Yield Curve

Highlights Fed: The large divergence between Treasury yields and risk assets means that the Fed will almost certainly cut rates during the next few months. The only question is whether a large sell-off in risk assets will be required to force the Fed’s capitulation. Maintain a cautious near-term (0-3 month) allocation to corporate credit. Duration: The economic data and shape of the yield curve do not suggest that the economy is heading into recession. Rather, they suggest that the economy is experiencing an external shock – akin to 1998 or 2015/16 – that can be offset by a relatively minor pivot in Fed policy. Investors should keep portfolio duration low. Corporate Balance Sheets: Growth rates for both corporate profits and debt should settle into the mid-single digits during the next few quarters. This will keep gross leverage and the default rate roughly stable. A sustained period of negative profit growth and tighter C&I lending standards would challenge this outlook. Feature Chart 1Markets Taking The Rate Cut For Granted Markets Taking The Rate Cut For Granted Markets Taking The Rate Cut For Granted Markets aren’t begging for a rate cut. Rather, they are behaving as though one has already occurred. This sort of set-up could lead to wider credit spreads and lower equity prices in the near-term. To elaborate, notice that the S&P 500 is only 3% off its late-2018 peak, but is down an alarming 8% relative to the Bloomberg Barclays Treasury Master Index. Meanwhile, the 10-year Treasury yield had fallen all the way to 2.06% as we went to press last Friday (Chart 1, bottom panel). The overall message from financial markets is that investors expect the Fed to cut rates very soon, but also think that a small number of cuts will be enough to forestall recession and keep risk assets supported. As we see it, the divergence between risk assets and Treasuries makes a rate cut during the next few months a near certainty. If the Fed does not appear sufficiently dovish at next week’s FOMC meeting, then risk assets will sell off. The resulting tightening of financial conditions will then force the Fed’s hand, leading to a rate cut in July or September. The alternative is that the Fed tries to get ahead of market sentiment by delivering a rate cut next week, even if such a move is not easily justified by the economic data. A New Trade In last week’s report, we recommended adding a fed funds futures calendar spread trade to take advantage of these near-term policy moves (Chart 2).1 Specifically, we advised investors to go long the August 2019 fed funds futures contract and short the February 2020 contract. Chart 2Exit Long Aug 2019 / Stay Short Feb 2020 Exit Long Aug 2019 / Stay Short Feb 2020 Exit Long Aug 2019 / Stay Short Feb 2020 We recommended buying the August 2019 fed funds futures contract to hedge the risk that the Fed tries to get ahead of market sentiment by cutting rates in June or July. As of last week, this contract would have earned a positive return in a scenario where the Fed delivered one 25 basis point rate cut in either June or July, and a negative return in a scenario where rates are unchanged. But as of last Friday, the contract’s risk/reward profile had shifted dramatically. The contract is now priced for a loss in both the “one rate cut” and “no rate cut” scenarios. We therefore exit our long position in the August 2019 fed funds futures contract for a gain of 8 bps.  .  The second leg of our proposed trade was to short the February 2020 fed funds futures contract. This remains an excellent bet. As of last Friday, a short position in the February 2020 contract will earn a positive return as long as three or fewer rate cuts occur between now and next February (Chart 2, bottom panel). In last week’s report, we recommended adding a fed funds futures calendar spread trade to take advantage of these near-term policy moves. Table 1 displays the expected returns from our proposed spread trade (long Aug 2019/short Feb 2020) as of last Friday, the most recent pricing available at the time of publication. Because of the rapid gains in the August 2019 contract price, an outright short position in the February 2020  contract now dominates the expected returns from the calendar spread trade in all likely scenarios. We therefore advise investors to exit the long position in the August 2019 contract, but to remain short the February 2020 contract. Table 1Expected Returns From Long Aug 2019 / Short Feb 2020 Fed Funds Futures Calendar Spread Trade Tracking The Mid-1990s Tracking The Mid-1990s Bottom Line: The large divergence between Treasury yields and risk assets means that the Fed will almost certainly cut rates during the next few months. The only question is whether a large sell-off in risk assets will be required to force the Fed’s capitulation. We advise near-term caution on credit spreads. While a near-term rate cut is likely, we also doubt that the Fed will deliver more than the 76 bps of rate cuts priced into the curve for the next 12 months. We therefore recommend that investors keep portfolio duration low and maintain a short position in the February 2020 fed funds futures contract.  More 1998 Than 2001 In the last section we reiterated our view that the Fed will deliver fewer than the 76 bps of rate cuts that are priced into the yield curve for the next 12 months. Our main justification is that such a large number of rate cuts will only occur if the economy enters recession. At present, the pre-conditions for an economic recession are simply not in place. Rather, the economy is experiencing an external shock – akin to 2015/16 and 1998 – that will require only a modest shift in Fed policy. In other words, if we use the mid-1990s cycle as a roadmap, today looks much more like 1998 than 2001. The divergence between manufacturing and services PMIs is exactly what occurred in 1998 and 2015/16. In a recent Special Report, we observed that every single post-WWII recession was preceded by either high inflation or rapid private debt growth (Chart 3).2 At present, inflation is muted and private debt growth is low. The economy is unlikely to experience a recession if there hasn’t been a prior build-up of excess demand. Chart 3Private Debt Growth, High Inflation & Recessions Private Debt Growth, High Inflation & Recessions Private Debt Growth, High Inflation & Recessions Second, economic indicators are much more consistent with the 2015/16 and 1998 episodes than with “pre-recession” conditions. The ISM Manufacturing PMI has fallen sharply, though it remains above 50, but the ISM Non-Manufacturing PMI looks much healthier. This divergence between manufacturing and services is exactly what occurred in 1998 and 2015/16 (Chart 4). It is consistent with a shock to global demand and trade that has relatively little impact on the U.S. consumer and the domestic economy’s large service sector. Chart 4Divergence Between Services And Manufacturing Divergence Between Services And Manufacturing Divergence Between Services And Manufacturing Granted, the PMIs compiled by Markit do not mirror the divergence between the ISM Manufacturing and Non-Manufacturing surveys. In fact, the Markit Services PMI has dropped sharply alongside its manufacturing counterpart (Chart 5). However, the Markit surveys also showed no divergence between manufacturing and services in 2015/16 and have no available data for 1998. We are therefore inclined to downplay the weakness in the Markit Services PMI for the time being. Chart 5MARKIT PMIs MARKIT PMIs MARKIT PMIs Third, employment growth usually starts to slow at least one year before the economy heads into recession. But it showed relatively little weakness in 1998 and 2015/16 (Chart 4, bottom panel). If May’s downbeat payrolls number turns out to be the start of a trend, then we will have to reconsider our view. But for now, even after last week’s report, employment growth remains solid. Finally, not only do the economic data suggest an episode similar to 1998 and 2015/16, but the slope of the yield curve does as well. While many have focused on the inversion of the 3-month/10-year Treasury slope, the 2-year/10-year slope remains above zero, and has indeed steepened in recent weeks. A more comprehensive look at the entire yield curve, adjusting for changes in the overall level of yields, shows that it looks very similar to the yield curve seen just ahead of the first 1998 rate cut. In contrast, the yield curve seen just before the first 2001 rate cut was more heavily inverted at the front-end, and long-dated yields priced-in much less of a rebound (Charts 6A & 6B). Chart 6 Chart 6 Bottom Line: The economic data and shape of the yield curve do not suggest that the economy is heading into recession. Rather, they suggest that the economy is experiencing an external shock – akin to 1998 or 2015/16 – that can be offset by a relatively minor pivot in Fed policy. Investors should keep portfolio duration low on the view that the Fed will cut rates by less than 76 bps during the next 12 months. Corporate Health Update Chart 7Weak Profit Growth In Q1 Weak Profit Growth In Q1 Weak Profit Growth In Q1 The full slate of first quarter corporate balance sheet data have now been released, and as expected, corporate profit growth cooled significantly compared to the rapid gains seen in 2018. As a result, our Corporate Health Monitor – an equal-weighted composite of six important financial ratios – ceased its recent improvement and jumped firmly back into “deteriorating health” territory (Chart 7). Our preferred measure of pre-tax profits contracted at an annualized rate of 17% in Q1, dragging the year-over-year growth rate down to 7%, from 15% in 2018 Q4 (Chart 7, bottom panel). The crucial relationship for corporate bond investors is between pre-tax profit growth and debt growth. If profit growth exceeds debt growth, then gross leverage will decline over time taking the default rate with it. Conversely, defaults tend to rise whenever profit growth fails to keep pace with debt growth.3 Corporate debt has been growing at an annualized pace of about 6-8%. This means that profit growth would have to slow to below those levels for us to become concerned about an increase in defaults. This could occur for the next quarter or two, as the weak global growth environment weighs on revenues (Chart 8). But our Profit Margin Proxy – corporate selling prices less unit labor costs – is in a strong uptrend, suggesting that the weakness may not be that dire. The crucial relationship for corporate bond investors is between pre-tax profit growth and debt growth.  There is also some reason to think that corporate debt growth might slow during the next few quarters. According to the Fed’s Senior Loan Officer Survey, C&I loan demand has weakened significantly in recent months, while lending standards remain approximately unchanged. Historically, it is extremely rare for loan demand to weaken without a simultaneous tightening in bank lending standards (Chart 9). However, if the current unusual situation were to persist, it would be quite positive from the perspective of corporate balance sheet health. It would suggest that firms are adding less debt to balance sheets, even though banks continue to make credit readily available. Chart 8Profit Margins Still Strong Profit Margins Still Strong Profit Margins Still Strong Chart 9Is Corporate Sector On A Debt Diet? Is Corporate Sector On A Debt Diet? Is Corporate Sector On A Debt Diet? Bottom Line: Growth rates for both corporate profits and debt should settle into the mid-single digits during the next few quarters. This will keep gross leverage and the default rate roughly stable. A sustained period of negative profit growth and tighter C&I lending standards would challenge this outlook.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, “When Expectations Are Self-Fulfilling”, dated June 4, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy/Global Fixed Income Strategy  Special Report, “The Risk From Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Bond yields have fallen a lot since the beginning of November, … : At the close on November 8th, the 10-year Treasury bond yielded 3.24%. By last Monday, it was yielding just 2.07%. … but the move isn’t terribly anomalous relative to history: In terms of nominal yields, the decline was just over a one-standard-deviation event; per real yields, it amounted to a -0.7 sigma move. The Fed may be preparing for a rate cut, but overweight duration positions will only pay off if several more follow: A one-and-done rate cut would stretch out the expansion and the bull markets in equities and spread product, but Treasuries are priced for an extended rate-cutting cycle. Feature Stocks are said to be the only asset that people want more of when prices rise, and less of when they fall. Lately, bonds have also seemed to have an upward-sloping demand curve, because more and more people have bought them as they’ve gotten more expensive. A BCA client who’s been shaking his head at the action got in touch with us last week to try to make some sense of it all. Experience tells him that big moves like the one that’s been unfolding since last November don’t go on forever. When they stop, mean reversion would suggest that they’re prone to retrace a good bit of territory. He came to us for some historical context to support or contradict his intuition, as summed up in something like the following statement. “Over the past 50 years, the current move equates to an x-standard-deviation event. Following similar instances, rates have risen by x basis points over the next six months, and by y basis points over the next twelve months.” The Empirical Record The sharp decline in the 10-year Treasury yield that began in early November can be viewed as three separate declines (Chart 1). In the first, the 10-year yield fell by 68 basis points (“bps”) over a span of 37 trading days. After retracing a third of the decline over the next 11 sessions, it slid by another 40 bps over 48 days. Following a one-half retracement over the ensuing 13 days, it shed 53 basis points in 32 days, capped off by a 36-bps decline across the final eight sessions (Table 1). Chart 1The Path To 2.07% The Path To 2.07% The Path To 2.07% Table 1A Lower 10-Year Treasury Yield In Three Steps Context Context Using the daily 10-year Treasury yield series beginning in 1962, we compared the individual yield declines for prior 37-, 48- and 32-day periods, as well as for the aggregate 141-day session spanning the entire stretch from the November 8th peak to the June 3rd trough. We also looked at the May 21st to June 3rd crescendo relative to past eight-day segments. The standardized moves range from three-quarters of a standard deviation below the mean for the 48-day middle leg to 1.5 and 1.8 for the 37- and 8-day moves, respectively (Table 2). All in all, the entire move grades out to 1.3 standard deviations below the mean – a somewhat unusual move, but nothing too special. Table 2Standardized Values Of Nominal 10-Year Treasury Yield Declines Context Context The current decline’s relative stature is undermined by the wild volatility of the late ‘70s and early ‘80s, when bond yields and annual inflation reached double-digit levels (Chart 2). To try to place the current episode on a more equal framework, we also calculated standardized moves in real (inflation-adjusted) yields. On a real basis, however, the current moves made even less of a splash. The 8-day decline (z-score = -1.2) was the only component that was more than a standard deviation from the mean, and the overall move amounted to just 0.7 standard deviations below the mean (Chart 3). Chart 2No Historical Anomaly In The Current Market No Historical Anomaly In The Current Market No Historical Anomaly In The Current Market Chart 3Little Impact In Terms Of Real Yields Little Impact In Terms Of Real Yields Little Impact In Terms Of Real Yields We are familiar with the electronic financial media’s increasingly popular convention of stating daily yield moves in proportion to the previous day’s closing yield.1 That convention has the advantage of fitting snugly aside stock price quotes on TV and computer screens, but it is ultimately nonsensical. The proportional change in a bond’s yield relative to its starting yield doesn’t come close to approximating the change in the value of that bond. Comparing proportional changes in bond yields across timeframes would be a way of putting today’s yield moves on a more equal footing with yield moves in the high-inflation, high-coupon era of the late seventies and early eighties, but it conveys no practical information. The margin by which long-maturity Treasuries have outperformed intermediate-maturity Treasuries is unusual, ... Our next steps were instead to compare Treasury total returns and the change in the slope of the yield curve to past flattening and steepening episodes. The moves here were also unavailing over both seven- and one-month periods, as the high-coupon ‘70s and ‘80s still dominated (Chart 4). In terms of the change in the 10-year Treasury yield, both nominal and real; Treasury index total returns; and the slope of the yield curve (3-month rate to 10-year yield), both the aggregate move since last October and its three component moves have amounted to one-standard-deviation events. They would only have had about a one-in-six chance of occurring randomly in a normally distributed population, but they do not represent unsustainable moves that cry out to be reversed. Chart 4Little Impact In Terms Of Treasury Total Returns, ... Little Impact In Terms Of Treasury Total Returns, ... Little Impact In Terms Of Treasury Total Returns, ... Digging a little deeper to consider total returns across different regions of the yield curve, we do find one apparent anomaly at the long end of the curve. The long Treasury index has outperformed the intermediate Treasury index by a two-standard-deviation margin over both a seven-month and a one-month timeframe (Chart 5). On a standalone basis, the long Treasury index has beaten the seven-month mean return by one-and-a-half standard deviations, and the one-month mean return by two standard deviations (Chart 6). The two-standard-deviation results would only be expected to occur one out of forty times, and thereby validate our client’s sense that something has been going on. ... and history suggests they’ll be partially unwound over the next six to twelve months. Chart 5... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... ... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... ... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... Chart 6... And Long-Maturity Returns Have Been Elevated ... And Long-Maturity Returns Have Been Elevated ... And Long-Maturity Returns Have Been Elevated Moving on to the second part of his inquiry, we reviewed the standalone performance of the long Treasury index, and the relative long-versus-intermediate performance, over subsequent six- and twelve-month periods. We focused our analysis on instances when historical z-scores were greater than or equal to their current levels to try to determine if we should expect current performance to reverse and, if so, how sharply. On a standalone basis, long Treasury index performance has gently reverted to the mean over the subsequent six and twelve months, posting returns over those periods within +/- 0.2 standard deviations of its long-run average (Table 3). Table 3Standardized Values Of Future Long-Maturity Treasury Index Returns Context Context Outlying relative long-versus-intermediate performance like we’ve witnessed over the last seven months has reversed more convincingly. The long Treasury index has underperformed its intermediate-maturity counterpart over six and twelve months when its z-scores were greater than or equal to their current levels over a seven- and one-month basis, falling roughly 0.5 standard deviations below the mean (Table 4). The future does not have to resemble the past, especially over small sample sizes, but relative long-end underperformance would accord with our constructive view of the U.S. economy. It would also be consistent with our anti-duration and pro-inflation biases. Table 4Standardized Values Of Future Difference Between Long- And Intermediate-Maturity Treasury Index Returns Context Context The Fed, Again The consistency of the comments from Fed officials last week would seem to suggest that they are trying to prepare the ground for a rate cut. A cut at next week’s FOMC meeting might be a little too abrupt, but it seems increasingly possible that the committee could guide markets to a cut at the next scheduled meeting at the end of July. Various officials have made it abundantly clear that they view trade tensions as a threat to the economy, and that the bank is prepared to adjust policy, if need be, to sustain the expansion. Uber-dovish St. Louis President Bullard, who said last Monday that, “a downward policy rate adjustment may be warranted soon,” no longer appears to be such an outlier. We do not think a rate cut is necessary, and we would be content to remain on the sidelines if we were on the committee, but our opinion is irrelevant. We endeavor not to be distracted by what we think should happen, devoting our focus instead to determining what’s most likely to happen. To that end, our estimate of the probability that the Fed’s next move might be a cut is rising by the speech/interview. When incorporating that probability into investment strategy, we have been thinking a lot about a question that keeps being raised within BCA: If the Fed cuts rates next week or next month, how will markets respond? Assuming the economic backdrop doesn’t deteriorate, we expect that a rate cut will keep the equity and credit bull markets going. The answer depends heavily on the context in which the Fed cuts, and we assume that if the Fed cuts after the economy has taken a dramatic turn for the worse, risk assets would decline. In that case, markets would presumably read the Fed’s decision as confirmation that things were even worse than they perceived and that a significant bout of risk aversion was right around the corner. On the other hand, if the cut came against a backdrop of decent, if unexciting, economic data, risk assets would likely rally. For an investor who cannot resist injecting his/her opinion into the mix, the market response would be supportive of risk assets if a rate cut was unnecessary, but negative if the economy couldn’t get along without it. Investment Implications We believe that the U.S. economy is doing just fine, thank you, and do not yet see the signs that the expansion requires more monetary accommodation if it is to continue. Assuming that the cast of the incoming data does not change enough to change our view, we would expect that a rate cut would defer the end of the expansion and thereby defer the end of the bull markets in risk assets. We are therefore content to stick with our recommendation that investors should remain at least equal weight equities and spread product. We are still looking for restrictive monetary policy to be the catalyst that ends the expansion, and anything that pushes restrictiveness further into the future ought to keep the market parties going. Our view has aligned with the house view over the last year, but there is no guarantee that it will continue to do so. A growing minority of managing editors has been repeatedly challenging the internal consensus in our daily meetings, and it will be debated vigorously at our monthly view meeting Monday morning in Montreal. It is possible that the house view, and the U.S. Investment Strategy view, could soon become less constructive, though our level of conviction remains fairly high.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 If a bond yielding 3% at Friday’s close ends Monday’s session with a yield of 2.94%, 6 bps lower, its yield is shown as having declined 2% on the day (-.0006/.03 = -2%).

Highlights Chart 1Bond Rally Supports Stocks Bond Rally Supports Stocks Bond Rally Supports Stocks Financial markets are pricing-in an intensifying global growth slowdown, but not all assets are responding equally. U.S. Treasuries have rallied strongly, while equities and credit spreads remain resilient. Case in point, the S&P 500 is only 5.9% off its Q3 highs in absolute terms, but is down 11.3% versus bonds (Chart 1). The markets are pricing-in that the Fed will react to slower growth by cutting rates and that easier Fed policy will keep risk assets supported. But consider what will happen if, at the June FOMC meeting, the Fed doesn’t seem as eager to cut rates as the market would like. The perception of less monetary support could prompt a sharp sell-off in equities and credit spreads. That tightening of financial conditions could then be enough to force the Fed’s hand, ultimately leading to the rate cut that the market has already come to expect. The odds of the above scenario are rising by the day, especially since the President’s decision to expand the trade war to Mexico. We recommend a cautious near-term (0-3 month) stance on credit spreads as a hedge against this mounting risk.  Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 139 basis points in May, dragging year-to-date excess returns down to +221 bps. As we noted in last week’s report, corporate bond spreads have not responded as aggressively as some other assets – commodities and Treasuries – to the escalating trade war and the deteriorating global growth data.1 This leaves the sector vulnerable to a near-term sell-off, especially if the Fed doesn’t validate the market’s dovish expectations at this month’s FOMC meeting. We advise investors to hedge their exposure to credit spreads on a 0-3 month horizon. Beyond that, assuming that the U.S. government’s tariff announcements eventually reach a plateau, the outlook for corporate bond excess returns is positive on a 6-12 month investment horizon. Spreads are comfortably above levels typically seen at this stage of the economic cycle (Chart 2) and, tariffs aside, the U.S. economy is growing at a reasonable clip. As for balance sheets, corporate profit growth contracted in the first quarter, dragging the year-over-year growth rate down to 7%. That is roughly equivalent to the trend rate in corporate debt growth, meaning that if profit growth stabilizes near that level our measure of gross leverage will stay flat (panel 4). We are also keeping a close eye on C&I lending standards. While the most recent data showed an easing in Q1, the continued contraction in loan demand poses a risk (bottom panel). Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 250 basis points in May, dragging year-to-date excess returns down to +443 bps. As with investment grade corporates, the risk of near-term spread widening is high. We noted in last week’s report that excess junk returns versus Treasuries outpaced the CRB Raw Industrials index by 9% during the past 12 months, a historically wide divergence that is bound to fade.2 Looking further out, high-yield bonds still look like a good bet on a 6-12 month investment horizon. Spreads are comfortably above typical levels from past cycles and the excess spread available in the junk index after accounting for expected default losses has risen to 325 bps, well above its historical average (Chart 3). Assuming historically average excess compensation and a 50% recovery rate, current junk spreads discount an expected 12-month default rate of 3.1%. This is well above the Moody’s baseline projection of 1.5% and even above the 2.7% default rate seen during the past 12 months. The spread-implied default rate should be easy to beat, though a persistent increase in job cut announcements could pose a risk (bottom panel). MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in May, dragging year-to-date excess returns down to -13 bps. The conventional 30-year zero-volatility spread widened 6 bps on the month, the combination of a 4 bps widening in the option-adjusted spread (OAS) and a 2 bps increase in the compensation for prepayment risk (option cost). At 49 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains slightly below its pre-crisis mean (Chart 4). Nonetheless, we see high odds that the MBS/Treasury basis will contract going forward. Falling mortgage rates and an uptick in refinancing activity led to the recent widening in MBS spreads. But with the housing activity data showing signs of improvement, we anticipate that mortgage rates are close to a trough and that refis will soon peak (panel 2). If the “risk off” sentiment in financial markets prevails in the near-term, then MBS will outperform corporate credit. But expected 6-12 month excess returns remain higher for corporate bonds than for MBS. We therefore maintain only a neutral allocation to MBS, despite increasingly attractive valuations. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to +107 bps. Sovereign debt underperformed duration-equivalent Treasuries by 205 bps on the month, dragging year-to-date excess returns down to +206 bps. Local Authorities outperformed the Treasury benchmark by 11 bps, bringing year-to-date excess returns up to +219 bps. Meanwhile, Foreign Agencies underperformed by 61 bps, dragging year-to-date excess returns down to +130 bps. Domestic Agencies underperformed by 1 bp in May, bringing year-to-date excess returns up to +28 bps. Supranationals outperformed by 4 bps on the month, bringing year-to-date excess returns up to +27 bps. Sovereign debt remains expensive relative to equivalently rated U.S. corporate credit (Chart 5), and the dollar’s relentless march higher presents a further headwind for the sector. We continue to recommend an underweight allocation. Previously, we made an exception for Mexican sovereign bonds, which trade cheap relative to U.S. corporates (bottom panel). However, with the U.S. government now threatening tariffs on imported Mexican goods, the peso will likely see heightened volatility in the coming months. We recommend standing aside on Mexican sovereigns for the time being. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 75 basis points in May, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 1% in May, and currently sits at 80% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, but close to the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) have outperformed short-dated munis (2-year and 5-year) by a wide margin since the beginning of the year, but long-end yield ratios remain relatively attractive. 20-year and 30-year Aaa-rated municipal bonds are particularly alluring. Yield ratios for those bonds remain above their pre-crisis averages, whereas 10-year, 5-year and 2-year Aaa yield ratios are close to one standard deviation below their respective pre-crisis means. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.3 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in May, with yields falling by more than 30 basis points for all maturities beyond 1 year. The 2/10 Treasury slope flattened 5 bps on the month and currently sits at 19 bps. The 5/30 slope was unchanged on the month and currently sits at 65 bps (Chart 7). The belly (5-year/7-year) of the curve looks particularly expensive relative to the wings (see Appendix B) and we continue to recommend a barbell curve positioning: Investors should overweight the long and short ends of the curve and avoid the belly.4 Further, this week we recommend an additional fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract. The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if 3 or more rate cuts occur between now and then. We would expect our spread trade to return +48 bps in a scenario where the Fed keeps rates flat until next March and +23 bps in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 116 basis points in May, dragging year-to-date excess returns down to +39 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.74%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps on the month and currently sits at 1.90%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.5 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 3% (annualized) clip in April, but has only risen 1.6% during the past year. 12-month trimmed mean PCE inflation has been higher, and actually just moved above the Fed’s target following last week’s April data release (Chart 8). In last week’s report we noted that core PCE inflation has a track record of converging toward the trimmed mean.6 As such, we recommend that investors remain overweight TIPS versus nominal Treasuries in U.S. bond portfolios. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +64 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and actually hit a new all-time low of 26 bps in mid-May, before settling at 28 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in May, bringing year-to-date excess returns up to +195 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 69 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst waning demand (bottom panel) and decelerating prices (panel 3). However, CMBS still offer reasonable compensation for this risk. Especially compared to other similarly-rated fixed income sectors.7 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in May, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread widened 3 bps on the month and currently sits at 51 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread product. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 75 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Image Image Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of May 31, 2019) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling 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 May 31, 2019) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling 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 +56 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 56 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) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12 Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 4 We have specifically been recommending a position short the 7-year bullet and long a duration-matched 2/30 barbell. 5 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Inverted Curves & Recessions: While an inverted U.S. Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today compared to past recessions. The Role Of The Term Premium: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. The Stance Of Monetary Policy: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Feature The rush into the safety of government debt accelerated rapidly last week, after another Trump Tariff Tweet targeted Mexican exports to the U.S. Investor confidence, already shaken by the escalation of the U.S.-China trade war, was further eroded by the news that the U.S. was willing to broaden the use of blunt economic tools like tariffs to deal with national security issues like illegal immigration. Global equity and credit markets sold off sharply, adjusting to both higher uncertainty and lower growth expectations. The biggest moves, however, came in the U.S. Treasury market. The 2-year Treasury yield fell -14bps to 1.92% after the Mexico tariff announcement and ended -34bps lower for the entire month of May – the largest monthly decline since November 2008 during the depths of the financial crisis. The 10-year Treasury yield fell -37bps on the month to 2.13%, below the fed funds target range of 2.25-2.5% and 22bps lower than the 3-month U.S. Treasury bill rate. This triggered the dreaded “inversion” signal that has preceded the majority of post-WWII U.S. recessions. The current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Given the well-known predictive properties of an inverted Treasury curve, investors are right to be more nervous about the outlook for U.S. economic growth and the potential for a recession. Multiple Fed rate cuts are now discounted in shorter-maturity Treasury yields. At the same time, the intense flight-to-quality bid for duration exposure has driven the term premium on longer-maturity Treasuries – and all other developed market government bonds – down to unprecedentedly negative territory (Chart of the Week). This can potentially alter the meaning of an inverted yield curve with regards to future economic growth and expected changes in monetary policy. Chart of the WeekUST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? UST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? UST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? In this Weekly Report, we discuss the typical drivers of yield curve inversions and conclude that the current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Could The Treasury Curve Be Wrong This Time? Chart 2This Is A GLOBAL Bond Rally This Is A GLOBAL Bond Rally This Is A GLOBAL Bond Rally The current sharp fall in government bond yields is not only occurring in the U.S. Treasury market. Yields are hitting new cyclical lows in many countries, with the 10-year German Bund yield ending May at an all-time low of -0.2%. Yield curves have bull-flattened during this move, with 10-year yields trading below 3-month Treasury bill rates not only in the U.S., but even in places like Canada and Australia (Chart 2). Global yields have been falling steadily since late in 2018, seemingly with little regard to the performance of risk assets in either direction. This suggests a more fundamental driver – like deteriorating growth expectations or perceptions of overly-tight monetary policy – rather than simple asset allocation decisions by investors. In July 2018, we published a Special Report discussing the drivers of yield curve shape in the major developed markets and the potential economic implications.1 For the U.S., we concluded that when the 10-year U.S. Treasury yield traded below the 3-month U.S. Treasury bill rate for an extended period of time (i.e. more than just a few days), the U.S. subsequently entered recession within twelve months, on average (Table 1). With the 10-year yield now trading below the 3-month rate, the clock may have already started counting down to a recession sometime in the next year. Table 1U.S. Curve Flattening, Inversions & Recessions Since 1960 The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. The New York Fed has a model that determines the probability of a U.S. recession one year ahead based on the slope of the 10-year/3-month Treasury curve.2 The current curve level translates into a 36% probability of a recession one year from now, which is in line with the probabilities seen before the three previous U.S. recessions (Chart 3). Chart 3New York Fed's Yield-Curve Based Recession Probability Model Flashing Red New York Fed's Yield-Curve Based Recession Probability Model Flashing Red New York Fed's Yield-Curve Based Recession Probability Model Flashing Red Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. In Chart 4, we show a “cycle-on-cycle” analysis of selected U.S. economic data series, comparing the current backdrop to past U.S. business cycles. For all panels, the solid line represents the current cycle, while the dotted line is the average of the past five U.S. business cycles. The data is lined up such that the vertical line in the chart represents the start date of past U.S. recessions as determined by the National Bureau of Economic Research. Shown this way, we can look how the data is evolving today and see how it compares to the way the data typically moves in the run-up to a recession. Based on the data, we can make the following conclusions: The current weakness in the U.S. manufacturing sector is in line with the start of past recessions, based on the depressed level of the ISM Manufacturing New Orders-to-Inventories ratio. The Conference Board’s U.S. leading economic indicator is usually contracting in the year prior to the onset of recession; today, the year-over-year growth rate is slowing but remains positive at 2.6%. The U.S. consumer is in much better shape today - initial jobless claims are not rising and consumer confidence is not falling, as typically happens in the run-up to an economic downturn. Non-financial corporate profits also typically start to contract about one year before a recession begins; today, profit growth has slowed from the tax cut fueled surge of 2018, but has not yet downshifted into negative territory on a year-over-year basis. We can apply the same cycle-on-cycle analysis to the U.S. Treasury curve to see how today compares to past pre-recessionary periods (Chart 5). Typically, the 2-year Treasury yield falls below the fed funds rate about one full year before the start of a recession, and ends up around 150bps below the funds rate when the downturn actually begins. In the current cycle, the 2-year dipped below the funds rate back in March of this year, and now sits 58bps below the funds rate. Both of those curve relationships, however, are influenced by the changing nature of the Treasury term premium. Chart 4Only A Manufacturing Recession Only A Manufacturing Recession Only A Manufacturing Recession Chart 5Mixed Messages From The Curve Mixed Messages From The Curve Mixed Messages From The Curve The New York Fed produces estimates of the Treasury term premium for all maturities, from one year up to ten years, which allows us to see how the term premium looks different today than prior to past U.S. recessions.3 As can be seen in the bottom two panels of Chart 5, the 10-year term premium has averaged between 100-150bps in the year prior to U.S. recessions, while the 2-year term premium has averaged between 25-50bps over the same period. Today, the term premia for 10-year and 2-year yields are now both deeply negative. This suggests that the current inversion of the 2-year/fed funds curve, and the 10-year/3-month curve, is likely giving too pessimistic a signal about future U.S. growth – a fact corroborated by the cycle-on-cycle analysis of U.S. economic data. Bottom Line: While an inverted Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today versus past recessions. The Message From Depressed Bond Term Premia Today, the estimated term premium for 10-year Treasuries and 2-year Treasuries is -88bps and -70bps, respectively. This means that not only are bond investors willing to accept yields below the expected path of interest rates over the life of a bond (i.e. a negative term premium), they are accepting an even lower term/risk premium for bonds with longer maturities and durations – bonds that are more risky strictly in terms of price volatility. Why would that be? Typically, bond term premia are driven by the following factors: The volatility of inflation The volatility of bond yields and returns The volatility of economic growth Investor risk aversion Proxies for the first three factors are presented in Chart 6, alongside the estimate of the 10-year Treasury term premium dating back to the early 1960s. Broadly speaking, bond term premia have been higher when realized inflation is more volatile (second panel), unemployment is high (third panel) and Treasury yield volatility is elevated. Today, all of those factors are at, or very close to, the lowest levels seen over the past 50 years. No wonder term premia are so depressed. Chart 6Term Premia Are Depressed For Structural Reasons ... Term Premia Are Depressed For Structural Reasons ... Term Premia Are Depressed For Structural Reasons ... Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve.  Investor risk aversion does not exhibit the same type of broad multi-decade trends as growth and inflation, but it is safe to assume that investors become more risk averse when the economic backdrop is more uncertain. Periods of stable growth, categorized by low variability of U.S. nominal GDP growth or a rising trend in the global leading economic indicator, are associated with narrow term premiums and low measures of market-implied bond volatility like the MOVE index of U.S. Treasury option prices (Chart 7). Chart 7... And Cyclical Reasons ... And Cyclical Reasons ... And Cyclical Reasons This result does seem counter-intuitive – more economic uncertainty should make bonds safer, not riskier! The key to remember here is that it is only the term premium component of yields that rises during periods of greater volatility. Actual bond yields fall during those same periods, but because of more fundamental drivers like falling inflation expectations and a lower expected path of interest rates as the Fed eases policy. Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve. Bottom Line: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. So Is The Fed Actually Running A Tight Monetary Policy? As we discussed in our yield curve Special Report last July, curve inversions typically occur during periods when monetary policy is considered restrictive. For example, every time the real fed funds rate (actual fed funds minus core PCE inflation) has been above the Fed’s estimate of the neutral r* real rate, the 10-year/3-month Treasury curve has inverted (Chart 8). Currently, the real funds rate is essentially equal to the Fed’s latest r* estimate, suggesting that monetary policy is neutral and not restrictive. Chart 8Too Soon For Sustained, Policy-Induced Yield Curve Inversion Too Soon For Sustained, Policy-Induced Yield Curve Inversion Too Soon For Sustained, Policy-Induced Yield Curve Inversion Other measures like the Taylor Rule can also provide an indication of whether monetary policy is too tight relative to real interest rates and measures of economic spare capacity. If policy was too restrictive, with a fed funds rate above the Taylor Rule, this would imply a more “fundamental” Treasury curve inversion. The Atlanta Fed’s interactive Taylor Rule tool provides estimates of a variety of Taylor Rules, using differing measures of the neutral real fed funds rate and measures of spare capacity.4 We show the results of those Taylor Rules in Table 2. Only one of twenty rules shown is currently producing a fed funds rate below the current 2.25-2.5% range, with fifteen rules indicating that a higher funds rate is still required. Table 2Taylor Rule Fed Funds Prescription Heat Map For 2019: Q2 The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Chart 9Our Fed Monitor Is Close To Calling For Rate Cuts Our Fed Monitor Is Close To Calling For Rate Cuts Our Fed Monitor Is Close To Calling For Rate Cuts Yet despite the more traditional indicators suggesting that the current level of the fed funds rate is not too high, that does not mean that there are not potential pressures on the Fed to cut rates. Our own Fed Monitor remains near the zero line, suggesting that no change in the Fed’s stance is warranted (Chart 9). Yet when looking at the individual components of the Fed Monitor, there has been enough softening of U.S. growth and inflation momentum to justify Fed rate cuts. Only the Financial Conditions component is preventing the overall Monitor from moving into the “easier policy required” zone. In other words, if equity and credit markets continue to sell off and the U.S. dollar continues to rally, a Fed rate cut becomes a higher probability outcome. Investment Conclusions Summing it all up, it does not appear that the current inverted Treasury yield curve is signaling a risk of a U.S. recession within the next 6-12 months. A very flat Treasury curve is appropriate with a Fed policy stance that is appropriately neutral. On a cyclical perspective, we still think that a small below-benchmark stance on overall portfolio duration for global bond investors is warranted, along with a modest underweight in U.S. Treasuries in currency-hedged global bond portfolios. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. Those cuts are largely discounted in the current level of yields, though. Our 12-Month Discounter now indicates that -75bps of rate cuts over the next year are priced into the U.S. Overnight Index Swap curve. A good tactical way to play for Fed cuts in 2019 is to implement a fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract – a position we are adding to our Tactical Overlay (see the table on page 15). The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if three or more rate cuts occur between now and then. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. We would expect our spread trade to return +45bps (unlevered) in a scenario where the Fed keeps rates flat until next March and +19bps (unlevered) in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. Bottom Line: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Go long an August 2019/February 2020 fed funds futures calendar spread trade to profit from near-term “insurance’ Fed rate cuts.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31, 2018, available at gfis.bcaresearch.com and usbs.bcaresearch.com. 2 Details of the NY Fed’s probit model of U.S. recession probability based on the slope of the Treasury curve can be found here: https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3 There are several methodologies used to estimate term premia for government bond yields; the one used by the New York Fed is the Adrian, Crump and Moench (ACM) approach, details of which can be found here: https://www.newyorkfed.org/research/data_indicators/term_premia.html 4 The Atlanta Fed’s interactive Taylor Rule tool can be found here: https://www.frbatlanta.org/cqer/research/taylor-rule.aspx?panel=1 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Is Low Inflation Transitory? Is Low Inflation Transitory? Is Low Inflation Transitory? Persistent /pə’sıst(ə)nt/ adj. If inflation runs persistently above or below 2 percent, then the Fed would be forced to adjust its policy stance to nudge it back towards target. Transitory /’trænsıtərı/ adj. If inflation’s deviation from target is only transitory, it means that it will return to target even if the Fed maintains its current policy stance. Symmetrical /sı‘metrık(ə)l/ adj. The Fed’s inflation target is symmetrical because the FOMC is as concerned with undershoots as it is with overshoots. More recently, some members are urging the Fed to demonstrate the target’s symmetry by explicitly pursuing an overshoot.  Last week, Chair Powell described recent low inflation readings as transitory (Chart 1). In other words, the Fed believes that interest rates are already low enough to send inflation higher over time. Equally, with downbeat inflation expectations signaling doubts about the symmetry of the Fed’s target (bottom panel), the committee is in no rush to hike. The result is status quo monetary policy for the time being. With the market priced for 25 basis points of rate cuts over the next 12 months, investors should keep portfolio duration low. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 95 basis points in April, bringing year-to-date excess returns up to +365 bps. The corporate bond sector’s strong outperformance has resulted in spread tightening across the credit spectrum. In fact, average index spreads for the Aaa, Aa and A credit tiers are now at or below our fair value targets.1 Only the Baa credit tier, which accounts for about 50% of index market cap, remains attractively valued, with an average spread 11 bps above target (Chart 2). We recommend that investors focus their investment grade credit exposure on Baa-rated bonds. The combination of above-trend economic growth and accommodative Fed policy creates a favorable environment for credit risk. Spreads should continue to tighten in the near-term. However, we will turn more cautious once Baa spreads reach our target. Gross corporate leverage ticked higher in Q4, breaking a year-long downtrend (panel 4). Meantime, while C&I lending standards eased slightly in Q1 after having tightened in Q4 (bottom panel), C&I loan demand contracted for the third consecutive quarter. Weaker loan demand in the Fed’s Senior Loan Officer Survey often precedes tighter lending standards, and tighter lending standards usually coincide with wider corporate bond spreads.    Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 137 basis points in April, bringing year-to-date excess returns up to +710 bps. Junk spreads for all credit tiers remain above our spread targets (Chart 3).2 At present: The Ba-rated option-adjusted spread is 214 bps, 35 bps above target. The B-rated spread is 356 bps, 79 bps above target. The Caa-rated spread is 709 bps, 145 bps above target. An alternative valuation measure, the excess spread available in the junk index after accounting for expected default losses, is currently 267 bps, slightly above average historical levels (panel 4). However, this measure uses the Moody’s baseline default rate forecast of 1.7% for the next 12 months. For that forecast to be realized, it would require a substantial decline from the current default rate of 2.4%. In a previous Special Report, we flagged some reasons why the Moody’s forecast might be too optimistic.3 Among them is the increase in job cut announcements, which remains a concern despite last month’s drop (bottom panel). If we assume that the default rate holds at 2.4% for the next 12 months, the default-adjusted junk spread would fall to 237 bps. Still reasonably attractive by historical standards, and consistent with positive excess returns. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in April, dragging year-to-date excess returns down to +27 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, as a 5 bps widening in the option-adjusted spread (OAS) was partially offset by a 4 bps drop in the compensation for prepayment risk (option cost). At 42 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains below the pre-crisis mean (Chart 4). In fact, we would assign high odds to MBS outperformance during the next few months. Not only is the OAS attractive, but mortgage refinancings – which have recently caused the nominal MBS spread to widen – have probably peaked (panel 2). Following its sharp decline earlier in the year, the 30-year mortgage rate has now leveled-off. Another downleg is unlikely, given the recent improvements in housing data. New home sales and mortgage purchase applications have both surged in recent months, while homebuilder optimism remains close to one standard deviation above its long-run mean.4 Moreover, even at current mortgage rates we calculate that only about 17% of the conventional 30-year MBS index is refinanceable.  All in all, given that corporate credit offers higher expected returns, we continue to recommend only a neutral allocation to MBS. However, MBS spreads are very likely to tighten during the next few months.   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 37 basis points in April, bringing year-to-date excess returns up to +152 bps. Sovereign debt outperformed duration-equivalent Treasuries by 83 bps on the month, bringing year-to-date excess returns up to +420 bps. Local Authorities outperformed the Treasury benchmark by 67 bps and Foreign Agencies outperformed by 40 bps, bringing year-to-date excess returns up to +208 bps and +192 bps, respectively. Domestic Agencies outperformed by 10 bps in April, bringing year-to-date excess returns up to +29 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +23 bps. The Fed’s on-hold policy stance and signs of improvement in leading global growth indicators could set the U.S. dollar up for a period of weakness. All else equal, a softer dollar makes USD-denominated sovereign debt easier to service, benefiting spreads. However, a period of dollar weakness driven by improving global growth would also benefit U.S. corporate bonds, and valuation is heavily tilted in favor of U.S. corporate debt relative to sovereigns (Chart 5). Given that the last period of significant sovereign outperformance versus corporates was preceded by much more attractive valuation (panels 2 & 3), we maintain an underweight allocation to sovereign debt for the time being. We make an exception for Mexican sovereign debt, where spreads are attractive compared to similarly rated U.S. corporates (bottom panel). Our Emerging Markets Strategy service also thinks that the market is taking too dim a view of Mexican government finances.5 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 52 basis points in April, bringing year-to-date excess returns up to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 3% in April, and currently sits at 78% (Chart 6). This is more than one standard deviation below its post-crisis mean and slightly below the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) outperformed short-dated munis (2-year and 5-year) dramatically last month, but yield ratios at the long end remain well above those at the short end of the curve (panel 2). In other words, the best value in the municipal bond space continues to be found at the long-end of the Aaa muni curve. We showed in a recent report that lower-rated and shorter-maturity munis are much less attractive.6 First quarter GDP data revealed that state & local government tax revenues snapped back sharply in Q1, following a contraction in 2018 Q4. Meanwhile, current expenditures actually ticked down. Incorporating an assumption for Q1 corporate tax revenues, we forecast that state & local government interest coverage jumped to 16% in Q1 from 4% in 2018 Q4.7  This is consistent with municipal ratings upgrades continuing to outpace downgrades for the time being (bottom panel). Treasury Curve: Adopt A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in April. The 2/10 Treasury slope steepened 10 bps on the month and currently sits at 21 bps (Chart 7). The 5/30 slope steepened 7 bps on the month and currently sits at 60 bps. In recent reports we have urged investors to adopt barbell positions along the yield curve. In particular, investors should avoid the 5-year and 7-year maturities and instead focus their allocations at the very short and long ends of the curve.8 There are three main reasons to prefer a barbell positioning. First, the 5-year and 7-year yields are most sensitive to changes in our 12-month discounter. In other words, those yields fall the most when the market prices in rate cuts and rise the most when it prices in rate hikes. With recession likely to be avoided this year, the market will eventually price rate hikes back into the curve. Second, barbells currently offer a yield pick-up relative to bullets. The duration-matched 2/10 barbell offers 8 bps more yield than the 5-year bullet (panel 4), and the duration-matched 2/30 barbell offers 5 bps more yield than the 7-year bullet. This means that investors will earn positive carry in barbell positions while they wait for rate hikes to get priced back in. Finally, almost all barbell combinations look cheap according to our yield curve fair value models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 81 basis points in April, bringing year-to-date excess returns up to +157 bps. The 10-year TIPS breakeven inflation rate rose 13 bps on the month and currently sits at 1.91% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.02%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. As we noted in a recent report, the Fed has clearly pivoted to a more dovish stance in an effort to re-anchor inflation expectations at levels more consistent with its 2% target.9 This change should support wider TIPS breakevens, though investors will also need to see evidence of firming realized inflation before meaningful upside materializes. So far, such evidence is in short supply. Year-over-year core PCE inflation dipped to 1.55% in March. However, as Fed Chair Powell went out of his way to mention in last week’s press conference, core PCE was dragged down by one-off adjustments in the ‘Clothing & Footwear’ and ‘Financial Services’ components. In fact, 12-month trimmed mean PCE inflation actually moved up in March. It now sits at 1.96%, just below the Fed’s target (bottom panel). The combination of a dovish Fed and above-trend economic growth should push TIPS breakevens higher over time. Maintain an overweight allocation to TIPS versus nominal Treasuries. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in April, bringing year-to-date excess returns up to +49 bps. The index option-adjusted spread for Aaa-rated ABS narrowed one basis point on the month and, at 32 bps, it remains close to its all-time low (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 40 basis points in April, bringing year-to-date excess returns up to +187 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level but somewhat higher than levels seen last year (Chart 10). In a recent report, we noted that non-agency CMBS offer the best risk/reward trade-off of any Aaa-rated U.S. spread product.10 While we remain cautious on the macro outlook for commercial real estate, noting that prices are decelerating (panel 3) and banks are tightening lending standards (panel 4) amidst falling demand (bottom panel), we view elevated CMBS spreads as providing reasonable compensation for this risk for the time being. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in April, bringing year-to-date excess returns up to +95 bps. The index option-adjusted spread tightened 2 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 25 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Image Image Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of April 30, 2019) The Fed's Inflation Dictionary The Fed's Inflation Dictionary 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 April 30, 2019) The Fed's Inflation Dictionary The Fed's Inflation Dictionary 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 +56 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 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Fed's Inflation Dictionary The Fed's Inflation Dictionary Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A High Bar For Rate Cuts”, dated April 30, 2019, available at usbs.bcaresearch.com 5 Please see Emerging Markets Strategy Special Report, “Mexico: The Best Value In EM Fixed Income”, dated April 23, 2019, available at ems.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 7 Corporate tax revenue is not released until the second GDP estimate. We assume that the 2019 Q1 value equals the 2018 Q4 value. 8 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Feature This week, instead of our regular Weekly Report, we will answer clients’ most frequently asked questions (FAQs) from our recent marketing trip to the old continent. Table 1 lists these questions and below we will attempt to weave a cohesive piece and answer all of these interesting questions. Clients inquiring about “how is everyone else positioned” or the related “what is the general investor sentiment like” is by far the most FAQ we always get from the road and we purposefully omit it from Table 1. Table 1Most FAQs From The Road 10 Most FAQs From The Road 10 Most FAQs From The Road During our last three developed markets (DM) trips, while we cannot comment on the positioning question, with regard to general investor sentiment, Australia and New Zealand are off the charts bullish. On the opposite end of the spectrum, Europe is extremely bearish, especially continental Europe. The U.S. is somewhere in the middle. Chart 1Fed’s Pivot On Display Fed’s Pivot On Display Fed’s Pivot On Display With that out of the way, the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate took center stage in our client interactions, especially the implications of the inversion for sector positioning and the duration of the business cycle. To set the record straight, a yield curve inversion does not forecast recession. Instead, it explicitly signals that the market expects the Fed’s next move to be an interest rate cut (top panel, Chart 1). In that context, the yield curve has never had a false-positive reading. Even in May 1998, it accurately forecast that the Fed would decrease the fed funds rate as it actually did in the fallout of the LTCM meltdown later that year (bottom panel, Chart 1). As equity investors, what consumes us is the SPX’s performance following the yield curve inversion. On that front, mid-December last year we showed the results of our research and made a simple observation that the yield curve inversion almost always takes place prior to the S&P peak (Table 2, Charts 2 & 3). Table 2Yield Curve Inversions And S&P 500 Peaks 10 Most FAQs From The Road 10 Most FAQs From The Road Chart 2 Chart 3…And Then The SPX Peaks …And Then The SPX Peaks …And Then The SPX Peaks In addition, today we show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in Table 3. Table 3Sector Returns From Y/C Inversion To SPX Peak 10 Most FAQs From The Road 10 Most FAQs From The Road While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Meanwhile, Table 4 highlights sector performance from the SPX peak until the U.S. recession hits. We first showed these results on May 22, 2018, and we are on track to publish a Special Report on May 5 on how to position portfolios at the onset of a Fed easing cycle, so stay tuned. Table 4Defensive Stocks Beat Late 10 Most FAQs From The Road 10 Most FAQs From The Road Investors remain infatuated with the recession signal that the yield curve inversion emits. Moreover, recent news of an onslaught of Unicorn IPOs that would bring stock supply to the equity market, near the $100bn mark on an annualized basis according to some estimates, have also brought forward recession fears, as smart money is cashing in on their investments. Chart 4 shows that $100bn per annum in IPOs has coincided with the SPX peak in the previous two cycles. Our long-held view remains that either a mega M&A deal in the tech or biotech space or Uber’s IPO at a stratospheric valuation could serve as the anecdote that confirms the current cycle’s peak. On the yield curve front specifically, the top panel of Chart 5 shows that the most important yield curve, the 10/2, has not yet inverted. Moreover, the 30/10 and the 30/5 slopes are steepening. True, we are late cycle, but we need all the slopes to invert to get a confirmation that the recession is a foregone conclusion. Chart 4Mind The Excess Supply Mind The Excess Supply Mind The Excess Supply Chart 510/2 Y/C Has Yet To Invert 10/2 Y/C Has Yet To Invert 10/2 Y/C Has Yet To Invert The Fed’s tightening cycle has not only inverted most parts of the yield curve starting early last December, but has inflicted some damage on profit margins. Following up from our recent profit margin work highlighting nil corporate pricing power at a time when wage costs are perking up, BCA’s Monetary Indicator signals more SPX margin pain in the coming months (Chart 6). In fact, sell-side estimates call for another three consecutive quarters of a year-over-year contraction in profit margins. Chart 6Margin Trouble Margin Trouble Margin Trouble In more detail, the earnings deceleration that commenced in Q4 2018 and is gaining steam is disconcerting. As a reminder, Q4 included the lower corporate tax rate and the Q/Q deceleration is not solely due to the tech sector profit warnings. Eight out of the 11 GICS1 sectors sharply decelerated, two modestly accelerated and only industrials steeply accelerated to a cyclical EPS peak growth rate (Table 5). This EPS breadth deterioration is eerily reminiscent of early-2015 (Chart 7) and is disquieting. Short-term caution is also warranted given the increase in investor complacency. The one sided positioning in the VIX futures market is worrisome. As a reminder, net speculative positions are now at a lower low than the February 2018 level when the VIX snapped to over 50 and caused a massive tremor in the equity market (net speculative positions shown inverted, Chart 8). Table 5Historical/Current/Future Earnings Growth Rates 10 Most FAQs From The Road 10 Most FAQs From The Road Chart 7Bad Breadth Bad Breadth Bad Breadth Chart 8Too Complacent Too Complacent Too Complacent But, before getting overly bearish there are some growth green shoots that suggest that Q2-to-Q3 will likely mark the trough in EPS/EBITDA growth and margins (Chart 9). Beyond these positive leading profit indicators, a resolution to the U.S./China trade tussle and China’s trifecta of policy easing measures will also aid in turning profit growth around and really power up U.S. cyclicals’ EPS growth rates. Following up from the January Fed meeting, on February 4 we penned a report titled “Don’t Fight The PBoC” and it is now clear with the recent manufacturing PMI release that China’s easing on all three fronts – credit (Chart 10), monetary (Chart 11) and fiscal (Chart 12) – is starting to pay some dividends. In that light, the U.S. cyclicals vs. U.S. defensives recent outperformance has more room to run. Chart 9Growth Green Shoots Growth Green Shoots Growth Green Shoots Chart 10Chineasing… Chineasing… Chineasing… Chart 11...On All… ...On All… ...On All… Chart 12…Fronts …Fronts …Fronts   Deep cyclicals have another major advantage this cycle compared with defensives. While at this stage of the business cycle one would expect capital intensive businesses to become debt saddled, cyclicals are still de-levering from the depths of the late-2015/early-2016 manufacturing recession, i.e. paying down debt and increasing cash flow. Defensives, however, are doing the exact opposite with relative cash flow growth problems and piling on debt. Thus, on a relative basis Chart 13 shows that the indebtedness profile clearly favors deep cyclicals vs. defensives. From a bigger picture perspective, while the U.S. has not really purged any debt and it has just shifted it around from the financial and household sectors to the non-financial business and government sectors (Chart 14), the near all-time high in non-financial business sector credit as a share of GDP is disconcerting (top panel, Chart 14). Clearly the excesses are in this segment of U.S. debt and it is unsurprising that debt saddled stocks have been underperforming equities with pristine balance sheets since the 2016 presidential elections (top panel, Chart 15). Such outperformance has staying power, especially given that we are late in the cycle and the Fed has raised interest rates to the point where parts of the yield curve are inverted and a default cycle looms large (bottom panel, Chart 15). Chart 13Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Chart 14U.S. Debt Profile Breakdown U.S. Debt Profile Breakdown U.S. Debt Profile Breakdown One sub-sector that epitomizes the current cycle’s excesses is commercial real estate (CRE). CRE prices have overshot the historical time trend by almost two standard deviations and it has already been three and a half years since they surpassed the previous all-time high (Chart 16). The recent pullback in the 10-year Treasury yield has pushed cap rates even lower and the bubble in CRE is further inflated. Looking back at the late-1980s pricking of that CRE bubble is instructive and when this cycle ends a big deflationary impulse will likely deal a blow to the CRE market.       Chart 15Hide In Pristine Balance Sheets Hide In Pristine Balance Sheets Hide In Pristine Balance Sheets Chart 16CRE Excesses Are A Yellow Flag CRE Excesses Are A Yellow Flag CRE Excesses Are A Yellow Flag Speaking of bubbles, the biggest bubble we currently see is not in equities, but in bonds. Table 6 shows that red is taking over and is reminiscent of mid-year 2016 when the 10-year U.S. Treasury yield troughed a hair above 1.3%. Globally, negative yielding debt is near all-time highs (Chart 17) and the excesses are even larger in the EM sovereign space and in select DM corporates. Mexico raising century debt in U.S. dollars, in cable and in euros is perplexing, as Mexico was at the epicenter of the 1982 LatAm crisis and again in 1994 with the Tequila crisis. Argentina also raising century debt recently in hard currency speaks to the magnitude of the current bond bubble. On the corporate side, Sanofi and LVMH placing negative yielding debt is beyond our understanding, or Total issuing a perpetual bond with a 1.75% coupon. Table 6Red Takes Over 10 Most FAQs From The Road 10 Most FAQs From The Road   Chart 17Bonds Are In A Bubble Bonds Are In A Bubble Bonds Are In A Bubble All of this is likely linked to the unintended consequences of global QE where fixed income investors are pushed out the risk spectrum and are forced into buying riskier credit. When this bond bubble gets pricked it will end in tears as it always does and the catalyst will likely be the next U.S. recession that will cause a global recession. While our cyclical 9-to-12 month equity market view is constructive and we believe the U.S. will avoid recession, our structural 1-to-3 year view is negative. Nevertheless, we constantly challenge our thesis and the biggest pushback to the negative structural view is the following: What if the Fed can engineer a soft landing in the U.S. as it did twice in the mid-1990s, and the business cycle runs hot for another 5 years (Chart 18)? What if the starting point of low interest rates with the real fed funds rates still close to zero is very stimulative for the U.S. economy as no recession has ever started with a fed funds rate perched near zero (Chart 19)? Finally, what if the late-2015/early-2016 manufacturing recession was actually an economic recession despite the fact that the NBER did not designate it as such and the business cycle got reignited, especially with President Trump’s election that lifted animal spirits? As a reminder, while S&P profits have contracted outside of an economic recession twice before, SPX sales had never achieved that feat, until late-2015/early-2016 (Chart 20). In other words, the revenue recession we had was unprecedented and felt like an economic recession. Chart 18The Fed Has Engineered A Soft Landing The Fed Has Engineered A Soft Landing The Fed Has Engineered A Soft Landing Chart 19Stimulative Real Rates Stimulative Real Rates Stimulative Real Rates Chart 20There Is Always A First Time There Is Always A First Time There Is Always A First Time If that were the case and the cycle were to extend into the 2020s, then the risk is that SPX EPS vault to $200 and valuations overshoot, i.e. the forward P/E multiple spikes to a 20 handle and the SPX catapults to 4,000. In that case, we would leave 1,000 points on the table and our SPX 3,000 view would be way offside. While this is a risk to our negative structural view, there are two sectors we really like for the long-term as we deem them secular growth plays and should do exceptionally well on a 10-year horizon: software and defense stocks. Three key drivers underpin our bullish view on software: galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A (Chart 21). Most importantly, the move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are in a structural uptrend. With regard to defense stocks, the three key pillars we highlighted in our “Brothers In Arms” Special Report on October 31, 2016 remain intact: the global rearmament is still gaining steam, a space race with manned missions to the moon now includes the U.S., China and India, and cybersecurity is a real threat for governments around the world (Chart 22). On all three fronts, defense stocks stand to benefit as they have beefed up their offerings to provide governments with a one-stop shop solution covering most of these needs. Chart 21Buy The Software Breakout Buy The Software Breakout Buy The Software Breakout Chart 22Defense Stocks Remain A Long-term Buy Defense Stocks Remain A Long-term Buy Defense Stocks Remain A Long-term Buy     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com

Highlights Chart 1What’s The Downside? What’s The Downside? What’s The Downside? How low can it go? This is the question most investors are asking these days about the 10-year Treasury yield. Our answer is that it can’t go much lower unless the U.S. economy falls into recession, an event we don’t anticipate in 2019. Considering the main macro drivers of the 10-year Treasury yield, we find that the Global Manufacturing PMI (Chart 1), U.S. dollar bullish sentiment (not shown) and Global Economic Policy Uncertainty (not shown) are all close to mid-2016 levels. In other words, the economic growth and policy environment is almost identical to the one that produced a 1.37% 10-year Treasury yield in mid-2016. What’s preventing a return to mid-2016 yield levels is that the Fed has delivered nine rate hikes since then, and rising wage growth confirms that the output gap has closed considerably (bottom panel). In other words, with short-maturity yields much higher than three years ago, we would need to see a much more pronounced growth slowdown, i.e. PMIs well below 50, to re-produce a sub-2% 10-year Treasury yield. If 2019 continues to follow the 2016 roadmap and the Global PMI bottoms-out around 50, then the 10-year Treasury yield has probably already found its floor. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 24 basis points in March, bringing year-to-date excess returns up to +268 bps. The Federal Reserve’s pause opens a window for corporate spreads to tighten during the next few months. We recommend overweight positions in corporate bonds for now, but will be quick to reduce exposure once spreads reach our near-term targets. Aaa spreads are already below target levels and we recommend avoiding that credit tier. Other credit tiers still have room to tighten, though Aa and A-rated bonds are only 3 bps and 5 bps above target, respectively (Chart 2).1 Once spreads reach more reasonable levels for this phase of the cycle, we will be quick to reduce corporate bond exposure because some indicators of corporate default risk are already sending warning signals.2 Most notably, corporate profits grew only 4.0% (annualized) in Q4 2018 while corporate debt rose 5.3% (annualized). The result is that our measure of gross leverage ticked higher for the first time since Q3 2017 (bottom panel). Going forward, with corporate profit growth likely to stabilize in the mid-single digit range, gross leverage will probably stay close to its current level. That would be consistent with a 3% speculative grade default rate, significantly above the 1.7% rate currently projected by Moody’s. Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview   Chart Chart High-Yield: Overweight High-Yield underperformed the duration-equivalent Treasury index by 23 basis points in March, dragging year-to-date excess returns down to +566 bps. Junk spreads for all credit tiers remain above our near-term spread targets.3 At present, the Ba-rated option-adjusted spread is 235 bps, 55 bps above our target. The B-rated spread is 285 bps, 102 bps above our target. The Caa-rated spread is 802 bps, 244 bps above our target (Chart 3). Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Elevated spreads mean that investors are currently well compensated for default risk, but that could change later in the year. In a recent report we showed that some leading default indicators – gross leverage, C&I lending standards and job cut announcements (bottom panel) – are showing signs of deterioration.4 Specifically, our model suggests that the speculative grade default rate could be 3% or higher during the next 12 months. Moody’s currently forecasts 1.7%. If the Moody’s forecast is correct, the high-yield default adjusted spread is 306 bps. If the Moody’s forecast turns out to be correct, then investors will take home a default-adjusted spread of 306 bps, well above the historical average of 250 bps. If our 3% forecast is correct, then the default-adjusted spread falls to 230 bps, slightly below the historical average (panel 4). In either case, investors are reasonably well compensated for bearing default risk, but that will change when spreads reach our near-term targets. We will be quick to cut exposure at that time. MBS: Neutral Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in March, dragging year-to-date excess returns down to +27 bps. The conventional 30-year zero-volatility spread widened 3 bps on the month, driven entirely by an increase in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) held flat at 40 bps. Falling mortgage rates since the beginning of the year have caused an increase in refinancing activity, leading to some widening in nominal MBS spreads (Chart 4). However, the tepid pace of new issuance in recent years means that the existing mortgage stock is not very exposed to refinancing risk. Consider that, despite an 80 bps drop in the 30-year mortgage rate, the MBA Refinance index has only risen to 1290. The Refi index’s historical average is 1824. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Further, housing starts and new home sales appear to have stabilized, meaning that there is probably not much further downside for mortgage rates. As a consequence, we don’t see much more scope for MBS spread widening. While MBS spreads appear relatively safe, the sector does not offer attractive expected returns compared to the investment alternatives. For example, the index option-adjusted spread for conventional 30-year MBS is well below its average historical level (panel 3) and the sector offers less compensation than normal compared to corporate bonds (panel 4). MBS also offer a poor risk/reward trade-off compared to other Aaa-rated spread products, as we showed in a recent report.5   Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 23 basis points in March, bringing year-to-date excess returns up to +115 bps. Sovereign debt outperformed duration-equivalent Treasuries by 13 bps on the month, bringing year-to-date excess returns up to +334 bps. Local Authorities outperformed the Treasury benchmark by 53 bps and Foreign Agencies outperformed by 42 bps, bringing year-to-date excess returns up to +139 bps and +151 bps, respectively. Domestic Agencies outperformed by 11 bps in March, bringing year-to-date excess returns up to +20 bps. Supranationals outperformed by 4 bps, bringing year-to-date excess returns up to +16 bps. The USD-denominated sovereign debt of most countries continues to look expensive relative to equivalently-rated U.S. corporate credit. However, in a recent report we highlighted that Mexican sovereign debt is an exception (Chart 5).6 Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Not only is Mexican sovereign debt cheap relative to U.S. corporates, but our Emerging Markets Strategy service has shown that the Mexican peso is cheap.7 The prospect of a stronger peso versus the U.S. dollar makes the spread on offer from Mexican sovereign debt look even more attractive.   Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 39 basis points in March, dragging year-to-date excess returns down to +52 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 1% in March, and currently sits at 82% (Chart 6). This is more than one standard deviation below its post-crisis mean and right around the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview The Municipal / Treasury yield ratio for short maturities (2-year and 5-year) remains well below the yield ratio for longer maturities (10-year, 20-year and 30-year). In other words, the best value in the municipal bond space is at the long-end of the curve, and we continue to recommend that investors favor those maturities. Recently released data from the Bureau of Economic Analysis shows that state & local government revenue growth declined in Q4 2018, for the first time since Q2 2017. As a result, our measure of state & local government interest coverage fell from a lofty 17 all the way down to 5 (bottom panel). Positive interest coverage means that state & local governments are still generating sufficient revenue to cover current expenditures and interest payments, and we therefore don’t anticipate a surge in muni ratings downgrades any time soon. We also continue to note that municipal bonds tend to perform better in the middle-to-late phases of the economic cycle, while corporate credit delivers its best returns early in the recovery.8 Investors should maintain an overweight allocation to municipal debt. Treasury Curve: Adopt A Barbell Curve Positioning Treasury yields fell dramatically in March, as the Fed surprised markets with a larger-than-expected downward revision to its interest rate projections. The result is that the overnight index swap curve is now priced for 34 basis points of rate cuts over the next 12 months (Chart 7). Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The 2/10 Treasury slope flattened 7 bps to end the month at 14 bps. The 5/30 slope steepened 1 bp to end the month at 58 bps. In recent reports we urged investors to adopt barbell positions along the yield curve. In particular, investors should avoid the 5-year and 7-year maturities and instead focus their allocations at the very short and long ends of the curve.9 There are three main reasons to prefer a barbell positioning. First, the 5-year and 7-year yields are most sensitive to changes in our 12-month discounter. In other words, those yields fall the most when the market prices in rate cuts and rise the most when it prices in rate hikes. As long as recession is avoided, the market will eventually price rate hikes back into the curve. Favor the 2/30 barbell over the 7-year bullet. Second, barbells currently offer a yield pick-up relative to bullets. The duration-matched 2/10 barbell offers 10 bps more yield than the 5-year bullet (panel 4), and the duration-matched 2/30 barbell offers 9 bps more yield than the 7-year bullet. This means that investors will earn positive carry in barbell positions while they wait for rate hikes to get priced back in. Finally, all barbell combinations look cheap according to our yield curve fair value models (see Appendix B). TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 44 basis points in March, dragging year-to-date excess returns down to +76 bps. The 10-year TIPS breakeven inflation rate fell 7 bps to end the month at 1.88% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate fell 8 bps to end the month at 1.98%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. Chart 8Inflation Compensation Inflation Compensation Inflation Compensation As we noted in last week’s report, with financial conditions no longer excessively easy, the Fed has pivoted to a more dovish stance in an effort to re-anchor inflation expectations at levels more consistent with its 2% target.10 This change should support wider TIPS breakevens, though investors will also need to see evidence of firming realized inflation before meaningful upside materializes. So far, such evidence is in short supply. Note that trimmed mean PCE inflation has rolled over again after having just touched 2% (bottom panel). Trimmed mean PCE is running at 1.84% year-over-year. Nevertheless, we would maintain an overweight allocation to TIPS versus nominal Treasuries. First, our commodity strategists see further upside in the price of oil (panel 2), and second, the 10-year TIPS breakeven inflation rate is 6 bps too low relative to the fair value from our Adaptive Expectations model (panel 4).11 ABS: Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in March, bringing year-to-date excess returns up to +40 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and currently sits at 34 bps, exactly equal to its pre-crisis low (Chart 9). Chart 9ABS Market Overview ABS Market Overview ABS Market Overview We showed in a recent report that Aaa-rated consumer ABS offer a relatively poor risk/reward trade-off compared to other U.S. fixed income sectors, a result that is echoed by the Excess Return Bond Map in Appendix C.12 This should not be surprising given that Aaa ABS spreads are close to all-time lows. What is surprising is that ABS spreads are so tight while the consumer delinquency rate is rising (panel 3). Although the delinquency rate remains well below pre-crisis levels, it will likely continue to rise going forward. Household interest payments are rising quickly as a share of disposable income (panel 3) and banks are tightening lending standards for both credit cards and auto loans (bottom panel). We recommend an underweight allocation to consumer ABS, preferring to take Aaa spread risk in MBS and CMBS. Non-Agency CMBS: Neutral Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in March, bringing year-to-date excess returns up to +146 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps to end the month at 73 bps, below its average pre-crisis level but somewhat higher than recent tights (Chart 10). Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview In a recent report we noted that non-agency CMBS offer the best risk/reward trade-off of any Aaa-rated U.S. spread product.13 While we remain cautious on the macro outlook for commercial real estate, noting that prices are decelerating (panel 3) and banks are tightening lending standards (panel 4) amidst falling demand (bottom panel), we view elevated CMBS spreads as providing reasonable compensation for this risk for the time being. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 2 basis points in March, dragging year-to-date excess returns down to +74 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 50 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 34 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Image Image Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +53 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 53 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of March 29, 2019) Finding The Floor Finding The Floor Table 5Butterfly Strategy Valuation: Standardized Residuals (As of March 29, 2019) Finding The Floor Finding The Floor Table 6Discounted Slope Change During Next 6 Months (BPs) Finding The Floor Finding The Floor Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 For further details on how we arrive at those spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 3 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 11 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 13 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights The yield curve has inverted: The 10-year Treasury bond yield fell below the 3-month T-bill rate following the March FOMC meeting and has remained there since. We never say it’s different this time, but there is not yet sufficient evidence to change course: The yield curve is almost always early as a standalone signal, and the depressed term premium may make it less sensitive right now. Monetary policy still looks decidedly accommodative to us, … : Our estimate of the equilibrium fed funds rate says policy’s easy, and that it’ll stay that way until the Fed gets serious about hiking rates again. … so asset allocation should continue to favor risk assets: There are global forces restraining Treasury yields, but the fed funds rate cycle is only partway through a stretch that has been uniformly unfavorable for Treasuries. Feature Last week’s data were soft, as the U.S. economy continues to show signs of decelerating. The consumer confidence survey disappointed hopes for an extended bounce back from January’s shutdown-shadowed release, housing starts were uninspiring, and the Case-Shiller index revealed that home-price gains continue to sag. Beyond the U.S., the message from manufacturing PMIs is glum, although the services sector seems to be holding up just fine. Our traveling colleagues report that investors around the world have developed a decided aversion to European assets. We remind our clients that deceleration is nothing new. It’s been the story so far this year, as the incremental decline in fiscal thrust ensured it would be. The inversion of the yield curve is new, however, and it’s commanding attention from the financial media and from investors drawn to a leading indicator that consistently works. We like the yield curve, too, and it’s one of the three components of our recession indicator, but it’s only one. The other two components have yet to confirm its message, and the way things look now, it may well be awhile before they do. The Yield Curve Has Inverted, The Yield Curve Has Inverted The 3-month-to-10-year segment of the yield curve inverted after the March FOMC meeting, and it dipped a little further into negative territory last week as the 10-year Treasury yield continued to melt. An inverted curve is one of the three components of our simple recession indicator,1 and we believe it can send an important signal about the economy’s vigor and the state of monetary policy. By itself, however, an inverted curve is not a sufficient precondition for a recession. It has also been something less than a timely guide to asset allocation, inverting a year ahead of a recession, on average, and six months before the S&P 500 peaks (Table 1). The yield curve has been a reliable recession warning signal, but it tends to be too early to serve as a practical guide to money management and asset allocation. Table 1Inverted Yield Curves, 1968 - 2018 Keep Calm And Carry On Keep Calm And Carry On   An inverted yield curve has called eight of the seven recessions that have occurred over the last 50 years, making it a dependable leading indicator (Chart 1). Year-over-year contraction in the Conference Board’s Leading Economic Index (LEI) has compiled the same enviable track record, calling all seven of the last half-century’s recessions with just one false positive (Chart 2). LEI tends to be timelier, however, sounding the alarm an average of five months after the curve inverts (Table 2). For our recession indicator, we also add a comparison of the fed funds rate to our estimate of the equilibrium fed funds rate, because recessions have only occurred when the fed funds rate has exceeded our estimate of the equilibrium rate (Chart 3). Chart 1The Yield Curve Has Been Reliable, Albeit Early The Yield Curve Has Been Reliable, Albeit Early The Yield Curve Has Been Reliable, Albeit Early Chart 2LEI Has Been Timelier LEI Has Been Timelier LEI Has Been Timelier Table 2LEI Contractions, 1968 - 2018 Keep Calm And Carry On Keep Calm And Carry On   The cycle is extended, and the inverted curve has made us even more alert for trouble in the economy and financial markets, but we do not think trouble is imminent. The LEI is clearly decelerating, but it has yet to contract. We currently peg the equilibrium fed funds rate at about 3⅛%, and project that it will rise to 3⅜% by the end of the year. We can’t know the equilibrium rate with exact precision in real time, but our estimate has been a reliable guide to financial market performance, and the fact that the fed funds rate is four 25-basis-point hikes from crossing the line gives us some comfort that neither a recession nor a bear market is waiting just around the corner. Chart 3Recessions Only Occur When Policy Is Tight Recessions Only Occur When Policy Is Tight Recessions Only Occur When Policy Is Tight Bottom Line: We are not dismissing the inverted yield curve, but our other recession-indicator inputs are not confirming its warning. Given the Fed’s new guidance, we expect that the next recession will not arrive before mid-to-late 2020. It’s A Little Bit Anomalous This Time At its best, an inverted yield curve is a signal from the bond market that the Fed has tightened monetary policy too much, heralding future rate cuts and a sharp slowdown. Anything affecting yields at the long end, however, has the potential to skew the curve’s signal. If long yields were somehow inflated, the curve would be less prone to invert and the signal would be delayed. If long yields were restrained, the curve would be prone to invert sooner and the signal might come especially early. Rate hikes invert the curve once the bond market decides they’re unnecessary, or expects that they’re going to be reversed soon. We believe that the yield curve currently has a bias to invert even earlier than it otherwise would. The question of how much the Fed’s asset purchases have affected the term premium,2 if at all, is far from settled within either the Fed or BCA, and is beyond the scope of this report. Nonetheless, we do think that QE1, QE2, and QE3 must have made some contribution to the decline in the term premium on long-term bonds (Chart 4). The bottom line is that we think the curve was disposed to invert earlier this time around. Its signal is still worth incorporating into our analysis, but we will seek confirmation from our other recession indicators before revamping our asset-allocation recommendations in line with an approaching inflection point in the business cycle. Chart 4The Curve Inverts More Easily When The Term Premium Is Negative The Curve Inverts More Easily When The Term Premium Is Negative The Curve Inverts More Easily When The Term Premium Is Negative The Fed And The Yield Curve We subscribe to the idea that the Fed induces recessions by removing monetary accommodation in an attempt to keep the economy from overheating. It’s simply too difficult to achieve a soft landing with policy tools that influence activity indirectly and with long and variable lags, given that the dual-mandate metrics are themselves lagging indicators. Compared to the path by which the Fed influences the economy, the path by which it inverts the curve is simple and straightforward. It raises short rates, and the long end rises as well, as the bond market discounts higher inflation and/or stronger growth, until investors no longer believe that inflation or growth prospects merit tighter policy, and long rates fall behind short rates. We reviewed moves in 10-year yields and 3-month rates across the different phases of the fed funds rate cycle (Chart 5) to see how the process has unfolded empirically. As the mechanics of yield curve inversion imply – short rates rise, long rates rise less or fall – the curve bear flattens when the Fed hikes the fed funds rate, and bull steepens when it cuts it (Table 3). The outcome fits the intuition: if the Fed’s attempt to slow the economy with higher short rates is successful, real interest rates will decline, inflation pressure will ease and bond yields should fail to keep pace with bill rates, especially if investors associate tightening campaigns with recessions. Conversely, if the Fed successfully boosts the economy with lower short rates, bond yields should fall less than short rates as the real component of rates rises, and the curve should steepen. Chart 5 Table 3The Yield Curve And The Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Depicting our stylized fed funds rate as a bell curve makes for an appealing picture, but it obscures the fact that the Fed often pauses for a while after hiking rates to their cyclical peak, or cutting them to their cyclical trough. Phase II doesn’t end until the beginning of the next rate-cutting campaign, and Phase IV doesn’t end until the beginning of the next series of rate hikes. A stricter representation of the fed funds rate cycle would have two phases of active hiking, followed by a state of limbo between the last hike and the first cut, then two phases of active cutting, followed by a lull during which the Fed waits for signs that it should remove accommodation. The expanded fed funds rate cycle is therefore composed of active hiking in Phase I and Phase II(a), pre-easing in Phase II(b), active easing in Phase III and Phase IV(a), and pre-hiking in Phase IV(b). Table 4 shows the average monthly changes in the yield curve and its components in the expanded fed funds rate cycle. There is quite a difference between Phase II(a), when the curve aggressively bear flattens, and Phase II(b), when the curve modestly bull flattens. Phase IV(a) features a sharp bull steepening, while the long end drifts higher in Phase IV(b) and short rates barely budge. Ultimately, the real action happens when the Fed is actively adjusting monetary policy, and the duration positioning implications are quite sensitive to the transitions into and out of the active phases. Table 4The Yield Curve And The Expanded Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Bonds And The Fed Funds Rate Cycle An inverted yield curve has provided a reliable early-warning signal about recessions, but it can be too early to drive asset-allocation decisions for a manager judged on relative returns. The curve moves in Tables 3 and 4 offer more timely implications for duration positioning within fixed-income portfolios across the fed funds rate cycle. It comes as no surprise that Treasuries perform better when the Fed is cutting rates (Phases III and IV) than they do when the Fed is hiking them (Phases I and II). Their returns should be inversely correlated with the direction of rates, and longer-maturity instruments should exhibit greater sensitivity to changes in the fed funds rate (Table 5). Table 5Treasuries And The Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Overweight duration within bond portfolios from when the Fed stops hiking rates until it stops cutting them; underweight duration when it’s actively hiking. Expanding the fed funds rate cycle to account for active hiking, active easing, and the pre-hiking/pre-cutting limbo periods makes the duration-positioning road map clearer. Treasuries lose ground in real terms when the Fed is actively hiking, with longer-maturity instruments bearing the brunt (Table 6). They deliver in a big way when the Fed is actively easing (Phase III and Phase IV(a)), with the Barclays Bloomberg Long Treasury Index posting double-digit annualized total returns. Longer Treasuries shoot out the lights once the Fed stops hiking (Phase II (b)), and they generate real total returns that compare favorably with bull-market equities when aggregating Phase II(b)’s pre-easing results with active-easing Phases III and IV(a). Table 6Treasuries And The Expanded Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Our terminal and equilibrium fed funds rate estimates are admittedly far from the consensus. Markets are skeptical of the FOMC’s one-more-hike projection, much less our three, four, or more terminal-rate call. With “secular stagnation” searches ascendant on Google Trends (as of Friday morning, the partially complete March 24-30 period already had the most searches of any week over the last twelve months), our equilibrium estimate is also surely out of step with the herd. If the Fed is not done, however, history says it’s not yet time to overweight duration. If we’re right, Treasuries still have the full Phase II(a) ahead of them, and won’t be a buy until the Fed desists, sometime in 2020 or beyond. Investment Implications We have taken note of the inverted yield curve, but we will not overreact to it. While it has been a reliable recession indicator for the last half-century, it consistently sounds the alarm too early to merit immediate investment action. Neither the LEI nor our equilibrium fed funds rate model has yet corroborated its warning, and the bombed-out term premium may have biased it to inverting even sooner than it otherwise would. There’s no need for Paul Revere to ready his horse just yet. We did not anticipate that the 10-year Treasury yield would decline as much as it has. The extent of the Fed’s dovishness caught us off guard, and the 10-year Treasury is having a very hard time escaping the gravity of the decline in major-economy sovereign yields around the world. Our Global Fixed Income Strategy service (GFIS) points out that the global yield decline has become extended (Chart 6), and it contends that global bond prices incorporate too much pessimism about global economic momentum. The GFIS team also notes that there’s no guarantee stock prices will fall to align with bond yields – over the last couple years, stocks and bonds have recoupled following yield scares via bond, not equity, sell-offs (Chart 7). Chart 6Enough Is Enough Enough Is Enough Enough Is Enough Chart 7Equities Have Been Smarter Than Bonds The Last Few Years Equities Have Been Smarter Than Bonds The Last Few Years Equities Have Been Smarter Than Bonds The Last Few Years We therefore remain constructive on the economy and financial markets, and advise that balanced portfolios should still maintain exposure to riskier assets. Much of that view depends on Chinese authorities relaxing their deleveraging campaign, global trade tensions easing, and some hint of green shoots appearing in the rest of the world. If those elements of our base-case scenario fail to materialize, we will likely become more cautious. We are not happy that the vindication of our high-conviction view on the terminal fed funds rate has been indefinitely delayed, but the silver lining of the Fed’s dovish surprise is that the bull market in equities and other risk assets has been granted an open-ended extension.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Report, “How Much Longer Can The Bull Market Last?,” published August 13, 2018. Available at usis.bcaresearch.com. 2 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument.

Highlights Duration: None of the economic indicators that have reliably signaled peak interest rates in prior cycles are sending a signal at the moment. This leads to the inevitable conclusion that further Fed rate hikes are likely at some point before the end of the cycle. With the Fed now projecting an essentially flat path for interest rates, the next surprise from the Federal Reserve will probably be a hawkish one. Fed: The Fed is currently waging a war on two fronts. It wants to keep interest rates low enough to send inflation expectations higher, back to levels consistent with its 2% target. But it also wants to avoid excessively easy financial conditions that could threaten the sustainability of the economic recovery. We expect that easier financial conditions will cause the Fed to shift back toward a tightening bias near the end of this year. Yield Curve: Inversion of the 3-month/10-year Treasury slope is cause for concern, if it persists. But we expect it to reverse in the coming months as global growth recovers and the Fed remains accommodative. Eventually, after financial conditions have eased sufficiently, the Fed’s next move will be a hawkish surprise. Investors can profit from this move by entering positive carry yield curve trades: short the 5-year or 7-year bullet and go long a duration-matched barbell. Feature The Last Dovish Surprise Or The Beginning Of The End? Treasury yields moved sharply lower following last week’s Fed meeting, as FOMC participants made larger-than-anticipated downward revisions to their interest rate projections. As of last December, 11 out of 17 Fed members expected to lift rates at least twice in 2019. Now, 11 out of 17 expect to keep rates flat (Chart 1). Chart 1Fed Sees No Hikes This Year Fed Sees No Hikes This Year Fed Sees No Hikes This Year Judging from the bond market’s reaction, the Fed clearly managed to deliver a dovish surprise at last week’s meeting. Now, the relevant question for investors becomes whether that dovish surprise can be repeated. With the Fed signaling an essentially flat path for interest rates, a dovish surprise from these levels would involve the suggestion of rate cuts. History tells us that rate cuts are only likely to occur if the economy is headed into recession, an event that still seems relatively far off. As such, we expect that the next surprise from the Fed will be a hawkish one, and that the next large move in Treasury yields will be higher. Our conviction that the economy is not yet close to recession comes from our analysis of economic markers that have reliably signaled peak interest rates in past cycles.1 For example, one such marker is when year-over-year nominal GDP growth falls below the 10-year Treasury yield (Chart 2). At present, year-over-year nominal GDP growth is running at 5.3%. That growth rate is bound to slow during the next few quarters, but it would need to slow a lot before it falls below the current 10-year Treasury yield of 2.40%. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative GDP Growth Suggests That Monetary Policy Remains Accommodative GDP Growth Suggests That Monetary Policy Remains Accommodative The New York Fed’s GDP Nowcast projects that real GDP growth will be 1.29% in the first quarter. Incorporating 2% inflation, that is roughly 3.3% in nominal terms. If Q1 turns out to be the trough in growth for the year, it suggests that interest rates still have considerable room to rise before the economic recovery ends. Second, we have observed that peak interest rates tend to coincide with material declines in the 12-month moving averages of single-family housing starts and new home sales. While the housing data weakened somewhat in 2018, the data have rebounded sharply since mortgage rates fell near the end of last year. Housing starts have already jumped back above their 12-month moving average, as has the weekly Mortgage Application Purchase index (Chart 3). Chart 3Housing & Employment Support Higher Rates Housing & Employment Support Higher Rates Housing & Employment Support Higher Rates Finally, we have noted that peak interest rates tend to coincide with an uptrend in initial jobless claims. Much like with housing, the initial claims data sent a warning near the end of last year. But that tentative increase in claims has already reversed course (Chart 3, bottom panel). None of those historically reliable indicators suggest that we have reached peak interest rates for the cycle.  We will continue to keep a close eye on nominal GDP growth, the housing data and initial jobless claims. But all in all, none of those historically reliable indicators suggest that we have reached peak interest rates for the cycle. This leads to the inevitable conclusion that further Fed rate hikes are likely at some point and that the next surprise from the Federal Reserve will probably be a hawkish one. Given this skewed risk/reward trade-off, we recommend that investors maintain below-benchmark duration in U.S. bond portfolios on the view that the next large move in Treasury yields will be higher. The difficult part is timing when that move will occur. In the remainder of this report we provide some thoughts on how to think about that timing, and also some trade ideas that should be profitable in the meantime. The New Battleground: Inflation Expectations Vs. Financial Conditions Recent remarks from Fed Chairman Jerome Powell and other FOMC participants have made it clear that an important rationale for the Fed’s pause is a desire to re-anchor inflation expectations at a level closer to the Fed’s target. For example, here is Chairman Powell from last week’s press conference: So, if inflation expectations are below two percent, they’re always going to be pulling inflation down, and we’re going to be paddling upstream and trying to, you know, keep inflation at two percent … And here is what the Chairman said about inflation expectations in his recent congressional testimony: In our thinking, inflation expectations are now the most important driver of actual inflation. With that in mind, consider that long-maturity TIPS breakeven inflation rates have been below “well anchored” levels for pretty much the entire post-crisis period, as have long-term inflation expectations from the University of Michigan Consumer survey (Chart 4). Chart 4The Fed Wants Higher Inflation Expectations The Fed Wants Higher Inflation Expectations The Fed Wants Higher Inflation Expectations The Fed has clearly made the re-anchoring of inflation expectations a priority, meaning that we should monitor TIPS breakeven inflation rates and survey measures of inflation expectations to assess when rate hikes might re-start. However, we don’t think that higher inflation expectations are absolutely necessary before the Fed resumes hiking. Consider what Fed officials were saying as recently as December: Governor Lael Brainard on December 7, 2018:2 The last several times resource utilization approached levels similar to today, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. Chairman Powell on June 20, 2018:3 Indeed, the fact that the two most recent U.S. recessions stemmed principally from financial imbalances, not high inflation, highlights the importance of closely monitoring financial conditions.   In other words, until recently the Fed seemed more concerned with financial conditions than with inflation expectations. What changed? Quite simply, financial markets sold off and financial conditions no longer appear excessively easy (Chart 5). Chart 5The Fed Doesn’t Want An Asset Bubble The Fed Doesn’t Want An Asset Bubble The Fed Doesn’t Want An Asset Bubble The Financial Conditions component of our Fed Monitor remains “easier” than its historical average, but shows that conditions have tightened significantly since last October (Chart 5, top panel). Junk spreads have widened since last October (Chart 5, panel 2), as has the excess corporate bond risk premium after accounting for expected default risk (Chart 5, panel 3). 4 The S&P 500’s 12-month forward Price/Earnings ratio is down to 16.5, from 17 last October and a 2018 peak of 18.8 (Chart 5, bottom panel). If financial markets rally during the next few months, then it is quite possible that financial conditions will once again force the Fed’s hand. In essence, financial asset valuations appear somewhat reasonable and are not an immediate cause for concern. This means that the Fed can turn its attention toward trying to drive inflation expectations higher. However, if financial markets rally during the next few months, then it is quite possible that financial conditions will once again force the Fed’s hand. The Outlook For Financial Conditions & Global Growth The Fed’s dovish policy shift should support a rally in risk assets in the coming months, though such a rally may also require evidence of improvement in global growth. Right now that evidence is scant. March Flash PMIs for the U.S. and Eurozone both fell last week, while Japan’s stayed flat below the 50 boom/bust line. This means that the Global Manufacturing PMI’s downtrend will almost certainly continue when the final March data are released next week (Chart 6). Chart 6Global Growth Is Weak ... Global Growth Is Weak ... Global Growth Is Weak ... However, while the coincident PMI data continue to soften, we have recently noticed some green shoots in leading global growth indicators (Chart 7). Chart 7... But Leading Indicators Are Improving ... But Leading Indicators Are Improving ... But Leading Indicators Are Improving First, our Global Leading Economic Indicator (LEI) Diffusion Index has moved above 50%, meaning that a majority of countries are seeing improvement in their LEIs for the first time since early 2018 (Chart 7, top panel). Second, our China Investment Strategy service’s Li Keqiang Leading Indicator – a composite of six indicators of Chinese money and credit growth – has stabilized. While a 2016-style surge in credit growth is unlikely, even a stabilization in this leading indicator will help prop up global growth in 2019 (Chart 7, panel 2). We do not think that 3-month/10-year curve inversion will last very long.  Finally, the CRB Raw Industrials index has rebounded smartly during the past few weeks, and is now threatening to break above its 200-day moving average (Chart 7, bottom panel). Investment Implications The Fed is currently waging a war on two fronts. It wants to keep interest rates low enough to send inflation expectations higher, back to levels consistent with its 2% target. But it also wants to avoid excessively easy financial conditions that could threaten the sustainability of the economic recovery. Asset prices are not extended at the moment, so the Fed can maintain an accommodative policy focused on driving inflation expectations higher. However, at some point the combination of accommodative policy and improving global growth will cause the Fed’s attention to turn back toward financial conditions. That will put rate hikes back on the table and send Treasury yields higher. Timing when that shift will occur is difficult, which is why we recommend that investors enter positive carry yield curve trades to boost returns while we await a hawkish surprise from the Fed later this year (see next section). What The Yield Curve Is Telling Us The Fed’s dovish surprise sent Treasury yields lower last week and also led to significant changes in the shape of the yield curve. In particular, investors have focused on the fact that the 10-year yield is now below the 3-month T-bill rate. That focus is not surprising, given that curve inversion has been a reliable leading indicator of recession in past cycles. We use the 2-year/10-year and 3-year/10-year slopes in our research into the phases of the cycle (Chart 8), and while both of those slopes remain positive – consistent with a “Phase 2” environment – we will keep a close eye on the 3-month/10-year slope in the coming weeks.5 Historically, inversion of the different curve segments has occurred at around the same time. Chart 8Still In Phase 2 Still In Phase 2 Still In Phase 2 Given that the Fed has already signaled a much more dovish policy stance and that global growth is likely to improve later this year, we do not think that 3-month/10-year curve inversion will last very long. However, if we are wrong and the 2-year/10-year and 3-year/10-year slopes are eventually pulled down into negative territory, then we may have to re-visit some of our asset allocation positions. But for now, we find the 5-year and 7-year maturities to be the most interesting points on the yield curve (Chart 9). In fact, the 5-year and 7-year yields are so low that investors can earn more yield by entering duration-matched barbells consisting of the long and short ends of the curve. For example, the 5-year Treasury note offers a lower yield than a duration-matched barbell consisting of the 2-year and 10-year notes. Similarly, the 7-year note offers less yield than a duration-matched barbell consisting of the 2-year note and 30-year bond (Chart 10). Chart 9 Chart 10Barbells Are Positive Carry Barbells Are Positive Carry Barbells Are Positive Carry Further, we have also observed that the 5-year and 7-year yields are most sensitive to changes in 12-month rate hike expectations. Chart 11 shows that when our 12-month discounter rises, the yield curve tends to steepen out to the 7-year maturity, and flatten thereafter. This means that the 5-year and 7-year yields have the most upside when rate hikes are eventually priced back into the curve. Chart 11Yield Curve Correlations Yield Curve Correlations Yield Curve Correlations Taken together, positive carry in the barbells and the sensitivity of 5-year and 7-year yields to 12-month rate expectations mean that investors should enter short positions in the 5-year or 7-year notes today, offset by long positions in duration-matched barbells (eg. the 2/10 or 2/30). These trades will earn significant capital gains when the Fed ultimately delivers a hawkish surprise, sending the 5-year and 7-year yields higher, and will also earn positive carry in the meantime, while we wait for financial conditions to ease enough to shift the Fed’s reaction function. We have also observed that the 5-year and 7-year yields are most sensitive to changes in 12-month rate hike expectations. These long barbell / short 5-year or 7-year bullet positions will only lose money if the market prices-in further rate cuts going forward. With the market already priced for 32 bps of cuts during the next 12 months, a further decline would be consistent with economic recession. This remains the least likely scenario. Bottom Line: Inversion of the 3-month/10-year Treasury slope is cause for concern, if it persists. But we expect it to reverse in the coming months as global growth recovers and the Fed remains accommodative. Eventually, after financial conditions have eased sufficiently, the Fed’s next move will be a hawkish surprise. Investors can profit from this move by entering positive carry yield curve trades: short the 5-year or 7-year bullet and go long a duration-matched barbell.   Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Running Room,” dated January 29, 2019, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/brainard20181207a.htm 3  https://www.federalreserve.gov/newsevents/speech/powell20180620a.htm 4 The Gilchrist and Zakrajsek (GZ) Excess Bond Premium is a measure of the excess spread available in a sample of nonfinancial corporate bonds, after removing a bottom-up estimate of expected default losses for each security. Default losses are estimated based on the Merton Default model, using each firm’s market value of equity and face value of debt. https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/files/… 5 Our research into the different phases of the cycle based on the slope of the yield curve can be found in U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income,” dated December 18, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification