Securitized Products

Highlights Chart 1Risks To The Bond Bear Market Risks To The Bond Bear Market Risks To The Bond Bear Market Two weeks ago we flagged that large net short positioning and elevated growth expectations left the Treasury market primed to benefit from any disturbance in the economic outlook. Since then the 10-year yield fell from a peak of 3.06% to 2.77%, before climbing back to 2.92%. With positioning still deeply net short and strong odds of a further decline in the economic surprise index (Chart 1), we continue to see an elevated risk that yields move lower on a 0-3 month horizon. But beyond that, less nimble investors should remain positioned for higher yields on a 6-12 month timeframe. The major risks in the global economy - Eurozone sovereign credit concerns and a strong dollar weighing on emerging market demand - are unlikely to put the Fed off its "gradual" pace of one rate hike per quarter unless they lead to a significant risk-off event in U.S. financial markets. Absent that sort of shock, the Fed will continue to lift rates "gradually" toward a neutral level near 3%, and eventually into restrictive territory. This rate hike path is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels. 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 45 basis points in May, dragging year-to-date excess returns down to -122 bps. Value has improved considerably since the start of the year. The 12-month breakeven spread for a Baa-rated corporate bond is back up to its 29th percentile relative to history (Chart 2). Market-derived inflation expectations also ebbed during the past month, with the 10-year and 5-year/5-year forward TIPS breakeven inflation rates now at 2.09% and 2.12% respectively. This is below the target range of 2.3% to 2.5% that would trigger a downgrade to our corporate bond allocation. The combination of more attractive value and a somewhat more supportive monetary environment (as evidenced by the decline in TIPS breakeven rates) increases the odds of near-term corporate bond outperformance, and we would not be surprised to see spreads tighten during the next few months. However, the longer run outlook for corporates remains negative. First quarter data showed a 5.7% annualized decline in pre-tax corporate profits, dragging the year-over-year growth rate down to 5.8% (bottom panel). As employee compensation costs accelerate in the second half of the year, we expect that corporate profit growth will fall sustainably below the pace of corporate debt growth leading to rising leverage (panel 4). Strong oil prices have caused the energy sector to outperform the overall index considerably since the middle of last year. Now, many energy sub-sectors no longer appear cheap on our model. We take this opportunity to downgrade a few energy sub-sectors from overweight to neutral, and adjust some other sector recommendations as well (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Bond Bear Still Intact Bond Bear Still Intact Table 3BCorporate Sector Risk Vs. Reward* Bond Bear Still Intact Bond Bear Still Intact 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 65 basis points in May, dragging year-to-date excess returns down to +36 bps. The average index option-adjusted spread widened 24 bps on the month, and currently sits at 356 bps. High-yield spreads are increasingly at odds with Moody's default rate projections. The latter call for the 12-month speculative grade default rate to fall to 1.5% by next April. The current 12-month trailing default rate is 3.7% (Chart 3). Using the Moody's default rate projection, and our own forecast for the recovery rate, we calculate the excess spread available in the Bloomberg Barclays High-Yield index to be 284 bps (after accounting for expected default losses). This is somewhat higher than the historical average of 248 bps. The current excess spread means that in an unchanged spread environment we would expect a High-Yield excess return (relative to duration-matched Treasuries) of +278 bps during the next 12 months. If the index spread were to tighten by 100 bps, we would expect an excess return of +675 bps. If the index spread were to widen by 100 bps we would expect an excess return of -120 bps (panel 3). If the excess spread were to simply revert to its historical average, then it would imply an excess High-Yield return of +427 bps. At the sector level, Moody's expects that most defaults during the next 12 months will come from the Media: Advertising, Printing & Publishing sector, followed closely by the Durable Consumer Goods and Retail sectors. Much of the projected improvement in the overall default rate results from a continued decline in Oil & Gas sector defaults compared to the past few years. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in May, dragging year-to-date excess returns down to -27 bps. The conventional 30-year zero-volatility MBS spread widened 4 bps on the month, driven entirely by a 4 bps increase in the compensation for prepayment risk (option cost). The option-adjusted spread held flat at 32 bps. Value in the MBS sector is by no means exciting. The nominal spread on a conventional 30-year MBS is near its all-time low, the option-adjusted spread is close to one standard deviation below its pre-crisis mean (Chart 4) and MBS no longer look very attractive compared to investment grade corporate credit (panel 3). The most compelling reason to hold agency-backed MBS is that mortgage refinancings are likely to remain very low, owing both to rising interest rates and the large number of homeowners that have already refinanced. Depressed refi activity should keep MBS spreads near historically low levels (bottom panel), even as stresses emerge in other spread product sectors, notably corporate bonds. We recently presented a method for calculating expected total returns for all different bond sectors, only using assumptions for the number of Fed rate hikes during the next 12 months and the expected change in spreads.1 Our results showed an expected total return of 2.9% for conventional 30-year MBS in a scenario where the Fed lifts rates by 100 bps and where spreads remain flat. The same scenario corresponds to 3.4% total return for the investment grade corporate index. 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 33 basis points in May, dragging year-to-date excess returns down to -40 bps. Sovereign debt underperformed the Treasury benchmark by 158 bps on the month, dragging year-to-date excess returns down to -242 bps. Foreign Agencies underperformed by 37 bps on the month, dragging year-to-date excess returns down to -56 bps. Local Authorities underperformed by 22 bps on the month, dragging year-to-date excess returns down to +37 bps. Supranationals underperformed by 2 bps on the month, dragging year-to-date excess returns down to +2 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to +7 bps. Global growth divergences and a stronger U.S. dollar weighed on Sovereign bond returns in May (Chart 5). While value in the sector improved somewhat as a result, it remains expensive relative to investment grade corporate credit (panel 2). With dollar strength likely to persist in the near-term, we remain underweight Sovereign bonds. Conversely, we reiterate our overweight recommendations on Foreign Agency and Local Authority bonds. Those sectors still offer compelling valuations and are less sensitive to a strong U.S. dollar than the lower-rated Sovereign sector. Supranationals and Domestic Agency bonds are low risk but do not offer sufficient spread to warrant much attention. Better low-risk spread product opportunities are available in the Agency CMBS and Consumer ABS sectors. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +110 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% on the month and, at 86%, it is very close to its post-crisis low (Chart 6). It remains somewhat elevated compared to the average level of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Technically, yield ratios have been supported by robust fund flows and subdued issuance (panels 2 & 3), while fundamentally our Municipal Health Monitor suggests that ratings upgrades will continue to outpace downgrades for the time being (not shown). The message from our Health Monitor is confirmed by the trend in state & local government net borrowing (bottom panel). First quarter data, released last week, showed a sizeable drop in net borrowing as state & local governments managed to grow revenues by $46 billion while growing expenditures by only $25 billion. This is consistent with governments working hard to repair their budgets, raising taxes and slowing spending growth, as we showed in a recent report.2 Given tight municipal valuations, we continue to see better opportunities in the corporate bond space than in municipal bonds. But we will look to upgrade munis at the expense of corporates as we approach the end of the credit cycle. Hopefully, from a more attractive entry point. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in May. The 2/10 Treasury slope flattened 3 bps to end the month at 43 bps. The 5/30 slope held steady at 32 bps. The short-end of the Treasury curve is still not adequately priced for the Fed's likely pace of one 25 basis point rate hike per quarter. Such a pace translates to a level of 100 bps on our 12-month discounter, which currently sits at only 73 bps (Chart 7). Similarly, the long-end of the Treasury curve is not adequately priced for the likely trend in inflation. The 10-year TIPS breakeven inflation rate is at only 2.09%, below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. We anticipate that higher TIPS breakevens at the long end of the curve will be roughly offset by loftier rate expectations at the short end of the curve, leaving the slope of the Treasury curve close to current levels during the next few months. In a recent report we introduced a framework for identifying the most attractively valued butterfly trades across the entire yield curve.3 The results, shown in Table 4, identify the 7-year bullet over the 1-year/20-year barbell as the most attractively valued butterfly trade that is geared toward curve steepening. According to our model, that trade is priced for 56 bps of 1/20 flattening during the next six months (panel 4). That seems excessive given the low level of long-maturity TIPS breakevens. Table 4Butterfly Strategy Valuation (As Of June 4, 2018) Bond Bear Still Intact Bond Bear Still Intact TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +95 bps. The 10-year TIPS breakeven inflation rate fell 10 bps on the month and currently sits at 2.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 13 bps and currently sits at 2.12%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.4 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. Recent trends show that inflation is steadily making progress toward the Fed's 2% goal. The 12-month rate of change in the core PCE deflator is back up to 1.8%, from 1.5% in February. However, the core PCE deflator has only increased by 0.15% in each of the past two months. Consistent monthly prints above 0.165% are required to reach the Fed's 2% target (Chart 8). We expect tight labor markets and strong pipeline pressures (panel 3) to drive inflation higher in the months ahead. Although, as we discussed last week, the risk of a significant overshoot of the Fed's inflation target during the next 6-12 months is low.5 ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -3 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp on the month and now stands at 41 bps, 7 bps above its pre-crisis low. While consumer ABS offer reasonably attractive expected returns relative to other low-risk spread product (Agency CMBS, Domestic Agency bonds and Supranationals), credit risk is slowly starting to build in the sector. The New York Fed's Household Debt and Credit report showed that the 90+ day credit card delinquency rate rose above 8% in Q1 for the first time since 2015. Meanwhile, the overall consumer credit delinquency rate continues to increase alongside a rising debt service ratio (Chart 9). On the supply side, banks reported tightening credit card lending standards for the fourth consecutive quarter in Q1, while auto loan lending standards were tightened for the eighth consecutive quarter. Periods of tightening lending standards tend to coincide with rising delinquencies and wider spreads (bottom panel). In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect Aaa-rated credit card ABS to return 2.3% and Aaa-rated auto loan ABS to return 2.4%.6 Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month and currently sits at 70 bps, close to one standard deviation below its pre-crisis mean. Banks eased lending standard on nonfarm nonresidential loans in Q1 for the first time since 2015, and continued easing could signal lower delinquencies in the future (Chart 10). Easier lending standards could also support commercial real estate prices, which have decelerated recently and currently pose a risk for spreads (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +13 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 48 bps. In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect non-agency Aaa-rated CMBS to return 2.8% and Agency CMBS to return 2.6%.7 Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.54%. The drop in the model's fair value compared to last month stems from a decline in the global PMI from 53.5 to 53.1, and a rise in dollar bullish sentiment from 60% to 67%. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. As resource slack dissipates, inflationary pressures mount and the same pace of global growth should be associated with a higher Treasury yield. This means that as we approach the end of the cycle, the 2-factor model will start producing fair value readings that are consistently too low. We can attempt to correct for this by incorporating a measure of resource slack into our model, in this case the employment-to-population ratio. A model for the 10-year Treasury yield based on the employment-to-population ratio and the Global PMI produces a fair value of 3.29% (Chart 11). As we move further toward the end of the cycle, and away from the zero-lower bound on the fed funds rate, we expect the regression coefficients shown in the bottom three panels will revert to their pre-crisis levels and Treasury fair value will revert closer to the one shown in the second panel. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 1Interest Rate Expectations Interest Rate Expectations Interest Rate Expectations Last week the Federal Reserve made some necessary tweaks to the language in its statement. Namely, with the year-over-year core PCE deflator now up to 1.88%, the Fed was forced to upgrade its assessment of inflation and note that it has "moved close" to the 2 percent target. To assuage concern that such a change might lead to a quicker pace of rate hikes, the statement also emphasized that the inflation target is "symmetric" and noted that its policy of "gradual increases in the federal funds rate" will continue. While the recent increase in inflation is not sufficient to nudge the Fed away from "gradualism", the more important observation is that yields are still not high enough to discount the Fed's gradual approach (Chart 1). The Fed has tightened policy once per quarter since December 2016, tapering asset purchases in place of a rate hike in September 2017. It should be obvious that, absent an economic shock, one rate hike per quarter is the Fed's definition of "gradual". And yet, the market is still priced for barely more than two hikes for the balance of 2018, and not even two rate hikes for all of 2019! Maintain a below-benchmark duration stance until the market comes to grips with the Fed's gradualism. 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 4 basis points in April, bringing year-to-date excess returns up to -77 bps. The Corporate index option-adjusted spread tightened somewhat in the first half of April, but widened anew during the past couple of weeks and recently made a new high for the year. Despite this sell-off, valuation remains expensive for investment grade corporates. The 12-month breakeven spread for an A-rated bond has only been tighter 27% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 28% of the time. We are preparing to cyclically scale back our corporate bond exposure, and will start the process once TIPS breakeven inflation rates reach our target range, signaling that monetary conditions are sufficiently restrictive. Our target range is 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Those rates currently sit at 2.16% and 2.23%, respectively. In a recent report we noted that corporate bond excess returns fall sharply once the 2/10 Treasury yield curve flattens to below 50 bps, though they typically remain positive until the curve actually inverts.1 The 2/10 Treasury slope currently sits at 45 bps. That same report also notes that while the outlook for corporate revenue growth is strong, rising employee compensation costs will likely soon put a dent in profit margins and cause gross leverage to resume its uptrend (panel 4). This will apply further widening pressure to spreads later in the year. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Coming To Grips With Gradualism Coming To Grips With Gradualism Table 3BCorporate Sector Risk Vs. Reward* Coming To Grips With Gradualism Coming To Grips With Gradualism 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 121 basis points in April, bringing year-to-date excess returns up to 102 bps. The average index option-adjusted spread tightened 16 bps on the month, and currently sits at 343 bps. The 12-month trailing speculative grade default rate moved higher for the second consecutive month, hitting 3.92% in March. Moody's baseline forecast still calls for it to fall to 1.7% by March of next year. Based on Moody's default rate projection and our estimate of the recovery rate, we forecast High-Yield default losses of 0.85% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an unchanged junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -140 bps during this time horizon, and 100 bps of spread tightening would lead to an excess return of +654 bps. However, such a large spread tightening is almost certainly over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cyclical lows (top panel). This would be consistent with behavior typically seen late in the cycle, once the 2/10 Treasury slope flattens to below 50 bps.2 MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 18 basis points in April, bringing year-to-date excess returns up to -22 bps. The conventional 30-year zero-volatility MBS spread tightened 4 bps on the month, split between a 1 bp tightening of the option-adjusted spread (OAS) and a 3 bps decline in the compensation for prepayment risk (option cost). While mortgages are no longer excessively cheap compared to corporate credit (Chart 4), we still see limited potential for spread widening during the next 6-12 months. Rising interest rates should serve to limit mortgage refinancing, and muted refis are closely linked to tight MBS spreads (bottom panel). We also view extension risk as relatively limited for conventional 30-year MBS. Using a model of excess MBS returns that we introduced in February, we estimate that despite the 25 bps increase in duration-matched Treasury yields that occurred in April, extension risk trimmed only 2 bps off monthly excess returns.3 Our excess return Bond Map also shows that conventional 30-year MBS require far fewer days of average spread tightening to earn 100 bps of excess return than most other Aaa-rated structured products (Non-Agency Aaa-rated CMBS being the exception), although they are also more likely to deliver losses. But given the benign refinancing back-drop, we remain reasonably positive on the sector.4 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 9 basis points in April, dragging year-to-date excess returns down to -7 bps. Sovereign debt underperformed the Treasury benchmark by 37 bps on the month, while Foreign Agencies underperformed by 15 bps and Domestic Agencies underperformed by 14 bps. Local Authorities delivered 14 bps of outperformance and Supranationals bested duration-equivalent Treasuries by 5 bps. Dollar strength hurt the performance of Sovereign debt last month, and relative valuation continues to show that Sovereigns are expensive relative to similarly-rated U.S. corporate bonds (Chart 5). We remain underweight USD-denominated Sovereign debt. Conversely, Foreign Agencies and Local Authorities continue to offer very attractive spreads, especially considering the duration and spread volatility characteristics of those sectors. Our excess return Bond Map shows that both sectors offer a superior risk/reward trade-off than the Barclays Aggregate and almost all of its components.5 The large presence of state-owned energy companies in the Foreign Agency sector means it should also benefit from higher oil prices in the coming months. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 65 basis points in April, bringing year-to-date excess returns up to 94 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% in April as fund inflows returned to the sector (Chart 6). Persistently low visible supply is also contributing to the strong technical environment for yield ratios. The tax-adjusted yield for a 10-year municipal bond is now about 46 bps below the yield offered by an equivalent-duration corporate bond. As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.6 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.7 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve rose considerably in April, steepening a touch out to the 5-year maturity point and flattening thereafter. The 2/10 Treasury slope flattened 1 basis point in April, and currently sits at 45 bps. The 5/30 slope flattened 9 bps on the month and currently sits at 34 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the slope of the yield curve during the next six months. With the 10-year TIPS breakeven inflation rate at 2.16%, it remains slightly below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. It will be difficult for the yield curve to flatten aggressively until that target is met. After that, curve flattening becomes much more likely. We continue to recommend a position in the 5-year bullet versus the duration-matched 2/10 barbell, primarily due to extremely attractive starting valuation. Our model suggests that the 2/5/10 butterfly spread is priced for 17 bps of 2/10 curve flattening during the next six months (Chart 7). With long-maturity TIPS breakevens still below target, we think that is too high a bar. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 93 basis points in April, bringing year-to-date excess returns up to 161 bps. The 10-year TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.16%. The 5-year/5-year forward TIPS breakeven inflation rate increased 6 bps and currently sits at 2.23%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.8 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. If the recent trend in inflation continues, then this re-anchoring will occur relatively soon. The annualized 6-month rate of change in the trimmed mean PCE deflator has already returned to the Fed's target, and the annual rate of change jumped from 1.71% to 1.77% in March (Chart 8). Pipeline measures of inflation pressure also continue to strengthen. Our Pipeline Inflation Indicator is in a strong uptrend and the prices paid component of the ISM manufacturing survey is closing in on 80, a level last seen in 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in April, bringing year-to-date excess returns up to -6 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 4 bps on the month and now stands at 40 bps, 7 bps above its pre-crisis low. Our recently introduced excess return Bond Map shows that both Aaa-rated credit card and Aaa-rated auto loan ABS exhibit lower risk and less potential for gains than the Barclays Aggregate index.9 It also confirms that credit card ABS are somewhat more attractive than auto loan ABS, offering approximately the same potential for excess return with less risk. Compared to other fixed income sectors, Aaa-rated ABS offer greater potential return and higher risk than Agency CMBS, Domestic Agencies and Supranationals. But the ABS sector also has a less attractive risk/reward profile than the Foreign Agency, Local Authority and Investment grade corporate sectors. Fundamentally, while consumer delinquencies remain low, they are heading higher alongside a rising household debt service coverage ratio (Chart 9). The persistent (though mild) deterioration in credit quality causes us to maintain a neutral allocation to the sector, despite reasonably attractive valuations. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in April, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month and currently sits at 69 bps, close to one standard deviation below its pre-crisis mean. Our excess return Bond Map shows that Aaa-rated non-Agency CMBS offer greater potential reward, but also greater risk, than the majority of other high-rated spread products. The exception is conventional 30-year Agency MBS, which offer a less attractive risk/reward trade-off.10 That being said, the fundamental picture for commercial real estate is less appealing than on the residential side. CMBS spreads continue to diverge from commercial property prices (Chart 10). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 26 basis points in April, bringing year-to-date excess returns up to 12 bps. The index option-adjusted spread was flat on the month and currently sits at 47 bps. According to our Bond Map, Agency CMBS offer greater potential excess return and less risk than both the Supranational and Domestic Agency sectors. We continue to view the Agency CMBS space as an attractive low-risk spread sector. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.70%. The drop in the model's fair value stems from a decline in the global PMI to 53.5 from a recent peak of 54.5. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. Logically, as slack dissipates in the economy and inflationary pressures mount, then the same level of global growth should be associated with a higher Treasury yield, all else equal. This means that at some point, as we approach the end of the cycle, the model will break down and consistently produce fair value readings that are too low. We suspect that we may be reaching this point. When we augment our model with an additional variable to measure the degree of resource utilization, in this case the employment-to-population ratio, we find that the new model projects a fair value of 3.28% for the 10-year Treasury yield (Chart 11). This 3-factor model would not have worked as well as our 2-factor model during the zero-lower bound period, as can be seen by looking at how rolling regression betas from each of the three variables moved sharply following the recession (bottom three panels). However, as we move further away from the zero-lower bound we expect the regression coefficients to return to pre-crisis levels, meaning that it will be important to monitor both trends in global growth and the amount of resource slack in the economy. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 4 For details on the Bond Map please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 1Inflation Pressures Mount Inflation Pressures Mount Inflation Pressures Mount Spread product underperformed equivalent-duration Treasuries for the second consecutive month in March. But last month's underperformance was different than February's in one important way. In February it was the fear of inflation and tighter Fed policy that prompted the sell-off in spread product. Investment grade corporate bonds underperformed Treasuries by 62 basis points, while the Treasury index provided a total return of -75 bps and TIPS outperformed nominals. In March, the sell-off in spread product coincided with Treasury returns of +94 bps and TIPS underperformed nominals. The negative correlation between yields and spreads re-asserted itself signaling that the sell-off was not driven by inflation, but by concerns about a potential slow-down in global growth. A severe slow-down in global growth is not imminent. But higher inflation and tighter Fed policy remain our chief concerns. With that in mind, core inflation printed higher again last month (Chart 1), and we think it is only a matter of time before our TIPS breakeven target range of 2.3% to 2.5% is met. That will trigger a reduction in our recommended allocation to corporate bonds. Stay tuned. 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 91 basis points in March, dragging year-to-date excess returns down to -81 bps. The sell-off of the past two months has returned some value to the investment grade corporate space, but spreads are still quite tight relative to history. The 12-month breakeven spread for a Baa-rated corporate bond has only been tighter 19% of the time since 1989.1 Our opinion of investment grade corporate bonds is unchanged. We continue to view value as relatively unattractive, and will reduce our overweight allocation once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are above 2.3%. Corporate profit data for the fourth quarter of 2017 were released last week, and our measure of EBITD for the non-financial corporate sector grew at an annualized rate of 2.4%, slightly below the 3% annualized increase in corporate debt. Gross leverage for the non-financial corporate sector ticked higher as a result (Chart 2). In a recent report we showed that sustained periods of corporate spread widening almost always coincide with rising gross leverage.2 We also showed that while most leading profit indicators are still in good shape, a profit margin proxy based on the difference between corporate selling prices and unit labor costs is sending a warning sign. We expect profit growth to fall sustainably below debt growth later this year, driven by rising unit labor costs. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Old Habits Die Hard Old Habits Die Hard Chart 3BCorporate Sector Risk Vs. Reward* Old Habits Die Hard Old Habits Die Hard 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 March, dragging year-to-date excess returns down to -19 bps. The average index option-adjusted spread widened 18 bps on the month and currently sits at 354 bps. The 12-month trailing speculative grade default rate ticked up to 3.56% in February, its highest reading since last July, but Moody's still expects it to decline to 1.96% during the next year. Based on the Moody's default rate projection and our own estimate of the recovery rate, we forecast High-Yield default losses of 0.97% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an un-changed junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -149 bps during this time horizon, and 100 bps of spread tightening would lead to an excess returns of +664 bps. However, such a large amount of spread tightening is probably over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cycle lows (top panel). We continue to await a firmer signal from our inflation indicators before reducing our allocation to high-yield. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in March, dragging year-to-date excess returns down to -39 bps. The conventional 30-year zero-volatility MBS spread widened 7 bps on the month, split between a 4 bps widening in the option-adjusted spread (OAS) and a 3 bps widening in the compensation for prepayment risk (option cost). The widening in MBS OAS has not been as severe as the widening in investment grade corporate OAS. As a result, mortgages no longer appear cheap relative to investment grade corporates (Chart 4). But while the value proposition in mortgages is less alluring, we still see limited potential for spreads to widen during the next 6-12 months. Refinancing risk will remain muted as interest rates rise (bottom panel), and in past reports we showed that extension risk will likely be immaterial.3 In the structured product space, Agency MBS offer 11 bps less spread than Aaa-rated consumer ABS, but are supported by falling residential mortgage delinquencies and easing bank lending standards. In contrast, consumer credit (auto loan and credit card) delinquency rates have bottomed and banks have begun to tighten lending standards (see page 12 for further details). 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 20 basis points in March, dragging year-to-date excess returns down to +2 bps. Sovereign debt underperformed the Treasury benchmark by 58 bps on the month, while Foreign Agencies underperformed by 38 bps and Local Authorities underperformed by 33 bps. Domestic Agencies outperformed duration-equivalent Treasuries by 6 bps, and Supranationals underperformed by a single basis point. USD-denominated sovereign bonds have performed worse than Baa-rated U.S. corporate bonds during the past six months, despite persistent weakness in the U.S. dollar (Chart 5). However, we do not think recent dollar weakness will provide much support for sovereign bond returns going forward. Rather, it is more likely that the U.S. dollar will appreciate during the next 6-12 months as the distribution of global growth shifts toward the United States. This month's issue of the Bank Credit Analyst discusses the cyclical and structural outlook for the U.S. dollar in detail.4 Elsewhere, Foreign Agencies and Local Authorities continue to offer attractive spreads after adjusting for duration and credit rating. We remain overweight those segments of the Government-Related universe despite an overall underweight allocation. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 56 basis points in March, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio widened 4% on the month, with short maturities performing somewhat worse than long maturities. The tax-adjusted yield for a 10-year municipal bond remains about 17 bps below the yield offered by an equivalent-duration corporate bond (Chart 6). As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.5 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.6 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve flattened in March, as long maturity yields fell quite sharply despite a small increase in yields out to the 2-year maturity point. The 2/10 slope flattened 15 basis points on the month and currently sits at 47 bps. The 5/30 slope flattened 7 bps on the month and currently sits at 41 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the path for the yield curve during the next six months. Last month the Fed lifted rates for the sixth time this cycle, and signaled its desire to hike another 2-3 times before the end of the year. But just as further rate hikes will apply flattening pressure to the curve, the recent rebound in inflation will exert some offsetting steepening pressure. The 10-year TIPS breakeven inflation rate is still 25-45 bps below a range that is consistent with inflation being anchored around the Fed's target. We recommend a curve steepening trade for now, specifically a position long the 5-year bullet and short a duration-matched 2/10 barbell, because upward pressure on inflation will make it difficult for the curve to flatten much further during the next few months. We will shift aggressively into flatteners once TIPS breakevens reach our target range. Further, the 2/5/10 butterfly spread is priced for 19 bps of 2/10 flattening during the next six months (Chart 7). In other words, the 2/10 slope needs to flatten by more than 19 bps for a long 5-year bullet position to underperform. We view this as unlikely. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in March, dragging year-to-date excess returns down to +67 bps. The 10-year TIPS breakeven inflation rate fell 7 bps on the month and currently sits at 2.05%. The 5-year/5-year forward TIPS breakeven inflation rate fell 2 bps on the month and currently sits at 2.18%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.7 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. If the recent trend in realized inflation continues, then this re-anchoring could occur relatively soon. February data show that the annualized 6-month rate of change in trimmed mean PCE rose to 2.03% (Chart 8), and while the 12-month rate of change held steady at 1.7%, it will start to move higher in March when the strong inflation prints from January and February 2017 are removed from the sample. Pipeline measures of inflation pressure also suggest that inflation will head higher, as evidenced by our Pipeline Inflation Indicator, and in particular, the Prices Paid component of the ISM Manufacturing index which just hit its highest level since 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in March, dragging year-to-date excess returns down to -19 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and currently sits at 44 bps, 11 bps above its pre-crisis low. While in prior research we highlighted that consumer ABS offer attractive spreads relative to many other sectors, we also pointed out that collateral credit quality is starting to weaken.8 With respect to value, Aaa-rated Consumer ABS offer a 12-month breakeven spread of 21 bps, while Agency MBS offer a spread of 6 bps and Agency CMBS offer a spread of 9 bps.9 However, household debt service ratios and delinquency rates appear to have bottomed for the cycle (Chart 9). While the pace of consumer credit accumulation remains robust, it has also moderated in recent months alongside rising delinquencies and tightening lending standards. We maintain a neutral allocation to ABS for the time being due to attractive valuation, but expect to downgrade in the future as household credit quality deteriorates. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 36 basis points in March, dragging year-to-date excess returns down to +11 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month and currently sits at 72 bps, close to one standard deviation below its pre-crisis mean. While a spread of 72 bps is still attractive compared to similarly-rated alternatives, we remain concerned about the gap that has emerged between CMBS spreads and the rate of appreciation in commercial real estate (CRE) prices (Chart 10). While bank lending standards on CRE loans are still tightening, they are tightening less aggressively than in recent years (bottom panel). This could eventually remove a headwind from CRE prices, but for now we view a position in non-agency CMBS as overly risky. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 22 basis points in March, dragging year-to-date excess returns down to -14 bps. The index option-adjusted spread widened 6 bps on the month and currently sits at 47 bps. The Agency CMBS sector continues to offer an attractive spread pick-up relative to similar investment alternatives, and has historically exhibited low excess return volatility.10 Remain overweight. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.96% (Chart 11). While the fair value reading from our 2-factor model remains elevated for now, we expect it to fall once March Global PMI data are released this week. Based on a combination of final PMI data and Flash estimates for countries that have yet to report final March figures, we estimate that the Global PMI will decline to 53.8 in March from 54.2 in February. When combined with the most recent reading for dollar bullish sentiment, this gives a fair value of 2.85% for the 10-year Treasury yield. We will provide an official update to the model in next week's report, after the data are finalized. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 1, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.74%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 The 12-month breakeven spread is the spread widening required during the next 12 months for the bond to break even with a position in an equivalent-duration Treasury security. 2 Please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 4 Please see Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?", dated March 29, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 9 The 12-month breakeven spread is the spread widening required during the next 12 months for the bond to break even with a position in an equivalent-duration Treasury security. 10 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Policymakers & Volatility: The major developed market central banks (Fed, ECB, BoJ), facing low unemployment rates and slowly rising inflation, are less able to respond to volatility spikes with more dovish monetary policies compared to past years. Investors should get used to a structurally higher level of volatility, likely for the remainder of the current business cycle upturn. Higher Volatilty & Spread Product: The relative risk-adjusted attractiveness of global spread product looks different when using a higher level of yield volatility, particularly when hedged into U.S. dollars. Continue to favor U.S. investment grade and high yield corporate debt over euro area and emerging market equivalents, even with the more elevated volatility backdrop. Feature If there is one lesson to be learned from recent events, it is that global policymakers can no longer be trusted to always make the most market-friendly decisions. Central bankers in most countries have shifted from solely supporting growth to fighting inflation pressures. The White House is now willing to risk a disruptive trade war to try and "correct" the large U.S. trade deficit, rather than focusing on stimulating growth solely through fiscal policy. Even geopolitical headlines have become more worrisome for investors, with Russia announcing new nuclear capabilities, China appointing a "president for life", the U.K. government remaining vague on the details of its Brexit negotiating stance and Italy's elections producing a hung parliament with anti-establishment parties outperforming expectations. The idea that central bankers have been explicitly putting a floor under risk assets, by focusing so much on financial conditions as a critical input into their economic and inflation forecasts, has become very entrenched among investors. The implication is that if risky assets sell off, central banks will shift to a more dovish stance, thus causing interest rate expectations to shift lower which eventually causes risk assets to rebound and financial conditions to ease. This has been most evident in the U.S., where a belief in the "Fed Put" - the idea that the Fed has implicitly sold investors a put option on equities by responding dovishly to market selloffs - goes all the way back to the Greenspan era. In the U.S., however, there is now greater uncertainty that a "Powell Put" even exists - or at least one as valuable as the "Yellen Put" and "Bernanke Put" before it. In other words, it may now take a much larger decline in risk assets to cause the Fed to question its economic forecasts enough to change them. New Fed Chairman Jay Powell said as much in his first appearance before the U.S. Congress last week, where he noted that the recent equity market turbulence was not "weighing heavily" on the Fed's outlook. In fact, Powell talked up a very bullish view on the U.S. economy, which markets took as a sign that the Fed could hike rates four times in 2018 - more than the three hikes currently embedded in the Fed's projections. A similar dynamic is playing out in Europe and Japan, where the European Central Bank (ECB) and Bank of Japan (BoJ) have been more vocal about the potential end of their respective asset purchase programs given the underlying strength of the euro area and Japanese economies. The belief in a "Draghi Put" or "Kuroda Put" is also strong, but is starting to wane. Central Bankers As Options Traders Chart 1A Smaller Response To Higher Volatility A Smaller Response To Higher Volatility A Smaller Response To Higher Volatility One way to see this changing backdrop is to look at the response of monetary policy expectations to increases in market volatility. During 2017, there were a few small flare-ups of equity market volatility in the U.S., euro area and Japan. In each of those episodes, interest rate markets were quick to price in easier monetary policy through a lower projected level of the funds rate in the U.S. or by pushing out the timing of the eventual first rate hike in Europe and Japan (Chart 1). The story is much different in 2018, where volatility has soared higher but there has been little change to the expected path of interest rates. Markets now understand that inflation-fighting central banks, who strongly believe in the Phillips Curve, now have to focus more on inflation than asset prices with unemployment rates at or below full employment levels. Using the language of options markets, the "strike price" on the put options allegedly sold by central bankers is now much lower. The implication is that bouts of market turbulence cannot generate lasting decreases in government bond yields that can eventually restore calm to financial assets. In other words, policymakers are now implicitly, but not intentionally, putting a floor under volatility rather than asset prices. This has made the investment backdrop much more challenging in 2018, as both absolute market returns and, especially, risk-adjusted returns will be far lower than investors have enjoyed over the past couple of years. This is one of the key themes that we outlined in our 2018 Outlook.1 It will take signs that more volatile markets are damaging economic growth and inflation expectations for this new dynamic to change. Yet there is little sign of that happening, at least among the "Big 3" central banks. The Federal Reserve In the U.S., economic data continues to print strongly. The February ISM manufacturing Index hit a 13-year high (Chart 2, top panel), with the export index hitting the highest level since 1988! The Conference Board index of consumer confidence hit the highest level since 2000 (2nd panel), while the Board's index of leading indicators continues to accelerate (3rd panel). The ISM new orders index remains at elevated levels that suggest that the latest upturn in capital spending should continue (bottom panel). Meanwhile, U.S. inflation gauges continue to grind slowly higher. The 3-month annualized growth rate of the core PCE deflator rose to 2.1% in January - above the Fed's 2% target - while the ISM Manufacturing Prices Paid index is now at a 6-year high (Chart 3). Inflation expectations from the TIPS market have recently stalled below levels that we deem consistent with the Fed's inflation objective (between 2.3% and 2.5% on both the 10-year TIPS breakeven and the 5-year TIPS breakeven, 5-years forward), but they continue to trend in the direction of the Fed's target. If the wage numbers in this Friday's February Payrolls report build on the breakout seen in the January data, then breakevens should begin to climb higher once again and would all but ensure that another Fed rate hike will occur later this month. Chart 2Fed Chair Powell Is Right##BR##To Be Optimistic On U.S. Growth Fed Chair Powell Is Right To Be Optimistic On U.S. Growth Fed Chair Powell Is Right To Be Optimistic On U.S. Growth Chart 3U.S. Inflation Now Moving##BR##Towards The Fed Target U.S. Inflation Now Moving Towards The Fed Target U.S. Inflation Now Moving Towards The Fed Target The ECB Chart 4Will The ECB Pull Forward Its Projections? Will The ECB Pull Forward Its Projections? Will The ECB Pull Forward Its Projections? Turning to the euro area, economic data has begun to dip lower in recent readings for cyclical indicators like the manufacturing PMI, which complicates the story for the ECB heading into this Thursday's policy meeting. We continue to expect any decision on a tapering of the ECB's asset purchase program to not take place until the summer. However, some minor changes to its forward guidance, like removing language suggesting that asset purchases could be increased if necessary, could happen this week. The more meaningful signal will come from the new set of ECB economic forecasts. Core euro area HICP inflation is not projected to return close to the ECB's 2% target until 2020, and if that timetable is pulled forward in the new forecasts, that would give the ECB a credible reason to begin signaling a taper later this year. With full euro area unemployment hitting an 8-year low of 8.6% in January - dipping below the OECD full employment NAIRU estimate of 8.7% - the ECB could raise its projections for both wage growth and core inflation (Chart 4). With our own core HICP diffusion index showing a sharp increase in January, the risk of future upside surprises in euro area realized inflation has increased. Yet core inflation is still only 1.0% - a long way from the ECB's 2% target. This is already reflected in measures of inflation expectations like CPI swap forwards, which remain between 50-75bps below the levels that prevailed the last time euro area core inflation was around 2% (bottom two panels). This suggest further upside for euro area bond yields if core inflation does start to print higher later this year. For now, the ECB is unlikely to make any earth-shattering changes to its monetary policy this week, but should signal another small incremental step towards a full-blown taper later in 2018. The BoJ BoJ Governor Haruhiko Kuroda threw a bit of a surprise at the markets last week in his testimony before the Japanese parliament following his reappointment as the head of the central bank. In response to a question on when the BoJ could consider beginning to exit its current Yield Curve Control (YCC) program, Kuroda stated that it could happen in fiscal year 2019 if the BoJ's inflation projections are realized. The media headlines took that as a sign that the BoJ was starting to change its forward guidance about its monetary policy, but that is an overreaction, in our view. Chart 5The Yen Leads The BoJ, Not Vice Versa The Yen Leads The BoJ, Not Vice Versa The Yen Leads The BoJ, Not Vice Versa Realized inflation remains well below the BoJ's target, with headline CPI inflation hitting 1.3% and 0.4%, respectively, in January (Chart 5). Even given the continued strength of the Japanese economy, with the unemployment rate now sitting at a 29-year low of 2.4%, inflation will have no realistic shot of reaching the BoJ 2% target without a weaker Japanese yen. The markets understand that dynamic, as our Japan months-to-hike measure - measuring the time until the first 25bps rate hike is priced into the Overnight Index Swap curve - has recently drifted up from 38 months to 47 months alongside the current appreciation of the yen (bottom panel). The BoJ remains the one major central bank that can still talk dovishly because inflation remains so low. Yet investors are aware that the BoJ is having greater difficulty operationally executing its asset purchase program, given its huge ownership share of Japanese government bonds and equity ETFs. So, like the Fed and the ECB, the BoJ's ability to credible respond in a dovish fashion to rising market turbulence - manifested through a rising yen - is severely hamstrung. Bottom Line: The major developed market central banks (Fed, ECB, BoJ), facing low unemployment rates and slowly rising inflation, are less able to respond to volatility spikes with more dovish monetary policies compared to past years. Investors should get used to a structurally higher level of volatility, likely for the remainder of the current business cycle upturn. What A Higher Volatility Regime Means For Global Spread Product If policymakers are now unable to take actions that can restore the low volatility regime seen last year, then this has implications for the relative attractiveness of global fixed income spread product. One way to see is this is to look at the ranking of volatility-adjusted yields for various global spread sectors. We present that in Table 1, where we take the currency-hedged yields for spread sectors and rank them according to two metrics: a) the outright hedged yield and b) the hedged yield relative to its trailing yield volatility.2 The sector yields are then re-ranked using the average ranking of those two metrics. We present the table with yields hedged into the four major developed market currencies (U.S. dollar, euro, yen and British pound). The level of those yields, shown against credit ratings, are graphically presented in the Appendix on pages 11 and 12. Table 1Ranking Currency-Hedged Global Spread Product Yields Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices We also show two versions of the yield rankings - one using trailing volatility over the past year in the denominator of the risk-adjusted yield, and the other using trailing volatility over three years in the denominator. This is important, as bond volatility over the past year has been historically depressed and is much lower than the three-year volatility measure for almost every spread sector. The conclusion is that many sectors that look most attractive using the more recent low volatility look less appealing with a more "normal" volatility level. For example, U.S. high-yield corporates are the top ranked sector in USD terms using a trailing one-year volatility, but that ranking falls to #10 using a higher three year volatility. Euro area high yield falls from #6 to #11 when applying the different volatility measures, while emerging market USD-denominated sovereign debt falls from #3 to #6. While the differences in the yield rankings are not as meaningful for higher-quality sectors, and for other base currencies besides the U.S. dollar, the main takeaway is that a higher volatility environment can alter the relative attractiveness of spread sectors given the current low level of yields. Thus, if central banks now have reduced ability to respond to volatility shocks by signaling a more dovish stance - given strong growth, tight labor markets and slowly rising inflation - then investors should judge spread product, and risk assets in general, using a higher level of volatility than seen last year. The conclusion is that we should be using the upper left column of Table 1, using the more "normal" level of yield volatility, when assessing the attractiveness of spread sectors within our recommended investment universe that uses the U.S. dollar as the base currency. With regards to corporate bonds in our model bond portfolio, that means favoring U.S. investment grade over euro area and emerging market equivalents and favoring U.S. high yield over euro area high yield. We are happy to report that we already have those recommendations implemented in our portfolio. While the absolute valuations of U.S. investment grade corporates, from a perspective of breakeven spreads, do look historically tight (Chart 6, middle panel), the same can be said for euro area investment grade corporates (Chart 7, middle panel). We are willing to take that trans-Atlantic spread risk favoring the U.S., however, given that currency hedging costs continue to favor U.S. dollar investments over euro-denominated equivalents. Chart 6Favor U.S. Corporate Bonds... Favor U.S. Corporate Bonds... Favor U.S. Corporate Bonds... Chart 7...Especially Versus Euro Area Corporates ...Especially Versus Euro Area Corporates ...Especially Versus Euro Area Corporates The story is cleaner for U.S. high yield over euro are high yield, as the default-adjusted spreads in the former (Chart 6, bottom panel) look far more attractive than in the latter (Chart 7, bottom panel). Bottom Line: The relative risk-adjusted attractiveness of global spread product looks different when using a higher level of yield volatility, particularly when hedged into U.S. dollars. Continue to favor U.S. investment grade and high yield corporate debt over euro area and emerging market equivalents, even with the more elevated volatility backdrop. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Appendix Appendix Chart 1Global Spread Product Yields, Hedged Into U.S. Dollars Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Appendix Chart 2Global Spread Product Yields, Hedged Into Euros Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Appendix Chart 3Global Spread Product Yields, Hedged Into British Pounds Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Appendix Chart 4Global Spread Product Yields, Hedged Into Japanese Yen Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcareseach.com. 2 Using rolling averages of 60-day realized hedged yield volatility. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Inflation Perks Up Inflation Perks Up Inflation Perks Up The Fed has struck a decidedly more upbeat tone in 2018. We noted last week that the Fed staff made upward revisions to its growth forecasts, and then Chairman Jerome Powell testified to Congress that "some of the headwinds the U.S. economy faced in previous years have shifted to tailwinds." So far this more optimistic outlook is borne out in the data. Core PCE inflation rose sharply in January. The annualized 6-month rate of change is back above the Fed's target (Chart 1), and the 12-month rate of change should follow once base effects kick-in in March. For our investment strategy the message is to stay the course. The re-anchoring of inflation expectations will impart another 18 bps to 38 bps of upside to the 10-year Treasury yield. How much higher yields rise beyond that will depend on how well credit markets and equities digest the less accommodative monetary environment. Stay at below-benchmark duration and be prepared to scale back on credit risk once our target range of 2.3% to 2.5% is reached by both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in February, dragging year-to-date excess returns down to +10 bps. Although last month's sell-off did return some value to the investment grade corporate space, the sector is still expensive compared to both its own history and other comparable sectors. The 12-month breakeven spread for a Baa-rated corporate bond has only been tighter 11% of the time since 1989 (Chart 2). Further, in last week's report we compared breakeven spreads across the investment grade bond universe, split by credit tier.1 Our results showed that municipal bonds offer greater breakeven spreads than investment grade corporates, after adjusting for the tax advantage. We also found that Foreign Agency debt is more attractive than investment grade corporate debt in both the Aa and Baa credit tiers. Local Authority debt is more attractive in the Baa credit tier. With a less than compelling valuation case for investment grade corporates, we will start to pare exposure once our TIPS breakeven inflation targets (mentioned on page 1) are met. This week we take a preliminary step toward de-risking by adjusting our recommended sector allocation (Table 3). The adjustments were made to both increase exposure to sectors that look cheap after adjusting for credit rating and duration, and also to lower the average duration-times-spread (DTS) of the portfolio. Specifically, we downgrade Cable/Satellite, Paper, Media/Entertainment, Brokerage/Asset Managers/Exchanges and Lodging. We upgrade Supermarkets, Tobacco, Life Insurance and P&C Insurance. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* From Headwinds To Tailwinds From Headwinds To Tailwinds Table 3BCorporate Sector Risk Vs. Reward* From Headwinds To Tailwinds From Headwinds To Tailwinds 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 52 basis points in February, dragging year-to-date excess returns down to +97 bps. The average index option-adjusted spread widened 17 bps on the month, and currently sits at 348 bps. The 12-month trailing speculative grade default rate edged down to 3.2% in January, and Moody's projects it will fall to 2% in one year's time. The projected decline is mostly driven by the continued waning of credit stress in the oil & gas sector. Using the Moody's projection as an input, we forecast High-Yield default losses of 1.3% for the next 12 months. This means that if junk spreads are unchanged from current levels we would expect High-Yield to return 251 bps in excess of duration-matched Treasuries (Chart 3). One hundred basis points of spread tightening would translate roughly to excess returns of 661 bps, and 100 bps of spread widening would translate to excess returns of -159 bps. Though High-Yield valuation is more attractive than for investment grade corporates - the 12-month breakeven spread for a B-rated security has been tighter than it is today 28% of the time since 1995, the same measure has been tighter only 13% of the time for a Baa-rated security - we still view the potential for spread tightening in high-yield as limited. First, 130 bps of spread tightening would lead to all-time expensive valuations in the High-Yield index - using the 12-month breakeven spread as our valuation measure. Second, the higher levels of implied equity volatility that are likely to prevail in an environment with a less-accommodative Fed will also limit how far spreads can fall (top panel). MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in February, dragging year-to-date excess returns down to -25 bps. February's underperformance was concentrated in GNMA and Conventional 15-year issues, and also in 3.5% and 4% coupons. Excess returns for Conventional 30-year MBS were roughly flat, and securities with coupons above 5% delivered strong positive performance. The conventional 30-year zero-volatility MBS spread narrowed 4 bps on the month, split between a 3 bps reduction in the compensation for prepayment risk (option cost) and a 1 bp tightening in the option-adjusted spread. In last week's report we showed that the value proposition in Agency MBS is comparable to a Aaa-rated corporate bond, but is much less attractive than other Aaa-rated securitizations (consumer ABS and CMBS).2 However, MBS are also likely to offer investors more protection in a risk-off environment. Refinancing risk will remain muted as interest rates rise (Chart 4), and in past reports we showed that extension risk will likely be immaterial.3 Valuation in MBS versus investment grade corporates is less attractive than it was a month ago, owing to the recent widening in corporate spreads, but the relative spread is still elevated compared to recent years (panel 3). MBS will start to look more attractive on a relative basis as corporate spreads recoup some of their February losses. After that, we stand ready to shift some exposure from corporate bonds to MBS once our end-of-cycle inflation targets are met. 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 20 basis points in February, dragging year-to-date excess returns down to +22 bps. Sovereign debt underperformed the Treasury benchmark by 108 bps on the month, Foreign Agencies underperformed by 20 bps and Supranationals underperformed by 2 bps. Local Authorities delivered excess returns of +11 bps, and Domestic Agencies performed in-line with the benchmark. The Sovereign index has returned only 9 bps in excess of Treasuries so far this year, compared to 40 bps from the Baa-rated corporate bond index (Chart 5).4 We expect this poor relative performance to continue in the months ahead as the composition of global growth shifts back to the U.S., putting upward pressure on the dollar. In last week's report we looked at 12-month breakeven spreads in each segment of the investment grade U.S. fixed income market.5 Our results showed that Sovereign debt looks expensive across every credit tier. In contrast, Foreign Agency debt and Local Authority debt offer elevated breakeven spreads. Foreign state-owned energy companies account for a large portion of the Foreign Agency index, and this sector's relative performance closely tracks the price of oil. With our commodity strategists now calling for average 2018 crude oil prices of $74/bbl and $70/bbl for Brent and WTI respectively, the Foreign Agency sector should stay well supported.6 Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 32 basis points in February, bringing year-to-date excess returns up to +86 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined a modest 1% on the month, concentrated at the long-end of the curve. January's abrupt increase in flows into municipal bond mutual funds reversed course last month (Chart 6). Interestingly, the sudden surge and subsequent reversal in flows was mirrored by the behavior of municipal bond issuance for new capital (panel 2). This suggests that both trends were driven by changes to the federal tax code. While we remain underweight municipal bonds for now, we stand ready to shift exposure out of corporate bonds and into municipal bonds once our end-of-cycle inflation targets are met. But in the meantime, we note that municipal bonds are already quite attractive compared to corporates. In last week's report we showed that tax-adjusted municipal bond breakeven spreads are much higher than for comparable-quality corporate bonds.7 We also note that the yield differential between a tax-adjusted Aaa-rated municipal bond and an equivalent-duration A3/Baa1 corporate bond is only -19 bps (bottom panel). Historically, this yield differential turns positive near the end of the credit cycle and investors get an even better opportunity to shift out of corporates and into Munis. We expect to get that opportunity this year. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve rose sharply and steepened in February. The 2/10 Treasury slope steepened 4 basis points and the 5/30 slope steepened 5 bps. As a result, our recommendation to favor the 5-year bullet versus a duration-matched 2/10 barbell returned +5 bps on the month, though it is still underwater 35 bps since the trade was initiated in December 2016. As we explained in a Special Report last year, bullet over barbell trades are designed to profit from curve steepening.8 But they also depend on what is initially priced into the yield curve. Our model of the 2/5/10 butterfly spread relative to the 2/10 Treasury slope shows that the 5-year note is currently 5 bps cheap on the curve (Chart 7). Or alternatively, it shows that the 2/5/10 butterfly spread is priced for roughly 26 bps of 2/10 curve flattening during the next six months (panel 4). In other words, if the 2/10 slope steepens during the next six months, or flattens by less than 26 bps, we would expect the 5-year bullet to outperform the 2/10 barbell. The window for curve steepening is clearly closing, given that the Fed has adopted a more aggressive tightening bias. However, with inflation on the rise and long-maturity TIPS breakeven inflation rates still below levels consistent with the Fed's target, we think 2/10 flattening in excess of 26 bps during the next six months is unlikely. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 9 basis points in February, bringing year-to-date excess returns up to +84 bps. The 10-year TIPS breakeven inflation rate rose 1 bp on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate fell 4 bps and currently sits at 2.21%. As we explained in a recent report, we view the first stage of the cyclical bond bear market as being driven by the re-anchoring of inflation expectations.9 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. If the recent trend in realized inflation continues, then this re-anchoring could occur relatively soon. January data show that the annualized 6-month rate of change in trimmed mean PCE jumped to 1.99% (Chart 8), and while the 12-month rate of change rose only slightly to 1.69%, it will start to move higher in March when the strong inflation prints from January and February 2017 are removed from the sample. Our Pipeline Inflation Indicator also suggests that inflation will move higher, as do leading indicators for both shelter and medical care inflation, as we showed in last week's report.10 ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 20 basis points in February, dragging year-to-date excess returns down to -16 bps. The index option-adjusted spread for Aaa-rated ABS widened 10 bps on the month and now sits at 45 bps, 12 bps above its pre-crisis low (Chart 9). The 12-month breakeven spread differential between Aaa-rated ABS and Aaa-rated corporate bonds currently sits at +13 bps, solidly above its post-2010 average (panel 3).11 Further, we noted in last week's report that consumer ABS exhibit relatively low excess return volatility.12 Although valuation is quite attractive, the evidence suggests that collateral credit quality is starting to weaken. Delinquency rates have bottomed for both auto loans and credit cards, and a rising household debt service ratio suggests they will continue to trend higher (panel 4). Banks have also noticed the deterioration in credit quality and have responded by tightening lending standards (bottom panel). Historically, tighter lending standards tend to coincide with periods of spread widening. Remain neutral ABS for now, based on still-attractive valuation relative to investment alternatives, but monitor credit trends for a signal on when to downgrade further. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in February, dragging year-to-date excess returns down to +47 bps. The index option-adjusted spread widened 4 bps on the month and currently sits at 62 bps, close to one standard deviation below its pre-crisis mean (Chart 10). In last week's report we observed that the 12-month breakeven spread of Aaa-rated non-Agency CMBS is elevated compared to other Aaa-rated sectors (consumer ABS being the exception), but that it also exhibits high excess return volatility.13 While there is no doubt that relative value is attractive, we are concerned about the gap that has emerged between CMBS spreads and the rate of appreciation in commercial real estate (CRE) prices (panel 4). It is possible that tight spreads are simply foreshadowing an imminent re-acceleration in prices, and in fact bank lending standards have become less of a headwind, tightening less aggressively than in recent years (bottom panel). But for now, we think non-Agency CMBS are still not worth the risk. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +8 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 41 bps. In last week's report we noted that the 12-month breakeven spread for Agency CMBS is higher than for all other Aaa-rated sectors, except for non-Agency CMBS and consumer ABS. We also noted that the sector has historically exhibited low excess return volatility. Remain overweight. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.96% (Chart 11). The fair value was revised down by 5 bps compared to last month due to a combination of more bullish dollar sentiment (bottom panel) and a tick lower in the Global PMI (panel 3). Of the four major economic blocs, PMIs declined in the U.S., Eurozone and Japan. Only the Chinese PMI managed a slight increase (panel 4). We see the risk of a significant relapse in the U.S. PMI as quite low, but recently highlighted that weakening leading indicators in China could soon bleed into lower Chinese PMI prints.14 This is a significant near-term risk to our below-benchmark duration recommendation. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 1, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.86%.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 4 The Baa-rated corporate index is the Sovereign sector's closest comparable in terms of average credit rating. 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22, 2018, available at ces.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies" dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 11 The breakeven spread measures the option-adjusted spread on offer per unit of duration. 12 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 13 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 14 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

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

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

Highlights Corporate Bonds & Inflation: The perception of accommodative monetary policy is the sole support for corporate bond performance. But this support will fade as inflationary pressures mount. Our first trigger to reduce exposure to corporate bonds will be when the 10-year TIPS breakeven inflation rate returns to a range between 2.4% and 2.5%. Corporate Debt & Buybacks: New tax legislation incentivizes firms to carry less debt in an optimal capital structure, but this is not likely to alter the current cyclical path of corporate sector re-leveraging. Share buybacks are also once again rising, an unambiguous negative for corporate balance sheet health. MBS: Absent a major monetary policy miscommunication that causes Treasury yields to spike dramatically, extension risk is not likely to be a significant driver of Agency MBS excess returns. We estimate that a monthly increase in yields exceeding 72 bps is required before extension risk becomes material. Feature Chart 1Watch This Space Watch This Space Watch This Space Inflation drives everything in the current environment. If the market comes to expect that inflation will return to the Fed's target, then Treasury yields have further upside. A relapse in inflation would likewise cause yields to fall. Elsewhere, with corporate balance sheets already in disrepair, accommodative monetary policy remains the sole support for spread product excess returns. Once inflation rises this support will also vanish, bringing an end to the credit cycle. With that in mind there is one chart we are tracking more closely than any other. It is the 10-year TIPS breakeven inflation rate and it has moved up significantly in recent months, from a mid-2017 low of 1.66% to its most recent reading of 2.11% (Chart 1). In last week's report we discussed why the 10-year breakeven rate will likely converge to a range between 2.4% and 2.5% before the end of the cycle, applying 29 bps to 39 bps of additional upward pressure to the nominal 10-year Treasury yield.1 This week, we focus on why this chart is so important for our spread product call. Specifically, we explain why a return of the 10-year TIPS breakeven rate to its fair value range between 2.4% and 2.5% will also likely trigger a reduction in our recommended allocation to corporate bonds. Trigger Warning: TIPS Breakevens & The Credit Cycle The range of 2.4% to 2.5% for the 10-year TIPS breakeven inflation rate represents where it has traded in prior periods when inflation is well anchored around the Fed's target. When it is below this range the assumption is that the Fed must respond dovishly whenever credit spreads widen or financial conditions tighten more generally.2 Why? Because when inflation is low the Fed needs the recovery to continue. It cannot allow tighter financial conditions to derail economic growth. Market participants know that this "Fed put" is in place and this makes it very difficult for spreads to gap meaningfully wider. For some context, let's consider the most recent period of significant spread widening between 2014 and 2016 (Chart 2). The initial catalyst for the sell-off was certainly the collapse in commodity prices and defaults in the energy sector, but why was the poor performance so broad based across the entire corporate bond universe? It is because the market assumed that the Fed would not respond dovishly to what was purely a commodity price shock. Notice that our 24-month Fed Funds Discounter, the number of rate hikes the market expects during the next two years, held steady at an elevated level throughout the entire period of spread widening (Chart 2, top panel). It was not until after the Fed capitulated in early 2016, and the discounter fell, that spreads started to recover. We therefore conclude that in order to see another significant sell-off in spread product we need to re-create the conditions that prevailed between 2014 and 2016. Specifically, we need a sense in the market that the Fed will not respond dovishly even if financial conditions tighten. The most likely catalyst for such a shift in market psychology is if inflation pressures are higher. The Fed would be less concerned about maintaining strong growth, and more concerned about containing inflation. Our sense is that a return to the range of 2.4% to 2.5% on the 10-year TIPS breakeven inflation rate will be the earliest signal of such a shift. Chart 2Wider Spreads Need A Hawkish Fed Wider Spreads Need A Hawkish Fed Wider Spreads Need A Hawkish Fed Chart 3Inflation Not Yet A Constraint Inflation Not Yet A Constraint Inflation Not Yet A Constraint The Empirical Evidence The link we have drawn between inflation and the end of the credit cycle is not pure theory. The historical record also shows that corporate bond excess returns are highest when inflationary pressures are lowest, and vice-versa. The readings from the Federal Reserve Bank of St. Louis' Price Pressures Measure (PPM) and from core PCE inflation have proven to be particularly useful in this regard (Chart 3).3 Table 1 shows that a level of 15% on the PPM has been a key threshold between positive and negative corporate bond excess returns. Monthly corporate bond excess returns have averaged +24 bps when the PPM is below 15%, but have averaged -5 bps when the PPM is between 15% and 30%. A PPM between 30% and 50% has historically been met with average monthly corporate bond excess returns of -17 bps. The PPM is currently at 7%, still supportive of our overweight allocation to corporate bonds. Table 2 repeats the exercise from Table 1, but this time for year-over-year core PCE inflation. The best periods for corporate bond performance have been when core PCE inflation is below 1.5%. In those periods monthly excess returns have averaged +25 bps. An inflation rate between 1.5% and 2% has led to more balanced corporate bond performance, with average monthly excess returns coming in at zero. Core PCE above 2% typically sends a negative signal for corporate bonds, with average monthly excess returns coming in at -13 bps when core PCE inflation is between 2% and 2.5%. Data released yesterday show that year-over-year core PCE inflation just ticked above 1.5% in December. It is therefore just starting to signal that the environment for corporate bond outperformance is becoming less favorable. Table 1Investment Grade Corporate Bond Excess Returns* Under Different Ranges ##br##Of Price Pressures Measure** (January 1990 To Present) The Most Important Chart In Finance The Most Important Chart In Finance Table 2Investment Grade Corporate Bond Excess Returns* Under Different Ranges##br## Of Year-Over-Year Core** PCE (December 1993 To Present) The Most Important Chart In Finance The Most Important Chart In Finance Bottom Line: The perception of accommodative monetary policy is the sole support for corporate bond performance. But this support will fade as inflationary pressures mount. Our first trigger to reduce exposure to corporate bonds will be when the 10-year TIPS breakeven inflation rate returns to a range between 2.4% and 2.5%. Corporate Debt, Buybacks & Tax Reform The preceding section takes for granted that corporate balance sheets are highly levered. Therefore, spreads will start to widen once inflationary pressures mount and monetary policy turns more restrictive. However, if firms suddenly started paying down debt and shoring up their balance sheets, then a significant enough improvement in corporate health could challenge our conclusions. On that note, the recently passed U.S. tax package does include a few incentives for firms to carry less debt in the capital structure: Lower corporate tax rates reduce the tax benefit from debt financing. Limiting the corporate interest tax deduction to 30% of earnings accomplishes the same thing. The ability to repatriate off-shore cash might also incentivize firms to pay off debt they had taken out to finance previous dividend and buyback programs. It is definitely conceivable that the first two provisions might incentivize less corporate debt issuance in the long run, but we doubt they will alter the cyclical picture. Chart 4 shows that the ratio of non-financial corporate debt to sales only tends to peak once the economy enters recession. In other words, firms in aggregate do not pay down debt unless prompted by slowing demand. As for repatriation, it is also possible that some firms might use repatriated cash to pay down debt, but we also doubt this effect will be large enough to alter the cyclical re-leveraging of the corporate sector. The temptation to use repatriated cash to boost share buybacks even further might be too great for firms to resist, and in fact we already see evidence of surging buyback announcements since the tax bill was introduced (Chart 5). Share buybacks obviously pose a significant risk to corporate bonds because they reduce the equity cushion in corporate capital structures. And in fact, aggregate share buybacks do tend to peak just prior to turns in the credit cycle. However, buyback activity is not a very reliable indicator of when the credit cycle is about to turn. Simply because it peaks at a different level in each cycle. Chart 4The History Of Corporate Leverage The History Of Corporate Leverage The History Of Corporate Leverage Chart 5Cue The Buyback Surge? Cue The Buyback Surge? Cue The Buyback Surge? The more reliable correlation is that periods when buybacks are declining have tended to coincide with periods of corporate bond underperformance (Chart 5, panel 2). This is most likely because tighter lending standards cause both corporate spreads to widen and buyback activity to decline, as banks make debt financing less available. This explains why the most recent decline in buyback activity did not coincide with corporate bond underperformance, because bank lending standards remained supportive and were not the driving force behind the reduction in buybacks (Chart 5, bottom panel). Bottom Line: New tax legislation incentivizes firms to carry less debt in an optimal capital structure, but this is not likely to alter the current cyclical path of corporate sector releveraging. Share buybacks are also once again rising, an unambiguous negative for corporate balance sheet health. Extension Risk In MBS Once the 10-year TIPS breakeven inflation rate reaches our trigger range of 2.4% to 2.5%, one of the beneficiaries of the reduction in our allocation to corporate bonds will likely be Agency MBS. These securities have become much more attractive relative to investment grade corporate bonds during the past year, as corporate bond option-adjusted spreads (OAS) narrowed and MBS OAS widened a tad (Chart 6). In fact, the OAS differential between a conventional 30-year Agency MBS and an investment grade corporate bond is only 19 bps away from its all-time high (Chart 6, panel 2). Chart 6An Attractive Option For De-Risking An Attractive Option For De-Risking An Attractive Option For De-Risking Last year's widening in MBS OAS is most likely due to the market pricing-in the run-off of the mortgages on the Fed's balance sheet. Now that the schedule for MBS run-off is well known, we think it is probably already reflected in current spreads. That is, we think current MBS OAS present an attractive opportunity to shift some allocation out of corporate bonds and into MBS, in the context of de-risking a U.S. fixed income portfolio. As was stated above, we think it is still a bit too soon to take risk off the table, but that will change once inflationary pressures are more pronounced. Another reason why we view Agency MBS as attractive is that the risk of future spread widening appears to be low. Mortgage refinancings, the main driver of MBS spread widening, should stay low as long as we remain in a rising rate environment. Further, with so much burn-out already in existing mortgage pools, even a decline in mortgage rates is not likely to cause a surge in refi activity (Chart 6, bottom panel). This leaves duration extension as the main risk for excess MBS returns. The opposite of refinancing risk, extension risk in MBS comes from the fact that the duration of these negatively convex securities rises when yields rise, thus leading to greater losses in a rising rate environment. A typical positively convex bond will see its duration decline as yields rise, damping the negative impact of rising rates. How worried do we need to be about the impact of extension risk on excess MBS returns? To answer this question we performed a regression of monthly excess MBS returns (relative to duration-matched Treasury securities) on three factors: The monthly change in duration-equivalent Treasury yields. The squared monthly change in duration-equivalent Treasury yields. The monthly change in OAS. As is shown in Table 3, the first factor is positively related to MBS returns. This is because it proxies for refinancing risk. Lower yields lead to more refinancing and wider MBS spreads, while higher yields lead to less refinancing and tighter MBS spreads. The squared yield factor is included as a proxy for extension risk, and it enters the model with a negative coefficient. For example, a small increase in yields is positive for MBS returns since it leads to less refi activity, but a large increase in yields eventually becomes negative for returns once it causes MBS duration to extend. The change in OAS is also a significant driver of MBS returns, but is un-correlated with the change in yields and so operates independently from the factors that drive refinancing and extension risk. The main message from our excess return model is illustrated in Chart 7. If we assume that the OAS remains flat, then the relationship between monthly excess MBS returns (relative to Treasuries) and the monthly change in Treasury yields can be illustrated with the following quadratic equation: Table 3Model Of Monthly Excess (%) Returns For Conventional ##br##30-Year Agency MBS (2000 - Present) The Most Important Chart In Finance The Most Important Chart In Finance Chart 7Model Of Monthly Excess (%) Returns For Conventional ##br##30-Year Agency MBS (2000 - Present) The Most Important Chart In Finance The Most Important Chart In Finance The Most Important Chart In Finance The Most Important Chart In Finance The chart shows that, all else equal, a monthly change in the duration-matched Treasury yield between -35 bps and +72 bps is consistent with positive excess MBS returns relative to Treasuries. It is only when the monthly change in yields exceeds +72 bps on the upside, or -32 bps on the downside, that negative convexity starts to bite. As is shown in Chart 8, monthly changes in Treasury yields of this magnitude - especially spikes of more than 72 bps - are quite rare. Chart 8Extension Risk Rarely Bites Extension Risk Rarely Bites Extension Risk Rarely Bites Bottom Line: Absent a major monetary policy miscommunication that causes Treasury yields to spike dramatically, extension risk is not likely to be a significant driver of Agency MBS excess returns. We estimate that a monthly increase in yields exceeding 72 bps is required before extension risk becomes material. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Long And Short Of It", dated January 23, 2018, available at usbs.bcaresearch.com 2 Wider credit spreads, a stronger dollar, a rising VIX and falling equity prices all signal tighter financial conditions. 3 For further details on the Price Pressures Measure please see: https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure/ Fixed Income Sector Performance Recommended Portfolio Specification

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

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