Securitized Products

Feature Recently we have received a number of client questions about the Fed's balance sheet. When will the Fed start to shrink its balance sheet (if at all)? If the Fed does decide to shrink its balance sheet, how long will that process take? How will the Fed control interest rates in the years ahead? And most importantly, how will these decisions impact financial markets? To answer these questions, this week we are sending you a Special Report titled "Cleaning Up After The 100-Year Flood" that was first published on June 10, 2014. This report explains how monetary policy is conducted at an operational level, and also how the dramatic expansion of the Fed's balance sheet forced the Fed to modify its approach. But first, we have some additional thoughts on how the Fed's balance sheet is likely to evolve during the next few years. The Fed's Stated Plan The most up-to-date guidance we have received about the Fed's balance sheet plans comes from Janet Yellen's recent Congressional testimony: The FOMC has annunciated that its longer run goal is to shrink our balance sheet to levels consistent with the efficient and effective implementation of monetary policy. And while our system evolves and I can't put a number on that, I would anticipate a balance sheet that's substantially smaller than at the current time. In addition, we would like our balance sheet to again be primarily Treasury securities, whereas as you pointed out, we have substantial holdings of mortgage-backed securities. From this, and similar statements from other Fed officials, we conclude that the Fed will allow its balance sheet to shrink once the fed funds rate is somewhere in the range of 1% to 1.5%.1 Surveys also show that the median primary dealer expects the Fed will change its balance sheet policy when the target fed funds rate is 1.38%. As such, and under reasonable assumptions for the pace of rate hikes, we think it is very likely that the Fed will start to let its balance sheet shrink sometime in 2018. MBS First, Treasuries Maybe Later Yellen's statement to Congress also makes clear that the Fed would be more comfortable with a balance sheet that consists entirely of Treasury securities. For this reason, the central bank will start by simply ceasing the reinvestment of its Agency bond and MBS portfolios. At least initially, the Fed will continue to reinvest the proceeds from its maturing Treasury portfolio. Yellen also left open the possibility that reinvestment could be "tapered" rather than just halted altogether. While this is possible, and in fact 70% of primary dealers think that reinvestments will be phased out over time while only 14% think they will be ceased all at once, it seems to us like a needless complication. We expect that reinvestments of Agency bonds and MBS will end all at once sometime in 2018. As for the Fed's holdings of Treasury securities, it is much less clear whether the Fed will allow these balances to run down. The accompanying Special Report describes in detail the differences between the Fed's pre-crisis mode of operation, when bank reserves were scarce, and the Fed's current mode of operation with large bank reserve balances. As of now, the Fed has stated that it intends to eventually drain bank reserves from the system and return to its pre-crisis mode of operation, but there are several possible advantages to running a system with an outsized Fed balance sheet and large bank reserve balances. Chart 1Reserves Can Be Drained Fairly Quickly Reserves Can Be Drained Fairly Quickly Reserves Can Be Drained Fairly Quickly None other than Ben Bernanke pointed out a few of those reasons in a blog post last fall.2 In our view, the most compelling is that regulatory changes have increased private sector demand for safe, short-maturity, liquid assets in recent years. If the Treasury department is unwilling to supply T-bills in sufficient numbers, then the Fed can supply safe, short-maturity, liquid assets to the market by purchasing long-maturity Treasury securities and replacing them with bank reserves. Of course, we take the Fed at its word when it says that it would like to eventually drain excess bank reserves from the system. But even in that case, the steady growth of currency in circulation means that bank reserves will decline over time even if the Fed keeps the asset side of its balance sheet flat. For example, Chart 1 shows what would happen to bank reserves if the amount of currency in circulation grows at a conservative 5% per year pace, and if the Fed decides to allow its Agency bond and MBS portfolios to run off at the beginning of next year while keeping its Treasury portfolio flat. We assume that MBS runs off the Fed's balance sheet at a pace of $15 billion per month, slightly below the recent pace of MBS reinvestment. During the past three years, the Fed has reinvested between $20bn and $40bn MBS each month with an average monthly reinvestment of $32bn. In this scenario, outstanding bank reserves would decline to zero by the end of 2025. At that point the Fed would have to start adding to its Treasury holdings just to keep pace with the amount of currency in circulation. Bottom Line: While it is very likely that the Fed will allow its Agency bond and MBS portfolios to run off starting in 2018, it is much more uncertain whether it will ever cease the reinvestment of its Treasury holdings. If the Fed does allow its Treasury holdings to run down as well, it will have to start buying Treasuries again before 2025. Investment Implications Treasuries As our U.S. Bond Strategy service has written several times,3 considered in isolation it is unlikely that any decision by the Fed to allow its Treasury holdings to run off will have much of on an impact on the Treasury curve. To see why, we need to consider the process by which the Fed currently rolls over maturing Treasury securities at auction. At the moment, balances of matured Treasury securities are added to upcoming note/bond auctions as non-competitive bids. In other words, as Treasury securities mature the Fed buys an equal amount at upcoming Treasury auctions. If the Fed were to cease this reinvestment, that amount would need to be added to the competitive portion of the auctions and would greatly increase the gross issuance of Treasury debt to the public. For a sense of scale, we calculate that Treasury issuance to the public would need to increase by $426bn in 2018 and $378bn in 2019 if the Fed were to cease the reinvestment of its portfolio at the end of this year (Chart 2). However, the fact that this process is intermediated by the Treasury department means we also have to consider potential changes to fiscal policy and the U.S. government's financing mix. For instance, since running down the Fed's Treasury portfolio would also reduce the amount of bank reserves in the system, it is very likely that the Treasury department would seek to increase issuance of T-bills to compensate for the banking sector's loss of safe, short-maturity liquid assets. At present, bill supply as a percent of total Treasury debt is near a multi-decade low (Chart 3) and any increase in T-bill issuance would limit the impact of Fed balance sheet run-off on long-dated Treasury yields. Chart 2Fed Runoff Will Increase Issuance To Public... Fed Runoff Will Increase Issuance To Public... Fed Runoff Will Increase Issuance To Public... Chart 3... But Mostly Through T-Bills ... But Mostly Through T-Bills ... But Mostly Through T-Bills Bottom Line: When forecasting Treasury issuance and any potential impact on yields we must consider both the Fed's balance sheet and fiscal policy together. In our view, whatever the government's financing requirement in the years ahead, a considerable portion will be met through increased T-bill issuance, limiting the impact on long-dated Treasury yields. Mortgage-Backed Securities As our U.S. Bond Strategy service has recently written,4 the unwinding of the Fed's MBS portfolio poses a considerable threat to MBS spreads for two reasons. First, the transfer of MBS from the Fed to the private sector will put upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility will increase pressuring MBS spreads wider (Chart 4). The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 5). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 6), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 4MBS Spreads Are##br## Linked To Vol MBS Spreads Are Linked To Vol MBS Spreads Are Linked To Vol Chart 5Annual MBS Excess Returns##br## Vs. Net Supply Since 1989 The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Chart 6Adjusted Net Issuance Will ##br##Turn Positive In 2018 Adjusted Net Issuance Will Turn Positive In 2018 Adjusted Net Issuance Will Turn Positive In 2018 Bottom Line: The unwinding of the Fed's MBS portfolio will pressure MBS spreads wider through increased supply and increased demand for volatility. Note: Please see the U.S. Bond Strategy Special Report, titled "Cleaning Up After The 100-Year Flood", dated June 10, 2014 available at usbs.bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 In a Q&A from June 2015 New York Fed President William Dudley floated 1% to 1.5% as a potentially reasonable range for the fed funds rate before the Fed considers changing its balance sheet policy. https://mninews.marketnews.com/content/feds-dudley-qa-markets-should-not-be-surprised-liftoff 2 https://www.brookings.edu/blog/ben-bernanke/2016/09/02/should-the-fed-keep-its-balance-sheet-large/ 3 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017. And also U.S. Bond Strategy Weekly Report, "Currencies: The Tail Wagging The Dog", dated August 18, 2015. Both available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com Cleaning Up After The 100-Year Flood In this Special Report we consider how the dramatic expansion of the Fed's balance sheet has influenced the conduct of monetary policy from an operational perspective. Massive reserve balances have made the federal funds market largely irrelevant, but the Fed's new overnight reverse repo facility will allow it to tighten policy when the time comes. The Fed will likely provide new guidelines for its exit strategy before the end of 2014. We anticipate how these guidelines will be modified to reflect the challenges of implementing monetary policy with a large balance sheet. Large reserve balances do not pose an inflation threat, but they do have implications for the state of banking sector regulation and the policy tools at the Fed's disposal. Chart 1What Are Implications Of Fed's Epic Intervention? The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Feature The Federal Reserve resorted to a number of very aggressive and extraordinary monetary policy measures to deal with the failure of Lehman Brothers, the subsequent financial crisis and Great Recession. The result has been a flood of liquidity that has supported asset prices and spurred the recovery, yet has left the central bank balance sheet exponentially larger than at any time in its 100-year history (Chart 1). In formulating its exit strategy the Fed will finally be forced to grapple publicly with the aftereffects of its dramatic intervention in financial markets, which has complicated how monetary policy is implemented at an operational level. This Special Report is divided into three sections. In the first section, Before The Storm, we provide some background on the process of money creation and explain how the Fed implemented monetary policy prior to the Great Recession. In the second section, The Flood Waters Rise, we consider how monetary policy is implemented today in light of the dramatic expansion of the Fed's balance sheet. In the third section, Building On Higher Ground, we examine the way forward for the Fed, describe how the exit is likely to be managed and discuss the potential problems with this approach. 1. Before The Storm Prior to the financial crisis, the Fed expressed the stance of monetary policy via a target for the federal funds rate. The federal funds rate is the rate at which banks borrow and lend reserves to each other in the overnight market. The Fed conducted its day-to-day operations with the goal of supplying all the reserves demanded by the banking sector, while steering the fed funds rate toward its target. To understand how this was accomplished, we first require some background on the money creation process. Money Creation: More Than Just A Printing Press Contrary to what many believe, the process of money creation does not begin at the Federal Reserve. Rather, it begins in the banking system at the point of loan origination and ends at the Fed (Figure 1). The process is set in motion when a bank makes a new loan. This loan creates a new asset on the aggregate balance sheet for the banking system. The newly created money typically ends up as a deposit, either at the same bank or elsewhere in the banking system.1 The increase to the asset side of the banking sector's balance sheet is offset by an equal increase on the liability side. Only then does the Fed enter the picture. In a fractional reserve system, banks must hold reserves equal to a proportion of their deposits. Therefore, in the pre-QE world illustrated in Figure 1, any increase in deposits also creates demand for more reserves. Crucially, only the Fed is able to supply the banking sector with the needed reserves. The Fed will increase the supply of reserves either by purchasing Treasury securities or lending money in the repo market. This increase on the asset side of the Fed's balance sheet is balanced by an increase in reserves on the liability side. The creation of new bank reserves is the final step in the money creation process. Figure 1The Money Creation Process The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Chart 2QE Has Not Encouraged Lending The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet This is not to suggest the Fed is powerless to control the rate of money creation. On the contrary, Fed policy is the most influential determinant of the rate of money growth. One important distinction, however, is that the Fed exerts control over the pace of money creation because it controls the overnight interest rate. The interest rate, in turn, is the most important driver of bank lending. Changes in the level of bank reserves not associated with changes in interest rates, QE for example, have no effect on credit growth (Chart 2). The Pre-Crisis Fed Funds Market How then, prior to the Great Recession, was the Fed able to maintain the fed funds rate at its target, while still satisfying the banking system's demand for reserves? It accomplished this task by maintaining what it calls a "structural deficiency" in the supply of bank reserves. In practice this means the Fed was careful to supply no more than the quantity of reserves demanded, so that each day it would typically add to the reserve supply to accommodate the newly created demand. As a practical matter, the Fed increases the supply of reserves by either buying securities or lending money in the repo market. Both of these transactions enter the Fed's balance sheet as an asset, which must be offset by a liability, in this case an increase in bank reserves. The Fed can also reduce the supply of reserves by either selling securities or borrowing in the repo market (using the securities it owns as collateral, deemed a reverse repo from the point of view of the borrower). Although due to the "structural deficiency" in the reserve market, the Fed would typically transact to increase reserve balances. Chart 3The Pre-Crisis 'Channel System' The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet If, for example, the Fed wanted to increase the fed funds rate. It would be slow to accommodate the increase in demanded reserves throughout the day. Banks in need of reserves to meet intra-day payment processing needs would bid up the fed funds rate towards the new target. Effective communication of the target fed funds rate also aided this process. Since the target for the fed funds rate was known in advance, and the banking sector believed the Fed would supply all necessary reserves at that target rate, most federal funds transactions tended to occur at rates very close to the target. By the end of the day, however, the Fed must always supply the exact amount of reserves demanded by the banking sector if it wants to maintain control of the fed funds rate. If the Fed were to supply more reserves than the banking system required, banks would try to lend the unwanted excess reserves in the fed funds market, driving the federal funds rate lower to the interest rate paid on excess reserves (IOER), which was zero prior to 2008. Or, consider the opposite case where the Fed supplies too few reserves. In this instance banks would clamor to borrow reserves to meet their regulatory requirement. This incremental demand would drive the federal funds rate higher to the Fed's discount window lending rate, which is always available for banks to access in times of severe stress. The IOER and discount window rate thus created a channel for the fed funds rate (Chart 3), within which the Fed could nudge the rate toward target by being either too quick, or too slow to accommodate increases in demanded reserves throughout the day. Bottom Line: A "structural deficiency" in reserve balances prior to 2008 allowed the Fed to conduct monetary policy by setting a target for the fed funds rate. Also, it is the level of interest rates, and not the level of reserves, that determines the rate of money creation in the economy. 2. The Flood Waters Rise The Federal Reserve began large scale asset purchases (quantitative easing) in late 2008, dramatically increasing the asset side of its balance sheet and consequently the supply of bank reserves (Figure 2). Suddenly, the banking system found itself with far more reserves than it demanded. Predictably, trading in the fed funds market dried up and the fed funds rate was driven toward its lower bound, the IOER.2 The Fed's target for the federal funds rate quickly became irrelevant. Figure 2Illustrative Post-Crisis Balance Sheets For The Fed And The Aggregatve Banking System*: ##br##An Explosion In Excess Reserves The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet In the presence of excess bank reserves, the Fed needs a mechanism to control the lower bound of overnight lending rates. In theory, the IOER could serve as a floor beneath the fed funds rate because banks should not be willing to lend reserves at a rate lower than what can be earned at the Fed. Yet the fed funds rate has consistently traded below the IOER since 2008 (Chart 4). The reason for this violation is that the IOER is only available to depository institutions with reserve accounts at the Fed. Other suppliers of short maturity funds, mostly the GSEs, are still willing to transact at lower rates (Chart 5). Chart 4In Need ##br##Of A Floor The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Chart 5Fed Funds Market Smaller, ##br## And Dominated By GSEs The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Chart 6Reverse Repo Facility Is New Floor On ##br##Rates Money Markets Under The Microscope The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet A new facility is required, that is capable of absorbing all of the supply of overnight funds including that emanating from outside the traditional banking system. The Fed answered this requirement by creating a fixed rate overnight reverse repo (RRP) facility. Once fully implemented, the Fed will stand ready to borrow overnight in unlimited amounts, at a rate that it chooses (i.e. is set independently of market forces). By making this facility available to a larger set of counterparties than the IOER, including money market funds and the GSEs, the Fed now has a "hard floor" on rates that it will be able to use to raise interest rates when the time comes. Even though it is still in a testing phase, the RRP already appears to be acting as a floor for overnight rates (Chart 6). Bottom Line: The stockpile of excess reserves created by the Fed's large scale asset purchase program has made the federal funds market largely irrelevant. The Fed is now only able to implement monetary policy by placing a floor under short-term interest rates, the RRP. 3. Building On Higher Ground From an operational perspective, there are two possible ways forward for the Fed as it prepares to lift rates. One option would be to return to the pre-crisis method of operation described in the first section. To do this, the Fed would first have to drain all excess reserves from the banking system by either selling securities, or deploying some of the tools on the liability side of its balance sheet, such as term deposits.3 This would re-launch the federal funds market and the Fed could return to setting policy in its traditional manner, by targeting the fed funds rate. Unfortunately, there are simply too many excess reserves in the system to make this a viable strategy, at least for the next several years. Moreover, the pace of asset sales required to drain excess reserves in a timely manner would lead to large spikes in the Treasury term premium. Instead, the Fed will almost certainly choose to maintain large reserve balances and operate monetary policy by lifting the floor RRP rate. Specifically, the Fed will set the RRP rate equal to (or slightly below) the IOER. It will then hike rates by increasing both in tandem. The Fed may still choose to set a target for the fed funds rate at a level somewhat above the RRP to maintain consistency in its communications, but this rate will be meaningless. We outline the likely sequence of the Fed's exit strategy in the following Box. Box The Exit Strategy Revisited The Fed first articulated the likely sequence of the exit strategy in the minutes to the June 2011 FOMC meeting.4 That sequence was as follows: Cease reinvestment of principal on securities holdings. Modify forward guidance on the path of the federal funds rate, and initiate reserve draining operations (e.g. term deposits). Begin raising the target federal funds rate. Begin sales of securities holdings, with a goal of returning the balance sheet to a more traditional size within two to three years. The above sequence suggests the Fed was planning to first drain excess reserves and then conduct monetary policy operations in the fed funds market, as it did prior to QE. This strategy has now been abandoned, and we expect to receive a modified exit sequence before the end of the year. The revised sequence will be consistent with the implementation of policy using a floor system, with large excess reserves, and could look something like: Modify forward guidance on the path of interest rates (including IOER, RRP and fed funds). Begin raising interest rates. First by raising the RRP rate to slightly below the IOER, and then by raising both rates in tandem. A few months after rate hikes begin; cease reinvestment of principal on Agency and Agency MBS holdings. Much later; cease reinvestment of principal on Treasury securities. The Fed will probably cease reinvestment of its MBS holdings prior to its Treasury holdings, and will then let its MBS holdings run-off passively to zero. The Fed will also probably let some of its Treasury holdings run-off passively, but could decide to maintain a permanently larger balance sheet, depending on the success of the RRP and floor system. In the next few years, as its balance sheet begins to shrink through passive run-off, the Fed may decide to drain the remaining excess reserves and return to its traditional operating method as outlined in Section1 above. Either way, U.S. monetary policy will operate under a "floor system", using the RRP rate, for at least the next few years. This new method of operation comes with several potential drawbacks, which we address below. Excess Reserves Are "Dry Powder" For The Banking System Chart 7Drivers Of Bank Lending The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Many have speculated that banks have been choosing to sit on large excess reserve balances. The thinking is that eventually the economy will reach a turning point and banks will decide to convert their excess reserves to loans en masse, leading to a surge in bank lending, and eventually, inflation. This implies that the presence of large excess reserve balances would force the Fed to hike rates more quickly than in their absence. This concern stems from a misunderstanding of the money creation process described above. The Fed could fall "behind the curve" and normalize policy too slowly, which could ultimately lead to higher inflation. However, this would simply be a consequence of keeping interest rates too low for too long. The presence of excess reserves does not in itself create a desire to lend and thus poses no additional inflation risk. For one thing, the banking system in aggregate is powerless to reduce the amount of excess reserves without the Fed also taking action to reduce the supply. As shown in Figures 1 and 2, the supply of excess reserves is determined solely on the Fed's balance sheet. There is no danger of excess reserves "leaking out" into the economy. More importantly, however, is that the process of money creation begins with the origination of a loan and ends when the Fed increases the supply of reserves. The catalyst for the process, the amount of bank lending, is determined by (Chart 7): loan demand banks' perceived profitability from additional lending banks' concerns about taking too much risk on the balance sheet, putting their viability at risk regulatory requirements concerning capital and liquidity The Fed exerts control over these four factors through its interest rate policy, but not through changes in the balance of excess reserves. Prior to 2008, the lack of excess reserves did not act to constrain bank lending, rather the Fed chose to encourage or discourage lending by decreasing or increasing the interest rate. Similarly, the large excess reserve balances since 2008 have not provided an incentive to lend. Excess Reserves and Bank Regulation One implication of the Fed having sole control over the supply of bank reserves is that, through QE, it has effectively forced reserves onto bank balance sheets. These reserves obviously factor into banks' calculations concerning required regulatory ratios for liquidity and capital. Liquidity Coverage Ratio Chart 8Fed Purchases Pushed ##br##Term Premium Lower The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Under the proposed liquidity coverage ratio (LCR), banks must maintain a balance of high-quality liquid assets (such as bank reserves and Treasury securities) equal to their expected net cash requirement during a 30-day period. In theory, should the Fed ever decide to reduce the supply of excess reserves, banks could have trouble meeting the LCR requirement. In removing reserves, however, the Fed would also be selling securities. Banks falling short of their LCR requirement would be natural buyers for the securities offloaded by the Fed. Thus, the Fed's operating decisions will probably not exert any influence over banks' ability to meet their liquidity requirements. The LCR, however, does have implications for the equilibrium level of the Treasury term premium. Much as the Fed's Treasury purchases pressured the term premium lower (Chart 8), any future Treasury sales could be expected to unwind this effect. Even so, bank demand for those same Treasury securities would mitigate some of the upside for the term premium. Supplementary Leverage Ratio Large U.S. banks face a supplementary leverage ratio (SLR) which requires them to hold capital equal to at least 5% of total assets, not risk-weighted. In other words, large excess reserves force banks to hold more capital, which could have an adverse economic impact. Banks falling short of the SLR can either raise capital, or reduce assets. If they are either unable or unwilling to raise capital, then the large balance of excess reserves thrust upon them by the Fed could in theory crowd out bank lending. In other words, if the banking sector refuses to increase capital, then the onus falls on the asset side of the balance sheet to adjust to SLR standards. Since the banking sector in aggregate is unable to reduce reserve balances, any desired contraction in total assets could conceivably translate into an incentive to reduce the pace of bank lending. As currently proposed the SLR does not appear to be too big a hurdle for the largest U.S. banks. It is very likely they will be able to meet the requirement through retained earnings and new equity issuance. Nevertheless, it still provides a potential drag on bank lending that would not exist under the traditional model of monetary policy operations. Collateral Shortage Chart 9RRP Alleviates Collateral Shortage The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet One side effect of the Fed's large scale asset purchases is that they have removed a lot of high-quality collateral from the financial system. Chart 9 shows that during periods when the Fed is adding to its balance sheet, the amount of collateral in the tri-party repo market declines. As the supply of collateral dwindles, repo rates are also pressured lower. The problem is that once repo rates approach the zero lower bound, counterparties have an increasing incentive to fail on delivery of repo contracts. Given the widespread use of repo financing, persistent repo fails have the potential to undermine liquidity in financial markets. Thankfully, the Fed's new tool for controlling the overnight interest rate, the RRP facility, solves this problem. In a reverse repo transaction, a counterparty purchases securities from the Fed with the understanding that it will sell them back the next day, earning the RRP rate in the process. This means the private sector once again gains access to collateral that had been cordoned off on the Fed's balance sheet. This should have the effect of keeping the repo rate above the floor set by the RRP, and well above zero. Repo fails have already levelled off and should begin to decline once the RRP facility is fully implemented. Financial Stability Concerns We have seen that monetary policy operates under a floor system when there are large reserve balances. One complication is that the U.S. is operating with two different floors, the IOER and the RRP. Due to its availability to a wider selection of counterparties, the RRP is the true floor on rates. From a monetary policy perspective, the easiest way forward is to set both rates at the same level and hike them in tandem. However, in a recent speech5 New York Fed President Dudley pointed out that from a financial stability perspective an RRP rate equal to the IOER could result in money flowing out of institutions eligible to receive IOER and into the less regulated shadow banking sector. It is therefore probable the Fed will choose to maintain the RRP at a level slightly below the IOER as rate hikes commence. We maintain focus on the RRP as the true floor on rates. President Dudley also made the case that the Fed's RRP facility could have positive implications for financial stability. He observed that with a Fed-backed short-term safe asset now more widely available, it could crowd out the creation of money-like liquid assets by the private sector. Those privately created liquid assets, such as commercial paper, are more prone to fire sales during times of stress. In a recent paper,6 John Cochrane agreed forcefully with this sentiment. Due to its potential for eliminating privately created money-like liquid assets, Cochrane referred to a monetary policy regime operating with large reserve balances as "a very desirable configuration of monetary affairs." The downside of the Fed providing a short-term safe asset is that it could encourage runs into the RRP during times of crisis. President Dudley rightly concludes that this is more of a technical hurdle that could be managed using caps on usage of the RRP facility. Bottom Line: The Fed will be able to operate monetary policy with large reserve balances, using the RRP as a floor on interest rates for several years while it decides by how much to run down its balance sheet and whether it should revert to its traditional fed funds rate target. Investors should remember that large reserve balances, by themselves, do not pose an inflation risk. Whether or not inflation becomes a problem will depend on the Fed's foresight to raise interest rates in a timely manner. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Alternatively it could be held in cash. This would be reflected on the banking sector's balance sheet as an increase in loans and a decrease in reserves, and on the Fed's balance sheet as an increase in currency in circulation and a decrease in reserves. 2 The Fed began paying interest on excess reserve balances on October 6, 2008. 3 The Fed's current Term Deposit Facility (TDF) temporarily drains reserves from the banking system by receiving funds from the banking sector for a period of 7 days, paying 26 basis points of interest. The early stages of the Fed exit strategy will rely more heavily on the overnight RRP facility rather than the TDF. But term deposits could be deployed once the Fed's balance sheet has returned closer to its traditional size, and the Fed decides it wants to drain the remaining excess reserves and return to its pre-crisis method of operation. 4 http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20110622… 5 "The Economic Outlook and Implications for Monetary Policy" available at http://www.newyorkfed.org/newsevents/speeches/2014/dud140520.html 6 Cochrane, John H. Monetary Policy with Interest on Reserves. Available at http://media.hoover.org/sites/default/files/documents/2014CochraneMonet…

Highlights Rate Volatility: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Treasury Yields: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. MBS: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Feature Low interest rate volatility has been a constant feature of the investing landscape during the past few years. In fact, you need to go back to the 1970s to find another period when interest rate volatility was consistently at or below its current level (Chart 1). Not surprisingly, the implied volatility priced into Treasury options is also as low as it has been during the past 30 years, with the exception of the period just prior to the financial crisis in 2007 (Chart 2). Chart 1Yield Volatility: Lowest Since The 70s Yield Volatility: Lowest Since The 70s Yield Volatility: Lowest Since The 70s Chart 2Implied And Realized Yield Volatility Move Together Implied And Realized Yield Volatility Move Together Implied And Realized Yield Volatility Move Together This begs the question of whether the current low-vol environment can be sustained, or whether overly complacent investors are in for a shock. At the very least, we believe that rate volatility has already passed its cyclical trough and will start to move up this year. Investors should prepare themselves for higher volatility. In this week's report we examine the key macro drivers of interest rate volatility and discuss the implications of rising vol for both Treasury yields, and crucially, mortgage-backed securities. Macro Uncertainty & Rate Volatility Chart 3Macro Drivers Of Rate Volatility Macro Drivers Of Rate Volatility Macro Drivers Of Rate Volatility In a Special Report published in 2014,1 we posited that the long-term trends in volatility across all asset classes are largely driven by common macroeconomic factors. Specifically, investor uncertainty regarding the outlook for economic growth and monetary policy. A 2004 paper by Alexander David and Pietro Veronesi2 provides some theoretical justification for this view, as the authors observed that investors tend to overreact to new information when macro uncertainty is high, and underreact when uncertainty is low. To test the linkage between interest rate volatility and macro uncertainty we consider three measures of uncertainty. The first two measures, shown alongside the MOVE index of implied Treasury volatility in Chart 3, are measures of GDP growth and T-bill rate forecast dispersion. We measure dispersion - the disagreement among forecasters - by looking at individual forecasts of GDP growth and T-bill rates and calculating the difference between the 75th and 25th percentiles. The series shown in Chart 3 are equal-weighted averages of the forecast dispersion calculated for five different time horizons, ranging from the current quarter to four quarters ahead. As can be seen in the top two panels of Chart 3, implied interest rate volatility is higher when the disagreement among forecasters is greater, consistent with our thesis. The third measure of uncertainty we consider is the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index tracks uncertainty about the macro environment by counting the number of mentions of certain key words in major global newspapers. Elevated readings from this index have also coincided with high rate volatility in the past (Chart 3, bottom panel). GDP Growth Forecast Dispersion Chart 4Forecast Dispersion & Corporate Lending Forecast Dispersion & Corporate Lending Forecast Dispersion & Corporate Lending Disagreement among GDP growth forecasts reached an all-time low in the fourth quarter of 2016, but has since recovered to slightly more typical levels. Historically, we have found that C&I lending standards and corporate sector balance sheet health correlate most closely with GDP growth forecast dispersion (Chart 4) and both measures suggest that forecast dispersion is biased upward. T-Bill Rate Forecast Dispersion T-bill rate forecast dispersion was abnormally low between 2011 and 2014 for two reasons. The first reason is quite simply the zero-lower-bound on interest rates. A short rate bounded at zero necessarily trimmed the distribution of possible T-bill rate forecasts, since forecasters logically assumed that further interest rate cuts were not possible. This impact will gradually dissipate the further the fed funds rate moves off zero. Chart 5Fed Says March Meeting Is Live Fed Says March Meeting Is Live Fed Says March Meeting Is Live The second reason for extremely low T-bill rate forecast dispersion was the Fed's forward guidance. During this timeframe the Fed was actively trying to convince the public that interest rates would remain low. The most obvious example being the "Evans Rule", where the Fed promised not to lift interest rates at least until the unemployment rate had fallen below a specific threshold. This activist forward guidance limited the range of conceivable T-bill rate forecasts and crushed interest rate volatility. Nowadays, the Fed is engaged in a different sort of forward guidance, trying to convince markets that every FOMC meeting is live and that rate hikes could occur at any moment. Essentially, the Fed is trying to inject volatility into the rates market. Just a few weeks ago, when asked about the low probability markets are assigning to a March rate hike (Chart 5), San Francisco Fed President John Williams replied flatly: "I don't agree. All our meetings are live." Global Economic Policy Uncertainty We have written a lot about the policy uncertainty index in recent reports,4 focusing specifically on how it has diverged from its historical relationships with many asset prices. At the very least, we expect that sustained elevated policy uncertainty will place upward pressure on asset price volatility at the margin. Bottom Line: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Rate Volatility & Treasury Yields Long-dated nominal Treasury yields can be decomposed in a few different ways. In recent reports we have focused on the decomposition of the nominal 10-year Treasury yield into its real and inflation components. By identifying different macro drivers for each component we concluded that nominal Treasury yields will increase this year, driven by a rising inflation component and relatively stable real yields.5 Alternatively, we can think of the nominal 10-year Treasury yield as consisting of an expectations component equal to the market's expected path of short rates over the next ten years, and a term premium that reflects all of the other market imbalances and uncertainties associated with taking duration risk. This second approach is complicated by the fact that it requires a model of ex-ante interest rate expectations and every commonly used model is fraught with its own unique difficulties.6 Setting that aside, if we use the Kim & Wright (2005)7 estimate of the 10-year term premium we observe an expectations component that generally tracks the fed funds rate and a term premium component that is correlated with implied Treasury volatility (Chart 6), although the latter correlation is less than perfect. This decomposition also suggests that nominal Treasury yields should rise. The Fed is much more likely to hike rates than cut them and we have concluded that rate volatility is likely to trend higher from current depressed levels. However, the relationship between rate volatility and the term premium is complicated. The main reason for the complicated relationship between interest rate volatility and the term premium is the fact that elevated interest rate volatility also tends to be correlated with high equity volatility (Chart 7). So while higher rate volatility puts upward pressure on the term premium, the associated increase in equity volatility tends to raise investor risk aversion and increase the perceived value of bonds as a hedge against equity positions. This mitigates some (or often all) of the impact of rising rate volatility on the term premium. Chart 6Which Way For The ##br##Term Premium? Which Way For The Term Premium? Which Way For The Term Premium? Chart 7MOVE & VIX Have Opposing##br## Impacts On Bond Yields MOVE & VIX Have Opposing Impacts On Bond Yields MOVE & VIX Have Opposing Impacts On Bond Yields Bottom Line: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. Rate Volatility & MBS The relationship between rate volatility and MBS is much more straightforward than for Treasury yields. We observe a tight correlation between nominal MBS spreads and the MOVE implied volatility index (Chart 8). Chart 8 suggests that, even in the near-term, MBS spreads are too low for current levels of rate vol. The relationship between MBS spreads and rate volatility is easily explained. The defining characteristic of a negatively convex asset, such as MBS, is that its duration is positively correlated with the level of interest rates (Chart 9). This correlation leads to increased losses when yields rise and lower gains when yields fall. It's not surprising that negatively convex assets perform best in low volatility environments. Chart 8MBS Spreads Are Linked To Vol MBS Spreads Are Linked To Vol MBS Spreads Are Linked To Vol Chart 9MBS Duration Moves With Yields MBS Duration Moves With Yields MBS Duration Moves With Yields We maintain an underweight allocation to MBS given that spreads are already low and that the volatility environment is poised to become less favorable. Further, if the Fed continues along its planned normalization path it is likely to cease the reinvestment of its MBS portfolio at some point in 2018. There are two reasons why this poses a risk for MBS. The first reason is that the unwinding of the Fed's MBS portfolio is likely to place upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility is likely to increase. The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 10). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 11), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 10Annual MBS Excess Returns ##br## Vs. Net Supply Since 1989 The Road To Higher Vol Is Paved With Uncertainty The Road To Higher Vol Is Paved With Uncertainty Chart 11Net Issuance Will Turn##br## Positive In 2018 Net Issuance Will Turn Positive In 2018 Net Issuance Will Turn Positive In 2018 During the past three years the Fed has been buying between $20bn and $40bn MBS per month, just to keep its balance sheet stable. Net new MBS issuance will not be strong enough to overcome this hurdle in 2017, but net MBS issuance (adjusted for Fed purchases) will swing quickly into positive territory in 2018 if the Fed decides to let its MBS portfolio run down. Bottom Line: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "Volatility, Uncertainty And Government Bond Yields", dated May 13, 2014, available at usbs.bcaresearch.com 2 "Inflation and earnings uncertainty and volatility forecasts", Alexander David and Pietro Veronesi, Manuscript, Graduate School of Business, University of Chicago (2004). 3 Please see www.policyuncertainty.com for further details. 4 Please see Theme # 4 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Bond Volatility - The Unwelcome Guest That Will Not Leave", dated June 16, 2015, available at usbs.bcaresearch.com 7 Don H. Kim and Jonathan H. Wright, "An Arbitrage-Free Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates", FEDS 2005-33. https://www.federalreserve.gov/econresdata/feds/2005/index.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Strong Growth & An Easy Fed Strong Growth & An Easy Fed Strong Growth & An Easy Fed More than a month has passed since the Fed's latest rate hike and, at least so far, the economy is displaying no ill effects. While the economic data continue to surprise to the upside, Fed rate hike expectations have moderated since mid-December (Chart 1). The combination of accelerating growth and accommodative monetary policy sets the stage for further outperformance in spread product. This message was underscored by last Friday's employment report which showed robust payroll gains of +227k alongside a slight deceleration in wage growth. This is consistent with an environment where growth remains above trend but the recovery in inflation proceeds more gradually. Against this back-drop we favor overweight positions in spread product and TIPS relative to nominal Treasuries, while also positioning for a bear-steepening of the Treasury curve. While we would not rule out a near-term correction in risk assets, due to extended positioning and elevated policy uncertainty, we would view any correction as a buying opportunity given the supportive growth and monetary policy back-drop. 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 5 basis points in January (Chart 2). The index option-adjusted spread tightened 2 bps on the month and, at 121 bps, it remains well below its historical average (134 bps). In a recent report1 we examined historical excess returns to corporate bonds given different levels of core PCE inflation. We found that excess returns are best when year-over-year core PCE is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with extremely accommodative monetary policy. When inflation is between 1.5% and 2% (year-over-year core PCE is currently 1.7%), average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. Excess returns do not turn decisively negative until core PCE is above 2%. Given the Fed's desire to nurture a continued recovery in inflation, we expect corporate bond excess returns to be low, but positive. The Technology sector is relatively defensive and is close to neutrally valued according to our model (Table 3). In addition, our Geopolitical Strategy service has observed that many of the firms in this sector carry significant exposure to China, a risk as U.S. protectionism ramps up.2 We therefore downgrade our position in Technology from overweight to neutral, and upgrade our positions in Wirelines, Media & Entertainment and Other Utilities from underweight to neutral. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Cue The Reflation Trade Cue The Reflation Trade Table 3BCorporate Sector Risk Vs. Reward* Cue The Reflation Trade Cue The Reflation Trade High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 124 basis points in January. The index option-adjusted spread tightened 21 bps on the month and, at 376 bps, it is currently 144 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default outlook, last week we upgraded high-yield from underweight to neutral. Still-tight valuation is the reason we maintain a neutral allocation as opposed to overweight. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is currently 152 bps (Chart 3). This is close to one standard deviation below its long-run average. Historically, we have found that a default-adjusted spread between 150 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of -164 bps. With the spread in this range a 90% confidence interval places 12-month excess returns between -500 bps and +171 bps. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 24 basis points in January. The conventional 30-year MBS yield rose 5 bps in January, driven by a 7 bps widening of the option-adjusted spread. The rate component of the yield held flat, while the compensation for prepayment risk (option cost) declined by 2 bps. MBS spreads remain extremely tight, relative both to history and Aaa-rated credit. Historically, the option-adjusted spread is correlated with net MBS issuance and robust issuance will eventually lead this spread wider. At least so far, net MBS issuance shows no sign of slowing down. While refinancing applications declined alongside the recent spike in Treasury yields, purchase applications have remained resilient (Chart 4). The Fed ceasing the reinvestment of its MBS portfolio would also significantly add to MBS supply. As we explained in a recent report,4 we expect the Fed will not start to wind down its balance sheet until 2018. However, if growth is stronger than we expect there is a chance the process could begin near the end of this year. In that same report we also observed that nominal MBS spreads are very low relative to both the slope of the yield curve and implied rate volatility. This poses a risk to MBS in the near-term. Government-Related: Cut To Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 21 basis points in January. Sovereign bonds outperformed by 75 bps, while Foreign and Domestic Agency bonds outperformed by 6 bps and 14 bps, respectively. Local Authorities outperformed by 34 bps and Supranationals outperformed by 2 bps. This week we downgrade the government-related sector from overweight to underweight, although we recommend maintaining an overweight allocation to both the Foreign Agency and Local Authority sectors. Sovereigns are not attractive compared to corporate credit, according to our model, and will struggle to outperform if the dollar remains in a bull market, as we expect it will. A stronger dollar increases the cost of debt servicing from the perspective on non-U.S. issuers. Foreign Agencies and Local Authorities both appear attractive relative to corporate credit, after adjusting for differences in credit rating and duration. Foreign Agencies in particular will perform well if oil prices continue to trend higher. Supranationals offer very little spread, and are best thought of as a hedge in spread widening environments. Domestic Agency debt can also be thought of in this vein, but with the added risk that spreads start to widen if any progress is made toward GSE reform. While any concrete movement on GSE reform is still a long way off, the new administration has brought the topic back into the headlines and this has led to some increased volatility in Domestic Agency spreads in recent weeks (Chart 5). Municipal Bonds: Upgrade To Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 40 basis points in January (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 2% in January and currently sits just below its post-crisis average. Even though net state & local government borrowing edged higher in Q4, issuance has rolled over in recent weeks and fund flows have sharply reversed course (Chart 6). As a result, our tactical yield ratio model - based on issuance, fund flows and ratings migration - shows that yield ratios are very close to fair value. Although the average M/T ratio still appears expensive if we include the global economic policy uncertainty index as an additional explanatory variable.5 While we remain cautious on the long-term prospects for state & local government health, we expect that improving trends in fund flows and issuance will support yield ratios for the next several months. Eventually we expect that increased state & local government investment will lead to higher issuance, but this will take some time to play out. In the meantime it will be crucial to monitor the federal government's progress on tax reform, particularly if there appears to be any appetite for removing municipal bonds' tax exempt status. Our sense is that the tax exemption will remain in place due to the administration's stated preference for increased infrastructure spending. But that outcome is highly uncertain. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview After a volatile end to last year, the Treasury curve was relatively unchanged in January. The 2/10 slope steepened by 1 basis point on the month and the 5/30 slope steepened by 2 bps. In previous reports we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen this year. This steepening will be driven by a continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. However, as we posited in a recent report,6 it could take until the end of this year before TIPS breakevens return to pre-crisis levels and core inflation returns to the Fed's target. To position for a steeper Treasury curve, we recommend that investors favor the 5-year bullet versus a duration-equivalent 2/10 barbell. Not only will the bullet outperform the barbell as the curve steepens, but the 5-year bullet is currently very cheap relative to the 2/10 slope (Chart 7). This trade has so far returned +29 bps since initiation on December 20. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 58 basis points in January. The 10-year TIPS breakeven inflation rate increased 10 bps on the month and, at 2.05%, it remains well below its pre-crisis range of 2.4% to 2.5%. The Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly adopt a more dovish policy stance if breakevens fall. This "Fed put" is a key reason why we remain overweight TIPS relative to nominal Treasuries, although we expect the uptrend in breakevens will moderate during the next few months. As we detailed in a recent report,7 while accelerating wage growth will ensure that inflation remains in an uptrend, the impact from wages will be mitigated by deflating import prices. Diffusion indexes for both PCE and CPI have also rolled over recently, suggesting that inflation readings will soften during the next couple of months. The anchor from slowly rising inflation will prevent TIPS breakevens from increasing too quickly, and breakevens are also too high compared to the reading from our TIPS Financial model - based on the dollar, oil prices and the stock-to-bond total return ratio (Chart 8). At the moment, only pipeline measures of inflationary pressure such as the ISM prices paid index (panel 4) suggest that breakevens will move rapidly higher in the near term. Remain overweight TIPS but expect the uptrend in breakevens to moderate in the months ahead. ABS: Maximum Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in January. Aaa-rated issues outperformed by 5 bps while non-Aaa issues outperformed by 17 bps. Credit card issues outperformed by 8 bps and auto loans outperformed by 5 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. At 51 bps, the spread remains well below its average pre-crisis level. As was noted in the Appendix to our year-end Special Report,8 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except Baa-rated corporates and Caa-rated high-yield in 2016. With ABS spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. The spread on Aaa-rated credit card ABS tightened 4 bps in January, and now sits at 49 bps. Meanwhile, the spread on Aaa-rated auto loan ABS tightened 1 bp on the month, and now sits at 54 bps. In early November we recommended favoring Aaa-rated credit cards relative to Aaa-rated auto loans. Collateral credit quality between credit cards and auto loans is clearly diverging in favor of credit cards (Chart 9, bottom panel), and in early November, our measure of the volatility adjusted breakeven spread (days-to-breakeven) was displaying no discernible valuation advantage in autos. Since November, however, autos have started to look more attractive (Chart 9, panel 3). If auto loan spreads continue to widen relative to credit cards we may soon shift back into autos. 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 6 bps on the month, and is now close to one standard deviation below its pre-crisis mean (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 22 basis points in January. The index option-adjusted spread for Agency CMBS tightened 4 bps on the month, and currently sits at 51 bps. The spread offered from Agency CMBS is similar to what is offered by Aaa-rated consumer ABS (52 bps) and greater than what is offered by conventional 30-year MBS (30 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.44% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.08%. The lower fair value is the result of a large spike in the uncertainty index in November that has yet to unwind (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. It is for this reason that we recently moved back to a below-benchmark duration stance.9 For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.44%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2016, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", dated January 18, 2016, available at gps.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 5 For further details on the model please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes for 2017", dated December 20, 2016, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Duration: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. Fed Balance Sheet: The Fed could start to reduce the size of its balance sheet as early as the end of this year, but more likely in 2018. In any case, allowing securities to run off its portfolio will not have much of an impact on long-dated Treasury yields. MBS: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Feature As we pointed out in our December 6 report, the bond selloff had proceeded too far, too fast, and was due for a pause. The 10-year Treasury yield then peaked at 2.6% on December 16 and has now fallen back to 2.4% as we go to press. It is of note that all of the reversal has come from the real component of yields while the compensation for expected inflation has remained firm (Chart 1). Chart 1Bear Market On Pause Bear Market On Pause Bear Market On Pause In our end-of-year "Themes For 2017" Special Report 1 we explained why we believe Treasury yields will level-off in the near term before heading higher throughout most of 2017. Now that we have entered this first "consolidation phase" it is time to consider what factors would cause us to reinstate a below-benchmark duration stance. But first, let us quickly recap our bearish 6-12 month outlook for Treasuries. The Cyclical Outlook For Treasury Yields Many of the headwinds that held back economic growth last year - including fiscal policy, inventory drawdowns and the impact of a distressed energy sector on capital spending - are poised to abate in 2017. With stronger growth and an already tight labor market, core inflation will continue to gradually rise toward the Fed's target. We expect trailing 12-month core PCE inflation will reach the Fed's 2% target near the end of 2017. Consequently, the cost of inflation protection embedded in bond yields will also converge with levels that are consistent with the Fed's target (Chart 2). We judge this level to be in the range of 2.4% to 2.5% for long-dated TIPS breakevens. With the 5-year/5-year forward TIPS breakeven rate at 2.13% and the 10-year TIPS breakeven rate at 2%, long-dated Treasury yields have approximately 30-50 bps of upside from the inflation component alone. Chart 2Breakevens Still Too Low Breakevens Still Too Low Breakevens Still Too Low Chart 3Real Yields Also Biased Higher Real Yields Also Biased Higher Real Yields Also Biased Higher We are less certain about how much higher real yields might move during the next 12 months. However, the downside in real yields is surely limited. Chart 3 shows that changes in the 10-year real yield and changes in our 12-month Fed Funds Discounter2 are almost always positively correlated. At present, the reading from our discounter is 46 bps, meaning the market is priced for about 2 more rate hikes during the next 12 months. Given our positive economic outlook, 2 or 3 rate hikes in 2017 sounds reasonable. Is Now The Time To Trim Duration? Barring any major economic setbacks we will consider three factors when making this decision: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation When we last shifted from a below-benchmark to a benchmark duration stance on December 6 the 10-year Treasury yield traded 14 bps above the fair value reading from our 2-factor Global PMI Model. At present, the 10-year yield is only 9 bps cheap on this model (Chart 4). In other words, valuation is essentially neutral. But since global PMI is likely to trend higher over the course of the year, we would be comfortable cutting duration at current valuation levels should the other two factors on our checklist fall into place. Factor 2: Uncertainty We've been talking a lot about uncertainty recently, mostly in reference to the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index exhibits a strong inverse correlation with Treasury yields over time and has shot higher during the past couple of months without a corresponding decrease in yields. When we consider the uncertainty index alongside Global PMI and bullish sentiment toward the U.S. dollar in our 3-factor model of Treasury yields, we find that the 10-year Treasury yield now appears 38 bps cheap (Chart 5). Chart 4Close To Fair Value... Close To Fair Value ... Close To Fair Value ... Chart 5...But Uncertainty Remains Elevated ... But Uncertainty Remains Elevated ... But Uncertainty Remains Elevated What is particularly odd is that the uncertainty index has diverged so sharply from measures of both consumer and small business confidence (Chart 6). This epic split can mean only one of two things: Chart 6Excessive Optimism Or A False Reading From The Uncertainty Index? Excessive Optimism Or A False Reading From The Uncertainty Index? Excessive Optimism Or A False Reading From The Uncertainty Index? Businesses and consumers are excessively optimistic in the face of an increasingly uncertain back-drop, or The uncertainty index is unable to distinguish between policy shocks with positive and negative economic implications We turn to history in an attempt to determine whether the warning from the uncertainty index should be heeded. Specifically, we searched for other one-month periods when there was a one standard deviation increase in the uncertainty index alongside increases in both consumer and small business confidence. Since 1991, ten months meet these criteria (Table 1). Table 1Periods Displaying One Standard Deviation Increase In Global Economic Policy##br## Uncertainty Index* And Increase In Both Consumer Sentiment Index** ##br##And Small Business Confidence Index*** (1991 To Present) Is It Time To Cut Duration? Is It Time To Cut Duration? First we note that Treasury yields declined in 7 out of the 10 flagged periods, but in many of those episodes the scale of the positive confidence shocks was not very large. The two months that appear most similar to the present situation are September 2008 and December 2013. Chart 7Investors Still Bearish Investors Still Bearish Investors Still Bearish The Fed announced the tapering of its asset purchases in December 2013 amidst signs of an improving economy. The hawkish Fed announcement and improving economic outlook sent yields higher on the month, while the uncertainty index spiked as a large number of Fed-related news stories hit the papers.4 One thing that makes December 2013 an imperfect comparable to the present day is that the uncertainty shock was relatively small compared to the confidence shocks. In September 2008 the confidence shocks were not as large as the uncertainty shock, much like today, and the 10-year Treasury yield managed a 2 bps increase. However, it is definitely unfair to draw a conclusion based on the extremely volatile price movements that were witnessed at the height of the financial crisis in September 2008. Based on the example of December 2013, we cannot decisively rule out the possibility that the uncertainty index is simply giving a false signal. However, if that is the case we would expect the uncertainty index to mean revert in relatively short order. Given the strong historical relationship between the uncertainty index and Treasury yields, we will wait for some mean reversion in the uncertainty index before shifting back to a below-benchmark duration stance. Factor 3: Sentiment & Positioning When we shifted from a below-benchmark to a benchmark duration stance measures of investor sentiment and positioning were at bearish extremes, sending a decisive signal that the bond market was oversold. As of today, some of these indicators have started to reverse course while others have not (Chart 7). Our BCA Bond Sentiment Indicator, a composite of a survey of bullish sentiment toward bonds and the 13-week rate of change in bond yields is no longer at an oversold extreme. However, net speculative positions in the 10-year Treasury futures contract have moved even further into "net short" territory. The J.P. Morgan client survey shows that investors remain below benchmark duration in aggregate, although active traders are no longer net short. Although some capitulation of shorts has already taken place, we will await some further normalization of positioning - particularly in net speculative futures - before reinitiating a below-benchmark duration stance. Bottom Line: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. The Fed's Balance Sheet & The Shortage Of Bills The minutes from December's FOMC meeting revealed that: Several participants noted circumstances that might warrant changes to the path for the federal funds rate could also have implications for the reinvestment of proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities Since then, three different FOMC members have also spoken about the size of the Fed's balance sheet. Philadelphia Fed President Patrick Harker said that the Fed should consider shrinking its balance sheet once the fed funds rate reaches 1%.5 Boston Fed President Eric Rosengren made the case for more immediate action6 and St. Louis Fed President James Bullard said the Fed should consider shrinking its balance sheet in 2017.7 Clearly, talk of unwinding the Fed's balance sheet is heating up. The Fed's only official stated position on this topic is that it will keep its balance sheet level until normalization of the fed funds rate is "well under way", a statement we have long interpreted to mean "until the fed funds rate is 1%, or perhaps even higher". As such, we would not expect any action on winding down the Fed's balance sheet until late this year at the earliest, and more likely in 2018. The Impact On Treasury Yields In any case, as we detailed in a report published in August 2015,8 we do not think that the Fed allowing its balance sheet to shrink will itself have much of an impact on Treasury yields. The reason relates to the way in which maturing Treasury securities are currently rolled over at auction and the persistent shortage of T-bills in the market. Chart 8Fed Runoff Will Increase##br## Issuance To Public ... Fed Runoff Will Increase Issuance To Public ... Fed Runoff Will Increase Issuance To Public ... At the moment, balances of matured Treasury securities are added to upcoming note/bond auctions as non-competitive bids. In other words, as Treasury securities mature the Fed buys an equal amount at upcoming Treasury auctions. If the Fed were to cease this reinvestment, that amount would need to be added to the competitive portion of the auctions and would greatly increase the gross issuance of Treasury debt to the public. For a sense of scale, we calculate that Treasury issuance to the public would need to increase by $426 bn in 2018 and $378 bn in 2019 if the Fed were to cease the reinvestment of its portfolio at the end of this year (Chart 8). We contend, however, that a significant portion of this extra financing requirement will be met through increased T-bill issuance and will therefore not impact long-dated Treasury yields. The Treasury department has had a stated goal of increasing T-bill issuance since May 2015 and bill supply as a percentage of total Treasury debt remains near a multi-decade low (Chart 9). Further, T-bills are still in high demand as evidenced by the fact that they are trading at a substantial premium to other money market instruments (Chart 10). This premium exists despite the fact that the Fed has been soaking up a lot of T-bill demand through its Overnight Reverse Repo facility (Chart 10, bottom panel). If the Fed were to phase this program out alongside a reduction in the size of its balance sheet - which is its current stated exit strategy - the shortage of T-bills would be exacerbated. Chart 9... But Mostly Through T-Bills ... But Mostly Through T-Bills ... But Mostly Through T-Bills Chart 10T-Bills In High Demand T-Bills In High Demand T-Bills In High Demand Of course there is a new regime about to enter the White House and the Treasury department, and also a lot of uncertainty about how large the deficit will be going forward. If the deficit is increased substantially then it would likely be necessary for the Treasury department to increase the size of both bill and coupon issuance in the years ahead. Bottom Line: It is necessary to consider both fiscal policy and the Fed's balance sheet together when forecasting Treasury issuance. Further, whatever the government's financing requirement, a considerable portion of it will be addressed through increased T-bill issuance in the years ahead. This will limit the impact on long-dated Treasury yields. A Quick Note On MBS Chart 11MBS Spreads Are Too Low MBS Spreads Are Too Low MBS Spreads Are Too Low Any unwind of the Fed's balance sheet will have a much greater impact on MBS spreads than on Treasury yields since it will add directly to the supply of MBS available to the public, which tends to correlate with MBS option-adjusted spreads (Chart 11). Of course, other factors such as the rate of prepayments will determine how quickly the Fed's MBS holdings run off and the state of the housing market will determine how much new mortgage origination takes place. We hope to explore these issues in more depth in the coming weeks. Of more immediate concern for MBS spreads though is the recent divergence between nominal spreads, rate volatility and the slope of the yield curve (Chart 11, bottom two panels). MBS spreads have not widened in recent weeks despite curve steepening and rising rate vol. MBS spreads are already low compared to investment alternatives and have upside in the near term, especially if the yield curve continues to steepen, as we expect it will. Looking further out, the eventual wind down of the Fed's balance sheet is another risk the MBS market will have to face. Bottom Line: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 207", dated December 20, 2016, available at usbs.bcaresearch.com 2 Our 12-month discounter measures the expected change in the fed funds rate during the next 12 months as discounted in the overnight index swap curve. 3 www.policyuncertainty.com 4 The uncertainty index is in part based on an algorithm that scans newspapers for coverage of policy-related economic uncertainty. 5 http://www.reuters.com/article/us-usa-fed-harker-idUSKBN14W1W4 6 http://www.cnbc.com/2017/01/09/reuters-america-interview-rosengren-urges-more-rate-hikes-slimmer-balance-sheet.html 7 http://www.businessinsider.com/lets-shrink-the-balance-sheet-bullard-says-2016-12 8 Please see U.S. Bond Strategy Weekly Report, "Currencies: The Tail Wagging The Dog", dated August 18, 2015, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Upside Risks & Uncertainty Upside Risks & Uncertainty Upside Risks & Uncertainty The evidence of economic acceleration continues to pile up and we maintain our view that bond yields will be higher than current forwards by the end of 2017. In the near-term, however, the bond market has been too quick to discount a more positive growth outlook, especially considering still-elevated levels of economic policy uncertainty. Our cautious optimism is echoed by the readings from our global PMI models and also by the Fed. The minutes from December's FOMC meeting revealed that more participants saw upside risks to growth and inflation than saw downside risks, but also that this improved economic forecast was judged to be more uncertain than any Fed forecast since 2013 (Chart 1). We remain bond bears on a 12-month horizon, but advocate a benchmark duration stance in the near term. A period of flat bond yields is the most likely outcome until elevated uncertainty levels revert to a more normal range (see the global economic policy uncertainty index). Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 82 basis points in December and by 478 basis points in 2016. The index option-adjusted spread tightened 6 bps on the month and 42 bps on the year. At 122 bps, the spread is currently well below its historical average (134 bps). Corporate spreads have tightened substantially since last February despite elevated gross leverage (Chart 2).1 As we pointed out in our end-of-year Special Report titled "Seven Fixed Income Themes For 2017",2 it is very rare for spreads to tighten when leverage is in an uptrend. While a rebound in profit growth will likely cause the uptrend in leverage to abate this year, spreads have already moved to discount a significant reversal. Although valuations are by no means attractive, accelerating economic growth and still-accommodative Fed policy will keep spreads at tight levels during the first half of this year. This sweet spot will persist at least until TIPS breakeven inflation rates return to pre-crisis levels, which would likely presage a hawkish shift in Fed policy. Energy sector debt returned 12.5% in excess of duration-equivalent Treasuries in 2016, compared to excess returns of under 5% for the overall corporate index. Despite this large outperformance, energy credits still appear attractive according to our model (Table 3), and should continue to outperform into the New Year. Table 3ACorporate Sector Relative Valuation##br## And Recommended Allocation* Cautious Optimism Cautious Optimism Table 3BCorporate Sector##br## Risk Vs. Reward* Cautious Optimism Cautious Optimism High-Yield: Underweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 188 basis points in December and by 1539 basis points in 2016. The index option-adjusted spread narrowed 46 bps on the month and 251 bps on the year. At 383 bps, it is currently 137 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default backdrop, we are actively looking to upgrade our allocation to high-yield debt. However, valuations do not present a sufficiently compelling opportunity at the moment. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is below 150 bps (Chart 3). This is close to one standard deviation below the long-run average. Historically, we have found that a default-adjusted spread between 100 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of close to zero. With the spread in this range, a 90% confidence interval would place 12-month excess returns between -3% and +4%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in December, but underperformed by 11 bps in 2016. The conventional 30-year MBS yield rose 5 bps in December, completely driven by a 5 bps increase in the rate component. The compensation for prepayment risk (option cost) and option-adjusted spread were both flat on the month. In 2016, the conventional 30-year MBS yield rose 6 bps. This was driven by a 12 bps increase in the rate component that was partially offset by a 9 bps decline in the option-adjusted spread. The option cost increased 3 bps on the year. Our underweight in MBS is predicated upon very low option-adjusted spreads, relative both to history and other comparable spread product (Chart 4). Historically, the option-adjusted spread is correlated with net MBS issuance and eventually we expect rising net issuance to lead the option-adjusted spread wider. Importantly, purchase applications have remained firm in the face of higher mortgage rates even though refinancings have collapsed (bottom panel). Another tail risk for the MBS market is the possibility that the Fed ceases the reinvestment of its mortgage portfolio. While we do not expect this to occur in 2017, with two rate hikes now in the bank the fed funds rate is approaching levels where the Fed might begin to consider it. A new Fed Chair in early 2018 might also be more inclined to wind down the balance sheet. Government Related: Overweight Chart 5Government Related Market Overview Government Related Market Overview Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 27 basis points in December. Foreign Agency and Sovereign bonds outperformed by 84 bps and 83 bps respectively, while Local Authorities outperformed by 22 bps. Domestic Agency bonds and Supranationals were a drag on performance during the month, underperforming the Treasury benchmark by 10 bps and 7 bps respectively. The government-related index outperformed the duration-equivalent Treasury benchmark by 150 bps in 2016. The best performing sub-sectors for the year were Sovereigns (outperformed by 322 bps), Local Authorities (outperformed by 286 bps) and Foreign Agencies (outperformed by 258 bps). Domestic Agency bonds outperformed Treasuries by 38 bps, while Supranationals underperformed by 11 bps. Foreign Agency bonds and Local Authority bonds continue to appear attractive relative to U.S. corporate credit, after adjusting for credit rating and duration. We recommend focusing our government related allocation in these two sectors. In contrast, Sovereigns and Supranationals both appear expensive relative to U.S. corporate credit, and we recommend avoiding these sectors. Spreads on Domestic Agency debt have room to tighten in the near-term (Chart 5). Spreads widened to the top of their recent range last month on rumors that the new government could seek to speed up the process of GSE reform. We view these concerns as premature. This week we also remove our recommendation to favor callable agencies over bullets. Bullets have tended to outperform when the 2/5 Treasury slope steepens (bottom panel). We expect the 2/5 curve to be biased steeper in the first half of this year. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 134 basis points in December, but underperformed the index by 103 basis points in 2016 (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 8% in December, but increased 13% during 2016. At present the average M/T ratio is 98%, only slightly below its post-crisis average (Chart 6). Although M/T ratios moved higher last year, trends in issuance and fund flows suggest they are still too low. As we noted in our year-end Special Report,4 our tactical model of the M/T yield ratio - based on issuance, fund flows, ratings changes and economic policy uncertainty - pegs current fair value for the average M/T yield ratio at 112%. Further, as was also highlighted in our year-end report, the municipal credit cycle is likely to take a turn for the worse in late 2017, with muni downgrades starting to outpace upgrades. This analysis is based on indicators of state & local government budget health that tend to follow our indicators of corporate sector health with a two year lag. Just last month Moody's downgraded $1.6 billion worth of the City of Dallas' general obligation debt from Aa3 to A1. The downgrade was justified based on the city's poorly funded public safety pension plan. Attention will increasingly turn to underfunded public pensions when state & local government budget health starts to deteriorate later 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 shifted higher and flattened in December. The 2/10 slope flattened by 1 basis point on the month and the 5/30 slope flattened 6 bps. For 2016 as a whole, the Treasury curve bear-steepened out to the 10-year maturity. The 2/10 slope steepened 4 bps and the 5/30 slope flattened 12 bps. In our year-end Special Report,5 we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen in the first half of 2017. This steepening will be driven by continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. A steepening curve environment will cause bullet trades to outperform barbells. On top of that, the 5-year bullet is currently extremely cheap on the curve (Chart 7). For these reasons we recommended entering a long 5-year bullet, short 2/10 barbell trade on December 20. This trade has already returned 8 bps since initiation, even though the 2/10 slope has flattened 10 bps during this period. A resumption of curve steepening will cause our long 5-year bullet, short 2/10 barbell trade to perform even better in the months ahead. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in December, and by 331 bps in 2016. The 10-year TIPS breakeven rate increased by 1 bp in December and by 41 bps in 2016. At present it sits at 1.96%, still well below the 2.4% to 2.5% range that is consistent with the Fed's 2% inflation target. As we explained in our year-end Special Report,6 the Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly back away from a hawkish policy stance should breakevens fall. But while breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. It is difficult for the Fed to drive long-dated inflation expectations higher while it is in the midst of a tightening cycle. For this reason, trends in actual inflation will be a more important determinant of TIPS breakevens than in the past. And while there are indications that the uptrend in realized inflation will persist, notably recent accelerations in wage growth and survey measures of prices paid (Chart 8). There is currently no indication that core and trimmed mean inflation are breaking out to the upside (bottom panel). We remain overweight TIPS relative to nominal Treasuries on the expectation that long-dated breakevens reach the 2.4% to 2.5% range in the second half of 2017, and that core PCE inflation reaches the Fed's 2% target by the end of the year. ABS: Maximum Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 17 basis points in December but outperformed the Treasury benchmark by 94 bps in 2016. Aaa-rated ABS underperformed Treasuries by 21 bps in December but outperformed by 75 bps in 2016, while non-Aaa ABS outperformed the benchmark by 13 bps in December and by 257 bps in 2016. The index option-adjusted spread for Aaa-rated ABS widened by 11 bps in December, but tightened by 10 bps in 2016. Further, the spread differential between Aaa-rated auto ABS and Aaa-rated credit card ABS narrowed substantially in 2016. The option-adjusted spread for Aaa-rated auto loan ABS has tightened by 20 bps since the end of 2015, while the option-adjusted spread for Aaa-rated credit card ABS has tightened by 10 bps. We have previously noted that, after adjusting for spread volatility, Aaa-rated auto loan ABS no longer offer an attractive opportunity relative to Aaa-rated credit cards (Chart 9). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, given the low spread differential and divergences in collateral credit quality (bottom panel). As was noted in the Appendix to our year-end Special Report,7 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except for Baa-rated corporates and Caa-rated high-yield in 2016. With spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. Non-Agency CMBS: Underweight Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Agency CMBS underperformed the duration-equivalent Treasury index by 40 basis points in December, but outperformed by 117 bps in 2016. The index option-adjusted spread for Agency CMBS widened 10 bps in December but tightened 6 bps in 2016. Agency CMBS still offer 50 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (51 bps) and greater than what is offered by conventional 30-year MBS (26 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in December, but outperformed by 313 bps in 2016. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps in December but tightened 48 bps in 2016. It has recently moved well below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.31% (Chart 11). Our 3-factor version of the model, which also incorporates the global economic policy uncertainty index, places fair value at 2.02%. The lower fair value is the result of a large spike in the global economic policy uncertainty index in November that barely reversed in December (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. However, unusually high uncertainty is one reason we are reluctant to adopt a below benchmark duration stance for the time being even though we expect yields to be higher in 12 months. At the time of publication the 10-year Treasury yield was 2.37% For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). With the MCI having just reached this estimate of equilibrium, the shaded region in Chart 13 shows the expected path of the federal funds rate assuming that the MCI remains at its equilibrium level. The upper-end of the shaded region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the shaded region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Monetary Conditions Vs. Equilibrium Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Fed Funds Rate Scenarios Fed Funds Rate Scenarios As can be seen in Chart 13, both the market and Fed are discounting a move in the MCI above its equilibrium level. This would be consistent with behavior witnessed in past cycles when the MCI broke above its equilibrium level several years before the next recession. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, 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 1More Upside From Inflation bca.usbs_pas_2016_12_06_c1 bca.usbs_pas_2016_12_06_c1 We moved to below benchmark duration on July 19, when the 10-year Treasury yield was 1.56%. As of last Friday's close, the 10-year Treasury yield was 2.4% and above the fair value reading from our global PMI model. While our economic outlook still justifies higher Treasury yields on a 12-month horizon, the selloff in bonds has moved too far, too quickly. We recommend tactically shifting to a benchmark duration stance. Longer run, the upside in Treasury yields will be concentrated in the inflation component. The cost of 10-year inflation compensation can rise another 49 bps before it is consistent with the Fed's target. But that adjustment will proceed gradually next year, alongside a shallow uptrend in realized inflation (Chart 1). Higher inflation compensation can occasionally be offset by lower real yields, but this only occurs when the increase in inflation compensation results from an easing of Fed policy, as in 2011-2012. With the Fed in the midst of a hiking cycle, the downside in real yields is limited. We would not be surprised to see the 10-year Treasury yield re-visit the 2%-2.2% range during the next month or two. At that point we would re-initiate a below benchmark duration stance, on the view that the 10-year yield will reach 2.80%-3% by the end of 2017. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in November. The index option-adjusted spread tightened 3 bps on the month and, at 129 bps, it is now slightly below its historical average (134 bps). Spread per unit of gross leverage1 for the nonfinancial corporate sector is slightly above its historical average (Chart 2). But unusually, spreads have been tightening this year despite sharply rising gross leverage. Since 1973, there has only been one other period when spreads tightened despite rising gross leverage. That was in 1986-88 when, similar to today, spreads were tightening from extremely oversold levels. Much like today, elevated spreads in 1986 resulted from distress in the energy sector that dissipated as oil prices recovered. This caused corporate spreads to widen dramatically and then tighten, while in the background gross leverage persistently climbed higher. The current recovery in oil prices could lead to further corporate spread tightening early next year. Indeed, energy sector credits still appear cheap on our model and we continue to recommend overweighting those sectors. This month we also upgrade Paper from neutral to overweight (Table 3). Table 3Corporate Sector Relative Valuation And Recommended Allocation* Too Far Too Fast, But The Bond Bear Is Still Intact Too Far Too Fast, But The Bond Bear Is Still Intact Table 3BCorporate Sector Risk Vs. Reward* Too Far Too Fast, But The Bond Bear Is Still Intact Too Far Too Fast, But The Bond Bear Is Still Intact However, corporate credit fundamentals are deteriorating rapidly and spreads will be at risk when the Fed adopts a more hawkish policy stance, possibly as early as the second half of next year.2 High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 128 basis points in November. The index option-adjusted spread tightened 23 bps on the month and, at 450 bps, it is 71 bps below its historical average. A model based on lagged spreads and default losses explains more than 50% of the variation in 12-month excess junk returns. This model currently forecasts excess junk returns of close to zero during the next 12 months (Chart 3), a forecast that is based on our expectation of a modest improvement in default losses (bottom panel). In a recent report,3 we examined the relationship between default-adjusted spreads and excess junk returns in more detail. We showed that a model based purely on ex-ante estimates of default losses explains around 34% of the variation in excess junk returns. We also showed that, historically, negative excess returns to junk bonds are only likely if the ex-ante default-adjusted spread is below 100 bps. Our current ex-ante default-adjusted spread is 201 bps. Historically, when the ex-ante default-adjusted spread is between 200 bps and 250 bps, junk earns positive excess returns 81% of the time. However, junk earns positive excess returns only 65% of the time if the spread is between 150 bps and 200 bps. Although our economic outlook for next year is fairly optimistic, high-yield valuations are stretched and we expect to get a better entry point from which to upgrade the sector during the next couple of months. MBS: Underweight Chart 4MBS Market Overview bca.usbs_pas_2016_12_06_c4 bca.usbs_pas_2016_12_06_c4 Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in November. Other than municipal bonds, MBS has been the worst performing fixed income sector relative to Treasuries, earning year-to-date excess returns of -17 bps. The conventional 30-year MBS yield rose 53 bps in November, driven by a 59 bps increase in the rate component. The compensation for prepayment risk (option cost) declined 10 bps, while the option-adjusted spread widened by 4 bps. Prior to the election, we had been tactically overweight MBS on the view that higher Treasury yields would lead to a lower option cost, benefitting MBS in the near term. Now that Treasury yields have moved substantially higher, our focus returns to the extremely depressed levels of MBS option-adjusted spreads (Chart 4). Extremely low option-adjusted spreads coupled with a housing market that should continue to recover - leading to steadily increasing net supply (bottom panel) - make for a poor risk/reward trade-off in MBS relative to other fixed income sectors. Against this back-drop, MBS are only worth a tactical trade if you have high conviction that Treasury yields are about to rise and option costs about to tighten. We do not expect the Fed to cease the reinvestment of its MBS purchases in 2017. But, if Janet Yellen is replaced as Fed Chair in early 2018, then it is possible that the new Fed will seek to end its involvement in the MBS market. This is a tail risk for MBS in 2018. Government Related: Overweight Chart 5Government Related Market Overview bca.usbs_pas_2016_12_06_c5 bca.usbs_pas_2016_12_06_c5 The government-related index underperformed the duration-equivalent Treasury index by 19 basis points in November (Chart 5). Domestic Agency bonds and Local Authority bonds outperformed the Treasury index by 2 bps and 61 bps, respectively. Sovereign debt underperformed by 122 bps, Foreign Agency debt underperformed by 54 bps and Supranationals underperformed by 6 bps. More than half of the underperformance in the Foreign Agency sector came from Mexico's state oil company, Pemex, in the aftermath of Donald Trump's election win. Losses in the Sovereign debt sector were similarly concentrated in Mexican issues. Strength in oil prices should permit Foreign Agency debt to outperform going forward, while the strong U.S. dollar will remain a drag on Sovereign debt. Local Authority and Foreign Agency debt both continue to offer attractive spreads relative to U.S. investment grade corporate bonds, after adjusting for duration and credit rating. In contrast, Supranationals and Sovereigns both appear expensive. We continue to recommend an underweight allocation to Sovereign debt within an otherwise overweight allocation to the government related sector. Bullet Agency issues outperformed callable Agency bonds in November, despite the large increase in Treasury yields (bottom panel). We expect this trend will soon reverse, and remain overweight callable versus bullet Agencies. Municipal Bonds: Underweight Chart 6Municipal Market Overview bca.usbs_pas_2016_12_06_c6 bca.usbs_pas_2016_12_06_c6 Municipal bonds underperformed the duration equivalent Treasury index by 83 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio rose from 99% to 107% in November, and is now above its post-crisis average (Chart 6). We downgraded municipal bonds to underweight on November 15,4 following Donald Trump's election victory. Lower tax rates under the new administration will undermine the tax advantage in municipal bonds, leading to outflows and higher M/T yield ratios. ICI data show that outflows have already begun. Net outflows from Muni funds have exceeded $7 billion in the four weeks since the end of October (panel 4). There are also longer-run concerns related to supply and state & local government credit quality. Depending on how it is structured, increased infrastructure spending next year could lead to a large increase in municipal bond supply. Also, state & local government downgrades are likely to increase later next year, following the lead of the corporate sector. Both of these issues are discussed in more detail in a recent Special Report.5 In October, the SEC finalized new liquidity management standards for open-ended investment funds. Funds must now determine a minimum percentage of net assets that must be invested in highly liquid securities, and no more than 15% of assets can be invested in securities deemed illiquid. At the margin, the new rule could limit funds' appetites for municipal bonds. Treasury Curve: Laddered Chart 7Treasury Yield Curve Overview bca.usbs_pas_2016_12_06_c7 bca.usbs_pas_2016_12_06_c7 November's bond rout was concentrated in the belly (5-10 years) of the Treasury curve. The 2/10 Treasury slope steepened 28 basis points on the month, while the 5/30 slope flattened by 8 bps. We believe that the yield curve has room to steepen further in 2017, based largely on the expectation that the Fed will maintain an accommodative stance of monetary policy at least until TIPS breakeven inflation rates are at levels more consistent with the Fed's 2% inflation target (Chart 7). In our view, this level is between 2.4% and 2.5% for long-dated TIPS breakevens. However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. Although we view a "dovish hike", i.e. an increase in the fed funds rate with no upward revision to the Fed's interest rate forecasts, as the most likely outcome. If we are wrong, an upward revision to the Fed's forecasts would cause the curve to bear-flatten on the day. At present, the market expects 55 bps of rate hikes during the next 12 months (panel 1). If expectations remain at these levels until after next week's FOMC meeting they will be consistent with the Fed's median forecast, assuming there are no upward revisions. Also, as we pointed out on the front page of this report, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year. TIPS: Overweight Chart 8TIPS Market Overview bca.usbs_pas_2016_12_06_c8 bca.usbs_pas_2016_12_06_c8 TIPS outperformed the duration-equivalent nominal Treasury index by 148 bps in November. The 10-year breakeven rate increased 21 bps on the month, and currently sits at 1.91%. The 5-year, 5-year forward TIPS breakeven inflation rate has risen to 2.06% from its early 2016 trough of 1.41%. However, it still has room to rise before it returns to levels that are consistent with the Fed's 2% target for PCE inflation (Chart 8). As economic growth improves next year the Fed will be keen to allow TIPS breakevens to rise toward its target, and will be slow to shift to a less accommodative policy stance. As such, we maintain our recommendation to overweight TIPS relative to nominal Treasuries, with a target of 2.4% to 2.5% for the 5-year, 5-year forward TIPS breakeven rate. While breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. With the Fed in the midst of a tightening cycle, it will be difficult for the Fed to lead inflation expectations sharply higher as in past cycles. Trends in realized inflation will be more important for long-dated breakevens this time around. Core and trimmed mean PCE inflation continue to grind slowly higher, a trend that is supported by the PCE diffusion index (panel 4). Assuming the current trend remains in place, core PCE inflation should finally reach the Fed's 2% target before the end of next year. ABS: Maximum Overweight Chart 9ABS Market Overview bca.usbs_pas_2016_12_06_c9 bca.usbs_pas_2016_12_06_c9 Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in November, bringing year-to-date excess returns up to +111 bps. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps on the month, while non-Aaa issues outperformed by 5 bps. Credit card ABS outperformed by 14 bps, while auto ABS outperformed by 7 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps in November and, at 43 bps, it is well below its average pre-crisis level. Last month we observed that after adjusting for trailing 6-month spread volatility, Aaa-rated auto loan ABS no longer offer a compelling spread pick-up relative to Aaa-rated credit card ABS. We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 9 days of average spread widening for Aaa-rated credit card ABS to underperform (Chart 9). This spread cushion is not sufficient to compensate for the fact that credit card quality metrics are in much better shape than those for auto loans. The auto loan net loss rate has entered a clear uptrend, while credit card charge-offs are still near all-time lows (bottom panel). CMBS: Underweight Chart 10CMBS Market Overview bca.usbs_pas_2016_12_06_c10 bca.usbs_pas_2016_12_06_c10 Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in November, bringing year-to-date excess returns up to +269 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 16 bps in November, and has now fallen below its average pre-crisis level (Chart 10). Rising delinquency rates and tightening lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Further adding to our caution is that more than 6000 commercial real estate loans backing public conduit CMBS deals are set to mature in 2017. This is almost 5x the number that matured last year, according to data from Trepp. Agency CMBS outperformed the duration-equivalent Treasury index by 52 basis points in November, bringing year-to-date excess returns up to +158 bps. Agency CMBS still offer 45 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (43 bps) and greater than what is offered by conventional 30-year MBS (22 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model bca.usbs_pas_2016_12_06_c11 bca.usbs_pas_2016_12_06_c11 The current reading from our 3-factor Global PMI model (which includes global PMI, dollar sentiment and global policy uncertainty) places fair value for the 10-year Treasury yield at 1.82%. However, the low reading mostly reflects a large spike in global policy uncertainty in November. Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor Global PMI model (which includes only global PMI and dollar bullish sentiment) as more representative of 10-year Treasury yield fair value at the moment. The fair value reading from our 2-factor model is currently 2.26% (Chart 11). At the time of publication the 10-year Treasury yield was 2.4%. For further details on our Global PMI model please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium bca.usbs_pas_2016_12_06_c12 bca.usbs_pas_2016_12_06_c12 Chart 13Fed Funds Rate Scenarios bca.usbs_pas_2016_12_06_c13 bca.usbs_pas_2016_12_06_c13 Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Secular Stagnation Vs. Trumponomics", dated November 15, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Duration: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. TIPS: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Yield Curve: An upward re-rating of the market's assessment of the equilibrium level of monetary conditions is necessary for the curve to steepen further from current levels. Spread Product: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Conversely, the sharp rise in yields turns us more cautious on MBS. Municipal Bonds: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Feature We had expected any flight to quality related to a Donald Trump victory to be brief, but would never have anticipated how brief it actually was. Treasury yields declined for about four hours as the results came in on election night, but since midnight EST last Tuesday the bond bear market has been supercharged. BCA's fixed income publications have maintained a below benchmark duration stance since July 19 with a year-end target of 1.95-2% for the 10-year Treasury yield. The 10-year yield is now above our year-end target, as Trump's surprise victory caused investors to question many long-held assumptions. Chief among them is the thesis of secular stagnation - the idea that a chronic imbalance between savings and investment has resulted in an extremely depressed equilibrium interest rate. The secular stagnation theory has ruled the day in U.S. bond markets, but even Larry Summers, who popularized the theory in recent years, has admitted that "an expansionary fiscal policy by the U.S. government can help overcome the secular stagnation problem and get growth back on track." 1 The market has been quick to take on board President Trump's promises of massive debt-financed infrastructure spending, and is now questioning the idea of permanently low interest rates. While much uncertainty about President Trump still abounds, one thing for certain is that the path of Treasury yields next year and beyond will be determined by whether Trumponomics can successfully tackle secular stagnation. As of now, we are cautious optimists. Last week BCA sent a Special Report2 to all clients that describes the likely outcomes of a Trump presidency. One of those outcomes is that a sizeable fiscal stimulus will be enacted next year. In this week's report we explore its potential impact on bond markets and re-assess our U.S. bond portfolio in light of this surprise change in the economic landscape. Duration The expected path of future rate hikes has moved sharply higher during the past week (Chart 1). If we assume that U.S. monetary conditions reach our estimate of equilibrium3 by the end of 2019, then the shaded region in Chart 1 shows a range of possible outcomes for the federal funds rate based on different scenarios for the U.S. dollar. The upper-bound of the shaded region corresponds to the path of the fed funds rate assuming the dollar depreciates by 2% per year, while the lower-bound assumes the dollar appreciates by 2% per year. The market's expected fed funds rate path has shifted into the upper-half of the shaded region, which assumes the U.S. dollar will depreciate. The thick black line corresponds to the assumption of a flat dollar. Chart 1The Market's Rate Hike Expectations: Pre- And Post-Election bca.usbs_wr_2016_11_15_c1 bca.usbs_wr_2016_11_15_c1 Since the U.S. dollar is very likely to appreciate in the event that a Trump administration enacts growth-enhancing fiscal stimulus, it would appear as though the market's expected interest rate path is already too high. However, we must consider the possibility that large-scale government investment could shift the savings/investment balance in the economy and lead to a higher equilibrium level of monetary conditions or that the U.S. economy reaches monetary equilibrium more quickly under President Trump. In that event, Treasury yields still have room to rise. Chart 2Not Much Gap Between Market & Fed bca.usbs_wr_2016_11_15_c2 bca.usbs_wr_2016_11_15_c2 Similarly, the gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart 2). The 5-year/5-year forward overnight index swap rate is now 2.05%, only about 80bps below the Fed's median estimate of the equilibrium fed funds rate. Meanwhile, our 12-month discounter - the market's expected change in the fed funds rate during the next 12 months - is already at 44bps. If there are no revisions to the Fed's interest rate forecasts at next month's meeting, then a level of 50bps on our discounter will be consistent with the Fed's expectations. This would be the first time the market and dots were lined up since 2014. The key point is that the balance of risks in the Treasury market has shifted. Prior to the election, Treasury yields had been under-estimating the potential for fiscal stimulus in 2017. Now, for Treasury yields to continue their move higher, we need to transition from a world where the Fed is continuously revising its interest rate forecasts lower to one where it is making upward revisions. To be clear, we do expect this transition to occur in 2017 but probably not during the next few months. Now that the Treasury market has reacted to the promise of fiscal stimulus, the next step is that it will demand to see some results. On that note, while Trump's infrastructure spending plan is assumed to be huge, at this point details are scarce. Further, our U.S. Investment Strategy service4 has pointed out that the effectiveness of fiscal stimulus depends critically on how well fiscal multipliers are working, and that estimates of fiscal multipliers can vary widely (Table 1). Table 1Ranges For U.S. Fiscal Multipliers Secular Stagnation Vs. Trumponomics Secular Stagnation Vs. Trumponomics Another risk to the bond bear market comes from a rapid increase in the U.S. dollar. Our modeling work shows that Treasury yields tend to rise alongside improvements in global growth (as proxied by the global manufacturing PMI), but that the impact of improving global growth on Treasury yields is dampened if bullish sentiment toward the U.S. dollar is also increasing (Chart 3). At present, the 10-year Treasury yield is very close to the fair value reading from our model, but the worry is that continued upward pressure on the dollar will cause the model's fair value to roll over in the months ahead. Another risk is the impact of a stronger dollar on emerging markets. A rebound in emerging market growth has contributed significantly to the strength in the overall global PMI since early this year (Chart 4). A strengthening dollar correlates with a weaker emerging market PMI (Chart 4, panel 2), and weakness on this front will weigh on the global growth component of our Treasury model. The possibility that President Trump will classify China as a "currency manipulator" once he takes office only exacerbates the risk from emerging markets. Chart 3Global PMI Model Global PMI Model Global PMI Model Chart 4EM Could Derail The Bond Bear bca.usbs_wr_2016_11_15_c4 bca.usbs_wr_2016_11_15_c4 Bottom Line: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. We therefore take this opportunity to book +35bps of profits on our tactical short December 2017 Eurodollar trade. Longer run, we expect Donald Trump will be able to deliver a sizeable fiscal stimulus package and that Treasury yields will be higher at the end of 2017. TIPS Chart 5TIPS Breakevens Still Depressed bca.usbs_wr_2016_11_15_c5 bca.usbs_wr_2016_11_15_c5 Our overweight recommendation on TIPS versus nominal Treasuries has also benefitted from Trump's win. The 10-year breakeven rate has increased +15bps since last Tuesday, but still has a long way to go before reaching levels that are consistent with the Fed hitting its inflation target (Chart 5). Trump's main economic policies - increased fiscal spending and more protectionist trade relationships - are both inflationary. The most likely candidate to derail the widening trend in breakevens would be a quicker pace of Fed rate hikes that offsets the inflationary fiscal impulse. We think a much more hawkish Fed policy is unlikely in the near term. With TIPS breakevens still so low the Fed will want to nurture their recovery toward pre-crisis levels. It is only once TIPS breakevens are much more firmly anchored at pre-crisis levels that the Fed will be enticed to significantly quicken the pace of hikes. Bottom Line: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Remain overweight TIPS versus nominal Treasuries. Yield Curve We had been positioned in Treasury curve flatteners on the view that the curve would flatten in advance of a December Fed rate hike, much as it did last year. Trump's surprise win has steepened the curve dramatically, and today we close both our curve trades taking losses of -86bps on our 2/10 flattener and -42bps on our 10/30 flattener. The best determinant of the slope of the yield curve in the long run is the deviation from equilibrium of our monetary conditions index (MCI). The curve tends to flatten as monetary conditions are being tightened toward equilibrium and steepen when monetary conditions are easing away from equilibrium. Chart 6 shows a model of the 2/10 Treasury slope versus the deviation from equilibrium of our MCI. The model works well over both pre- and post-crisis time intervals, and the trailing 52-week beta between the slope of the curve and the MCI's deviation from equilibrium is in line with the beta estimated for the entire post-1990 time interval (Chart 6, bottom panel). Chart 6The Yield Curve & Monetary Conditions The Yield Curve & Monetary Conditions The Yield Curve & Monetary Conditions The curve had appeared too flat relative to fair value prior to last week's steepening, but now appears slightly too steep (Chart 6, panel 3). Since the dollar is unlikely to depreciate substantially and the fed funds rate is unlikely to be cut, the only way that the curve can continue steepening from current levels is if the market starts to revise up its assessment of the equilibrium level of monetary conditions. This is consistent with the dynamic we observed with the level of Treasury yields. Given the rapid moves we've seen in the past week, to be confident that further curve steepening is in store we need to forecast that Trump's fiscal measures will conquer secular stagnation and that the Fed will start revising up its assessment of the equilibrium rate. Much like with the level of Treasury yields, we are reluctant to bet on further steepening in the near term, before we have seen some action on Trump's fiscal policies. However, the steepening trade has gathered enough momentum at this juncture that betting on flatteners equally does not seem wise. Bottom Line: We advocate a laddered position across the Treasury curve at the moment, while we await clarity on President Trump's fiscal proposals. The Treasury curve has room to steepen further if sizeable fiscal stimulus is implemented next year. Spread Product In recent weeks we have advocated a maximum underweight (1 out of 5) allocation to high-yield and a neutral allocation (3 out of 5) to investment grade corporates, while also avoiding the Baa credit tier. This cautious stance on corporate debt was in place for two reasons. First, the junk spread had tightened in recent months despite a slight increase in the VIX and there was a sizeable risk that a Fed rate hike in December could prompt a spike in implied volatility, with a knock-on effect on spreads. Junk spreads have since widened to be more in-line with the VIX (Chart 7), and the much steeper Treasury curve tells us that the market is now less likely to consider a Fed rate hike in December - which we still expect - a policy mistake. Consequently, we are marginally less worried about a large spike in the VIX index that would translate into wider high-yield spreads. Second, high-yield spreads were simply too low relative to our forecast for default losses in 2017 (Chart 8). A model consisting of lagged junk spreads and realized default losses explains more than 50% of the variation in excess junk returns over 12-month periods.5 Previously, this model had predicted excess junk returns of close to zero, but today's spread levels are consistent with excess junk returns of +157bps during the next 12 months. Not inspiring by any means, but still better than nothing. Given the slightly better entry level for spreads and less near-term risk of a Fed-driven volatility event, we upgrade our allocation to high-yield from maximum underweight (1 out of 5) to underweight (2 out of 5). We maintain our neutral (3 out of 5) recommendation on investment grade corporates, but remove the recommendation to avoid the Baa credit tier. The past week's large increase in Treasury yields also leads us to downgrade our allocation to MBS from overweight (4 out of 5) to underweight (2 out of 5). The low level of option-adjusted spreads makes the long-term outlook for MBS uninspiring, but we had expected that the option cost component of spreads would tighten as Treasury yields moved higher (Chart 9). Now that Treasury yields have risen sharply and the option cost has tightened, we take the opportunity to adopt a more cautious outlook on the sector. Chart 7Spreads Re-Converge With VIX bca.usbs_wr_2016_11_15_c7 bca.usbs_wr_2016_11_15_c7 Chart 8Expect Low But Positive Excess Returns bca.usbs_wr_2016_11_15_c8 bca.usbs_wr_2016_11_15_c8 Chart 9Allocate Away From MBS bca.usbs_wr_2016_11_15_c9 bca.usbs_wr_2016_11_15_c9 Bottom Line: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Now that the MBS option cost has tightened in response to higher Treasury yields, the outlook for the sector is less inspiring. Municipal Bonds A Donald Trump presidency is full-stop negative for the municipal bond market. Further, as we highlighted in a recent Special Report,6 no matter the election result the outlook for state & local government health is likely to turn more negative in the second half of next year. Trump's tax cuts de-value the tax advantage of municipal debt and will drive flows out of the sector leading to wider Municipal / Treasury (M/T) yield ratios. We had been overweight municipal bonds since August 9, anticipating that a Clinton victory might provide us with a very attractive level from which to downgrade the sector heading into 2017. It was not to be, but municipal bond yields have still not quite kept pace with the sharp increase in Treasury yields, so we are able to downgrade today with M/T ratios not far off the low-end of their post-crisis range (Chart 10). In addition to tax cuts, Trump's infrastructure plan could also be a large negative for the muni market depending on how much of it is financed at the state & local government level. While the specifics of Trump's plan are not yet known, historically, most public infrastructure spending is financed at the level of state & local government (Chart 11). Another potential risk is that if large scale tax reform is on the table in 2017, then there is always the possibility that municipal bonds will lose their tax exemption altogether. At the moment it is difficult to assign odds to such an outcome. Chart 10Municipal / Treasury ##br##Yield Ratios bca.usbs_wr_2016_11_15_c10 bca.usbs_wr_2016_11_15_c10 Chart 11State & Local Government ##br##Drives Public Investment bca.usbs_wr_2016_11_15_c11 bca.usbs_wr_2016_11_15_c11 Bottom Line: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/ 2 Please see BCA Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 3 For further details on how we estimate the equilibrium level of monetary conditions please see U.S. Bond Strategy Special Report, "Peak Policy Divergence And What It Means For Treasury Valuation", dated February 9, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, 2016, available at usis.bcaresearch.com 5 For further details on this modeling framework please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Targeting 2% bca.usbs_pas_2016_11_08_c1 bca.usbs_pas_2016_11_08_c1 The Fed did its best to avoid roiling markets so close to today's election, but still managed to hint at a December rate hike. The post-meeting statement was tweaked so that now only "some further evidence" rather than "further evidence" is required in order to lift the funds rate. We remain below benchmark duration in anticipation of a December rate hike. Before the end of the year we expect our 12-month discounter to reach at least 40-50bps (meaning the market will expect a further 1-2 hikes in 2017) from its current level of 28bps, and for the 10-year Treasury yield to reach 1.95-2%. While our global PMI model pegs fair value for the 10-year Treasury yield at 2.27%, the uptrend in the 10-year yield will face severe technical resistance as it approaches 2% (Chart 1). Positioning has already moved to net short duration, signaling that the bond sell-off is becoming stretched. While a Clinton victory would all but ensure a December rate hike, a Trump victory could cause a large enough market riot that the Fed delays until 2017. This would only be a brief hiccup in the return of the 10-year yield to the 1.95-2% range, and would not signal a long-lasting trend reversal. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview bca.usbs_pas_2016_11_08_c2 bca.usbs_pas_2016_11_08_c2 Investment grade corporate bonds outperformed the duration-equivalent Treasury index by +56bps in October, but have already given back -26bps of those gains so far this month (Chart 2). The index option-adjusted spread is -2bps tighter than at the end of September and, at 136bps, it remains very close to its historical average. Corporate credit performance faces two immediate risks. The first is today's election and the second is the prospect of a Fed rate hike in December. A Clinton victory would likely prompt a knee-jerk rally in risk assets and virtually ensure a rate hike next month. In that case we would be inclined to further trim exposure to credit risk in the coming weeks as the rate hike approaches. Already, we recommend investors avoid the Baa credit tier within a neutral allocation to investment grade corporates. In a recent report we pointed out that highly-rated credit (A-rated and above) performed well in the initial stages of last year's run-up in rate hike expectations, but then started to suffer once market-implied rate hike probabilities approached 100%.1 Conversely, a Trump victory would likely prompt a flight-to-safety event in markets which, depending on its severity, could also cause the Fed to delay the next rate hike into 2017. In that event, the prospect of delayed Fed tightening would make us more likely to increase credit exposure in the near term, especially if any knee-jerk sell-off in risk assets creates better value in corporates. Table 3Corporate Sector Relative Valuation And Recommended Allocation* (Continued) "Some"thing To Talk About "Some"thing To Talk About Table 3BCorporate Sector Risk Vs. Reward* "Some"thing To Talk About "Some"thing To Talk About High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by +92bps in October, but has already underperformed the Treasury benchmark by -108bps so far in November. The index option-adjusted spread is +25bps wider since the end of September and, at 505bps, it is 16bps below its historical average. In a Special Report2 published last week we noted that while the default rate will not re-visit its previous lows (at least until after the next recession), it should decline from 5.4% to close to 4% during the next 12 months (Chart 3). However, even a slightly brighter default outlook will not be enough for junk bonds to sustain their current pace of outperformance. A simple model of lagged junk spreads and default losses explains more than 50% of the variation in 12-month high-yield excess returns. This model suggests that even with lower default losses, excess junk returns will be +264bps during the next 12 months (panel 3). The reason is that lower default losses are more than offset by the lower starting point for spreads. Junk spreads should also come under widening pressure in the very near term, as a December Fed rate hike spurs an increase in implied volatility. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. MBS: Overweight Chart 4MBS Market Overview bca.usbs_pas_2016_11_08_c4 bca.usbs_pas_2016_11_08_c4 Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +2bps in October, but are underperforming the benchmark by -7bps so far in November. Year-to-date, MBS have outperformed the duration-equivalent Treasury index by a mere +22bps. Since the end of September, the conventional 30-year MBS yield has risen +23bps, driven by a +21bps increase in the rate component. The option-adjusted spread has widened +2bps, while the compensation for prepayment risk (option cost) has remained flat. Unattractive option-adjusted spreads and the prospect of further increases in issuance make for bleak long-run return prospects in MBS. However, the likelihood that Treasury yields will continue to rise in the near-term means that MBS could outperform due to a decline in the option cost component of spreads (Chart 4). We will likely reduce exposure to MBS once a December rate hike has been fully digested by the market, and the uptrend in Treasury yields starts to taper off. The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to ease standards on GSE-eligible mortgage loans, while demand for these same loans continues to increase. The combination of easing lending standards and strengthening demand means that issuance is likely to continue its march higher, as does the persistent uptrend in existing home sales (bottom panel). Government Related: Overweight Chart 5Government Related Market Overview bca.usbs_pas_2016_11_08_c5 bca.usbs_pas_2016_11_08_c5 The government-related index outperformed the duration-equivalent Treasury index by +5bps in October, but has already underperformed the Treasury benchmark by -9bps so far in November. The Foreign Agency and Local Authority sub-sectors drove October's outperformance, returning +24bps and +14bps in excess of Treasuries respectively. Domestic Agency debt outperformed the Treasury benchmark by +3bps, while Supranationals (-7bps) and Sovereigns (-10bps) both underperformed. After adjusting for differences in credit rating and duration, Foreign Agency and Local Authority bonds still appear attractive relative to investment grade U.S. corporate debt. Sovereigns, on the other hand, appear modestly expensive. We continue to recommend avoiding Sovereign issues while remaining overweight the other sub-sectors of the government related index. In a recent report,3 we observed that the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the U.S. dollar. As such, a continued bull market in the U.S. dollar will remain a significant headwind for sovereigns. At the country level, the only nations whose USD-denominated debt offers a spread advantage over Baa-rated U.S. corporate debt are Hungary, South Africa, Colombia and Uruguay. Unusually, bullet agency debt outperformed callable agency debt last month even though Treasury yields moved higher (Chart 5). Within Domestic Agency bonds, we continue to favor callable over bullet issues on the expectation that this divergence will not persist. Municipal Bonds: Overweight Chart 6Municipal Market Overview bca.usbs_pas_2016_11_08_c6 bca.usbs_pas_2016_11_08_c6 Municipal bonds underperformed the duration-equivalent Treasury index by -12bps in October, dragging year-to-date excess returns down to -152bps (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio is largely unchanged since the end of September, and remains close to its post-crisis average. In recent months, trends in M/T yield ratios have fluctuated alongside the betting market odds for today's Presidential election. A Trump victory would cause yield ratios to widen sharply, as President Trump's promised tax cuts would substantially de-value the tax advantage in municipal bonds. We expect yield ratios to tighten in the event that Clinton prevails, as any expectation of a Trump victory works its way out of the price. Due to attractive yield ratios relative to recent history, we are inclined to remain overweight municipal bonds in the near-term. However, we will likely downgrade the sector if yield ratios move back to previous lows. As we detailed in a recent Special Report,4 historical lags between the corporate and municipal credit cycles suggest that municipal bond downgrades will start to increase in the second half of next year, alongside a deterioration in state & local government balance sheets. Further, state & local government investment spending is poised to move higher next year, regardless of the election result, leading to even greater muni issuance (Chart 6). Elevated fund flows have offset the impact of strong issuance this year, the risk is that they will not keep pace going forward. Treasury Curve: Stay In Flatteners Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve has bear-steepened significantly since the end of September. The 2/10 Treasury slope has steepened +16bps and the 5/30 slope has steepened +14bps. As a result, our two curve flattener trades have struggled. Our 2/10 Treasury curve flattener has returned -41bps since initiation on September 6. Our 10/30 Treasury curve flattener has returned -25bps since initiation on September 20. Our other tactical trade - short December 2017 Eurodollar - has returned +16bps since initiation on July 12. All three of the above tactical trades are premised on the view that the Fed will deliver a rate hike in December, and that such a rate hike has not yet been fully discounted by the market. At present, we calculate that the market-implied probability of a December rate hike is 62%, as discounted in fed funds futures. The historical pattern suggests the yield curve should bear flatten as the rate hike probability approaches 100%. Unusually, the correlations between both the 2/10 and 10/30 Treasury slopes and the level of Treasury yields have moved into positive (bear-steepening) territory (Chart 7). This is especially unusual for the 10/30 slope, where the correlation has been firmly in negative (bear-flattening) territory since 2013. We continue to recommend holding curve flatteners, and expect both correlations to revert into negative (bear-flattening) territory in advance of a December rate hike, as they did last year. Any surge in bullish dollar sentiment between now and December would only increase the flattening pressure on the curve (bottom panel). So far bullish dollar sentiment has remained relatively flat, but we cannot discount a large increase in the run-up to the next rate hike, as occurred last year. TIPS: Overweight Chart 8TIPS Market Overview bca.usbs_pas_2016_11_08_c8 bca.usbs_pas_2016_11_08_c8 TIPS outperformed the duration-equivalent nominal Treasury index by +112bps in October. The 10-year breakeven rate has increased +8bps since the end of September, and currently sits at 1.68%. The 10-year TIPS breakeven rate has increased substantially during the past couple months, and has now converged with the fair value reading from our TIPS Financial model (Chart 8). Rising expectations of a Fed rate hike and a flatter Treasury curve will weigh on TIPS during the next month, and we would not be surprised to see breakevens temporarily cease their uptrend as attention turns to Fed hawkishness following today's election. But we also expect that TIPS breakevens will resume their uptrend heading into next year. As we flagged in a recent report,5 the sensitivity of TIPS breakevens to core inflation has increased since the financial crisis. We posit that the reason for this increased sensitivity is that the Fed's ability to control long-dated inflation expectations has been impaired by the zero-lower bound on rates. As a result, the trend in breakevens is increasingly taking its cue from the realized inflation data. Realized inflation continues to trend steadily higher (bottom two panels), and diffusion indexes suggest that further gains are ahead (panel 4). Given that breakevens remain well below pre-crisis levels, we intend to remain overweight TIPS relative to nominal Treasuries and ride out any near-term volatility related to a Fed rate hike. ABS: Maximum Overweight Chart 9ABS Market Overview bca.usbs_pas_2016_11_08_c9 bca.usbs_pas_2016_11_08_c9 Asset-Backed Securities outperformed the duration-equivalent Treasury index by +10bps in October, bringing year-to-date excess returns up to +101bps. Aaa-rated ABS outperformed the Treasury benchmark by +8bps on the month, while non-Aaa issues outperformed by +24bps. The index option-adjusted spread for Aaa-rated ABS has tightened -3bps since the end of September and, at 45bps, is considerably below its pre-crisis average (Chart 9). According to our days-to-breakeven measure, there still exists a valuation advantage in Aaa-rated auto ABS relative to Aaa-rated credit card ABS, but that advantage is rapidly evaporating (panel 3). We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 10 days of average spread widening for Aaa-rated credit card ABS to underperform. Moreover, credit card ABS exhibit superior collateral credit quality relative to autos. Credit card charge-offs remain near all-time lows, while the auto net loss rate appears to have bottomed (bottom panel). Further, the Fed's senior loan officer survey shows that auto lending standards have tightened for two consecutive quarters, while credit card lending standards were unchanged in Q3 following 25 consecutive quarters of net easing (panel 4). We recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans within a maximum overweight allocation to consumer ABS. CMBS: Underweight Chart 10CMBS Market Overview bca.usbs_pas_2016_11_08_c10 bca.usbs_pas_2016_11_08_c10 Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date outperformance up to +194bps. The index option-adjusted spread for non-agency Aaa-rated CMBS has tightened -3bps since the end of September, and remains very close to its pre-crisis average (Chart 10). The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to tighten standards on all classes of commercial real estate (CRE) loans (panel 3). The survey also shows that CRE loan demand continues to increase, though at a less rapid pace than in prior quarters. While CRE prices continue to march higher (bottom panel), tightening lending standards and a rising delinquency rate (panel 4) make us cautious on non-agency CMBS. Agency CMBS outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date excess returns up to +105bps. Agency CMBS still offer 56bps of option-adjusted spread. This is greater than what is offered by Aaa-rated consumer ABS (45bps) and conventional 30-year MBS (19bps) for a similar amount of spread volatility. We continue to recommend overweight positions in Agency CMBS. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our Global PMI Treasury model places fair value for the 10-year Treasury yield at 2.27% (Chart 11). This model is based on a linear regression of the 10-year Treasury yield on three factors, using a post-financial crisis time interval.6 The three factors are: Global Growth: Measured using the Global Manufacturing PMI (sourced from JP Morgan and Markit) Global Growth Divergences: Proxied by bullish sentiment toward the U.S. dollar (sourced from Marketvane.net) Economic Uncertainty: Measured using the Global Economic Policy Uncertainty Index (sourced from policyuncertainty.com) The correlation between the global PMI and the 10-year Treasury yield is strongly positive (panel 3). However, improving global growth is offset by any increase in bullish sentiment toward the U.S. dollar. For a given level of global growth any increase in bullish sentiment toward the dollar represents a drag on interest rate expectations. As such, bullish dollar sentiment enters our model with a negative sign (panel 4). The final component of our model - global economic policy uncertainty - captures changes in Treasury yields related to headline risk and "flights to quality". This factor enters our model with a negative sign - more uncertainty correlates with lower bond yields (bottom panel). Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium bca.usbs_pas_2016_11_08_c12 bca.usbs_pas_2016_11_08_c12 Chart 13Fed Funds Rate Scenarios bca.usbs_pas_2016_11_08_c13 bca.usbs_pas_2016_11_08_c13 Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 6 For additional details on the model please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, 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)

There are two key risks that could derail a bear-flattening of the yield curve. The first is a Trump election victory, the second is a flaring of stress in the non-U.S. banking sector.

In this week's report, we lay out all of the arguments in favor of and against lifting rates before the end of the year. Specifically, we identify seven key questions about the economic outlook that will undoubtedly be the focus of this week's FOMC deliberations.