Yield Curve

Dear client, In addition to this week’s abbreviated report, we are also sending you a Special Report on currency hedging, authored by my colleague Xiaoli Tang. Xiaoli’s previous work mapped out a dynamic hedging strategy for developed market equity investors in various home currencies. In this report, she extends the work to emerging market exposure. I hope you will find the report insightful. Next week, in lieu of our weekly report on Friday, we will be sending you a joint Special Report on the UK on Tuesday, together with our Global Fixed Income colleagues. Kind regards, Chester Highlights The DXY index is up for the year, but further gains will be capped at 2-3% from current levels. Long yen positions are offside amid the dollar rally. This should wash out stale longs, and underpin the bull case. Lower the limit-sell on the gold/silver ratio to 68. We were stopped out of our short AUD/MXN position amidst a broad-based selloff in EM currencies. We are reinitiating the trade this week. Feature Chart I-1The Dollar Has Been Strong In 2021 The Dollar Has Been Strong In 2021 The Dollar Has Been Strong In 2021 The DXY index has once again kissed off the 90 level and is gaining momentum in March. Year-to-date, the DXY index is up 1.1%. This performance has been particularly pronounced against other safe haven currencies, such as the Swiss franc and the Japanese yen. GBP and AUD have fared rather well in this environment (Chart I-1). As the “anti-dollar,” the euro has also suffered.  Our technical indicators continue to warn that the dollar still has upside. Net speculative positions are at very depressed levels, consistent with many sentiment indicators that are bearish USD. However, this time around, any dollar rally could be capped at 2-3%, in sharp contrast to the bounce we witnessed in March 2020.  The Message From Dollar Technical Indicators Our dollar capitulation index has bounced from very oversold levels, and is now sitting above neutral territory (Chart I-2). The index comprises a standardized measure of sentiment, net speculative positioning and momentum. It is very rare that a drop in this index below the -1.5 level does not trigger a rebound in the dollar. This time around, the bounce has been rather muted. Chart I-2BCA Dollar Capitulation Index Suggests Some Upside BCA Dollar Capitulation Index Suggests Some Upside BCA Dollar Capitulation Index Suggests Some Upside Part of the reason has been concentration around dollar short positions. Investors throughout most of the pandemic executed their bearish dollar bets through the euro, yen and the Swiss franc (countries that already had negative interest rates). Positioning on risk on currencies such as the Australian dollar and the Mexican peso were neutral. This also explains the underperformance of the yen, as the dollar rises. From a sizing standpoint, ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different. What To Do About The Yen The yen has been one of our core holdings on three fundamental pillars: it is cheap, it tends to rise during dollar bear markets and the economy in Japan is more hostage to deflation than the US. This bodes well for real rates in Japan, relative to the US. Over the last month, our long yen position has been put offside. First, demand for safe havens has ebbed as US interest rates have gapped higher (Chart I-3, panel 1). King dollar has once again become the safe haven of choice. As Chart I-1 illustrates, low beta currencies such as the Swiss franc and yen, that tend to do relatively well when the dollar is rallying, have underperformed.  Yield curve control (YCC) in Japan is also negative for the yen as interest rates rise (panel 2). Economic momentum in Japan is also rolling over (panel 3). Prime Minister Yoshihide Suga’s mulling to extend the state of emergency in the Tokyo region could further cripple any Japanese economic recovery. Chart I-3A Healthy Reset In The Yen A Healthy Reset In The Yen A Healthy Reset In The Yen Chart I-4USD/JPY Support Should Hold USD/JPY Support Should Hold USD/JPY Support Should Hold For short-term investors, USD/JPY is very overbought and is approaching strong resistance (Chart I-4). In our view, a washing out of stale shorts would provide a healthy reset for the bear market to resume. Meanwhile, USD/JPY and the DXY change correlations during risk-off periods, where the yen appreciates versus the dollar.  Therefore, a market reset is also positive for the yen.     Housekeeping Chart I-5Remain Short AUD/MXN Remain Short AUD/MXN Remain Short AUD/MXN We were stopped out of our short AUD/MXN trade last week for a loss of 6.1%. We are reinitiating the trade this week. The case for the trade, made a month ago, remains intact. A short-term recovery in the US economy, relative to the rest of the world, argues for an AUD/MXN short. In fact, a divergence has occurred between the BRL/MXN and the AUD/MXN exchange rate (Chart I-5). Domestic factors have certainly tempered the Brazilian real, but the underperformance of metal prices relative to oil in recent months is also a factor. We expect some convergence to occur, with MXN appreciating much faster than the AUD.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have stepped up: Personal income rose by 10% in January, while personal spending rose by 2.4% month-on-month. The ISM report was stellar. The manufacturing PMI improved from 58.7 to 60.8 in February. Prices paid rose to 86. Factory orders were slightly above expectations at 2.6% month-on-month in January.   The DXY index rose by 165 bps this week.  The narrative of a counter-trend reversal in the DXY index isn playing out. As the story unfolds, it will be important to establish targets. Our bias is that the DXY stalls before 93-94 is reached.  Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area remain weak: Core CPI in the Eurozone came in at 1.1%, in line with expectations. The unemployment rate declined from 8.3% to 8.1% in January. January retail sales were weak at -6.4% year-on-year. The euro fell by 1.7%% against the US dollar this week. It will be almost impossible for the euro to rise in an environment where the dollar is in a broad-based decline. Given elevated sentiment on the euro, a healthy reset is necessary for the bull market to resume. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been marginally positive: The employment report was positive, with the unemployment rate dipping to 2.9% and an improvement in the jobs-to-applicants ratio in January. Consumer confidence in February is rebounding from very low levels. The Japanese yen fell by 1.5% against the US dollar this week. The recovery in the Japanese economy is fragile, and tentative signs of a renewed lockdown will knock down confidence. In this transition phase, yen long positions could be hostage to losses. Longer-term, the yen is cheap and will benefit from a broad-based dollar decline. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been in line: Mortgage approvals rose 99K in January, in line with expectations. The construction PMI rose from 49.2 to 53.3 in February. Nationwide house prices are soaring, rising 6.9% in February on a year-on-year basis. The pound fell by 0.8% against the dollar this week. It is however the best performing currency this year. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia was robust: Home lending remained in an uptrend. Owner-occupied loans increased by 11% in January, while investor loans increased by 9.4%. Terms of trade are soaring, rising 24% year-on-year in February. The current account surplus came in near a record A$14.5 billion in Q4. GDP grew by 3.1% QoQ in Q4. The Aussie fell by 1.8% his week. Terms of trade will continue being a tailwind for the AUD/USD. We also like the AUD/NZD cross, as a valuation and terms-of-trade bet. However, we expect that any positive surprises in the US will hurt AUD relative to the Americas. One way to play this is by shorting AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week: Terms of trade rose by 1.3% in Q4. CoreLogic home prices rose 14.5% in February. The New Zealand dollar fell by 2.4% against the US dollar this week. The kiwi ranks as the most unattractive currency in our FX framework. For one, it has catapulted itself to the most expensive currency in our PPP models. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada was positive: The Nanos confidence index rose from 58.2 to 59.4 in February. Annualized 4Q GDP came in at 9.6%, above expectations. Building permits rose 8.2% month-on-month in January. The Canadian dollar fell 0.4% against the US dollar this week. Oil prices remain very much in an uptrend, which is underpinning the loonie. Better US economic performance in the near term should also help the CAD. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data out of Switzerland have been improving: Swiss GDP rose by 0.3%  quarter-on-quarter in 4Q. The KOF leading indicator rose from 96.5 to 102.7 in February. The February manufacturing PMI rose from 59.4 to 61.3. Switzerland remains in deflation, with the core CPI that came in at -0.3% year-on-year in February. The Swiss franc fell by 2.6% against the US dollar this week. Safe -haven currencies continue to be laggards, as rates rise and gold falls to the wayside. This is bullish on  procyclical currencies, and negative the Swiss franc. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The data out of Norway has been robust: The unemployment rate fell from 4.4% to 4.3% The manufacturing PMI increased from 51.8 to 56.1 in February. The current account balance was robust in Q4. It should increase significantly in Q1 this year given the large trade balance in January. Being long the Norwegian krone is one of our high-conviction bets in the FX portfolio. The Norwegian krone fell by 1% against the US dollar this week, but outperformed the euro, amongst other currencies. The NOK ticks all the boxes of an attractive currency – cheap valuations, a liquidity discount, and primed to benefit from a global growth rebound. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Most Swedish data releases were in line with expectations: GDP came in at -0.2% quarter-on-quarter, below expectations. Retail sales rose 3.1% year-on-year, above expectations. The trade balance came in at a surplus of SEK 5.2 billion  in January. The manufacturing PMI remained elevated at 61.6 in February. The Swedish krona fell by 2.4% against the US dollar this week. Manufacturing data is improving in Sweden but the economy remains hostage to COVID-19, compared to Norway. That is weighing on the krona. That said, Sweden is a highly levered play on the global cycle. Therefore, once the pandemic is behind us, the SEK will outperform. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Chart 1Back To Fair Value Back To Fair Value Back To Fair Value February was a terrible month for the bond market. In fact, the Bloomberg Barclays Treasury Master Index returned -1.8%, its worst month since November 2016. The 5-year/5-year forward Treasury yield rose 37 bps. At 2.19%, it is now fairly valued for the first time since 2019, at least according to survey estimates of the long-run neutral fed funds rates (Chart 1). We outlined a checklist for increasing portfolio duration in our Webcast two weeks ago. So far, only two of the five items on our list have been checked. In particular, dollar sentiment and cyclical economic indicators continue to point toward higher yields, even though the market is now priced for a rate hike cycle that is slightly more hawkish than the Fed’s median forecast from December. We anxiously await this month’s revisions to the Fed’s interest rate forecasts. If the Fed’s forecasts remain unchanged from December, then we may get an opportunity to add some duration back into our recommended portfolio. Stay tuned. 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 65 basis points in February, bringing year-to-date excess returns up to +68 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen in recent weeks, this does not yet pose a risk for credit spreads. The 5-year/ 5-year forward TIPS breakeven inflation rate remains below 2%. We won’t be concerned about restrictive monetary policy pushing credit spreads wider until it reaches a range of 2.3% to 2.5%. Despite the positive macro backdrop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have only been more expensive 3% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Stay Bearish On Bonds Stay Bearish On Bonds Table 3BCorporate Sector Risk Vs. Reward* Stay Bearish On Bonds Stay Bearish On Bonds High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 115 basis points in February, bringing year-to-date excess returns up to +178 bps. Ba-rated credits outperformed duration-matched Treasuries by 111 bps on the month, besting B-rated bonds which outperformed by only 104 bps. The Caa-rated credit tier delivered 138 bps of outperformance versus duration-matched Treasuries. We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is merely in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.3% for the next 12 months (panel 3). This represents a steep drop from the 8.3% default rate observed during the most recent 12-month period. However, only 2 defaults occurred in January, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, have also fallen dramatically (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in February, dragging year-to-date excess returns down to -2 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 6 bps in February, but it remains low relative to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) tightened 1 bp on the month to 24 bps. This is considerably below the 57 bps offered by Aa-rated corporate bonds and the 42 bps offered by Agency CMBS. It is only slightly above the 22 bps offered by Aaa-rated consumer ABS. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates. This means that mortgage refinancings are likely close to a peak. A drop in refi activity would be a positive development for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, relative OAS valuation favors Aa-rated corporates and Agency CMBS over MBS. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) meaning that we could still see spreads adjust higher. Last year’s spike in the mortgage delinquency rate is alarming (panel 4), but it will have little impact on MBS returns. The increase was driven by household take-up of forbearance granted by the federal government. Our US Investment Strategy service has shown that a considerable majority of households will remain current on their loans once the forbearance period ends, causing the delinquency rate to fall back down.3  Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 3 basis points in February, dragging year-to-date excess returns down to +21 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 95 bps in February, dragging year-to-date excess returns down to -116 bps. Foreign Agencies outperformed the Treasury benchmark by 31 bps on the month, bringing year-to-date excess returns up to +25 bps. Local Authority bonds outperformed by 63 bps in February, bringing year-to-date excess returns up to +203 bps. Domestic Agency bonds outperformed by 1 bp, bringing year-to-date excess returns up to +16 bps. Supranationals underperformed by 2 bps, dragging year-to-date excess returns down to +5 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage versus US corporates for all credit tiers except Ba. We recommend that investors take advantage of this spread pick-up by favoring investment grade EM Sovereigns over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over EM Sovereigns and the extra spread available in B-rated and lower EMs comes from distressed credits in Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +102 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (bottom panel), the same goes for Revenue bonds in the 8-12 year maturity bucket (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 0.3%. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 1% and 10%, respectively. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields moved up dramatically in February, with the curve steepening out to the 7-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 30 bps on the month to reach 130 bps. The 5/30 slope, meanwhile, held steady at 142 bps. Slopes across the entire yield curve traded directionally with yields for the bulk of February. That is, until last Thursday when a surge in bond yields occurred alongside flattening beyond the 5-year maturity point. As a result, the 2/5/10 butterfly spread spiked (Chart 7), moving into positive territory for the first time in a while (panel 4). This curve behavior raises an interesting question. Was last week’s sharp underperformance in the belly a one-off move driven by convexity selling and other technical factors, as many have suggested?5 Or, are we now close enough to a potential Fed liftoff date that we should expect some segments of the yield curve to flatten on days when yields rise? We will be watching the correlations between different yield curve segments and the overall level of yields closely during the next few weeks, but as of today, we think it’s premature to declare that the 5/10 slope has transitioned into a regime where it flattens on days when yields move higher. That being the case, we expect further increases in bond yields to coincide with a falling 2/5/10 butterfly spread, and we retain our recommended position long the 5-year bullet and short a duration-matched 2/10 barbell. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in February, bringing year-to-date excess returns up to +183 bps. The 10-year TIPS breakeven inflation rate rose 2 bps on the month to hit 2.17%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps in February to reach 1.91%. February’s TIPS outperformance was concentrated at the front-end of the curve, as investors started to price-in the possibility of higher inflation during the next year or two that eventually subsides. It’s interesting to note that, despite last month’s surge in bond yields, the 5-year/5-year forward TIPS breakeven inflation rate fell, moving further away from the Fed’s 2.3% to 2.5% target range in the process (Chart 8). The Fed will continue to strive for an accommodative policy stance at least until this target is met. Last month’s price action caused our recommended positions in inflation curve flatteners and real yield curve steepeners to perform very well, but we think further gains are possible in the coming months. The 2/10 CPI swap slope has only just dipped into negative territory (panel 4). With the Fed officially targeting a temporary overshoot of its 2% inflation target, this slope should remain inverted for some time yet. With the Fed also continuing to exert more control over short-dated nominal yields than over long-term ones, short-maturity real yields will continue to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in February, bringing year-to-date excess returns up to +20 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +13 bps. Non-Aaa ABS outperformed by 9 bps on the month, bringing year-to-date excess returns up to +58 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent, and now another round of checks is pushing the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 12 basis points in February, bringing year-to-date excess returns up to +87 bps. Aaa Non-Agency CMBS underperformed Treasuries by 5 bps in February, dragging year-to-date excess returns down to +37 bps. Meanwhile, non-Aaa CMBS outperformed by 75 bps, bringing year-to-date excess returns up to +262 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 11 basis points in February, bringing year-to-date excess returns up to +39 bps. The average index option-adjusted spread tightened 3 bps on the month to reach 42 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. This is especially true when you consider the Fed’s continued pledge to purchase as much Agency CMBS as “needed to sustain smooth market functioning”. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 26TH, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of February 26TH, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 39 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 39 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Stay Bearish On Bonds Stay Bearish On Bonds Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of February 26th, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, January 2021”, dated January 25, 2021, available at usis.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 5 https://www.bloomberg.com/news/articles/2021-02-25/convexity-hedging-haunts-markets-already-reeling-from-bond-rout?sref=Ij5V3tFi Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Dear Client, In addition to this week’s abbreviated report, we are sending you a Special Report on Bitcoin. I don’t recommend you buy it. Best regards, Peter Berezin Highlights Real government bond yields have increased in recent weeks, which could put further downward pressure on equity prices in the near term. Nevertheless, we continue to advocate overweighting equities over a 12-month horizon. Historically, rising real yields have been most toxic for stocks when yields have increased in response to hawkish central bank rhetoric. This is manifestly not the case today. The Fed’s accommodative stance should limit any near-term upward pressure on the US dollar. Investors should favor cyclical and value-oriented stocks over defensive and growth-geared plays. Higher Real Yields: A Near-Term Risk For Stocks Chart 1Government Bond Yields Have Increased Since Bottoming Last Year Government Bond Yields Have Increased Since Bottoming Last Year Government Bond Yields Have Increased Since Bottoming Last Year Bond yields have jumped in recent weeks. After bottoming at 0.52% in August, the US 10-year Treasury yield has climbed to 1.54%, up from 0.93% at the beginning of the year. Government bond yields in the other major economies have also risen (Chart 1). While inflation expectations have bounced, the most recent increase in yields has been concentrated in the real component of bond yields (Chart 2). Optimism about a vaccine-led global growth recovery, reinforced by continued fiscal stimulus – especially in the US – has prompted investors to move forward their expectations of how soon and how high policy rates will rise (Chart 3). Chart 2AThe Real Component Has Fueled The Most Recent Rise In Bond Yields (I) The Real Component Has Fueled The Most Recent Rise In Bond Yields (I) The Real Component Has Fueled The Most Recent Rise In Bond Yields (I) Chart 2BThe Real Component Has Fueled The Most Recent Rise In Bond Yields (II) The Real Component Has Fueled The Most Recent Rise In Bond Yields (II) The Real Component Has Fueled The Most Recent Rise In Bond Yields (II) How menacing is the increase in bond yields to stock market investors? Chart 4 shows that there has been a close correlation between real yields and the forward P/E ratio at which the S&P 500 trades. The 5-year/5-year forward real yield, in particular, has moved up sharply, which could put further downward pressure on stocks in the near term. Chart 3Path Of Expected Policy Rates Being Revised Upwards Path Of Expected Policy Rates Being Revised Upwards Path Of Expected Policy Rates Being Revised Upwards Chart 4Rise In Real Rates Is A Headwind For Equity Valuations Rise In Real Rates Is A Headwind For Equity Valuations Rise In Real Rates Is A Headwind For Equity Valuations Nevertheless, we continue to advocate overweighting equities over a 12-month horizon. As we pointed out two weeks ago, rising real yields have historically been most toxic for stocks when yields have increased in response to hawkish central bank rhetoric. This is manifestly not the case today. In his testimony to Congress this week, Jay Powell downplayed inflation risks, stressing that the US economy was “a long way” from the Fed’s goals. He pledged to tread “carefully and patiently” and give “a lot of advance warning” before beginning the process of normalizing monetary policy. We expect the 10-year Treasury yield to stabilize in the 1.6%-to-1.7% range, still well below the level that would threaten the health of the economy. Favor Cyclical And Value-Oriented Stocks In  A Weaker Dollar Environment The Fed’s accommodative stance should limit any near-term upward pressure on the US dollar. Whereas stocks are most sensitive to absolute changes in long-term real bond yields, the dollar is more sensitive to changes in short-term real rate differentials with US trading partners (Chart 5). Since the Fed is unlikely to tighten monetary policy anytime soon, US short-term real rates could fall further as inflation rises.  Chart 5The Dollar Is Sensitive To Changes In Short-Term Real Rate Differentials The Dollar Is Sensitive To Changes In Short-Term Real Rate Differentials The Dollar Is Sensitive To Changes In Short-Term Real Rate Differentials Chart 6Cyclical Stocks Tend To Benefit The Most From Stronger Global Growth And A Weaker Dollar Cyclical Stocks Tend To Benefit The Most From Stronger Global Growth And A Weaker Dollar Cyclical Stocks Tend To Benefit The Most From Stronger Global Growth And A Weaker Dollar   Cyclical stocks, which are overrepresented outside the US, tend to benefit the most from strengthening global growth and a weakening dollar (Chart 6). Value stocks also generally do well in a weak dollar-strong growth environment (Chart 7). Moreover, bank shares – which are concentrated in value indices – typically outperform when long-term bond yields are rising (Chart 8). Chart 7AA Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (I) A Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (I) A Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (I) Chart 7BA Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (II) A Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (II) A Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (II)     Chart 8Bank Shares Typically Excel When Long-Term Bond Yields Are Rising Bank Shares Typically Excel When Long-Term Bond Yields Are Rising Bank Shares Typically Excel When Long-Term Bond Yields Are Rising In contrast, as relatively long-duration assets, growth stocks often struggle when bond yields go up. The same is true for more speculative plays such as cryptocurrencies. In this week’s Special Report, we discuss the fate of Bitcoin, arguing that investors should resist buying it.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com     Global Investment Strategy View Matrix When Good News Is Bad News When Good News Is Bad News Special Trade Recommendations When Good News Is Bad News When Good News Is Bad News Current MacroQuant Model Scores When Good News Is Bad News When Good News Is Bad News

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

Highlights Chart 1Inflation Indicators Hook Up Inflation Indicators Hook Up Inflation Indicators Hook Up There’s no doubt that inflationary pressures are building in the US economy. The latest piece of evidence is January’s ISM Manufacturing PMI which saw the Prices Paid component jump above 80 for the first time since 2011 (Chart 1). Large fiscal stimulus is clearly leading to bottlenecks in certain industries that were not negatively impacted by the pandemic, and this could cause consumer price inflation to rise during the next few months. However, the Fed will not view a spike in inflation as sustainable unless it is accompanied by a labor market that is close to maximum employment. The Fed estimates that “maximum employment” corresponds to an unemployment rate of 3.5% to 4.5%, and we calculate that average monthly payroll growth of about +500k is required to reach that target by the end of the year. The bottom line is that rising inflation will not lead to Fed tightening this year. We continue to expect liftoff in late-2022 or the first half of 2023. 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 3 basis points in January. The index option-adjusted spread widened 1 bp on the month, leaving it 4 bps above its pre-COVID low. As discussed in last week’s report, the combination of above-trend economic growth and accommodative monetary policy means that the runway for spread product outperformance remains long.1 However, given that investment grade corporate bond spreads are extremely tight, investors should look to other spread products when possible. One valuation measure, the investment grade corporate index’s 12-month breakeven spread – with the index re-weighted to maintain a constant credit rating distribution over time – is down to its 4th percentile (Chart 2). This means that the breakeven spread has only been tighter 4% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 4% of the time (panel 3). While we don’t anticipate material underperformance versus Treasuries, we see better value outside of the investment grade corporate space. Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration (see page 9). We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration (see page 8). Finally, the supportive macro environment means that we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors pick up the additional spread offered by high-yield corporates, particularly the Ba credit tier where spreads remain wide compared to average historical levels (see page 6). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* No Tightening In 2021 No Tightening In 2021 Table 3BCorporate Sector Risk Vs. Reward* No Tightening In 2021 No Tightening In 2021 High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in January. The average index option-adjusted spread widened 2 bps on the month, leaving it 47 bps above its pre-COVID low. Ba-rated credits outperformed duration-matched Treasuries by 50 bps on the month, besting B-rated bonds which outperformed by only 33 bps. The Caa-rated credit tier delivered 157 bps of outperformance versus duration-matched Treasuries. We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is merely in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only six defaults occurred in December, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, have also fallen dramatically (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in January. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened sharply in January, despite a continued rapid pace of refinancing activity (Chart 4). The option-adjusted spread adjusted downward in January and it now sits at 25 bps (panel 3). This is considerably below the 61 bps offered by Aa-rated corporate bonds and the 45 bps offered by Agency CMBS. It is only slightly above the 20 bps offered by Aaa-rated consumer ABS. The primary mortgage spread has tightened dramatically during the past few months (bottom panel), a key reason why refinancing activity has been so strong despite the back-up in Treasury yields. With the mortgage spread now closer to typical levels, it stands to reason that further increases in Treasury yields will be matched by higher mortgage rates. As such, mortgage refinancing activity could be close to its peak. While a drop in refinancing activity would be a reason to get more bullish on MBS, we aren’t yet ready to pull that trigger. The gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2), and we could still see spreads adjust higher. Last year’s spike in the mortgage delinquency rate is alarming (panel 4), but it will have little impact on MBS returns. The increase was driven by household take-up of forbearance granted by the federal government. Our US Investment Strategy service recently showed that a considerable majority of households will remain current on their loans once the forbearance period expires, causing the delinquency rate to fall back down.3 Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 24 basis points in January (Chart 5). Sovereign debt and Foreign Agencies underperformed duration-equivalent Treasuries by 21 bps and 7 bps, respectively, in January. Local Authority bonds outperformed the Treasury benchmark by 140 bps while Domestic Agency bonds and Supranationals outperformed by 15 bps and 7 bps, respectively. Last week’s report contains a detailed look at valuation for USD-denominated EM Sovereigns.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage versus US corporates for all credit tiers except Ba. We recommend that investors take advantage of this spread pick-up by favoring investment grade EM Sovereigns over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over EM Sovereigns and the extra spread available in B-rated and lower EMs comes from distressed credits in Turkey and Argentina.   Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 108 basis points in January (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year and 6-8 year maturity buckets offer an after-tax yield pick-up versus Credit for investors with effective tax rates above 3% and 16%, respectively. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 21% and 33%, respectively.    All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in last week’s report. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in January. The 2/10 Treasury slope steepened 20 bps to 100 bps. The 5/30 Treasury slope steepened 13 bps to 142 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and stimulative fiscal policy will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on a duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels.       TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 143 basis points in January. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 14 bps and 1 bp on the month. They currently sit at 2.15% and 2.06%, respectively. Core CPI rose 0.09% in December, causing the year-over-year rate to dip from 1.65% to 1.61%. Meanwhile, 12-month trimmed mean CPI ticked up from 2.09% to 2.10%, widening the gap between trimmed mean and core (Chart 8). We expect 12-month core inflation to jump during the next few months, narrowing the gap between core and trimmed mean. As such, we remain overweight TIPS versus nominal Treasuries, even though the 10-year TIPS breakeven inflation rate looks expensive on our Adaptive Expectations Model (panel 2).5 We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in January. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps in January, while non-Aaa issues outperformed by 48 bps (Chart 9). The stimulus from the CARES act led to a significant increase in household income when individual checks were mailed out last April. Since then, households have used this stimulus to build up a considerable buffer of excess savings (panel 4). The large stock of household savings means that the collateral quality of consumer ABS is very high, and this situation won’t change any time soon with even more fiscal stimulus on the way. Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 75 basis points in January. Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in January, while non-Aaa issues outperformed by 185 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The average index spread tightened 4 bps on the month to reach 45 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. This is especially true when you consider the Fed’s continued pledge to purchase as much Agency CMBS as “needed to sustain smooth market functioning”. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 29TH, 2021) No Tightening In 2021 No Tightening In 2021 Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 29TH, 2021) No Tightening In 2021 No Tightening In 2021 Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 86 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 86 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) No Tightening In 2021 No Tightening In 2021 Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of January 29th, 2021) No Tightening In 2021 No Tightening In 2021 Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, January 2021”, dated January 25, 2021, available at usis.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 5 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Rates: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Municipal Bonds: Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. Economy: December’s employment report showed the first monthly contraction in nonfarm payrolls since April. However, this negative headline reflects the transitory impact of the latest COVID wave. It does not signal renewed weakness in the pace of economic recovery. Feature A Politically Driven Bond Rout In a Special Report last October, we argued that the bond market was vulnerable in a scenario where the November 3rd election resulted in the Democratic party winning the House, Senate and White House.1 It took some time, but after Democrats won both of Georgia’s Senate seats in last week’s special election, we are finally seeing the impact on the bond market. Nominal Treasury Yields First, the 10-year nominal Treasury yield moved above 1% for the first time since March. It currently sits at 1.13% (Chart 1). Meanwhile, the front-end of the Treasury curve held steady as the Fed continued to signal that liftoff is unlikely to occur within the next two years. The result has been a persistent steepening of the nominal curve (Chart 1, bottom panel). The 10-year nominal Treasury yield moved above 1% for the first time since March. We are positioned for a bear-steepening of the nominal Treasury curve, but the speed of this most recent move raises the question of how much further the bond sell-off can run. As we wrote in our year-end Special Report, we see yields continuing to rise until the 5-year/5-year forward Treasury yield reaches levels consistent with survey estimates of the long-run equilibrium fed funds rate (Chart 2).2 This would be in line with where yields peaked during the prior two global growth recoveries (2013/14 and 2017/18). At present, survey responses put our target for the 5-year/5-year forward Treasury yield at roughly 2% to 2.25%, still 18 to 43 bps above current levels. Chart 1Nominal Curve Bear-Steepening Nominal Curve Bear-Steepening Nominal Curve Bear-Steepening Chart 2How Much Upside For Yields? How Much Upside For Yields? How Much Upside For Yields? The prospect of greater fiscal stimulus under a Democratic government doesn’t necessarily translate into a higher ceiling for Treasury yields, but it does increase the speed with which yields will reach our target. All in all, we remain positioned for a bear-steepening of the nominal Treasury curve but will re-consider this stance if the 5-year/5-year forward yield reaches a range of 2% to 2.25%. Inflation Compensation Chart 3Stay Overweight TIPS For Now Stay Overweight TIPS For Now Stay Overweight TIPS For Now The recent 20 bps jump in the 10-year nominal Treasury yield was driven by a 15 bps increase in the 10-year TIPS yield and a 5 bps increase in the 10-year TIPS breakeven inflation rate. Notably, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates have both pushed above 2% and are sitting at 2.08% and 2.06%, respectively. While these long-maturity TIPS breakevens have recovered nicely, the Fed won’t be tempted to adopt a more hawkish policy stance until they reach a range of 2.3 – 2.5 percent, a range that has been consistent with “well-anchored” inflation expectations in the past (Chart 3).. While TIPS breakeven inflation rates aren’t yet high enough to worry the Fed, they are starting to look elevated compared to actual inflation. At 2.08%, the 10-year TIPS breakeven inflation rate is 27 bps above the fair value reading from our Adaptive Expectations Model (Chart 3, panel 3).3 Given this expensive valuation, we are currently looking for an opportunity to tactically reduce our allocation to TIPS. We expect that opportunity will come when the 12-month core and trimmed mean inflation rates re-converge (Chart 3, bottom panel). The low level of core CPI inflation relative to the trimmed mean suggests that inflation has near-term upside as some downtrodden sectors that are excluded from the trimmed mean recover from the pandemic. But inflation will moderate once that “snapback phase” is over, and we should get an opportunity to reduce our TIPS allocation.4   Along with an overweight allocation to TIPS versus nominal Treasuries, we also recommend owning inflation curve flatteners. The inflation curve tends to flatten when the cost of inflation protection rises, and this has indeed been the case during the past few weeks (Chart 4). It will make sense to exit this flattener when we tactically reduce our TIPS allocation, but this will only be a temporary move. In the long run, the inflation curve will eventually invert and then remain in negative territory for an extended period. This is the result of the Fed’s plan to engineer an overshoot of its 2% inflation target. If the Fed is successful, it means that it will be attacking its inflation target from above for the first time since the 1980s. In such an environment, it makes sense for the inflation curve to be inverted. Chart 4Inflation Curve Flattening Inflation Curve Flattening Inflation Curve Flattening Real Yield Curve Chart 5Real Curve Steepening Real Curve Steepening Real Curve Steepening Our final rates curve recommendation is a real yield curve steepener. This position has also performed well during the recent bond rout, as a 14 bps increase in the 10-year real yield occurred alongside a 13 bps drop in the 2-year real yield (Chart 5). As with our other rates positions, we are inclined to stay the course. A 2/10 real yield curve steepener can be thought of as the combination of a 2/10 nominal curve steepener and a 2/10 inflation curve flattener. During the recent bond sell-off, the 2/10 real curve has steepened by 27 bps, split between 17 bps of nominal curve steepening and 10 bps of inflation curve flattening. We will likely maintain our real yield curve steepener as a core portfolio position even if we eventually close our inflation curve flattener. Gradual progress toward fed funds liftoff and the resulting steepening of the nominal curve should be sufficient to steepen the real yield curve, even if inflation takes a pause. Corporate Credit Chart 6Move Down In Quality Move Down In Quality Move Down In Quality Corporate spreads have reacted well to the news of a Democratic sweep, even though it means that a corporate tax hike is coming in 2021. All else equal, the one-time hit to profits from a tax hike is negative for corporate balance sheets, but this is a minor consideration when the macro back-drop remains so positive for spread product. The combination of above-trend economic growth and highly accommodative monetary policy will encourage investors to keep adding credit risk, and the average investment grade and high-yield index spreads have still not quite recovered to their pre-COVID tights (Chart 6). We continue to view the Ba credit tier as the most attractive from a risk/reward perspective, as the incremental spread pick-up in Ba compared to Baa is elevated compared to what we’ve seen in recent years (Chart 6, panel 3). Bottom Line: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Fiscal Policy In 2021 Chart 7Organic Household Income Has Recovered Organic Household Income Has Recovered Organic Household Income Has Recovered Our US Political Strategy service debuted last week with a report that considers the outlook for fiscal policy in 2021 given that Democrats now have control of the House, Senate and White House.5 In short, the Democrats now have complete control of the government but their majorities in the House and Senate are thin. This means that the most radical parts of the Democratic agenda, like the Green New Deal, will be hard to pass. However, the Democrats will be able to deliver two reconciliation bills in 2021. The first bill could come soon and will likely focus on additional COVID relief and social support, such as $2000 checks to individuals instead of $600 ones. After that, the Democrats will focus on expanding and entrenching the Affordable Care Act (Obamacare). They will partially repeal the Trump tax cuts to help finance these priorities. On the issue of COVID relief, we are no longer concerned about the US economy receiving enough stimulus to avoid a double-dip recession. We had previously estimated that a further $600 billion to $1 trillion of income support for households would be required to support consumer spending at reasonable levels.6 This estimate now looks too high because non-CARES act household income has recovered much more quickly than we had anticipated. Non-CARES act household income is already back to pre-COVID levels (Chart 7). In our prior research, we assumed this wouldn’t happen until July 2021. In any event, another round of $2000 checks will provide more than enough income support to sustain a recovery in consumer spending. A Democratic sweep suggests big fiscal thrust in 2021 and less contraction in 2022. More generally, our US Political Strategy team has estimated the medium-term path for the US deficit under a “Democratic Status Quo” scenario that assumes another round of $2000 checks and that the remaining $2.5 trillion of the proposed HEROES Act will be enacted. It also considers a “Democratic High” scenario that adds Joe Biden’s $5.6 trillion policy agenda on top of the Democratic Status Quo (Chart 8). Biden will not achieve all of his agenda, so the reality will lie somewhere between the Democratic Status Quo and Democratic High scenarios. In either case, we will see considerably more fiscal thrust compared to the Republican Status Quo and Baseline scenarios. Chart 8Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 A Blue Sweep After All A Blue Sweep After All Municipal Bonds The prospect of federal government aid for challenged state & local governments is a crucial issue for municipal bond investors. Fortunately, the Democratic party’s HEROES act contains more than $1 trillion of aid to state & local governments and this will likely form the basis of the next COVID relief package. On top of that, further support for household incomes will also help support state & local tax revenues that are already recovering (Chart 9). Chart 9State & Local Austerity Will Continue State & Local Austerity Will Continue State & Local Austerity Will Continue That said, we are likely still in for a considerable period of state & local austerity given the large budget gaps that have opened during the past nine months. However, the expectation of help from the federal government makes us even more confident that state & local governments will muddle through without a spate of muni downgrades or defaults. We maintain our “maximum overweight” recommendation for tax-exempt municipal bonds, though valuation is turning more expensive by the day. Muni yield spreads versus Treasuries are contracting, particularly at the long end of the curve (Chart 10A) and valuations appear more expensive if we look at yield ratios instead of spreads (Chart 10B). In both cases, value looks better at the front end of the curve than at the long end. Chart 10AMuni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Chart 10BMuni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Bottom Line: The new Democratic government will deliver more than enough income support to sustain the recovery in consumer spending. Aid for state & local governments is also forthcoming and it will help sustain municipal bond outperformance versus both Treasuries and investment grade corporates. Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. December Payrolls Only A Temporary Setback At first blush, last week’s December employment report looks disastrous. Nonfarm payrolls fell by 140 thousand, the first monthly contraction since April. The contraction looks especially worrying when you consider that payrolls remain almost 10 million below pre-COVID levels and should be rising quickly at this stage of the economic recovery (Chart 11). Chart 11Payrolls Contracted In December Payrolls Contracted In December Payrolls Contracted In December Chart 12Permanent Unemployment Fell In December Permanent Unemployment Fell In December Permanent Unemployment Fell In December The grim headline numbers, however, severely overstate the magnitude of the problem. Rather than implying underlying economic weakness, the drop in payrolls reflects the transitory impact of the pandemic’s latest violent wave. December’s job losses came from the Leisure and Hospitality sector (-498k), the sector most impacted by the virus. Job gains remained solid elsewhere in the economy (+358k). The unemployment rate held flat at 6.7% in December, but encouragingly, this stable number masks both an increase in the number of temporarily unemployed (or furloughed) workers and a drop in the number of permanently unemployed workers (Chart 12). Those furloughed workers will return to work once the virus is better contained. Meanwhile, the drop in the number of permanently unemployed suggests that the economic recovery is taking hold. It will only gain momentum as the COVID vaccine is rolled out and additional fiscal stimulus is delivered in 2021.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 4 For more details on inflation’s “snapback phase” please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 5 Please see US Political Strategy Weekly Report, “Buy Reflation Plays On Georgia’s Blue Sweep”, dated January 6, 2021, available at usps.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear Client, I am writing as the US Capitol goes under lockdown to tell you about a new development at BCA Research. Since you are a subscriber of Geopolitical Strategy, we wanted you to be the first to know. This month we are launching a new sister service, US Political Strategy, which will expand and deepen our coverage of investment-relevant US domestic political risks and opportunities. Over the past decade, we at Geopolitical Strategy have worked hard to craft an analytical framework that incorporates policy insights into the investment process in a systematic and data-dependent way. We have learned a lot from your input and have refined our method, while also building new quantitative models and indicators to supplement our qualitative, theme-based coverage. While our method served us well in 2020, the frantic US election cycle often caused clients to lament that US politics had begun to crowd out our traditional focus on truly global themes and trends. We concurred. Therefore we have decided to expand our team and deepen our coverage. With a series of new hires, we are now better positioned to provide greater depth on US markets in US Political Strategy while redoubling our traditional global sweep in the pages of Geopolitical Strategy. Going forward, US Political Strategy will cover executive orders, Capitol Hill, federal agencies, regulatory risk, the Supreme Court, emerging socioeconomic trends, and their impacts on key US sectors and assets. It will be BCA Research’s newest premium investment strategy service and will include the full gamut of weekly reports, special reports, webcasts, and client conferences. Meanwhile Geopolitical Strategy will return to its core competency of geopolitics writ large – including the US in its global impacts, but diving deeper into the politics and markets of China, Europe, India, Japan, Russia, the Middle East, and select emerging markets.  Both strategies will utilize our proprietary analytical framework, which relies on data-driven assessments of the “checks and balances” that shape policy outcomes (i.e. comparing constraints versus preferences). As you know best, we are agnostic about political parties, transparent about conviction levels and scenario probabilities, and solely focused on getting the market calls right. To this end, we offer you a complimentary trial subscription of US Political Strategy. We aim to become an integral part of your work flow – separating the wheat from the chaff in the political and geopolitical sphere so that you can focus on honing your investment process. We know you will be pleased to see Geopolitical Strategy return to its roots – and we hope you will consider diving deeper with us into US politics and markets. We look forward to hearing from you. Happy New Year! All very best, Matt Gertken, Vice President BCA Research   The outgoing Trump administration is powerless to stop the presidential transition and the US military and security forces will not participate in any “coup.” Investors should buy the dip if social instability affects the markets between now and President-elect Joe Biden’s Inauguration Day. Democrats have achieved a sweep of US government with two victories in Georgia’s Senate election. The Biden administration is no longer destined for paralysis. Investors no longer need fear a premature tightening of US fiscal policy. Fiscal thrust will expand by around 6.9% of GDP more than it otherwise would have in FY2021 and contract by 12.3% of GDP in FY2022. Democrats will partly repeal the Trump tax cuts to pay for new spending programs, including an expansion and entrenchment of Obamacare. Big Tech is the most exposed to the combination of higher corporate taxes and inflation expectations. Investors should go long risk assets and reflation plays on a 12-month basis. We recommend value over growth stocks, materials over tech, TIPS over nominal treasuries, infrastructure plays, and municipal bonds. The special US Senate elections in Georgia produced a two-seat victory for Democrats on January 5 and have thus given the Democratic Party de facto control of the Senate.Financial markets have awaited this election with bated breath. The “reflation trade” – bets on economic recovery on the back of ultra-dovish monetary and fiscal policy – had taken a pause for the election. There was a slight setback in treasury yields and the outperformance of cyclical, small cap, and value stocks, which rallied sharply after the November 3 general election (Chart 1). The Democratic victory ensures that US corporate and individual taxes will go up – triggering a one-off drop in earnings per share of about 11%, according to our US Equity Strategist Anastasios Avgeriou (Table 1). But it also brings more proactive fiscal policy. Since the Democrats project larger new spending programs financed by tax hikes, the big takeaway is that the US economic recovery will gain momentum and will not be undermined by premature fiscal tightening. Chart 1Markets Will Look Through Unrest To Reflation Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep   Table 1What EPS Hit To Expect? Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 2Democrats Won Georgia Seats, US Senate Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Republicans Snatch Defeat From Jaws Of Victory The results of the Georgia runoffs, at the latest count, are shown in Chart 2. Republican Senator David Perdue has not yet officially lost the race, as votes are still being tallied, but he trails his Democratic challenger Jon Ossoff by 16,370 votes. This is a gap that is unlikely to be changed by subsequent vote disputes or recounts (though it is possible and the results are not yet declared as we go to press). President-elect Joe Biden only lost 1,274 votes to President Trump when ballots were recounted by hand in November. The Democratic victory offers some slight consolation for opinion pollsters who underestimated Republicans in the general election in certain states. Opinion polls had shown a dead heat in both of Georgia’s races, with Republican Senators Perdue and Kelly Loeffler deviating by 1.4% and 0.4% respectively from their support rate in the average of polls in December. Democratic challengers Jon Ossoff and Raphael Warnock differed by 1.3% and 2.3% from their final polling (Charts 3A & 3B). Chart 3AOpinion Pollsters Did Better … Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 3B… In Georgia Runoffs Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep By comparison, in the November 3 general election, polls underestimated Perdue by 1.3% and overestimated Warnock by 5.3% (Chart 4). On the whole, the election shows that state-level opinion polling can improve to address new challenges. Our quantitative Senate election model had given Republicans a 78% chance of winning Georgia. This they did in the first round of the election, but conditions have changed since November 3, namely due to President Trump’s refusal to concede the election after the Electoral College voted on December 14.1 Our model is based on structural factors so it did not distinguish between the two Senate candidates in the same state. For the whole election, the model predicted that Democrats would win a net of three seats, resulting in a Republican majority of 51-49. Today we see that the model only missed two states: Maine and Georgia. But Georgia has made all the difference, with the result to be 50-50, for Vice President Kamala Harris to break the tie (Chart 5). Chart 4Ossoff In Line With Polls, Warnock Slightly Beat Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 5Our Quant Model Missed Maine And Georgia – And Georgia Carries Two Seats To Turn The Senate Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep COVID-19 likely took a further toll on Republican support in the interim between the two election rounds. The third wave of the COVID-19 pandemic has not peaked in the US or the Peach State. While the number of cases has spiked in Georgia as elsewhere, the number of deaths has not yet followed (Chart 6). Chart 6COVID-19 Surged Since November Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Lame Duck Trump Risk Before proceeding to the policy impacts of the apparent Democratic sweep of both executive and legislative branches, a word must be said about the presidential transition and President Trump’s final 14 days in office. First, the Joint Session of Congress to count the Electoral College ballots to certify the election of the new US president has been interrupted as we go to press. There is zero chance that protesters storming the proceedings will change the outcome of the election. The counting of the electoral votes can be interrupted for debate; it will be reconvened. Disputes over the vote could theoretically become meaningful if Republicans controlled both the House and the Senate, as the combined voice of the legislature could challenge the legitimacy of a state’s electoral votes. But today the Republicans only control the Senate, and while some will press isolated challenges, based on legal disputes of variable merit, these challenges will not gain traction in the Senate let alone in the Democratic-controlled House. What did the US learn from this controversial election? US political polarization is reaching extreme peaks which are putting strain on the formal political system, but Trump lacks the strength in key government bodies to overturn the election. Second, there was no willingness of state legislatures to challenge their state executives on the vote results. This has to do with the evidence upon which challenges could be lodged, but there is also a built-in constraint. Any state legislature whose ruling party opposes the popular result will by definition put its own popular support in jeopardy in the next election. Third, the Supreme Court largely washed its hands of state-level disputes settled by state-level courts. Historically, the Supreme Court never played a role in presidential elections. The year 2000 was an exception, as the high court said at the time. The 2020 election has established a high bar for any future Supreme Court involvement, though someday it will likely be called on to weigh in. Hysteria regarding the conservative leaning on the court – which is now a three-seat gap – was misplaced. The three Supreme Court justices appointed by Trump took no partisan or interventionist role. Nevertheless, the court’s conservative leaning will be one of the Trump administration’s biggest legacies. The marginal judge in controversial cases is now more conservative and will take a larger role given that Democrats now have a greater ability to pass legislation by taking the Senate. President Trump is still in office for 14 days. There is zero chance of a successful military coup or anything of the sort in a republic in which institutions are strong and the military swears allegiance to the constitution. Attempts to oppose the Electoral College and Congress will be opposed – and ultimately they will be met with an overwhelming reassertion of the rule of law. All ten of the surviving secretaries of defense of the United States have signed an open letter saying that the election results should no longer be resisted and that any defense officials who try to involve the military in settling electoral disputes could be criminally liable.2 With Trump’s options for contesting the election foreclosed, he will turn to signing a flurry of executive orders to cement his legacy. His primary legacy is the US confrontation with China, so he will continue to impose sanctions on China on the way out, posing a tactical risk to equity prices. The business community will be slow to comply, however, so the next administration will set China policy. There is a small possibility that Trump will order economic or even military action against Iran or any other state that provokes the United States. But Trump is opposed to foreign wars and the bureaucracy would obstruct any major actions that do not conform with national interests. Basically, Trump’s final 14 days may pose a downside risk to equities that have rallied sharply since the November 9 vaccine announcement but we are long equities and reflation plays. Sweeps Just As Good For Stocks As Gridlock The balance of power in Congress is shown in Chart 7. The majorities are extremely thin, which means that although Democrats now have control, there will remain high uncertainty over the passage of legislation, at least until the 2022 midterm elections. Investors can now draw three solid conclusions about the makeup of US government from the 2020 election: The White House’s political capital has substantially improved – President-elect Joe Biden no longer faces a divided Congress. He won by a 4.5% popular margin (51.4% of the total), bringing the popular and electoral vote back into alignment. He will have a higher net approval rating than Trump in general, and household sentiment, business sentiment, and economic conditions will improve from depressed, pandemic-stricken levels over the course of his term. The Senate is evenly split but Democrats will pass some major legislation – Thin margins in the Senate make it hard to pass legislation in general. However, the budget reconciliation process enables laws to pass with a simple majority if they involve fiscal matters. Hence, Democrats will be able to legislate additional COVID relief and social support that they were not able to pass in the end-of-year budget bill. They can pass a reconciliation bill for fiscal 2022 as well. They will focus on economic recovery followed by expanding and entrenching the Affordable Care Act (Obamacare). We fully expect a partial repeal of Trump’s Tax Cut and Jobs Act, if not initially then later in the year. Democrats only have a five-seat majority in the House of Representatives – Democrats will vote with their party and thus 222 seats is enough to maintain a working majority. But the most radical parts of the agenda, such as the Green New Deal, will be hard to pass. Chart 7Democrats Control Both Houses Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep With the thinnest possible margin, the Senate has a highly unreliable balance of power. Table 2 shows top three Republicans and Democrats in terms of age, centrist ideology, and independent mentality. Four senators are above the age of 85 – they can vote freely and could also retire or pass away. Centrist and maverick senators will carry enormous weight as they will provide the decisive votes. The obvious example is Senator Joe Manchin of West Virginia, who has opposed the far-left wing of his party on critical issues such as the Green New Deal, defunding the police, and the filibuster. Table 2The Senate Will Hinge On These Senators Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep The Democrats could conceivably muster the 51 votes to eliminate the filibuster, which requires a 60-vote majority to pass most legislation, but it will be very difficult. Senators Dianne Feinstein (D, CA), Angus King (I, ME), Kyrsten Sinema (D, AZ), Jon Tester (D, MT), and Manchin are all skeptical of revoking this critical hurdle to Senate legislation.3 We would not rule it out, however. The US has reached a point of “peak polarization” in which surprises should be expected. By the same token, Republican Senators Lisa Murkowski and Susan Collins often vote against their party. Collins just won yet another tough race in Maine due to her ability to bridge the partisan gap. There are also mavericks like Rand Paul – and Ted Cruz will have to rethink his populist strategy given his thin margins of victory and the Trump-induced Republican defeat in the South. Not shown are other moderates who will be eager to cross the political aisle, such as Senator Mitt Romney of Utah. None of the above means Democrats will fail to raise taxes. All Democrats voted against Trump’s Tax Cut and Jobs Act, which did not end up being popular or politically beneficial for the Republicans. The Democratic base is fired up and mobilized by Trump to pursue its core agenda of increasing the government role in US society and the economy and redressing various imbalances and disparities. This requires revenue, especially if it is to be done with only 51 votes via the budget reconciliation process. The two Democratic senators from Arizona are vulnerable, but they will toe the party line because Trump and the GOP were out of step with the median voter. Moreover, Arizonians voted for higher taxes in a state ballot measure in November. Since 1980, gridlocked government has resulted in higher average annual returns on the S&P500. But since 1949, single-party sweeps have slightly edged out gridlocked governments in stock returns, though the results are about the same (Chart 8). The point is that gridlock makes it hard for government to get big things done. Sometimes that is positive for markets, sometimes not. The macro backdrop is what matters. The Federal Reserve is unlikely to start tightening until late 2022 at earliest and fiscal thrust in 2021-22 will be more expansionary now that the Democrats have control of the Senate. This policy backdrop is negative for the dollar and positive for risk assets, especially equity sectors that will suffer least from impending corporate tax hikes, such as energy, industrials, consumer staples, materials, and financials. Chart 8Sweeps Don’t Always Underperform Gridlock Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Meanwhile, Biden will have far less trouble getting his cabinet and judicial appointments through the Senate (Appendix). His appointees so far reflect his desire to return the US to “rule by experts,” as opposed to Trump’s disruptive style of personal rule. Investors will cheer the return to technocrats and predictable policymaking even if they later relearn that experts make gigantic mistakes too. Fiscal Policy Outlook The critical feature of the Trump administration was the COVID-19 pandemic, which sent the US budget deficit soaring to World War II levels relative to GDP. In the coming years, the change in the budget deficit (fiscal thrust) will necessarily be negative, dragging on growth rates (Chart 9). Fiscal policy determines how heavy and abrupt that drag will be. Chart 9US Budget Deficit Surged – Pace Of Normalization Matters Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 10 presents four scenarios that we adjusted based on data from the Congressional Budget Office. The baseline would see an extraordinary 6.7% of GDP contraction in the budget deficit that would kill the recovery, which the Georgia outcome has now rendered irrelevant. The “Republican Status Quo” scenario is now the minimum. Chart 10Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep The “Democratic Status Quo” scenario assumes that the $600 per household rebate will be increased to $2,000 per family and that the remaining $2.5 trillion of the Democrats’ proposed HEROES Act will be enacted. The “Democratic High” scenario adds Biden’s $5.6 trillion policy agenda on top of the Democratic status quo, supercharging the economic recovery with a fiscal bonanza. Biden will not achieve all of this, so the reality will lie somewhere between the solid blue and dotted blue lines. This Democratic status quo implies a 6.9% of GDP expansion of the deficit in FY2021. It also implies that the deficit will contract by 12.3% of GDP in FY2022, instead of 13.5% in the Republican status quo scenario. The economic recovery will be better supported. So, too, will the Fed’s timeline for rate hikes – but the Fed’s new strategy of average inflation targeting shows that it is targeting an inflation overshoot. So the threat of Fed liftoff is not immediate. The longer the extraordinary fiscal largesse is maintained, the greater the impact on inflation expectations and the more upward pressure on bond yields (Chart 11). Big Tech will be the one to suffer while Big Banks, industrials, materials, and energy will benefit. Chart 11Bond Bearish Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Our US Political Risk Matrix There is no correlation between fiscal thrust and equity returns. This is true whether we consider the broad market, cyclicals/defensives, value/growth stocks, or small/large caps (Chart 12). Normally, fiscal thrust surges when recessions and bear markets occur, leading to volatility in asset prices. However, in the new monetary policy context, the risk is to the upside for the above-mentioned sectors, styles, and segments. Looking at sector performance before and after the November 3 election and November 9 vaccine announcement, there has been a clear shift from pandemic losers to pandemic winners. Big Tech and Consumer Discretionary (Amazon) thrived during the period before the vaccine, while value stocks (industrials, energy, financials) suffered the most from the lockdowns. These trends have reversed, with energy and financials outperforming the market since November (Chart 13). The Biden administration poses regulatory risks for Big Oil and arguably Big Banks, but these will come into play after the market has priced in economic normalization and the emerging consensus in favor of monetary-fiscal policy coordination, which is very positive for these sectors. Chart 12Fiscal Thrust Not Correlated With Stocks Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 13Energy And Financials Turned Around With Vaccine Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep In the case of energy, as stated above, the Biden administration will still struggle to get anything resembling the Green New Deal approved in Congress. Nevertheless, environmental regulation will expand and piecemeal measures to promote research and development, renewables, electric vehicles, and other green initiatives may pass. Large cap energy firms are capable of adjusting to this kind of transition. Coal companies are obviously losers. In the case of financials, Biden’s record is not unfriendly to the financial industry. His nominee for Treasury Secretary, former Fed Chair Janet Yellen, approved of the relaxation of some of its more stringent financial regulations under the Trump administration. Big Banks are no longer the target of popular animus like they were after the 2008 financial crisis – in that regard they have given way to Big Tech. Our US Investment Strategist Doug Peta argues that the Democratic sweep will smother any gathering momentum in personal loan defaults, which would help banks outperform the broad market. Biden’s regulatory approach to Big Tech will be measured, as the Obama administration’s alliance with Silicon Valley persists, but tech stands to suffer the most from higher taxes, especially a minimum corporate tax rate. With a unified Congress, it is also now possible that new legislation could expand tech regulation. There is a bipartisan consensus emerging on tech regulation so Republican votes can be garnered. Tech thrives on growth-scarce, disinflationary environments whereas the latest developments are positive for inflation expectations. In the recent lead-up to the Georgia vote, industrials, financials, and consumer discretionary stocks have not benefited much, even though they should (Chart 14). These are investment opportunities. Chart 14Upside For Energy And Financials Despite Regulatory Risk Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep In our Political Risk Matrix, we establish these views as our baseline political tilts, to be applied to the BCA Research House View of our US Equity Strategy. The results are shown in Table 3. When equity sectors become technically stretched, the political impacts will become more salient. Table 3US Political Risk Matrix Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Investment Takeaways Over the past few years our sister Geopolitical Strategy has written extensively about “Civil War Lite,” “Peak Polarization,” and contested elections in the United States. We will dive deeper into these themes and issues in forthcoming reports, but for now suffice it to say that extremist events will galvanize the majority of the nation behind the new administration while also driving politicians of both stripes to use pork-barrel spending to try to stabilize the country. Congress will err on the side of providing too much fiscal stimulus just as surely as the Fed is bent on erring on the side of providing too much monetary stimulus. That means reflation, which will ultimately boost stocks in 2021. We also expect stocks to outperform government bonds, at least on a tactical 3-6 month timeframe. As the above makes clear, we prefer value stocks over growth stocks. Specifically we favor cyclical plays like materials over the big five of Google, Apple, Amazon, Microsoft, and Facebook. An infrastructure bill was one of the few legislative options for the Biden administration under gridlock, now it is even more likely. Infrastructure is popular and both presidential candidates competed to see who could offer the bigger plan. Moreover, what Biden cannot achieve under the rubric of climate policy he can try to achieve under the rubric of infrastructure. The BCA US Infrastructure Basket correlates with the US budget deficit as well as growth in China/EM and we recommend investors pursue similar plays. In the fixed income space, Treasury inflation protected securities (TIPS) are likely to continue outperforming nominal, duration-matched government bonds. Our US Bond Strategist Ryan Swift is on alert to downgrade this recommendation, but the change in US government configuration at least motivates a tactical overweight in TIPS. The chances of US state and local governments receiving fiscal support – previously denied by the GOP Senate – has increased so we will also go long municipal bonds relative to treasuries.   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com   Appendix Table A1Biden’s Cabinet Position Appointments Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep   Footnotes 1     Perdue defeated Ossoff on November 3 but fell short of the 50% threshold to avoid a second round; meanwhile the cumulative Republican vote in the multi-candidate special election outnumbered the cumulative Democratic vote on November 3. 2     Ashton Carter, Dick Cheney, William Cohen, et al, “All 10 living former defense secretaries: Involving the military in election disputes would cross into dangerous territory,” Washington Post, January 3, 2021, washingtonpost.com. 3    Jordain Carney, “Filibuster fight looms if Democrats retake Senate,” The Hill, August 25, 2020, thehill.com.  

Highlights Chart 12020 Returns 2020 Returns 2020 Returns After a tumultuous start to the year, corporate bonds rallied in 2020 H2, managing to eke out small annual gains versus Treasuries. Specifically, investment grade corporates outperformed duration-equivalent Treasuries by 4 basis points in 2020 and high-yield outperformed by 185 bps (Chart 1). Treasuries, for their part, bested cash by 7% on the year but returns have been trending down since August. As we look forward to 2021, the economic cycle is in what we call a sweet spot for spread product returns. Economic growth is above trend, but inflation is low and monetary conditions are highly accommodative. This macro back-drop will lead to positive spread product returns versus Treasuries and a moderate bear-steepening of the Treasury curve in 2021. However, stretched valuations for investment grade corporates mean that investors must be selective within spread product. We think the Ba credit tier offers the best risk-adjusted opportunity in the corporate bond space, and also recommend favoring tax-exempt municipal bonds over equivalent-quality investment grade corporates. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-matched Treasury index by 79 basis points in December and by 4 bps in 2020. The investment grade corporate index eked out a small gain relative to the duration-matched Treasury index in 2020. Corporates underperformed Treasuries by 18% from the beginning of the year until March 23, the day that the Fed stopped the bleeding in credit markets by unveiling its suite of emergency lending facilities. With the Fed’s backstops in place, the corporate index went on to outperform Treasuries by 22% between March 23 and the end of the year (Appendix A). As we noted in our 2021 Key Views Special Report, the corporate bond index option-adjusted spread is not quite back to its pre-COVID low.1 However, valuation is close to all-time expensive after adjusting for changes in the index’s average credit rating and duration. The 12-month breakeven spread for the Bloomberg Barclays Corporate Index (adjusted to keep the average credit rating constant) has only been tighter 4% of the time since 1995 (Chart 2). The same figure for the Baa-rated credit tier is 5%. As noted, the macro environment of above-trend growth and accommodative Fed policy is very positive for spread product returns. However, better value exists outside of the investment grade corporate space. In particular, we advise investors to look at Ba-rated high-yield corporates and tax-exempt municipal bonds. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 190 basis points in December and by 185 basis points in 2020. Ba-rated junk bonds outperformed duration-matched Treasuries by 431 bps in 2020, while B-rated and Caa-rated bonds lagged by 13 bps and 238 bps, respectively. Since the March 23 peak in spreads, Ba-rated bonds outperformed Treasuries by 33%, B-rated bonds outperformed by 30% and Caa-rated bonds outperformed by 36% (Appendix A). We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is in line with historical averages.2   Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only seven defaults occurred in November, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, are also falling rapidly (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms.    Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Cyclical Sweet Spot The Cyclical Sweet Spot Table 3BCorporate Sector Risk Vs. Reward* The Cyclical Sweet Spot The Cyclical Sweet Spot   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in December but underperformed by 17 bps in 2020. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 10 bps on the month to reach 61 bps (Chart 4). This is higher than the 58 bps offered by Aa-rated corporate bonds, the 49 bps offered by Agency CMBS and the 24 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we continue to view the elevated primary mortgage spread as a material risk for MBS investors. The elevated spread suggests that mortgage rates need not rise alongside Treasury yields in the near-term, meaning that mortgage refinancings can continue at their current rapid pace (panel 3). Our view is that expected prepayment losses embedded in MBS spreads (aka the option cost) are too low relative to this pace of refinancing. Last year’s spike in the mortgage delinquency rate was driven by households that were granted forbearance by the federal government’s CARES act (panel 4). The risk for MBS holders is that these households will not be able to resume their regular mortgage payments when the forbearance period ends this spring. While the situation bears close monitoring, our sense is that excess savings built up during the past nine months will be sufficient to prevent a surge of bankruptcies when the forbearance period ends. The recent stimulus package provides households with even more assistance. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 62 basis points in December but underperformed by 161 bps in 2020. Sovereign debt outperformed duration-equivalent Treasuries by 176 bps in December but underperformed by 98 bps in 2020. Foreign Agencies outperformed the Treasury benchmark by 7 bps in December but underperformed by 640 bps in 2020. Local Authority debt outperformed Treasuries by 146 bps in December but underperformed by 86 bps in 2020. Domestic Agency bonds outperformed by 14 bps in December but underperformed by 9 bps in 2020. Supranationals outperformed by 2 bps in December and by 3 bps in 2020. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, 2020’s dollar weakness was mostly relative to other Developed Market currencies (Chart 5). Value has improved somewhat for EM Sovereigns during the past few weeks, but the index continues to offer less spread than the Baa-rated US Credit index (panel 4). At the country level, Turkey, Colombia, Mexico, Russia, South Africa and Indonesia are the only countries that offer a spread pick-up relative to duration and quality-matched US corporates. Of those, only Mexico looks attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 56 basis points in December but underperformed by 286 bps in 2020 (before adjusting for the tax advantage). We upgraded municipal bonds to “maximum overweight” in our recent 2021 Key Views Special Report.3 Attractive valuations are the main reason for this move. First, spreads between Aaa-rated municipal bonds and equivalent-maturity Treasuries are elevated compared to history across the entire yield curve (Chart 6). Second, municipal bonds look even more attractive relative to duration and quality-matched credit. The Bloomberg Barclays Revenue Bond index offers a greater yield than the quality-matched Credit index across the entire maturity spectrum (before adjusting for the tax advantage). The same is true for the Bloomberg Barclays General Obligation index beyond the 12-year maturity point (panel 3). While the failure to include state & local government aid in the recent relief bill is a big blow to municipal budgets that are already stretched, we think municipal bond spreads offer more-than-adequate compensation for default/downgrade risk. State & local governments are already engaging in austerity measures that will help protect bondholders (bottom panel) and State Rainy Day Fund balances were at all-time highs heading into the COVID downturn. Both of these things should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in December. The 2/10 Treasury slope steepened 13 bps to 81 bps. The 5/30 Treasury slope steepened 7 bps to 129 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and the recently passed fiscal relief bill will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar levels.        TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 141 basis points in December and by 117 bps in 2020. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 22 bps and 18 bps on the month. They currently sit at 2.01% and 2.07%, respectively. Core CPI rose 0.22% in November, pushing the year-over-year rate from 1.63% to 1.65%. Meanwhile, 12-month trimmed mean CPI fell from 2.22% to 2.09%, narrowing the gap between trimmed mean and core (Chart 8). We anticipate further narrowing in 2021 Q1 and therefore expect core CPI to print relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven inflation rate looks somewhat elevated on our Adaptive Expectations Model (panel 2).4 Inflation pressures may moderate once the core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure in the first half of this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel).   ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in December and by 98 bps in 2020. Aaa-rated ABS outperformed the Treasury benchmark by 12 bps in December and by 81 bps in 2020. Non-Aaa ABS outperformed by 33 bps in December and by 207 bps in 2020 (Chart 9). On paper, the Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 is quite negative for ABS. However, as we explained in a recent report, we don’t anticipate a material impact on spreads.5 For one thing, Aaa ABS spreads are already well below the borrowing cost offered by TALF. But more importantly, consumer credit quality is strong. As we first explained last June, the stimulus received from the CARES act led to a significant increase in disposable income and a jump in the savings rate (panel 4).6 Faced with an income boost and few spending opportunities, many households paid down consumer debt. Given the recently passed additional fiscal support and the substantial savings that have already accrued, we see household balance sheets as being in a good place. As such, we advise moving down-in-quality to pick up extra spread in non-Aaa ABS.   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 113 basis points in December but underperformed by 57 bps in 2020. Aaa Non-Agency CMBS outperformed Treasuries by 58 bps in December and by 56 bps in 2020. Non-Aaa Non-Agency CMBS outperformed Treasuries by 277 bps in December but underperformed by 360 bps in 2020 (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted.7 Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 50 basis points in December and by 105 bps in 2020. The average index spread tightened 7 bps in December to reach 49 bps (bottom panel). At its September meeting, the Fed decided to slow its pace of Agency CMBS purchases. It is no longer looking to increase its Agency CMBS holdings, but rather, will only purchase what is “needed to sustain smooth market functioning”. This is nonetheless a backstop of the market, and it does not change our overweight recommendation.   Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities The Cyclical Sweet Spot The Cyclical Sweet Spot Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 85 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 85 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Cyclical Sweet Spot The Cyclical Sweet Spot Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 4 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

This is US Bond Strategy’s final report of the year. Our regular publication schedule will resume on January 5th with our Portfolio Allocation Summary for January 2021. We wish you a happy, healthy and prosperous new year.   Highlights Interest Rate Policy: The Fed has given us a checklist of three criteria that must be met before it will lift rates off the zero bound. After those criteria are met, the pace of the eventual rate hike cycle will be determined by how quickly inflation expectations move back to “well-anchored” levels. We don’t expect Fed liftoff in 2021. Balance Sheet Policy: The Fed will only increase the pace or lengthen the maturity of its asset purchases if the economy or risk assets undergo a significant negative shock in 2021. Absent that, Fed communications in late-2021 will increasingly focus on the eventual tapering of asset purchases. Given the current vague guidance about when tapering will start, a scaled-down repeat of the 2013 Taper Tantrum is possible in late-2021 or 2022. Emergency Lending Facilities: The Fed will not undertake efforts to subvert Congress and re-establish its emergency lending facilities in 2021. However, the absence of the facilities will not have a negative impact on financial markets. Fiscal/Monetary Coordination: Looking beyond 2021, we see the lines between fiscal and monetary policy continuing to blur. The Fed will be increasingly incentivized to dip its toes into the fiscal arena and fiscal policymakers will let it. Feature Chart 1An Eventful Year An Eventful Year An Eventful Year It would be an understatement to say that 2020 was a busy year for the Federal Reserve. The Fed cut rates to the zero bound when the recession struck in March. It also exploded its balance sheet to fresh all-time highs and rolled out brand-new emergency lending facilities to support flagging credit markets (Chart 1). Then, to top it all off, the Fed concluded a Strategic Review of its monetary policy strategy in August and officially adopted an Average Inflation Target. This report touches on the market implications of 2020’s big Fed moves, but its focus is on what the Fed is likely to do in 2021. The first three sections discuss how we see the Fed’s interest rate policy, balance sheet policy and emergency lending facilities evolving next year. The final section considers a longer time horizon as it discusses what might be the next frontier for monetary policy: increased cooperation between monetary and fiscal authorities. Interest Rate Policy With the fed funds rate at its effective lower bound, bond investors will spend 2021 trying to determine the eventual start date and magnitude of the next tightening cycle. This will be especially complicated because the Fed’s adoption of an Average Inflation Target means that old models of its reaction function must be discarded. We discussed the implications of the move toward Average Inflation Targeting in a September Special Report.1 To quickly recap, the Fed made three main changes that will influence our outlook for interest rate policy in 2021. First, the Fed edited its Statement on Longer-Run Goals and Monetary Policy Strategy to include a new interpretation of its price stability mandate. The new Statement reads: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.2 Second, the Fed modified its Statement on Longer-Run Goals and Monetary Policy Strategy to signal that it will rely less on labor market indicators to forecast future inflation. In its old Statement, the Fed talked about minimizing “deviations of employment from the Committee’s assessments of its maximum level.” The revised Statement talks about mitigating “shortfalls of employment from the Committee’s assessment of its maximum level.” In other words, the Fed is saying that it will be less inclined to view an unemployment rate below its estimated natural level (NAIRU) as a signal that inflation is about to accelerate. The Fed’s adoption of an Average Inflation Target means that old models of its reaction function must be discarded. Finally, at the September FOMC meeting, the Fed translated the changes it made to its Statement on Longer-Run Goals and Monetary Policy Strategy into more explicit guidance about when it will consider lifting rates off the zero bound. That guidance is as follows: … it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.3 The Timing Of Liftoff Table 1A Checklist For Liftoff The Fed In 2021 The Fed In 2021 Digging into the new guidance, we identify three criteria for lifting rates off the zero bound (Table 1). First, the unemployment rate must reach levels consistent with the Committee’s assessments of NAIRU. Currently, those estimates range from 3.5% to 4.5% (Chart 2). Practically, we view this as the least important of the three criteria. NAIRU estimates are revised based on what happens with inflation, and the Fed has already acknowledged that it is now less inclined to view a sub-NAIRU unemployment rate as an inflationary signal. In short, if inflation were to rise sustainably above 2% with the unemployment rate still at 5%, the Fed would simply revise up its NAIRU estimates and begin the rate hike cycle. Chart 2Criteria For Lifting Rates Criteria For Lifting Rates Criteria For Lifting Rates The Fed’s second criterion for lifting rates is also the most specific. Inflation must rise to 2 percent before the Fed will consider hiking rates. In a recent speech, Fed Vice-Chair Richard Clarida said he interprets this to mean that 12-month PCE inflation must be at least 2% before the Fed will consider hiking (Chart 2, bottom panel).4 This is helpful for bond investors. We can be certain that no rate hikes will occur at least until 12-month PCE inflation reaches 2%. Finally, the Fed also wants to be certain that inflation is “on track to moderately exceed 2 percent for some time.” This means that the event of 12-month PCE reaching 2% won’t automatically lead to a rate increase. The Fed must also view inflation gains as sustainable. This will likely become an issue in the first half of 2021 when we know that base effects will push 12-month PCE sharply higher, possibly even above 2%. However, we also know that those gains will be short lived.5 Of course, the Fed also knows about the impact of base effects and it will look past any temporary jump in inflation in H1 2021. More generally, while we advise investors to not pay much attention to the Fed’s NAIRU estimates, the unemployment rate will play a role in the Fed’s determination of whether above-2% inflation is sustainable. That is, the Fed is more likely to view above-2% inflation as sustainable if the unemployment rate is 4% than it is if the unemployment rate is 6%. What Does The Market Think? The bond market has been quick to price-in the big shift in the Fed’s interest rate guidance. At present, the overnight index swap curve is priced for a single 25 basis point rate hike in mid-2023 and only one more by mid-2024 (Chart 3). We see a good chance that the Fed’s three liftoff criteria are met before then, a view that forms the basis of our below-benchmark portfolio duration recommendation for 2021.6 In addition, the New York Fed’s Survey of Market Participants shows that only 43% of respondents expect liftoff before the end of 2023 and only 31% before the end of 2022 (Table 2A). This is further evidence that bond yields have room to rise if it looks like the Fed’s three liftoff criteria will be met in 2022 or the first half of 2023. Finally, the New York Fed’s survey shows that market participants understand the Fed’s three liftoff criteria and that differences in opinion about the timing of liftoff reflect differences in views about the economic outlook, not differences in understanding the Fed’s reaction function. The bulk of survey respondents think that the unemployment rate will be between 3.5% and 4.2% (consistent with the Fed’s NAIRU estimates) and that 12-month PCE inflation will be between 2.2% and 2.5% at the time of liftoff (Table 2B). Chart 3The Fed May Lift Rates Sooner Than Markets Expect The Fed May Lift Rates Sooner Than Markets Expect The Fed May Lift Rates Sooner Than Markets Expect Table 2ALiftoff Expectations The Fed In 2021 The Fed In 2021 Table 2BMarkets Understand The Fed’s Guidance The Fed In 2021 The Fed In 2021 The Pace Of Tightening And Why We’re Watching Inflation Expectations We’ve seen the three criteria upon which the Fed will condition its decision to hike rates off the zero bound. But the timing of liftoff is not the only thing that bond investors need to consider. We also need to get a sense of how quickly rate hikes will proceed once the next tightening cycle begins. According to the Fed’s interest rate guidance, even after liftoff the Fed will seek to maintain accommodative monetary conditions until it has achieved its price stability goal under its new Average Inflation Target. Recall that this goal is defined as achieving “inflation that averages 2 percent over time”. This is somewhat vaguer than the Fed’s liftoff guidance. Over what time period should we seek to hit average 2% inflation? One option is to start calculating the average when the new regime was adopted in August. In that case, average PCE inflation is running at 0.96%, well below 2%. Alternatively, we could calculate average inflation since the Fed last cut rates to zero in March 2020 (1.50%) or average inflation since the Fed cut rates to zero in December 2008 (1.43%). The point is that the Fed has not given us a clearly defined target. Differences in opinion about the timing of liftoff reflect differences in views about the economic outlook. For this reason, it’s important for bond investors to understand why the Fed has shifted to an Average Inflation Target. The reason has to do with trying to re-anchor inflation expectations. Box 1 shows an example of an Expectations-Augmented Phillips Curve, the Fed’s go-to framework for thinking about inflation. As the accompanying quote from Janet Yellen explains, the Fed thinks about inflation’s long-run trend as being driven by expectations. Shocks to economic slack and import prices can cause inflation to deviate from its long-run trend, but expectations drive the trend itself. This makes it critical for a central bank to keep expectations well anchored near its inflation target. Box 1The Expectations-Augmented Phillips Curve (aka The Fed’s Inflation Model) The Fed In 2021 The Fed In 2021 This is the underlying rationale for the Fed’s Average Inflation Target. The Fed has observed that inflation expectations have been too low in recent years. In the Fed’s model, this signals that inflation’s long-run trend has shifted down. In order to get expectations back up to target, the Fed understands that it will probably need to accept a period of above-target inflation. Since economic agents have just experienced a long period of sub-2% inflation, it will probably require a significant period of above-2% inflation before their expectations sustainably shift higher.7 To sum it all up, the Fed will seek to keep monetary conditions accommodative, and thus supportive for risk assets, until inflation expectations are deemed to be re-anchored. At that point, monetary policy will shift to a neutral or restrictive stance and risk asset performance will be challenged. But don’t just take our word for it. Here is what Vice-Chair Clarida said in a recent speech (referenced above): It is important to note, however, that the goal of the new framework is to keep inflation expectations well anchored at 2 percent, and, for this reason, I myself plan to focus more on indicators of inflation expectations themselves – especially survey-based measures – than I will on the calculation of an average rate of inflation over any particular window of time. It is clear that inflation expectations will dictate the eventual pace of Fed tightening. But the question of what measure of inflation expectations to track remains unresolved. Measures of inflation expectations fall into three main categories: Market-based measures Survey measures Trend measures Market-based measures are derived from inflation-linked bonds. Specifically, we derive TIPS breakeven inflation rates for different time horizons by taking the difference between a nominal yield and TIPS yield of the same maturity. In this publication, we often refer to the 10-year and 5-year/5-year forward TIPS breakeven inflation rates and have found that a range of 2.3% to 2.5% has historically been consistent with periods when inflation expectations were deemed “well anchored” (Chart 4A). One potential issue with using market-based measures of inflation expectations is that TIPS prices can sometimes move around for reasons unrelated to changing inflation expectations. That is, regulations or broader portfolio diversification concerns could change the risk premium an investor is willing to accept from TIPS, even if that investor’s underlying inflation view is unchanged. Academics have made attempts to solve this problem by using affine term structure models to decompose yields into various components. Chart 4B presents one such model from D’Amico, Kim and Wei (DKW).8 The DKW model splits the TIPS breakeven inflation rate (or inflation compensation) into an inflation expectation, a liquidity premium that compensates investors for the lower liquidity in TIPS compared to nominal Treasuries and an inflation risk premium that represents the extra compensation investors require to take inflation risk. We are skeptical of the usefulness of affine term structure models. In general, these models have too few inputs to reliably generate the components they purport to measure. However, the Fed clearly pays some attention to the DKW decomposition. If a future increase in TIPS breakeven inflation rates is driven entirely by movement in the liquidity or inflation risk premium components, it would be reasonable to question whether the Fed will react. Chart 4AInflation Expectations: Market-Based Measures The Fed In 2021 The Fed In 2021 Chart 4BA Decomposition Of TIPS##br## Breakevens The Fed In 2021 The Fed In 2021 Survey measures of inflation expectations are exactly that: Responses from surveys, usually of professional forecasters or households (Chart 4C). One drawback of survey measures compared to market-based measures is that they are updated less frequently. Another is that survey respondents, particularly households, may only be able to distinguish very large swings in prices. That said, the Fed tracks a wide range of survey measures and they were even singled out by Vice-Chair Clarida as being particularly important in the above quote. Trend inflation measures are statistical measures of the trend in the actual PCE or CPI inflation data. Chart 4D shows both a very simple trend measure, the 10-year annualized rate of change, and a slightly more complex trend measure based on an exponential smoothing rule. Academics have developed even more complex trend inflation measures.9 The logic behind these measures is that expectations tend to adapt only slowly to changes in the actual inflation data. Chart 4CInflation Expectations: Survey Measures The Fed In 2021 The Fed In 2021 Chart 4DInflation Expectations: Trend Measures The Fed In 2021 The Fed In 2021 Finally, we should point out a relatively new measure that the Fed will be using to track inflation expectations going forward. It is called the Common Inflation Expectations Index and it is a composite of 21 different survey and market-based inflation measures (Chart 4E), no trend inflation measures are included.10 Chart 4EIntroducing The Common Inflation Expectations Index The Fed In 2021 The Fed In 2021 To summarize, the Fed has given us a checklist of three criteria that must be met before it will lift rates off the zero bound. After those criteria are met, the pace of the eventual rate hike cycle will be determined by how quickly inflation expectations move back to levels that are considered “well anchored”. Once that happens, the Fed will no longer have an incentive to keep monetary conditions accommodative and risk asset performance will be challenged. Charts 4A-4E in this report provide a wide array of different measures of inflation expectations to monitor. We will keep an eye on all of them, but in particular, we will track the Common Inflation Expectations Index’s progress back to 2.1% and the 5-year/5-year forward TIPS breakeven inflation rate’s progress back to a range of 2.3%-2.5%. While we don’t expect the Fed’s rate hike criteria to be met in 2021, a 2022 liftoff is possible if the COVID vaccine spurs a rapid economic recovery. However, we do expect that, in 2021, the market will start to price-in an earlier liftoff date and quicker pace of tightening than is currently discounted, thus pushing bond yields higher. The Financial Conditions Wildcard Chart 5Financial Conditions Financial Conditions Financial Conditions Our base case view is that the eventual pace of Fed tightening will be determined by inflation expectations. However, there is one wildcard that could cause the Fed to abandon its inflation expectations goal and tighten policy earlier. That wildcard is financial conditions. Presently, financial asset valuations are a mixed bag (Chart 5). Corporate bond spreads are tight, but not at all-time expensive levels. Equity P/E ratios are very elevated, but equities don’t look expensive compared to bonds. If these valuations stay relatively stable, the Fed will continue to rely on inflation expectations to guide the pace of tightening. However, if inflation expectations take a long time to rise, it is conceivable that such a long period of low interest rates could lead to historically stretched financial asset valuations. In short, if inflation doesn’t return within the next couple of years, the Fed may have to tighten policy to take the wind out of an asset bubble that might otherwise burst and lead to an economic recession. We stress that we are not yet close to this point and that the bar for the Fed to abandon its inflation goal will be very high, but we would place financial conditions alongside inflation expectations as the two most important variables to monitor to assess the eventual pace of Fed tightening. Balance Sheet Policy With the funds rate pinned at zero and the Fed’s interest rate guidance essentially set in stone, changes to the pace and composition of asset purchases are the principal tool that the Fed will use to provide more or less immediate monetary accommodation in 2021. The Fed is currently purchasing $80 billion of Treasuries and $40 billion of Agency MBS each month, with Treasury purchases spread out across the yield curve. If this pace and distribution of Treasury purchases is maintained in 2021, the Fed will end up purchasing less and less of the Treasury flow. The Treasury Department has a stated policy goal of increasing the average maturity of the outstanding debt and it has been pursuing that goal by raising the amount of coupon issuance at the expense of bills. The Treasury has already given us its planned coupon issuance schedule for Q4 2020 and Q1 2021. Chart 6 shows that net Fed coupon purchases will gradually decline as a percentage of gross issuance, assuming the Treasury follows through with its plan and the Fed’s balance sheet policy is unchanged. Chart 6The Path For Treasury Supply And Fed Demand The Fed In 2021 The Fed In 2021 Can The Fed Do More? … Will The Fed Do More? It is possible that the Fed will use its balance sheet to provide more monetary easing in 2021. There are two ways it could do this. First, it could simply increase the monthly pace of asset purchases. Alternatively, it could keep the same pace of purchases but shift Treasury buying toward the long-end of the curve. The idea here would be to prevent long-dated yields from rising too quickly. One or both of these changes could happen in 2021, but only if the economy experiences a negative growth shock or risk asset prices (equities and corporate credit) fall significantly. In that case, the Fed will want to be seen as responding to a negative shock, but absent that, the Committee seems comfortable with its current balance sheet strategy. Chart 7Rate-Sensitive Sectors Have Recovered Rate-Sensitive Sectors Have Recovered Rate-Sensitive Sectors Have Recovered Some have suggested that, even if the economic recovery stays on track, the Fed will try to use its balance sheet to lean against rising long-maturity bond yields. We doubt this. First, it is not obvious that the Fed would be able to stop the 10-year Treasury yield from rising to a range of, say, 1.25% to 1.5% by increasing bond purchases in that maturity range by a few billion dollars. As long as the Fed’s interest rate guidance is unchanged, the market’s interest rate expectations will continue to exert a powerful influence on bond yields across the entire curve. Unless the Fed announces a cap on long-dated bond yields, and pledges to buy enough securities to enforce that cap, we are skeptical about the effectiveness of just changing the quantity of asset purchases. Second, it is also not clear that a 10-year Treasury yield between 1.25% and 1.5%, in the context of a steepening yield curve and improving economic growth, would be a problem for either the economy or risk assets. In fact, these sorts of environments tend to be very positive for risk asset performance.11 It is only when the Fed is shifting to a more restrictive monetary policy stance and the yield curve is flattening that bond yields start to exert a negative influence on the economy and risk assets. Even if the Fed is not worried about a moderate bear-steepening of the Treasury curve, a case could be made for providing more easing right now in order to spur a quicker recovery. This question was posed to Chair Powell several times at the last FOMC press conference. In response, Powell noted that the sectors of the economy that are most sensitive to interest rates – residential investment and consumer spending on durable goods – have already recovered (Chart 7). The lagging sectors of the economy – particularly consumer spending on services – cannot recover until the COVID vaccine is widely distributed, irrespective of the level of interest rates. In our view, this is an acknowledgement that the Fed does not see much value in trying to provide further accommodation through the balance sheet channel. All in all, our base case scenario is that the Fed will maintain its current pace and maturity distribution of asset purchases throughout 2021. However, it will increase the pace and/or lengthen the maturity if there is a significant shock to the economy and/or financial markets. Later in 2021, if the recovery stays on track, Fed communications will increasingly take up the issue of when it will be appropriate to taper its pace of asset purchases. The Exit From Asset Purchases And The Possibility Of A Taper Tantrum Chart 8Remember The Taper Tantrum Remember The Taper Tantrum Remember The Taper Tantrum The Fed has already given us a timeline for how it will wind down its asset purchases. According to the minutes from the November FOMC meeting, most participants support a timeline where the Fed will start tapering its pace of asset purchases sometime before the first rate hike. It will then begin lifting interest rates and will stop purchases altogether sometime after that. At the December FOMC meeting, the Fed gave us additional guidance on when it will start the tapering process. Unfortunately, this guidance is quite vague and only confirms the fact that tapering will start before the liftoff date. Specifically, the Fed said that tapering will begin when “substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” Because the guidance around the timing of the tapering process is quite vague, we think it’s possible that it could sneak up on investors and lead to a sharp upward re-adjustment in rate hike expectations, and thus a bond sell-off. In essence, a tamer version of the 2013 Taper Tantrum is possible in late-2021 or 2022. On May 22, 2013, Fed Chair Ben Bernanke explained the Fed’s plan to eventually start tapering its asset purchases. Because investors took this to mean that the rate hike cycle would start much sooner than anticipated, the bond market underwent a sharp re-adjustment. The market quickly went from pricing-in only 35 bps of rate hikes over the next 24 months to 116 bps, and Treasury returns fell precipitously as a result (Chart 8). The Fed has learned a few lessons about communications since then, and it will do its best to keep market expectations aligned with its own strategy. However, unless firmer guidance is provided about when tapering will begin, the risk of a hawkish surprise around the tapering announcement remains.  Bottom Line: The Fed will only increase the pace or lengthen the maturity of its asset purchases if the economy or risk assets undergo a significant negative shock in 2021. Absent that, Fed communications in late-2021 will increasingly focus on the eventual tapering of asset purchases. Given the current vague guidance about when tapering will start, a scaled-down repeat of the 2013 Taper Tantrum is possible in late-2021 or 2022. Emergency Lending Facilities In addition to cutting rates to zero and massively scaling up the size of its balance sheet, the Fed also responded to the COVID recession by launching a slew of emergency lending facilities, some re-treads from the financial crisis and some brand new. Facilities to support the corporate bond market (The Primary and Secondary Market Corporate Credit Facilities) and the Municipal Liquidity Facility were particularly successful at capping bond spreads versus Treasuries, even if their actual usage was quite low. In fact, corporate bond spreads peaked on the very day that the Fed announced its corporate credit facilities in March (Chart 1). More recently, however, Treasury Secretary Steve Mnuchin refused to authorize the continuation of most of the Fed’s emergency lending facilities beyond the end of the year. We wrote in November that, even with the Treasury taking back the funds used to set up the facilities, the Fed could re-launch them in 2021 if incoming Treasury Secretary Janet Yellen provides her approval.12 However, a late addition to the recently passed fiscal stimulus package appears to prohibit the re-authorization of the facilities without Congressional approval. At the time of publishing, we have not been able to see the details of the new provision, so there remains some uncertainty about what the Fed can and cannot do in this regard. Credit spreads are no longer trading at distressed levels, primary issuance markets are functioning properly, and the Fed’s facilities have hardly been used at all. Nonetheless, while the new bill raises interesting questions about Fed independence in the long-run, we doubt that markets will respond negatively to the absence of the Fed’s emergency facilities in 2021. Credit spreads are no longer trading at distressed levels, primary issuance markets are functioning properly, and the Fed’s facilities have hardly been used at all (Table 3). Table 3Usage Of The 2020 Federal Reserve Emergency Lending Facilities The Fed In 2021 The Fed In 2021 In short, we don’t see the Fed going out of its way to re-establish the facilities in 2021 because it will become clear that they are no longer needed. The Next Regime Shift In Fed Policy: Fiscal/Monetary Coordination The adoption of an Average Inflation Target represents a major regime shift in Federal Reserve policy. In the final section of this report, we expand our horizon beyond 2021 and speculate about what the next major regime shift for the Fed might be. The 2020 recession made two things crystal clear. First, traditional fiscal policy becomes essentially impotent once interest have been reduced to the zero-lower-bound. Once there, Fed policy is most impactful when it focuses on lending to the private sector. Lending to the private sector through an emergency lending facility is an act that blurs the distinction between monetary and fiscal policy. This was made abundantly clear by Congress’ recent push to legislate the Fed’s activities in this arena. Second, it is difficult for fiscal policy to act quickly enough during an economic downturn. While the CARES act was delivered in a timely manner, it has taken many months to pass a follow-up bill. The Fed’s independence allows it to act immediately when it is economically necessary, while Congress’ increasing polarization makes swift action a challenge. If we take these two observations to their logical conclusion, and throw in the strong chance that the traditional channels of monetary policy will be increasingly blocked in the future as rates bump up against zero, it seems to us that the strict separation of responsibilities between fiscal and monetary policymakers will fade over time. More specifically, greater time spent at the zero-lower-bound will incentivize the Fed to get more and more creative with its quasi-fiscal private lending facilities. Further, Congress will be more than happy to allow this encroachment as it finds itself unable to respond effectively in times of crisis. Of course, this will also lead to periodic push-back as some members of Congress fret about the Fed’s over-reach, but we expect this push-back will be the exception rather than the rule. Greater time spent at the zero-lower-bound will incentivize the Fed to get more and more creative with its quasi-fiscal private lending facilities.  In fact, the best idea might be for fiscal and monetary policymakers to join together proactively to craft programs that can be deployed during the next recession. One example of such an idea was recently presented by Julia Coronado and Simon Potter.13 Coronado and Potter’s idea relies on the use of instant payment processing technology (which the Fed is already working on) to create digital accounts at the Federal Reserve for every household. Once those accounts are in place, the federal government could issue Recession Insurance Bonds, zero coupon bonds with some pre-determined face value, and grant one bond to every household in the country. Then, during the next economic downturn, the Fed could decide to do a “people’s QE” where it buys all the Recession Insurance Bonds leaving every household with a direct cash payment equal to the face value of the bond. This scheme directly addresses the two main problems we named earlier. It is fiscal policy, not monetary policy, so it can still be effective at the zero-lower-bound. Also, Congress can take its time to deliberate on the bill that authorizes the creation of the Recession Insurance Bonds, as this can be done proactively during a period of economic recovery. Then, the Fed can use its ability to move quickly during the next downturn to “activate” the bonds and deliver the fiscal stimulus that Congress actually passed years earlier. While likely not a story for 2021, we see increased cooperation between monetary and fiscal policymakers as the next big regime shift for the Fed.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 https://www.federalreserve.gov/monetarypolicy/files/monetary20200916a1.pdf 4 https://www.federalreserve.gov/newsevents/speech/clarida20201116a.htm 5 For a more complete discussion of our 2021 inflation outlook please see “BCA Outlook 2021: A Brave New World”, dated November 30, 2020, available at bca.bcaresearch.com 6 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 7 This is the theory of adaptive expectations and we use it to model changes in the 10-year TIPS breakeven inflation rate. For further details please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 8 https://www.federalreserve.gov/econres/notes/feds-notes/tips-from-tips-update-and-discussions-20190521.htm 9 Fed Governor Lael Brainard references several of these trend measures in this recent speech: https://www.federalreserve.gov/newsevents/speech/brainard20201021a.htm&…; 10 More details on how this aggregate measure is constructed can be found here: https://www.federalreserve.gov/econres/notes/feds-notes/index-of-common-inflation-expectations-20200902.htm 11 For more details on how corporate credit performs during different yield curve environments please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 13 https://www.piie.com/publications/policy-briefs/reviving-potency-monetary-policy-recession-insurance-bonds

Highlights Below-Benchmark Portfolio Duration: The economic recovery will continue (and even accelerate) in 2021. Meanwhile, the Fed’s forward interest rate guidance is already as dovish as it will get. Keep portfolio duration below-benchmark in 2021, targeting a level of 1.25% to 1.5% for the 10-year Treasury yield.  Overweight TIPS Versus Nominal Treasuries: We remain overweight TIPS versus nominal Treasuries for the time being but are actively looking for an opportunity to get tactically underweight. This opportunity could emerge in the first half of 2021 when core and trimmed mean inflation re-converge and when the 10-year TIPS breakeven inflation rate looks expensive on our model.  Own Nominal Yield Curve Steepeners, Real Yield Curve Steepeners And Inflation Curve Flatteners: The nominal yield curve will continue to trade directionally with yields. Therefore, higher yields will coincide with a steeper nominal curve in 2021. Rising inflation and the Fed’s new Average Inflation Target both argue for a flatter inflation curve in 2021. We also recommend a real yield curve steepener as a high octane play on both a steeper nominal curve and flatter inflation curve. Overweight Spread Product Versus Treasuries: We see the economy as entering what we call “Phase 1” of the economic cycle in 2021, an environment of above-trend growth, low inflation and accommodative monetary policy. This is an environment where spread product typically performs very well relative to Treasuries. Move Down In Quality Within Corporates: Investment grade corporates will outperform Treasuries in 2021, but the potential for further spread compression is limited. Junk spreads have more room to tighten, and the Ba credit tier looks particularly attractive from a risk/reward perspective A Maximum Overweight Allocation To Municipal Bonds: Tax-exempt municipal bonds offer the best opportunity in the US fixed income space. Investors should adopt a maximum overweight allocation, and in particular, they should shift some allocation out of investment grade corporates and into Munis with the same credit rating and duration, but with a greater after-tax yield. Feature BCA published its 2021 Outlook on November 30. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer six key US fixed income views for 2021. This report is limited to the six key investment views listed on page 1, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2021” report that will delve into our outlook for the Fed next year. Outlook Summary First, a brief summary of the main economic views presented in BCA’s 2021 Outlook:1 The third wave of COVID infections will be a drag on economic activity in 2020 Q4 and 2021 Q1, but inventory re-stocking and the large build-up of household savings will prevent the US economy from falling into a double-dip recession. Ultimately, the vaccine roll-out will cause US GDP to grow well above trend in 2021. Inflation is likely to spike in the first half of 2021 due to base effects and the re-opening of some service sectors that were shuttered during the pandemic. But this initial surge will dissipate in the second half of the year. The wide output gap that opened in 2020 will persist in 2021 and will prevent a broad-based acceleration in consumer prices. The Fed’s forward interest rate guidance is as dovish as it will get. A large portion of the Outlook is devoted to considering longer-run economic and political trends that were accelerated by the global policy response to COVID-19. Specifically, rising populism, heavier corporate regulation and a greater appetite for MMT-like taxing and spending policies. The ultimate outcome of these trends will be significantly higher inflation, on the order of 3% to 5%, in the second half of the decade. Key View #1: Below-Benchmark Portfolio Duration Chart 1Treasury Yields In 2020 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The economic recovery will continue (and even accelerate) in 2021. Meanwhile, the Fed’s forward interest rate guidance is already as dovish as it will get. Keep portfolio duration below-benchmark in 2021, targeting a level of 1.25% to 1.5% for the 10-year Treasury yield. Our recommendation to maintain below-benchmark portfolio duration rests on two key pillars. The first is BCA’s view that the economic recovery will continue in 2021 and will even accelerate once enough of the population has received the COVID vaccine. The second pillar is our view that the Federal Reserve’s reaction function is as dovish as it will get. In other words, having already laid out the conditions that must be in place for it to begin the next rate hike cycle, the Fed will not undertake further efforts to guide interest rates lower in the face of economic recovery. Chart 1 provides a bit more context for our assessment of Fed policy. This year, economic growth and inflation expectations troughed in March and moved rapidly higher throughout the summer. Bond yields, however, stayed relatively flat between March and August. The reason is that, even as the economic outlook improved, the Fed was steadily guiding markets towards a dramatic shift in its forward interest rate guidance. Specifically, the adoption of an Average Inflation Target – a pledge to allow a moderate overshoot of the 2% inflation target to make up for past downside misses. The result of the Fed’s dovish shift is that the increase in inflation expectations between March and August was entirely offset by falling real yields (Chart 1, panel 3), leaving nominal yields close to unchanged. However, the Fed made its Average Inflation Target official at the Jackson Hole Symposium in August. Then, in September, it formalized its forward rate guidance by promising not to lift rates off the zero bound until inflation reaches 2% and is expected to moderately overshoot for a while. These events changed the dynamic in the bond market. The Fed is no longer trying to guide markets towards a more dovish reaction function. That reaction function is now officially in place, and presumably in the market price. Indeed, nominal bond yields have risen in concert with improving economic conditions since August, and we expect that trend to continue in 2021. Our Golden Rule of Bond Investing states that we should set portfolio duration by considering our own expectations for future changes in the fed funds rate relative to what is already priced in the yield curve. Appendix A at the end of this report shows that the Golden Rule once again performed well in 2020. Looking ahead, the market is currently pricing-in one full 25 basis point rate hike by mid-2023 and then only one more by mid-2024 (Chart 2). We see high odds that inflation could sustainably reach 2% – the Fed’s stated criteria for lifting off the zero bound – before that, necessitating some Fed tightening in 2022. Chart 2Market Priced For Liftoff In 2023 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income How High Could Yields Go In 2021? To answer this question, we first look at the 5-year/5-year forward Treasury yield relative to survey estimates of the longer-run equilibrium fed funds rate. In theory, long-dated forward yields should be relatively insulated from near-term shifts in the policy rate and should settle near levels consistent with estimates of the equilibrium fed funds rate. In practice, we find that the 5-year/5-year forward Treasury yield does settle near these levels, but only during periods of global economic recovery when investors are presumably more inclined to envision the closing of the output gap and an eventual neutralizing of monetary policy. Notice that during the past two global growth upturns, 2013/14 and 2017/18, the 5-year/5-year forward Treasury yield peaked close to survey estimates of the long-run equilibrium fed funds rate from the New York Fed’s Survey of Market Participants and the Survey of Primary Dealers (Chart 3A). If the same thing happens next year, the 5-year/5-year forward Treasury yield will rise to a range of roughly 2% to 2.25%, 54 bps to 79 bps above current levels. Chart 3AHow High Can Yields Rise? 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 3BLess Upside In 10y Than In 5y5y 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We see less upside next year for the benchmark 10-year yield than for the 5-year/5-year forward. Long-dated forward rates are not mathematically influenced by the near-term outlook for the policy rate, but the yield on the 10-year Treasury note embeds those expectations. Since it is unlikely that inflation will be strong enough to prompt a Fed rate hike in 2021, the yield curve will steepen as the economic outlook improves and the 10-year yield will rise by less than the 5-year/5-year forward. Looking at Chart 3B, next year’s bond market moves will look a lot more like 2013/14 than like 2017/18. The Fed kept rates at zero in 2013/14. This led to yield curve steepening and caused the 10-year Treasury yield to peak at a level well below survey estimates of the long-run equilibrium fed funds rate. In contrast, the Fed was hiking rates in 2017/18. This led to a flatter yield curve and caused the 10-year yield to peak at around the same level as the 5-year/5-year forward. All in all, while we could see the 5-year/5-year forward Treasury yield reach a range of 2% to 2.25% next year, we expect the 10-year Treasury yield to reach a range of 1.25% to 1.5%. Will The Fed Use Its Balance Sheet To Stop Treasury Yields From Rising? By far, the most common disagreement we’ve received from clients on our call for higher bond yields is that the Fed will simply use its balance sheet to prevent any increase in long-maturity yields. We don’t see this as having a meaningful impact. For one, the Fed will only take significant steps to ease monetary policy if it looks like the economic recovery is under threat. This would require a large tightening of financial conditions, meaning significantly lower stock prices and wider corporate bond spreads. We don’t see a 1.25% to 1.5% 10-year Treasury yield in the context of a steepening yield curve, low inflation and improving economic growth as likely to cause such an event. Granted, the Fed could take more minor actions, like keeping the same pace of purchases but shifting them further out the curve, but a significant tightening of financial conditions is likely required for them to increase the monthly pace of bond buying. Second, even if the Fed does decide to ramp up the pace of bond buying (either overall or only at the long-end of the curve), if it keeps the same forward interest rate guidance, then bond yields will be driven by the market’s perceived progress toward the conditions that would prompt the start of the next tightening cycle. It won’t matter how many bonds the Fed buys in the meantime. Our Golden Rule of Bond Investing has a strong track record that it achieves by focusing only on changes in the fed funds rate relative to expectations. It does not consider asset purchases at all, and we are also inclined to view them more as a distraction. Key View #2: Overweight TIPS Versus Nominal Treasuries Chart 4Adaptive Expectations Model 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We remain overweight TIPS versus nominal Treasuries for the time being but are actively looking for an opportunity to get tactically underweight. This opportunity could emerge in the first half of 2021 when core and trimmed mean inflation re-converge and when the 10-year TIPS breakeven inflation rate looks expensive on our model. TIPS breakeven inflation rates fell dramatically when the COVID crisis struck in March, but they then rebounded just as quickly and are now near fair value according to our Adaptive Expectations Model (Chart 4). Our model forecasts the future 12-month change in the 10-year TIPS breakeven inflation rate based on where the rate currently sits relative to several different measures of actual CPI inflation. Right now, our model is looking for a 12 basis point decline in the 10-year breakeven rate during the next year, but this forecast will rise if CPI prints strongly in the coming months, which is exactly what we expect. Chart 5Expect Higher Inflation In H1 2021 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income As noted in the above Outlook Summary, base effects and the re-opening of some service sectors will cause inflation to jump in the first half of 2021. A good way to see this is to look at the gap between 12-month core and trimmed mean CPI (Chart 5). Core inflation fell dramatically in March and April and is now in the process of bouncing back. Meanwhile, trimmed mean inflation measures were much more stable in the spring because they filtered out those sectors that experienced huge negative inflation prints during quarantine.   We think the gap between core and trimmed mean CPI is a good guidepost for our TIPS strategy. As long as the gap remains wide, we see upside risks to inflation. However, once the gap closes, that will signal that the “snapback phase” from re-opening the economy is over and that inflation pressures will moderate in line with the wide output gap. Shelter inflation is one of the components of inflation that is most sensitive to the output gap, and it has already been rolling over in line with the rising unemployment rate (Chart 5, bottom panel). Overall, our TIPS strategy in 2021 is to remain overweight TIPS versus nominal Treasuries for the time being. However, we are actively looking for an opportunity to get tactically short TIPS versus nominals. This could occur sometime in the first half of 2021 when core and trimmed mean inflation have re-converged and when (hopefully) the 10-year TIPS breakeven inflation rate looks more expensive on our model. Key View #3: Own Nominal Yield Curve Steepeners, Real Yield Curve Steepeners and Inflation Curve Flatteners Chart 62/5/10 Butterfly Spread Valuation 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The nominal yield curve will continue to trade directionally with yields. Therefore, higher yields will coincide with a steeper nominal curve in 2021. Rising inflation and the Fed’s new Average Inflation Target both argue for a flatter inflation curve in 2021. We also recommend a real yield curve steepener as a high octane play on both a steeper nominal curve and flatter inflation curve. Nominal Yield Curve With the funds rate pinned at zero and the Fed unlikely to actually lift it until 2022 (at the earliest), it is quite clear that the slope of the nominal yield curve will continue to trade directionally with yields as we head into 2021. That is, with volatility at the front-end of the curve completely suppressed, the yield curve will steepen when yields rise and flatten when they fall. In that context, we recommend complementing our below-benchmark portfolio duration view with nominal yield curve steepeners. Our preferred way to implement a nominal yield curve steepener is to buy the 5-year Treasury note and short a barbell consisting of the 2-year note and 10-year note. Allocations to the 2-year and 10-year should be weighted so that the duration of the 2/10 barbell matches that of the 5-year note. As we have explained in prior research, this sort of position is designed to profit from 2/10 yield curve steepening and it has worked well during the past few months (Chart 6).2  The one problem with this 5 over 2/10 trade is that it is not cheap. The 5-year yield is below the yield on the 2/10 barbell (Chart 6, panel 3) and the 5-year bullet looks expensive on our fair value model (Chart 6, bottom panel). However, we should also note that the 5-year looked much expensive during the last period of zero-bound rates in 2012. Given today’s very similar policy environment, we could see the 5-year yield getting even more expensive in 2021. Inflation Curve Chart 7Favor Inflation Curve Flatteners... 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Our second recommended yield curve position relates to the inflation curve, either the TIPS breakeven inflation curve or the CPI swap curve. Here, we recommend owning inflation curve flatteners for two reasons. First, short-maturity inflation expectations are more sensitive to the actual inflation data than long-maturity expectations. We saw a prime example of this relationship in 2020. The 2-year CPI swap rate plunged into negative territory when inflation fell in March while the 10-year CPI swap rate held relatively stable in comparison (Chart 7). Subsequently, the 2-year CPI swap rate rose much more quickly than the 10-year rate this summer as inflation rebounded. Looking ahead, with inflation biased higher in the first half of 2021, we should see greater upside in short-maturity inflation expectations than in long-maturity ones. The Fed’s adoption of an Average Inflation Target is the second reason to favor inflation curve flatteners. If the Fed is ultimately successful at achieving an overshoot of its 2% inflation target, it will mean that the Fed will be attacking its inflation target from above rather than from below for the first time since the 1980s. Logically, the inflation curve should be inverted in this sort of environment. This means that the inflation curve still has a lot of room to flatten from current levels (Chart 7, bottom panel). Real Yield Curve Chart 8...And Real Yield Curve Steepeners 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The Fisher Equation tells us that real yields are simply the difference between nominal yields and inflation expectations. Viewed that way, it is easy to see that – all else equal – a steeper nominal curve will lead to a steeper real yield curve. Meanwhile, a flatter inflation curve will also lead to a steeper real yield curve. In that sense, a real yield curve steepener is just a combination of the nominal curve steepener and inflation curve flattener that we already mentioned (Chart 8). As inflation rises, it will pressure short-dated inflation expectations higher relative to long-dated ones. This will exert bull-steepening pressure on the real yield curve. Meanwhile, investors starting to price-in eventual rate hikes will lead to nominal yield curve steepening. This will exert bear-steepening pressure on the real yield curve. With that in mind, a real yield curve steepener is a high conviction position for us in 2021. We have less conviction on the outright direction for real yields, though we suspect that long-maturity real yields have already troughed for the cycle. Key View #4: Overweight Spread Product Versus Treasuries We see the economy as entering what we call “Phase 1” of the economic cycle in 2021, an environment of above-trend growth, low inflation and accommodative monetary policy. This is an environment where spread product typically performs very well relative to Treasuries.  Most spread sectors will likely end the year having underperformed duration-equivalent Treasuries in 2020. However, this simple fact obscures the actual pattern of spread movements that was witnessed during the year. Spreads widened sharply when COVID struck but they peaked on March 23, the same day that the Federal Reserve announced its slew of emergency lending facilities.3 Spread product has been outperforming Treasuries since then (see Appendix B), a trend we expect will continue in 2021. The phase of the economic cycle when the economy is just emerging from a recession is typically one where risk assets perform well. The principal reason to expect spread product outperformance to continue is that the phase of the economic cycle when the economy is just emerging from a recession is typically one where risk assets perform well. It tends to be an environment where economic activity is growing at an above-trend pace, but inflation is still low and monetary conditions are accommodative. This is the perfect environment for credit spreads to tighten. The slope of the yield curve is a useful variable for summarizing the above macro conditions and we often use it to define three phases of the economic cycle (Chart 9): Chart 9The Three Phases Of The Cycle 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Phase 1 is defined as the time between the end of the last recession and when the 3-year/10-year Treasury slope flattens to below 50 bps. Phase 2 is defined as when the 3-year/10-year Treasury slope is between 0 bps and 50 bps. Phase 3 is defined as the time between when the 3-year/10-year Treasury slope turns negative and the start of the next recession. As we are just now emerging from recession and the 3-year/10-year slope is above 50 bps and steepening, we see the economy as being firmly in Phase 1 of the cycle. Historically, this phase has been the best one for spread product returns relative to duration-matched Treasuries (Table 1). Table 1Corporate Bond Performance In Different Phases Of The Cycle 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The main risk to this view of spread product is that we are not yet emerging from the recession and the corporate default rate may have another leg higher. Our sense, however, is that the default rate has already peaked. Gross leverage (the ratio between total corporate debt and pre-tax corporate profits) and job cut announcements are two variables that correlate very tightly with the default rate (Chart 10). Starting with leverage, net earnings revisions – a leader profit indicator – have already troughed and the corporate financing gap has turned negative (Chart 11). A negative financing gap means that the corporate sector has sufficient retained earnings to cover its capital expenditures. In other words, most firms are flush with cash and they won’t need to issue more debt in the coming quarters. Further, job cut announcements have come down sharply during the past few months (Chart 11, bottom panel). Chart 10The Default Rate Correlates With Gross Leverage And Job Cuts 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 11Firms Have Enough Cash 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The above trends in corporate profits, corporate debt and job cut announcements are consistent with what we’re already seeing on the default front. The US corporate sector was experiencing upwards of 20 default events per month back in May, June and July. But only seven defaults occurred in November, following five in October and six in September (Chart 12). Chart 12The Default Rate Has Peaked 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The bottom line is that the macro environment of above-trend growth, low inflation and accommodative monetary policy is one where we should expect spread product to outperform Treasuries. Relative valuation dictates which spread sectors we prefer over other ones, and the next two Key Views address this issue. Key View #5: Move Down In Quality Within Corporates Investment grade corporates will outperform Treasuries in 2021, but the potential for further spread compression is limited. Junk spreads have more room to tighten, and the Ba credit tier looks particularly attractive from a risk/reward perspective. As noted in the previous section, the macroeconomic environment is one where spread product should flourish. However, valuation in certain sectors could limit how much further spread tightening is possible. In particular, valuation looks to be a constraint for investment grade corporates. In absolute terms, investment grade corporate spreads look like they still have some room to compress (Chart 13). The overall index spread is 12 bps above its pre-COVID level. The Aa, A and Baa-rated spreads are 16 bps, 11 bps and 13 bps above, respectively. Only seven defaults occurred in November, following five in October and six in September. However, valuation looks much worse in risk-adjusted terms. Chart 14 shows the 12-month breakeven spread, i.e. the spread widening required for the sector to underperform Treasuries on a 12-month investment horizon. In addition, we re-weight the overall corporate index to ensure that it maintains a constant credit rating distribution over time, and we show all breakeven spreads as percentile ranks relative to their own histories. For example, a reading of 8% for the Baa credit tier means that the 12-month breakeven spread for the Baa credit tier has only been lower than it is today 8% of the time since our data begin in 1995. Chart 13IG Spreads Still Above ##br##Pre-COVID levels 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 14IG Looks More Expensive In Risk-Adjusted Terms 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Adding it all up, we think there is scope for investment grade corporates to modestly outperform Treasuries in 2021, but there are also more attractively priced sectors that investors may want to consider. Municipal bonds are one particularly attractive alternative to investment grade corporates (we discuss our view on municipal bonds in the next section), but investors are also advised to pick-up additional spread by moving down in quality within the corporate credit space. High-Yield corporate bonds have significantly more scope for tightening than their investment grade counterparts, with the overall junk index spread still 69 bps above its pre-COVID level (Chart 15). Within junk, the Ba credit tier looks like the best place to camp out from a risk/reward perspective. The incremental spread offered by Ba-rated junk bonds compared to Baa-rated corporates is elevated compared to history, 111 bps above its 2019 low (Chart 15, panel 2). In contrast, the additional spread pick-up you get from moving into the lower junk tiers (B & Caa) is more in line with typical historical levels (Chart 15, bottom 2 panels). Chart 15Ba-Rated Bonds Look Best 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Another reason to be cautious about chasing the extra spread in the B-rated and below credit tiers is that the High-Yield index is pricing-in a fairly rapid decline in the default rate for the next 12 months (Chart 16). If we assume a 25% recovery rate and target an excess spread of 150 bps above default losses,4 then we calculate a spread-implied default rate of 3.1%. That is, we should only expect junk bonds to outperform duration-matched Treasuries if the default rate comes in below 3.1% during the next 12 months. This would represent a steep decline of 5.3% from the 8.4% default rate we just witnessed during the past 12 months, but this sort of big drop in the default rate would not be out of line with what typically happens when the economy emerges from recession. For example, in the last recession, the 12-month default rate peaked at 14.6% in November 2009 and then fell to 3.6% by November 2010, a decline of 11%! Chart 16Spread-Implied Default Rate 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income All in all, we view the Ba-rated credit tier as the sweet spot within corporate credit in terms of offering the best combination of risk and reward. We also expect the default rate to fall quickly enough that the lower-rated junk credit tiers will outperform Treasuries, but the risk here is greater and the potential additional compensation is not historically elevated. Investment grade corporate spreads will remain tight, but have limited room to compress further. Investors are advised to look at Ba-rated corporates and municipal bonds instead.  Key View #6: A Maximum Overweight Allocation To Municipal Bonds Tax-exempt municipal bonds offer the best opportunity in the US fixed income space. Investors should adopt a maximum overweight allocation, and in particular, they should shift some allocation out of investment grade corporates and into Munis with the same credit rating and duration, but with a greater after-tax yield. At present, we think that tax-exempt municipal bonds represent the best opportunity in US fixed income. Muni spreads have certainly tightened since March, but valuation remains attractive relative to both Treasuries and investment grade corporates. First, let’s consider value relative to Treasuries (Chart 17). Spreads between Aaa-rated municipal bonds and maturity-matched Treasuries are elevated compared to history across the entire yield curve. 2-year Munis even offer a 3 bps yield pick-up over 2-year Treasuries before adjusting for the tax advantage. Further out the curve, value is worst at the 5-year part of the curve where the breakeven effective tax rate between Munis and Treasuries is 42%, slightly above the top marginal tax rate of 37%. But value improves again for longer maturities. The breakeven effective tax rate between 10-year Munis and Treasuries is 24% and it is a mere 10% for 30-year bonds.5 Next, we can look at relative value between Munis and credit. This is where the attractiveness of munis really stands out (Chart 18). After controlling for credit rating and duration, municipal revenue bonds offer a yield advantage over the Bloomberg Barclays Credit Index across the entire yield curve, before any adjustment is made for the municipal tax exemption. General Obligation (GO) Munis only offer a before-tax yield advantage over credit beyond the 12-year maturity point, but the GO Muni/credit spread is nonetheless historically elevated for all maturity buckets. Chart 17Muni/Treasury Yield Spreads 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 18Munis Versus Credit 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income This is all well and good, but it could easily be countered that municipal bonds only offer such attractive valuations because the COVID recession has been an historically challenging period for state & local government balance sheets. If this period leads to a spate of downgrades and defaults, then municipal bonds no longer look cheap. All this is true, but we think investors’ worst fears in this regard will not be realized. For one thing, state & local governments have been very quick to clamp down on spending and cut employment (Chart 19). Coming out of the last recession, Muni/Treasury yield spreads had almost fully recovered by the time that state & local government austerity began. Also, state budgets were in pretty good shape heading into the COVID downturn, with all-time high Rainy Day Fund balances (Chart 19, bottom panel). Chart 19State & Local Austerity Has Begun 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We recommend that investors take advantage of historically attractive municipal bond spreads by adopting a maximum overweight allocation. In particular, investors should shift allocation out of investment grade rated corporate bonds, where valuations are stretched, and into municipal bonds that offer the same credit rating and duration with a greater yield pick-up. Finally, Chart 20 shows the spread between different municipal bond sectors and the Bloomberg Barclays US Credit Index. We match the credit rating and duration in each case, but we make no adjustments for the municipal tax exemption. The message from Chart 20 is that the yield advantage in investment grade Munis is broad based, with the exception of the Electric sector. We also see that attractive valuations do not extend to high-yield Munis, which appear expensive relative to High-Yield Credit. Chart 20Municipal Bond Sector Valuation 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Appendix A:  The Golden Rule Of Bond Investing Our Golden Rule of Bond Investing says that we should determine what change in the fed funds rate is priced into the overnight index swap curve for the next 12 months, and then decide whether the Fed will deliver a hawkish or dovish surprise relative to that expectation. We contend that if the Fed delivers a hawkish surprise, then a below-benchmark portfolio duration positioning will pay off. Conversely, if the Fed delivers a dovish surprise, then an above-benchmark portfolio duration positioning will profit. Chart A1 shows how the Golden Rule has performed in every calendar year going back to 1990. We include year-to-date performance for 2020. In 31 years of historical data, our Golden Rule performed well in 23. It provided the wrong recommendation in 8 years, though 3 of those years were during the zero-lower-bound period between 2009 and 2015 when 12-month rate expectations were essentially pinned at zero.6 Chart A1The Golden Rule's Track Record 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income At the beginning of this year, the market was priced for 13 bps of rate cuts in 2020. The funds rate actually fell by 146 bps, leading to a dovish surprise of 133 bps. Based on a historical regression, we would expect a dovish surprise of 133 bps to coincide with a Treasury index yield that falls by 81 bps. In actuality, the index yield fell by 122 bps, more than our Golden Rule predicted. Chart A2 shows how close changes in the Treasury index yield have been to our Golden Rule’s prediction in each of the past 31 years. This regression between the change in Treasury index yield and the monetary policy surprise is the main source of error in our Treasury return forecasts. Chart A2Treasury Index Yield Changes Versus Fed Funds Surprises 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Based on our expected -81 bps index yield change, we would have expected the Treasury index to deliver 6.5% of total return in 2020 and to outperform cash by 5.5%. In actuality, the index earned 7.9% of total return and outperformed cash by 7%. Charts A3 and A4 show how index total and excess returns have performed relative to our Golden Rule’s expectations in each of the past 31 years. Chart A3Treasury Index Total Returns Versus The Golden Rule’s Predictions 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart A4Treasury Index Excess Returns Versus The Golden Rule’s Predictions 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Appendix B: Spread Product Performance In 2020 Table B1Spread Product Year-To-Date Performance 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Table B2Performance Since March 23 Announcement Of Emergency Fed Facilities 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2021: A Brave New World”, dated November 30, 2020, available at bca.bcaresearch.com 2 Please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 3 We discussed these facilities in detail in two Special Reports published jointly this year with our US Investment Strategy team. US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020 and US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup Part 2: Shocked And Awed”, dated July 28, 2020. Both reports available at usbs.bcaresearch.com 4 Our research has shown that this is the minimum excess spread investors should require to be confident that junk bonds will outperform duration-matched Treasuries. For more details please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 The breakeven effective tax rate is the effective tax rate that makes the after-tax muni yield the same as the Treasury yield. If the investor’s personal tax rate is above the breakeven effective tax rate, they will get an after-tax yield pick-up from owning the municipal bond over the Treasury. 6 We say the Golden Rule “worked” if a dovish surprise coincided with positive Treasury index excess returns versus cash, or if a hawkish surprise coincided with negative Treasury excess returns versus cash. Recommended Portfolio Specification