All in all, the 2/10 Treasury slope is +12 bps, 12 bps steeper than it was at the end of August. The 5/30 slope is +67 bps, 10 bps steeper than at the end of August. Our fair value models (see Appendix B) continue to show that bullets are expensive relative to barbells across the entire Treasury curve. In particular, 5-year and 7-year maturities look very expensive compared to the short and long ends of the curve. Notice that the 2/5/10 butterfly spread, the spread between the 5-year bullet and a duration-matched 2/10 barbell, remains negative despite the recent 2/10 steepening (Chart 7). We have shown in prior research that the 5-year and 7-year maturities are the most highly correlated with our 12-month Fed Funds Discounter. Our discounter is currently at -74 bps, meaning that the market is priced for nearly three more Fed rate cuts during the next 12 months (top panel). We expect fewer cuts than that, and as such, think the Discounter is more likely to rise. 5-year and 7-year maturities would underperform the rest of the curve in that scenario. We also continue to hold our short position in the February 2020 fed funds futures contract. That contract is currently priced for 2 more rate cuts during the next 3 FOMC meetings. That outcome is possible, but our base case economic outlook is more consistent with 1 further cut, likely occurring this month. TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 38 basis points in September, dragging year-to-date excess returns down to -142 bps. The 10-year TIPS breakeven inflation rate fell 3 bps in September, and then another 2 bps last week. It currently sits at 1.51%, well below levels consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations is becoming increasingly stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low, nowhere near the 2.3% - 2.5% range that is consistent with the Fed’s target. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.8 That being said, the 10-year TIPS breakeven inflation rate is currently 43 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and we maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in September, dragging year-to-date excess returns down to +72 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 36 bps, very close to its minimum pre-crisis level (Chart 9). ABS also appear unattractive on a risk/reward basis, as both Aaa-rated auto loans and credit cards have moved into the “Avoid” quadrant of our Excess Return Bond Map (Appendix C). The Map uses each bond sector’s spread, duration and volatility to calculate the likelihood of earning or losing 100 bps of excess return versus Treasuries on a 12-month horizon. At present, the Map shows that ABS offer poor expected return for their level of risk. In addition to poor valuation, the ABS sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate in the future (panel 3). Meanwhile, senior loan officers continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in September, bringing year-to-date excess returns up to +227 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS held flat on the month, before widening 4 bps last week. It currently sits at 75 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate is somewhat unfavorable, with lenders tightening loan standards (panel 4) amidst falling demand (bottom panel). Commercial real estate prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 2 basis points in September, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread held flat on the month, before widening by 5 bps last week. It currently sits at 61 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 74 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Crunch Time Crunch Time Crunch Time Crunch Time Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +48 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 48 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of October 4, 2019) Crunch Time Crunch Time Table 5Butterfly Strategy Valuation: Standardized Residuals (As of October 4, 2019) Crunch Time Crunch Time Table 6 Crunch Time Crunch Time Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12Excess Return Bond Map (As Of October 4, 2019) Crunch Time Crunch Time Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 4 The 12-month breakeven spread is the spread widening required to break even with a duration-matched position in Treasuries on a 12-month horizon. It can be approximated by OAS divided by duration. 5 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Corporate Bonds: High corporate debt levels will be a problem for corporate bond investors during the next downturn, but spreads will not respond to them until inflationary pressures mount and monetary policy turns restrictive. Maintain an overweight allocation to corporate bonds versus Treasuries, with a preference for the Baa and high-yield credit tiers. MBS: Agency MBS spreads are competitive with high-rated (Aaa, Aa, A) corporate bonds, and look even more attractive on a risk-adjusted basis. We recommend that investors swap the Aaa, Aa and A-rated corporate bonds in their portfolios for agency MBS. Municipal Bonds: Investors should upgrade municipal bonds from neutral to overweight, given the recent back-up in Municipal / Treasury yield ratios. Within munis, investors should retain a preference for long-maturity Aaa-rated bonds, where yields are most compelling. Feature We attended BCA’s annual Investment Conference last week. The event always provides a good opportunity to hear from some expert panelists and find out what issues are front and center in our clients’ minds. More than anything else, two themes kept popping up in the different presentations and in conversations with attendees: Large corporate debt balances Under-priced inflation risk We can’t help but see a strong connection between the two. On Corporate Debt The consensus among panelists and attendees was very much in line with our own view: Highly levered balance sheets will be a problem for corporate bond investors during the next default cycle, but don’t help us determine when that default cycle will occur. Chart 1 shows that, despite the persistent increase in the debt-to-profits ratio, corporate bankruptcies are well contained. We examined the reasons for this divergence in a recent report, concluding that accommodative monetary policy is holding down the default rate by keeping interest costs low and giving banks the confidence to roll over maturing debt.1 Essentially, banks will look through signs of deteriorating corporate balance sheet health until the Fed shifts to a more restrictive policy stance. Chart 1Corporate Balance Sheets Are In Bad Shape, But Defaults Are Low Corporate Balance Sheets Are In Bad Shape, But Defaults Are Low Corporate Balance Sheets Are In Bad Shape, But Defaults Are Low On Inflation This is where inflation becomes important. The Fed is currently running an accommodative monetary policy because many years of low prices have convinced investors that inflation might never return. As a result, the 10-year TIPS breakeven inflation rate is only 1.53%, well below the 2.3% - 2.5% range consistent with the Fed’s target. The Fed must maintain an accommodative policy stance until it achieves its goal of re-anchoring inflation expectations. Only then will monetary policy turn restrictive, raising the risk of a corporate default cycle. We have long held the view that a 10-year TIPS breakeven inflation rate above 2.3% would cause us to turn much more cautious on corporate credit. It might take many months of core inflation printing near the Fed’s target before investors start to believe that it will stay there indefinitely. Many conference panelists thought that inflation risks are currently under-priced, and while we tend to agree that it is premature to declare the death of the Phillips curve, we expect it will still take some time before inflation expectations hit our 2.3% - 2.5% target range. We have shown in prior research that inflation expectations adapt only slowly to changes in the actual inflation data.2  At present, the fair value reading from our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate is only 1.94% (Chart 2). This fair value will move higher if inflation continues to print near current levels, but that process will take some time. In other words, it might take many months of core inflation printing near the Fed’s target before investors start to believe that it will stay there indefinitely. Chart 2Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model Chart 3Inflation Not Far From Target Inflation Not Far From Target Inflation Not Far From Target While the adaptive process might take a long time, it’s important to note that inflation is already quite close to the Fed’s target. Trailing 12-month trimmed mean PCE inflation came in at 1.96% in August, while year-over-year core PCE hit 1.77% (Chart 3). Trimmed mean inflation has been more stable than other inflation measures since the financial crisis, and core PCE has tended to drift toward the trimmed mean over time.      On Corporate Debt & Inflation In our view, the two themes of high corporate debt and under-priced inflation risk are tightly linked. It has taken a very long time for the economy to recover from the financial crisis. As a result, inflation has been low for a prolonged period and the Fed has been forced to maintain an accommodative policy stance. That accommodative policy stance encourages banks to extend credit, and encourages firms to issue debt. Eventually, inflation pressures will mount, the Fed’s policy will turn restrictive and weak corporate balance sheets will be exposed. Only then, will corporate spreads widen significantly. Until that time, the pertinent question is whether corporate spreads offer adequate compensation for the risk that inflationary pressures emerge earlier than anticipated. For now, our answer is yes, with the caveat that the risk/reward trade-off is more attractive in the lower credit tiers. The 12-month high-yield breakeven spread is very attractive, well above its historical median (Chart 4). But within investment grade, we view only the Baa-rated credit tier as offering adequate compensation (Chart 4, bottom panel). There are better alternatives to owning Aaa, Aa and A-rated corporate bonds, as discussed in the next section. Chart 4Corporate Bond Valuation Corporate Bond Valuation Corporate Bond Valuation Favor Agency MBS Over High-Rated Corporate Credit Chart 5MBS More Attractive Than High-Rated Corporate Bonds MBS More Attractive Than High-Rated Corporate Bonds MBS More Attractive Than High-Rated Corporate Bonds As noted above, investment grade corporate bonds rated A or higher don’t offer much expected compensation at current spread levels. In fact, our prior research notes that their spreads are already below our cyclical targets.3 But on the plus side, the average option-adjusted spread (OAS) for conventional 30-year agency MBS has widened in recent months and now looks like an attractive alternative to high-rated corporate credit. We recommend that investors shift out of Aaa, Aa and A-rated corporate credit and into agency MBS for three reasons. 1) Expected Compensation Is Competitive The average OAS for conventional 30-year agency MBS now stands at 52 bps. This is only 6 bps below the average OAS offered by a Aa-rated corporate bond, and 37 bps less than that offered by an A-rated credit (Chart 5). That’s not bad for a Aaa-rated bond with agency backing. 2) Risk-Adjusted Compensation Is Stellar MBS spreads look much more attractive when we consider the risk profile. Specifically, when we consider that the average duration of the MBS index has fallen sharply this year, while the average duration of the investment grade corporate bond index has risen (Chart 5, panel 2). In fact, the average duration of the MBS index is only 2.9, compared to 7.8 for an A-rated corporate bond. This means that the MBS spread needs to widen by 18 bps over the next 12 months for an investor to see losses, while the A-rated spread needs to widen by only 11 bps (Chart 5, bottom panel). We recommend that investors shift out of Aaa, Aa and A-rated corporate credit and into agency MBS. Because MBS exhibit negative convexity, their duration declines when yields fall. By contrast, non-callable investment grade corporate bonds have positive convexity and have seen their durations rise. This means that, all else equal, negatively convex securities start to look more attractive on a risk-adjusted basis after a large decline in bond yields. This is also the main reason why negatively convex high-yield corporate bonds currently look much more attractive than investment grade corporate bonds.4 Interestingly, MBS did not look so attractive relative to corporate bonds in 2015/16, the last time that MBS index duration fell sharply. That’s because corporate bond spreads also widened during that period. This time around, corporate bond spreads have been stable as MBS index duration has plunged. Unless you think that Treasury yields have further downside, which we do not,5 agency MBS look like a good buy. 3) Macro Risks Are Lower While, as discussed above, we are not yet sounding the alarm about the macro risks to corporate bonds, we are even less concerned about the macro risks surrounding agency MBS. Mortgage refinancing activity is the most important macro driver of MBS spreads, and it should stay relatively low for a very long time. At such low mortgage rates, most homeowners have already had an opportunity to refinance, so refi burnout is currently very high. This is obvious when we observe that there was only a small spike in refi activity this year, despite a very large decline in mortgage rates (Chart 6). Chart 6Muted Refi Activity Will Keep Nominal Spreads Low Muted Refi Activity Will Keep Nominal Spreads Low Muted Refi Activity Will Keep Nominal Spreads Low Chart 6 also shows that the nominal MBS spread is highly correlated with refi activity, and that it remains near its historical tights. This spread contains both the OAS – which is a proxy for an MBS investor’s expected return – and the portion of the spread that is expected to be lost as a result of prepayment activity. The fact that the OAS is reasonably elevated compared to history while the overall nominal spread remains low means that MBS are pricing-in very little buffer for prepayment losses. Given the macro back-drop, this seems appropriate. Beyond refi risk, we also note that the credit quality of outstanding mortgages remains very high. The median FICO score on new mortgages has barely come down since the financial crisis (Chart 7). Further, while mortgage lending standards have been easing for the bulk of the post-crisis period, the Fed’s July Senior Loan Officer survey reported that the banks that view lending standards as tighter than the post-2005 average outnumber those that view standards as easier. Stronger housing activity data generally lead to higher mortgage rates, which in turn limit refi activity. Finally, there is very little reason to be concerned about significant weakness in housing activity. Of the six major housing activity data series that we track, all have rebounded sharply since this year’s drop in mortgage rates (Chart 8). Stronger housing activity data generally lead to higher mortgage rates, which in turn limit refi activity. Chart 7Mortgage Lending Standards Are Tight Mortgage Lending Standards Are Tight Mortgage Lending Standards Are Tight Chart 8Housing Activity Hooking Up Housing Activity Hooking Up Housing Activity Hooking Up   Bottom Line: Agency MBS spreads are competitive with high-rated (Aaa, Aa, A) corporate bonds, and look even more attractive on a risk-adjusted basis. We recommend that investors swap the Aaa, Aa and A-rated corporate bonds in their portfolios for agency MBS. Upgrade Municipal Bonds On July 23, we advised investors to reduce municipal bond exposure from overweight to neutral.6 The rationale was purely valuation driven. We saw no immediate signs of municipal credit distress, but noted that yields were simply too low relative to the alternatives. Today, we similarly see no signs of immediate credit distress. In fact, municipal bond ratings upgrades continue to outpace downgrades, our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage is strong (Chart 9).7 Chart 9Muni Credit Quality Is Not A Concern Muni Credit Quality Is Not A Concern Muni Credit Quality Is Not A Concern The difference, however, is that yield ratios have rebounded dramatically since early August, and municipal bonds have once again become attractive (Chart 10). Chart 10Munis Attractive Once Again Munis Attractive Once Again Munis Attractive Once Again Bottom Line: Investors should upgrade municipal bonds from neutral to overweight, given the recent back-up in Municipal / Treasury yield ratios. Within munis, investors should retain a preference for long-maturity Aaa-rated bonds, where yields are most compelling.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 4 The high-yield bond index is negatively convex because most high-yield credits carry embedded call options. Investment grade corporate bonds tend to be non-callable. 5 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Municipal Health Monitor please see U.S. Bond Strategy Special Report, “Trading The Municipal Credit Cycle”, dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Waiting For A Manufacturing Rebound Waiting For A Manufacturing Rebound Waiting For A Manufacturing Rebound The 2015/16 roadmap is holding. As in that period, the ISM Manufacturing PMI has fallen into recessionary territory, but the Services PMI remains strong (Chart 1). As is typically the case, bond yields have taken their cue from the manufacturing index. The resilient service sector and global shift toward easier monetary policy will support an eventual rebound in manufacturing, and the Fed will continue to play its part this month with another 25 basis point rate cut. As for the Treasury market, much stronger wage growth than in 2016 will prevent the Fed from cutting rates back to zero. This means that the 10-year yield will not re-visit its 2016 trough of 1.37% (Chart 1, bottom panel). Strategically, investors should maintain a benchmark duration stance for now, but stand ready to reduce duration once the global manufacturing data stabilize. 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 105 basis points in August, dragging year-to-date excess returns down to +323 bps. In remarks last week, Fed Chairman Powell noted that the Fed has lowered the market’s expected path of interest rates, and that he views this easing of financial conditions as providing important support for the economy.1  The July FOMC minutes echoed this sentiment, sending a strong signal that the Fed will do everything it can to prevent a significant tightening of financial conditions. The accommodative monetary environment is extremely positive for corporate spreads. In terms of valuation, Baa-rated securities offer the most value in the investment grade corporate bond space (Chart 2). Baa spreads remain 13 bps above our cyclical target (panel 2).2 Conversely, Aa and A-rated spreads are 2 bps and 1 bp below target, respectively (panel 3). Aaa spreads are 15 bps below target (not shown). The main risk to spreads comes from the relatively poor state of corporate balance sheets. Our measure of gross leverage – total debt over pre-tax profits – was already high, and was revised even higher after the Bureau of Economic Analysis’ annual GDP revision (panel 4). But for now, likely in large part due to accommodative Fed policy, loan officers aren’t inclined to cut off the flow of credit. C&I lending standards remain in “net easing” territory (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The 2019 Manufacturing Recession The 2019 Manufacturing Recession Table 3BCorporate Sector Risk Vs. Reward* The 2019 Manufacturing Recession The 2019 Manufacturing Recession 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 114 basis points in August, dragging year-to-date excess returns down to +551 bps. The average index option-adjusted spread widened 22 bps on the month. At 385 bps, it is well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 49 bps above our target (Chart 3), B-rated spreads are 151 bps above our target (panel 3) and Caa-rated spreads are 398 bps cheap (not shown).3   Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 3.2% over the next 12 months. This translates into 207 bps of excess spread in the High-Yield index after adjusting for expected default losses (panel 4). That 207 bps of excess spread is comfortably above zero, though it is below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 63 basis points in August, dragging year-to-date excess returns down to -31 bps. The conventional 30-year zero-volatility spread widened 9 bps on the month, driven entirely by the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat at 29 bps. At 51 bps, the OAS for conventional 30-year MBS has widened back close to its average pre-crisis level (Chart 4). However, value is less attractive when we look at the nominal MBS spread, which remains near its all-time lows.4 The nominal spread has also widened less than would have been expected in recent months, considering the jump in refi activity (panel 2). The mixed valuation picture means we are not yet inclined to augment MBS exposure. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. An increase in Treasury yields would cause refi activity to slow, putting downward pressure on MBS spreads. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation. 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 12 basis points in August, dragging year-to-date excess returns down to +152 bps. Sovereign debt underperformed duration-equivalent Treasuries by 45 bps on the month, dragging year-to-date excess returns down to +442 bps. Local Authorities underperformed the Treasury benchmark by 31 bps, dragging year-to-date excess returns down to +212 bps. Meanwhile, Foreign Agencies underperformed by 11 bps, dragging year-to-date excess returns down to +141 bps. Domestic Agencies outperformed by 13 bps in August, bringing year-to-date excess returns up to +44 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +39 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). Investors should favor Mexican sovereigns within an otherwise underweight allocation to the sector as a whole. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 104 basis points in August, dragging year-to-date excess returns down to -46 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 9% in August, and currently sits at 85% (Chart 6). The ratio is close to one standard deviation below its post-crisis mean, but slightly above the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We shifted our recommended stance on municipal bonds from overweight to neutral near the end of July.5 The reason for the downgrade was that the sector had become extremely expensive. Yield ratios have risen somewhat since then, but not yet by enough for us to re-initiate an overweight recommendation. We also continue to observe that the best value in the municipal bond space is found at the long-end of the Aaa curve. 2-year and 5-year M/T yield ratios remain below average pre-crisis levels, while yield ratios beyond the 10-year maturity point are above. 20-year and 30-year Aaa M/T yield ratios, in particular, are the most attractive (panel 2). Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our recent shift to a more cautious stance was driven purely by valuation and not a concern for municipal bond credit quality. A further cheapening in the coming months would cause us to re-initiate an overweight stance.    Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in August, as the global manufacturing recession continued to pull yields down. At present, the 2/10 Treasury slope is just above the zero line at 2 bps, 11 bps flatter than at the end of July. The 5/30 slope is currently 60 bps, 9 bps flatter than at the end of July. Our 12-month Fed Funds Discounter is currently -98 bps (Chart 7). This means that the market is priced for almost four more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of uncertainty surrounding the timing of the next move higher in yields, four rate cuts on a 12-month horizon seems excessive given the underlying strength of the U.S. economy. For this reason, we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts over the next four FOMC meetings. One of those rate cuts will occur this month, but if the global manufacturing data recover, further cuts may not be needed. A short position in this contract continues to make sense. On the Treasury curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 174 basis points in August, dragging year-to-date excess returns down to -104 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.55% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate also fell 21 bps in August. It currently sits at 1.74%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.6 Eventually, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors also need to see evidence that inflation will be sustained near 2%. On that note, recent trends are encouraging. Through July, trimmed mean PCE is running at 2.22% on a trailing 6-month basis (annualized) and at 1.99% on a trailing 12-month basis (bottom panel). As a result, the 10-year TIPS breakeven inflation rate looks very low relative to the reading from our Adaptive Expectations model, a model based on several different measures of inflation (panel 4).7 Supportive Fed policy and rising inflation should support wider TIPS breakevens in the coming months, remain overweight.  ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in August, bringing year-to-date excess returns up to +74 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month. It currently sits at 28 bps, below its minimum pre-crisis level of 34 bps (Chart 9). ABS also appear unattractive on a risk/reward basis, as both Aaa-rated auto loans and credit cards have moved into the “Avoid” quadrant of our Excess Return Bond Map (see Appendix C). The Map uses each bond sector’s spread, duration and volatility to calculate the likelihood of earning or losing 100 bps of excess return versus Treasuries. At present, the Map shows that ABS offer poor expected return for their level of risk. In addition to poor valuation, the ABS sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate in the future (panel 3). Meanwhile, senior loan officers continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 16 basis points in August, dragging year-to-date excess returns down to +218 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 6 bps on the month. It currently sits at 69 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate is somewhat unfavorable, with lenders tightening loan standards (panel 4) amidst falling demand (bottom panel). Commercial real estate prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in August, dragging year-to-date excess returns down to +88 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 56 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 98 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. The 2019 Manufacturing Recession The 2019 Manufacturing Recession The 2019 Manufacturing Recession The 2019 Manufacturing Recession Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of September 6, 2019) The 2019 Manufacturing Recession The 2019 Manufacturing Recession Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of September 6, 2019) The 2019 Manufacturing Recession The 2019 Manufacturing Recession Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +49 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 49 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The 2019 Manufacturing Recession The 2019 Manufacturing Recession Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12Excess Return Bond Map (As Of September 6, 2019) The 2019 Manufacturing Recession The 2019 Manufacturing Recession     Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 https://www.cnbc.com/2019/09/06/watch-fed-chairman-jerome-powells-qa-in-zurich-live.html 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 The nominal spread is simply the difference between MBS index yield and the duration-matched Treasury yield. No adjustment is made for prepayment risk. 5 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Adaptive Expectations Model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1Keep Tracking The CRB / Gold Ratio Keep Tracking The CRB / Gold Ratio Keep Tracking The CRB / Gold Ratio The Fed cut rates by 25 basis points last week, a move that Chairman Powell described as an “insurance” cut meant to counter the risks from trade tensions and global growth weakness. Powell also described the move as a “mid-cycle adjustment to policy” and not “the beginning of a lengthy cutting cycle”. We agree with the Fed’s “mid-cycle” view of the U.S. economy and think an extended cutting cycle is unwarranted, but the market clearly disagrees. Long-end yields fell on Powell’s remarks and fell further as U.S. / China trade tensions re-escalated during the past few days. The 2015/16 period continues to be a good roadmap for the current environment, and we expect the next big move in Treasury yields will be higher. The timing of that move, however, is highly uncertain. Our political strategists expect an increase in saber-rattling between the U.S. and China in the coming months, and bond yields will not rise until either trade tensions ease and/or the global growth data recover. We recommend a tactical neutral allocation to portfolio duration, but expect to switch back to below-benchmark when those conditions are met. The CRB / Gold ratio will continue to be a good guide for the 10-year yield (Chart 1). 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 63 basis points in July, bringing year-to-date excess returns up to +432 bps. Corporate spreads widened somewhat following Jerome Powell’s perceived hawkishness at last week’s FOMC meeting, but that spread widening will prove fleeting. The Fed remains committed to keeping monetary policy accommodative and that means doing everything it can to prevent a significant tightening of financial conditions.1 The soaring price of gold is the strongest indicator of the Fed’s dovishness, and it is also a buy signal for corporate credit (Chart 2). In terms of valuation, Baa-rated securities offer the most value in investment grade corporate bond space. Baa spreads remain 7 bps above our cyclical target.2 Conversely, Aa and A-rated spreads are 3 bps and 4 bps below target, respectively (panel 4). Aaa spreads are 16 bps below target (not shown). The Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed that commercial & industrial (C&I) lending standards eased for the second consecutive quarter. C&I loan demand continued to contract, but less aggressively than its recent pace (bottom panel). Easing lending standards usually coincide with spread tightening, and vice-versa.  Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in July, bringing year-to-date excess returns up to +673 bps. The average index option-adjusted spread tightened 6 bps in July, then widened 26 bps in the first two days of August. At 397 bps, it is currently well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 71 bps above our target (Chart 3), B-rated spreads are 142 bps above our target (panel 3) and Caa-rated spreads are 298 bps above our target (not shown).3 Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 2.9% over the next 12 months, not far from our own projection.4 This would translate into 238 bps of excess spread in the High-Yield index, after adjusting for default losses (panel 4). This is comfortably above zero, and only just below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +32 bps. The conventional 30-year zero-volatility spread tightened 10 bps on the month, consisting of a 9 bps tightening in the option-adjusted spread (OAS) and a 1 bp decline in the compensation for prepayment risk (option cost). Falling mortgage rates hurt MBS in the first half of this year, as lower rates led to an increase in refi activity that drove MBS spreads wider (Chart 4). In fact, the conventional 30-year index OAS moved all the way back to its pre-crisis mean, before tightening last month (panel 3). However, as we noted in a recent report, the nominal 30-year MBS spread remains very tight, at close to one standard deviation below its historical mean.5 The mixed valuation picture means we are not yet inclined to augment MBS exposure, especially given the recent downleg in Treasury yields that could spur another small jump in refis. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation.   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 30 basis points in July, bringing year-to-date excess returns up to +164 bps. Sovereign debt outperformed duration-equivalent Treasuries by 68 bps on the month, bringing year-to-date excess returns up to +490 bps. Local Authorities outperformed the Treasury benchmark by 31 bps, bringing year-to-date excess returns up to +244 bps. Meanwhile, Foreign Agencies outperformed by 49 bps, bringing year-to-date excess returns up to +153 bps. Domestic Agencies outperformed by 6 bps in July, bringing year-to-date excess returns up to +31 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +36 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). While this remains an attractive option from a valuation perspective, the President’s on again/off again tariff threats make it a risky near-term proposition. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 102 basis points in July, bringing year-to-date excess returns up to +58 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 8% in July, and currently sits at 78% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, and even below the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We noted the strong outperformance of municipal bonds in our report two weeks ago, and recommended cutting exposure from overweight to neutral, based on how expensive the bonds have become.6 In that report we noted that Aaa-rated Municipal / Treasury yield ratios for 2-year, 5-year and 10-year maturities were all more than one standard deviation below average pre-crisis levels. Only 20-year and 30-year Aaa-rated municipal bonds continue to look cheap, and we recommend that investors focus muni exposure on that segment of the market. Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our shift to a more cautious stance is driven purely by valuation, and not any immediate concern for municipal bond credit quality. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in July, before undergoing a roughly parallel shift down of about 30 bps in the first two days of August, following the FOMC meeting and news about the escalation of the U.S./China trade war. As we go to press, the 2/10 Treasury slope stands at 16 bps, 9 bps flatter than at the end of June. The 5/30 slope is currently 76 bps, exactly equal to its end-of-June level. Our 12-month Fed Funds Discounter is currently -78 bps (Chart 7). This means that the market is priced for roughly three more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of the uncertainty surrounding the timing of the next move higher in yields, three rate cuts on a 12-month horizon still seems excessive given the underlying strength of the U.S. economy. For this reason we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts spread over the next four FOMC meetings. A short position continues to make sense. On the yield curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +71 bps. The 10-year TIPS breakeven inflation rate rose 8 bps in July to reach 1.77%, before falling back to 1.67% in the first few days of August (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate followed a similar path and currently sits at 1.88%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.7 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at an annualized rate of 2.48% during the past three months. However, the 12-month rate of change remains at 1.5%. The 12-month trimmed mean PCE inflation rate is currently running at 2%, exactly equal to the Fed’s target. In a recent report we noted that 12-month core PCE inflation has a track record of converging toward the trimmed mean.8 We see continued upside in core inflation over the remainder of the year, and therefore recommend an overweight allocation to TIPS versus nominal Treasuries.  ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in July, bringing year-to-date excess returns up to +59 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. It currently sits at 31 bps, well below the pre-crisis mean of 64 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed a continued tightening in lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). On the bright side, stronger demand for both credit cards and auto loans was reported for the first time since the fourth quarter of 2016. All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS.       Non-Agency CMBS: Neutral     Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to +234 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 64 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst falling demand (bottom panel). However, on a positive note, commercial real estate prices recently accelerated and are now much more consistent with current CMBS spreads (panel 3). Despite the mixed fundamental picture, CMBS still offer excellent compensation compared to other similarly-rated fixed income sectors.9 Agency CMBS: Overweight   Agency CMBS outperformed the duration-equivalent Treasury index by 26 bps in July, bringing year-to-date excess returns up to +119 bps. The index option-adjusted spread tightened 3 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 78 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Image Image Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of August 2, 2019) Underinsured Underinsured Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of August 2, 2019) Underinsured Underinsured Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +55 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Underinsured Underinsured Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation