Yield Curve

Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Tightest Global Labor Market Since The Mid-2000s Tightest Global Labor Market Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve The Most Important Client Questions From A Long Road Trip The Most Important Client Questions From A Long Road Trip Chart 3Inflation Typically Follows Economic Growth With A Long Lag Inflation Typically Follows Economic Growth With A Long Lag Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 A Boost To Inflation Expectations From Higher Oil In 2018 A Boost To Inflation Expectations From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue The Normalization Of U.S. Inflation Expectations Will Continue The Normalization Of U.S. Inflation Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? A Communications Problem For Jerome Powell? A Communications Problem For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 ECB Will Fully Taper By The End Of 2018 ECB Will Fully Taper By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD UST-Bund Spread Will Widen Next Year, Supporting The USD UST-Bund Spread Will Widen Next Year, Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... CB Liquidity Has Supported Risk Assets... CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year ...But That Tailwind Will Fade Next Year ...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy This Is Why China Is Tightening Monetary Policy This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 bca.gfis_wr_2017_11_14_c13 bca.gfis_wr_2017_11_14_c13 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises The Most Important Client Questions From A Long Road Trip The Most Important Client Questions From A Long Road Trip Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Most Important Client Questions From A Long Road Trip The Most Important Client Questions From A Long Road Trip Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Fed Must Fall Behind The Curve Fed Must Fall Behind The Curve Fed Must Fall Behind The Curve Jerome Powell will assume the Fed Chairmanship at a critical juncture for monetary policy. Core PCE inflation is still well below the Fed's 2% target, and yet, the slope of the 2/10 Treasury curve is a mere 71 bps (Chart 1). Such a flat yield curve alongside such low inflation suggests that the market believes the Fed will tighten the yield curve into inversion before inflation even regains the Fed's target. That would be an unprecedented policy mistake that the new Chairman will seek to avoid at all costs. This means either inflation will soon rise, justifying the FOMC's median rate hike projections, or inflation will stay low and the Fed will be forced to take a dovish turn. Either way the Fed must "fall behind the curve" and start chasing inflation higher. The act of falling behind the inflation curve means that long-maturity TIPS breakevens are likely to widen, the yield curve will steepen and the policy back-drop will stay accommodative for spread product. We recommend positioning for all three of these outcomes. 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 52 basis points in October, bringing year-to-date excess returns up to 288 bps. The average index option-adjusted spread tightened 6 bps on the month, and now sits at 97 bps. Two weeks ago we noted that there is simply not much room for investment grade corporate spreads to tighten.1 Looking at 12-month breakeven spreads shown as a percentile rank relative to history, we see that A-rated paper has only been more expensive than it is today 7% of the time. Baa-rated paper has been more expensive only 9% of the time (Chart 2).2 Further, we calculate that at current duration levels Baa-rated option-adjusted spreads can only tighten another 36 bps before the sector is more expensive than it has ever been. Similarly, A-rated spreads can tighten another 14 bps, Aa-rated spreads another 17 bps and Aaa-rated spreads another 7 bps. All this to say that corporate bonds are essentially a carry trade at this stage of the cycle. The important question is how much longer we can pick up the carry before a period of significant spread widening. With low inflation keeping monetary policy accommodative and accelerating profit growth putting downward pressure on leverage (bottom 2 panels), the carry trade appears safe for now (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Into The Fire Into The Fire Table 3B Corporate Sector Risk Vs. Reward* Into The Fire Into The Fire 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 51 basis points in October, bringing year-to-date excess returns up to 580 bps. The index option-adjusted spread (OAS) tightened 9 bps on the month, and currently sits at 339 bps. Based on our current forecast for default losses we calculate that, if junk spreads remain flat, high-yield excess returns will be 230 bps for the next 12 months. If spreads tighten by 100 bps we should expect excess returns of 606 bps, and if spreads widen by 100 bps we should expect excess returns of -145 bps (Chart 3). Given that the OAS for the high-yield index can only tighten another 139 bps before it reaches all-time expensive valuations, 606 bps is a fairly optimistic excess return projection. But equally, with inflation pressures still muted and monetary policy still accommodative, more than 100 bps of spread widening is also unlikely. Our base case forecast is that high-yield excess returns will be between 2% and 5% (annualized) on a 6-12 month investment horizon.3 In a recent report we noted that high-yield generally looks more attractive than investment grade after adjusting for differences in spread volatility between the two sectors.4 Specifically, we calculate that it will take 39 days of average spread tightening before B-rated bonds reach all-time expensive levels. The same calculation shows it will take 19 days for A-rated debt. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in October, bringing year-to-date excess returns up to 31 bps. The conventional 30-year zero-volatility MBS spread was roughly flat on the month, as was the option-adjusted spread (OAS) and the compensation for prepayment risk (option cost). Last month we upgraded Agency MBS from underweight to neutral, noting that OAS have become significantly more attractive during the past year, particularly relative to corporate credit (Chart 4). The spread widening likely resulted from the market pricing-in the impact of the Fed's balance sheet run-off. Now that the run-off has begun, and its future pace has been well telegraphed, its impact has probably also been fully priced. While OAS is the correct measure of MBS carry because it adjusts for expected losses due to prepayments, it is the change in the nominal spread that determines capital gains and losses. With that in mind, it is difficult to see a catalyst for significantly wider nominal MBS spreads on a 6-12 month horizon. The two factors that correlate most closely with nominal MBS spreads - credit spreads and mortgage refinancings - are likely to stay depressed (bottom panel). Higher mortgage rates would obviously prevent refinancings from rising. But we showed in a recent report that even if rates move lower the coupon and age distribution of outstanding mortgages has made refi activity much less sensitive to rates than in the past.5 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 12 basis points in October, bringing year-to-date excess returns up to 193 bps. Sovereign bonds underperformed the Treasury benchmark by 5 bps on the month. Foreign and Domestic Agency bonds outperformed by 2 bps and 9 bps, respectively. Supranationals outperformed by 4 bps. The underperformance in Sovereigns was concentrated in Mexican debt, which sold off as the White House took a hard line on NAFTA negotiations. Local Authority bonds outperformed by 62 bps in October, bringing year-to-date excess returns up to 367 bps (Chart 5). Excess returns for Local Authority debt - mostly taxable municipal debt and USD-denominated Canadian provincial debt - have exceeded excess returns from Baa-rated corporate debt so far this year, despite the sector's average credit rating of Aa3/A1. In a recent report we looked at whether USD-denominated Emerging Market Sovereign debt is an attractive alternative to U.S. high-yield corporates.6 We observed that hard currency EM sovereigns and similarly rated U.S. corporate bonds offer almost exactly the same breakeven spread, and also that EM Sovereigns have been getting comparatively cheaper since early last year. Further, we observed that periods when EM Sovereigns outperform U.S. corporates tend to coincide with falling U.S. rate hike expectations, as measured by our 24-month fed funds discounter. At present, our 24-month discounter is at 74 bps, meaning the market expects less than three Fed hikes during the next two years. We anticipate a better opportunity to move into EM Sovereigns once U.S. rate hike expectations have adjusted higher. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in October (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 251 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged down in October and currently sits at 87%, still extremely tight relative to its post-crisis trading range. M/T yield ratios look much more attractive at the long-end of the curve (Chart 6), and we continue to recommend that investors extend maturity within their municipal bond allocations. Congress released its first draft of proposed tax legislation last week, and while it will certainly undergo some changes in the coming months, it appears as though it will not be very negative for municipal bondholders. Crucially, the top marginal personal tax rate remains unchanged at 39.6% and demand for munis should benefit from the removal of other deductions. A reduction of the corporate tax rate to 20% remains a risk, but that will likely be revised higher as the bill is re-written. Fundamentally, state & local government health improved sharply in Q3, with net borrowing likely falling to $157 billion from $211 billion in Q2, assuming that corporate tax revenues are unchanged (Chart 6).7 The rate of growth in state & local tax revenues now exceeds expenditures and that should put further downward pressure on borrowing in the coming quarters. However, a decline in state & local government borrowing is already reflected in historically tight M/T yield ratios. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in October alongside a sharp move higher in the expected pace of Fed rate hikes (Chart 7). The 2/10 Treasury slope flattened 8 bps and the 5/30 slope flattened 7 bps. The upward adjustment in rate hike expectations benefited our recommendation to short the July 2018 fed funds futures contract. That trade is now 13 bps in the money since it was initiated on July 10. Further, the July 2018 contract is still discounting fewer than two rate hikes between now and next July. If two more hikes are delivered by July our trade will earn an additional 5 bps. If three more hikes are delivered it will earn an additional 31 bps. In a recent report we discussed why the Fed must soon "fall behind the curve" on inflation and allow the yield curve to steepen.8 Essentially, unless the Fed starts to chase inflation higher it will soon invert the yield curve without having met its inflation goal. That would be a severe policy mistake. This means that either inflation must start to rise, or the Fed must slow its pace of rate hikes. Both scenarios lead to a steeper yield curve. We continue to position for a steeper curve via a long position in the 5-year bullet versus a short position in the 2/10 barbell. At the moment our model shows the 5-year bullet trading roughly in-line with its fair value, or alternatively that the 2/5/10 butterfly spread is priced for an unchanged 2/10 slope on a 6-month horizon.9 TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 33 basis points in October, bringing year-to-date excess returns up to -99 bps. The 10-year TIPS breakeven inflation rate rose 4 bps on the month but, at 1.86%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. As was pointed out on the front page of this report, the Fed must "fall behind the curve" on inflation if it wants to avoid a policy mistake. Our expectation is that this will occur because inflation will move higher in the coming months. The 6-month rate of change in trimmed mean PCE has already bounced off its lows (Chart 8) and pipeline measures of inflation are soaring (panels 3 & 4). However, even if inflation remains stubbornly low, we think any downside in long-maturity TIPS breakeven rates will prove fleeting. We are approaching an inflection point where if inflation does not rise the Fed will have to adopt a much more dovish policy stance. This should limit any downside in long-dated breakevens. As long as the Fed can maintain interest rates low enough for realized inflation to eventually recover to its target, then we anticipate that long-maturity TIPS breakeven rates will settle into a range between 2.4% and 2.5% by the time that occurs. According to our model, the 10-year TIPS breakeven inflation rate is currently trading in-line with other financial market variables - oil, the trade-weighted dollar and the stock-to-bond total return ratio (panel 2). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in October, bringing year-to-date excess returns up to 81 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps on the month, bringing year-to-date excess returns up to 71 bps. Non-Aaa ABS outperformed the benchmark by 32 bps, bringing year-to-date excess returns up to 176 bps. The index option-adjusted spread for Aaa-rated ABS tightened 5 bps in October and, at 33 bps, it remains well below its average pre-crisis trading range. We continue to favor credit cards over auto loans within Aaa-rated ABS, despite the modest additional spread pick-up available in autos (Chart 9). The main reason is that auto loan net losses have been trending steadily higher for several years while credit card charge-offs are still depressed (panel 4). However, even the credit card space is starting to see rising delinquency rates, albeit off a low base, and banks are tightening lending standards on both auto loans and cards (bottom panel). We expect that tight labor markets and solid income growth will prevent a surge in consumer delinquencies, but these are nonetheless troubling signals that bear monitoring. From a valuation perspective, with the 33 bps OAS offered from Aaa-rated Consumer ABS now only slightly higher than the 29 bps offered by Agency Residential MBS, we advocate a neutral allocation to consumer ABS. Further increases in delinquencies could warrant an eventual downgrade, stay tuned. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 71 basis points in October, bringing year-to-date excess returns up to 182 bps. The index option-adjusted spread (OAS) for non-agency Aaa-rated CMBS tightened sharply in October, from 74 bps to 65 bps. At current levels it is now one standard deviation below its pre-crisis average (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we view the risk/reward trade-off in non-Agency CMBS as quite unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 34 basis points in October, bringing year-to-date excess returns up to 96 bps. The index OAS for Agency CMBS tightened 6 bps on the month but, at 46 bps, the sector continues to offer an attractive spread pick-up relative to other low-risk spread product. The Aaa-rated consumer ABS OAS is only 33 bps, and the OAS on conventional 30-year Agency MBS is a mere 29 bps. Such an attractive spread pick-up in a sector that benefits from Agency backing is probably worth grabbing. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.69% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.67%. The Global Manufacturing PMI increased to 53.5 in October, its highest level in six-and-a-half years. Bullish sentiment toward the dollar also edged higher, but not by enough to prevent the fair value reading from our 2-factor Treasury model from climbing. Last month's fair value reading was 2.65%. The U.S. and Eurozone PMIs continued to trend up, while the Chinese PMI held flat. The Japanese PMI ticked down from 52.9 to 52.8. Most importantly, of the 36 countries we track 34 now have PMIs above the 50 boom/bust line. The global economic recovery has become incredibly broad based, a bearish development for U.S. Treasury yields. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 2 We use breakeven spreads to adjust for the changing duration of the index over time. We calculate the 12-month breakeven spread as option-adjusted spread divided by duration. We ignore the impact of convexity. 3 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Update", dated October 10, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 9 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Global "Low-flation" Vs. Oil Reflation: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Fed Tightening Vs. Trump Easing: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018 Strong Growth Vs. Modest Inflation In Europe: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Feature The bull market in global risk assets continued last week, with the S&P 500 hitting yet another all-time record and other major bourses in both Developed Markets and Emerging Markets hitting multi-year highs. This is a sensible reflection of the strength and persistence of the current coordinated global economic upturn, which is boosting corporate profit growth worldwide. At the same time, the health of the current expansion has dampened risk-aversion among investors. This is helping to keep market volatility at depressed levels with only modest changes expected for both inflation and monetary policy. Yet there are storms brewing on the horizon that have the potential to shake up this low-volatility, risk-seeking backdrop. Specifically, a potentially less stable outlook for global inflation, amidst uncertainty over the direction of fiscal policy in the U.S. and monetary policy at the Fed and European Central Bank (ECB), could pose a threat to the current Goldilocks environment for risk assets (Chart of the Week). In this Weekly Report, we discuss some macroeconomic "trade-offs" that investors will have to grapple with over the next 6-12 months, and how to position bond portfolios accordingly. Chart of the WeekMarkets Not Worried About The Fed Or ECB Markets Not Worried About The Fed Or ECB Markets Not Worried About The Fed Or ECB Trade-Off #1: "Low-flation" Vs. Rising Oil Prices Chart 2Global Inflation Pressures Are Slowly Building Global Inflation Pressures Are Slowly Building Global Inflation Pressures Are Slowly Building Realized inflation data across the major developed economies is showing no imminent threat of breaching, or even just reaching, central bank targets. This is occurring despite a robust, coordinated global economic expansion that is generating some of the fastest growth rates seen since the Great Recession. With nearly ¾ of the countries in the OECD now with unemployment rates below the estimates of the full employment NAIRU, subdued inflation readings remain a puzzle for both investors and policymakers (Chart 2). The term "low-flation" has been used to describe this backdrop of inflation rates remaining low seemingly regardless of what is happening with growth. Bond investors have reacted to this by keeping market-based inflation expectations at levels below central bank inflation targets, suggesting a potential problem with the credibility of policymakers. Yet a fresh challenge to the low-flation thesis will soon come from the global oil markets. Last week, our colleagues at BCA Commodity & Energy Strategy upgraded their oil price targets for the fourth quarter of 2017 and all of 2018.1 Their estimates for global oil demand were revised upward based on the improving economic momentum, as evidenced by the IMF recently boosting its own forecasts for world GDP growth to 3.6% for all of 2017 and 3.7% for 2018. Combined with continued discipline on output from the so-called "OPEC 2.0" coalition of Russia & Saudi Arabia - currently responsible for 22% of the world's oil production - the global oil market is expected to see demand exceeding supply until late 2018 (Chart 3). The positive demand/supply balance should lead the Brent oil price benchmark to average just over $65/bbl in 2018 (Table 1), which would be a 13% increase from current levels. This is a move that global bond markets are likely to notice, given the strong correlation that still exists between market-based inflation expectations and oil prices in the developed economies. Chart 3A Positive Fundamental Backdrop For Oil A Positive Fundamental Backdrop For Oil A Positive Fundamental Backdrop For Oil Table 1Upgrading The BCA Oil Price Forecasts How To Trade The Trade-Offs How To Trade The Trade-Offs In Charts 4 & 5, we show the market-based pricing on inflation expectations at the 10-year maturity for the U.S. (using TIPS breakevens), the U.K., Germany, Japan, Canada and Australia (using CPI swaps). For each country, we also show the Brent oil price denominated in local currency terms. We add one additional data point to the charts, shown as an asterisk, incorporating the 2018 average Brent oil price expectation converted at current exchange rates versus the U.S. dollar. As can be seen, the higher oil price that our commodity strategists are expecting should act to put upward pressure on the inflation expectations component of government bond yields in the major developed markets. Chart 4Upward Pressure On Inflation Expectations ... Upward Pressure On Inflation Expectations... Upward Pressure On Inflation Expectations... Chart 5... From Higher Oil Prices In 2018 ...From Higher Oil Prices In 2018 ...From Higher Oil Prices In 2018 Of course, the unchanged currency assumption made in Charts 4 & 5 is unrealistic. Yet given the significant increase in oil prices that we are expecting next year (+13%), it is also unrealistic to expect enough currency appreciation in any country to fully offset the inflationary impact from oil. In fact, given the BCA view that the U.S. dollar should enjoy one last cyclical boost next year as the Fed delivers more rate hikes than the market is currently discounting, inflation expectations may actually rise by more than we are showing in our charts in non-U.S. countries (given that oil is priced in U.S. dollars). In Table 2, we show the forecast for the local-currency Brent oil price for 2018 and the date that oil prices were last at that level in each country (all in 2015 after the cyclical peak in oil prices that began in 2014). We also present the data on 10-year government bond yields, the 2-year/10-year slope of yield curves, market-based inflation expectations, and realized headline and core inflation rates for the major developed economies. We show the current levels for all those variables, plus the levels that prevailed the last time oil was at the levels we are forecasting. The major differences that stand out are: Table 2Bond Markets Now Vs. The Last Time Oil Prices Were In The Mid-$60s How To Trade The Trade-Offs How To Trade The Trade-Offs Yield levels are not dramatically different than where they were in 2015 in the U.S., Canada and Australia, but are lower now in the U.K., Euro Area and Japan thanks to central bank asset purchase programs. Yield curves are much flatter now in the U.S., U.K., Canada and Japan, but are steeper in the Euro Area and Australia. Market-based inflation expectations now are very close to the levels that prevailed in 2015, except in Japan where they are much lower. Headline inflation rates are much higher now everywhere except Australia, while core inflation rates are a lot higher in the U.K., a touch higher in the U.S. and Euro Area, and lower everywhere else. The conclusion from Table 2 is that there is potential for bond yields to rise as oil prices head higher in the U.S., U.K. and Euro Area given that inflation expectations are at the same levels as 2015 but realized inflation rates are higher. This would suggest that owning inflation protection in these countries is a sensible way to play the "low-flation vs. oil reflation" trade-off - trades that we already have in place in our Tactical Trade Overlay by being long Euro Area CPI swaps and owning U.S. TIPS versus nominal U.S. Treasuries and (see table on page 16). We are reluctant to add U.K. inflation protection to this list, however, and may even look to go the other way given the likelihood that the currency-fueled surge in U.K. inflation is in the process of peaking out. In sum, bond markets will be unable to ignore a combination of strong global growth (still called for by rising global leading economic indicators), tightening labor markets and rising oil prices in 2018. As investors come to grips with oil trading with a 60-handle for the first time since 2015, inflation expectations should widen out in all developed market countries that are at, or beyond, full employment. This should put upward pressure on nominal bond yields as well, and potentially trigger bear-steepening of yield curves if central banks do not respond to higher oil-driven inflation with a faster tightening of monetary policy. Bottom Line: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Trade-Off #2: Fed Tightening Vs. Trump Easing Last Friday, the U.S. Senate passed President Trump's budget plan by the slimmest of margins (51 to 49), allowing for an increase in federal deficits of up to $1.5 trillion over the next decade. Trump immediately put pressure on the U.S. House of Representatives to also pass the Senate plan, and the initial comments from House Republican leadership was that they would also endorse the Senate budget proposal which included significant tax cuts for corporations and some households. This is unsurprising given that the Republicans need a major, economy-boosting legislative victory to present to voters in next year's U.S. Midterm elections. The U.S. Treasury market responded to this news on Friday in a fashion that we believe to be sensible - the curve bear-steepened, with the 2-year/30-year spread widening 4bps on the day. We have written about the interaction between budget deficits, Fed policy and the slope of the Treasury curve in past Weekly Reports this year, most recently at the beginning of this month.2 Chart 6 is taken from that most recent report, and we feel that it is important to go through our logic once again after last week's events. Chart 6UST Curve: Bear-Steepener First, Bear-Flattener Later UST Curve: Bear-Steepener First, Bear-Flattener Later UST Curve: Bear-Steepener First, Bear-Flattener Later The Treasury curve typically steepens during periods when the U.S. federal budget deficit is widening (top panel). The Treasury curve is typically negatively correlated to the real fed funds rate, steepening when the real rate is falling and vice versa. Budget deficits usually are widening during periods of soft economic growth, when tax receipts are slowing and counter-cyclical fiscal spending is increasing. This is also typically correlated to periods when spare capacity in the U.S. economy is opening up and inflation pressures are diminishing (middle panel), hence giving the Fed cover to lower interest rates and putting steepening pressure on the Treasury curve. The current backdrop is atypical, as a fiscal stimulus is being proposed at a time when the economy is already at full employment with little sign of slowing. At the same time, the Fed is in a tightening cycle - albeit a slow one because of relatively subdued inflation - which usually does not occur during periods of widening budget deficits. This represents another difficult "trade-off" for investors to process. A so-called "full employment" fiscal stimulus should be inflationary at the margin, by definition, if it boosts economic growth to an above-potential pace. That would steepen the Treasury curve as longer-term inflation expectations rise, until the Fed steps in with rate hikes to offset the impact of the fiscal stimulus. If the Fed felt that the greater fiscal deficit was becoming a problem for medium-term inflation stability, then there could be a faster pace of rate hikes that would boost the real funds rate and put flattening pressure on the Treasury curve. A more straightforward way to describe that would be a scenario where the Trump tax cuts end up boosting U.S. real GDP growth to something close to 3% next year, which results in the U.S. unemployment rate falling to a "3-handle". This would likely put upward pressure on U.S. realized inflation and steepen the Treasury curve as the market prices in higher inflation - IF the Fed is slow to respond to that inflation pickup. When inflation rises by enough to threaten the Fed's 2% inflation target, perhaps even rising above that level, then the Fed would step in with more rate hikes. The result: a higher real fed funds rate and a flatter Treasury curve. That scenario is how we envision the next year playing out. Various FOMC members have already noted that they cannot account for any fiscal stimulus in their economic projections until they see the details. Furthermore, many members of the FOMC are expressing concern that the downdraft in inflation was enough of a surprise to raise questions about the Fed's understanding of the underlying inflation process. This suggests that the Fed will want to see inflation, both realized and expected, rise first before increasing the pace of rate hikes beyond current projections. Net-net, we see the Trump fiscal stimulus steepening the Treasury curve in 2018 before the Fed flattens it with tighter monetary policy. One caveat for the latter is the upcoming decision on the next Fed Chair. President Trump, ever the reality game show host, noted last week that the finalists for this season's episode for "The Apprentice: FOMC" are now down to Jerome Powell, John Taylor and current Chair Janet Yellen. Both Powell and, of course, Yellen would represent a continuation of the current cautious FOMC framework, while Taylor would likely be more hawkish given his public comments on Fed policy decisions (and the output of his own Taylor Rule!). If Taylor were to be appointed by Trump as the new Fed Chair, the Treasury curve may not steepen much on the back of fiscal easing if the markets begin to discount a more aggressive Fed. Bottom Line: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018. Trade-Off #3: Strong European Growth Vs. Mild Inflation The ECB meets later this week, and is expected to make a decision on the size and scope of its asset purchase program for next year and beyond. The latest Bloomberg survey of economists is calling for a cut in the monthly pace of asset purchases from €60bn/month to €30bn/month, but with an extension of the program until September 2018.3 The same survey calls for the ECB to deliver a hike in the deposit rate in Q1/2019, with a hike in the benchmark interest rate in Q2/2019. We agree with the former, although we think there will be no rate hikes of any kind until the 4th quarter of 2019, at the earliest. Chart 7Why Would The ECB NOT Taper? Why Would The ECB NOT Taper? Why Would The ECB NOT Taper? The trade-off between robust European growth and still modest rates of core inflation are the reason we expect the ECB to be very late to begin hiking policy rates after the asset purchase program is completed. It is clear from a variety of data, from almost all countries in the Euro Area, that the economy is expanding at a robust, above-potential pace (Chart 7). Headline inflation has increased steadily off the 2015 lows and now sits at 1.5%, still below the ECB's target of "just below 2%". The ECB has played down this pickup in inflation, given that is has largely been driven by the rise in oil prices since the 2015 lows. There is certainly a strong correlation between the annual change of oil prices (denominated in euros) and Euro Area headline inflation (middle panel), and the ECB expects fading oil price momentum to result in Euro Area headline inflation drifting back to 1% in early 2018. Yet the oil price increase that our commodity strategists are calling for next year would boost the year-over-year growth rate to a pace around 40%, which has in the past been consistent with 2% headline inflation outcomes. A rising euro would help mitigate the impact from oil, but as mentioned earlier, we see more potential for some modest depreciation of the euro versus the U.S. dollar after the run-up seen in 2017. Despite the pickup in headline inflation already underway, core inflation in Europe remains benign at 1.1%. Our measure of the "breadth" of the rise in core inflation across 75 individual subsectors - the Euro Area core inflation diffusion index - sits right around the "50 line" suggesting that just as many components of Euro Area core inflation are rising as are falling. Yet with broad Euro Area unemployment approaching 8%, and with some measures of wage inflation starting to awake as a result, the odds are increasing that continued strong growth will result in additional upward momentum in core inflation. The ECB is already forecasting a return of core inflation to 1.9% in 2019, which is why some reduction in the pace of asset purchases will be announced this week. The entire asset purchase program was only put in place in 2015 to fight a deflation threat after oil prices collapsed in 2014, and that has now passed with inflation steadily grinding higher. So the "trade-off" for investors in Europe, between strong growth and moderate inflation, will be resolved by the ECB shifting to a less-accommodative monetary policy stance. In terms of the impact on Euro Area bond yields, however, the change in the pace of bond buying matters even more than the size of the asset purchases. In Chart 8, we show the ECB's monetary base and three scenarios for how it will evolve through asset purchases until the end of 2018: Base Case: The ECB slows the pace of bond buying to €30bn/month starting in January 2018 until September 2018, then cuts that down to €15bn/month for the remainder of 2018 and stops the program completely at year-end. Dovish Scenario: The pace of bond buying is maintained at €60bn/month until the end of 2018, with no commitment to end the program then. Hawkish Scenario: The ECB tapers its purchases by €10bn/month for the first six months of next year, then ends the program in July 2018. In the bottom two panels of Chart 8, we show the year-over-year growth rate of the ECB's balance sheet, with those three scenarios, and compare them to the benchmark 10-year German Bund yield and our estimate of the German term premium. In all three scenarios, even the dovish one where the ECB keeps on buying at the current pace, the growth rate of the monetary base will decelerate in 2018. As can be seen in the chart, that growth rate has been highly correlated to yields and the term premium during the life of the ECB's asset purchase program. The conclusion here is that central bank asset purchase programs need to increase in size versus previous years to maintain the same impact on bond yields over time. Put another way, asset purchases represent a signaling mechanism ("forward guidance") from a central bank to the markets about future changes in interest rates when they are already at the zero bound. Increasing the size of the purchases sends a more powerful message than simply keeping the pace of buying unchanged. This is especially true if the underlying economy is growing and inflation is rising, which would typically cause investors to price in a higher expected path of interest rates into the government bond yield curve. So, unless the ECB takes the highly unlikely step of increasing the size of its asset purchases for next year, then there are no outcomes from this week's ECB meeting that should be expected to be sustainably bullish for longer-dated European government bonds. At the same time, there will be no signals given on future changes in short-term interest rates, as the ECB has maintained for some time that rates will not be touched until "some time" after the asset purchase program has ended (Q4/2019, in our view). Hence, Euro Area yield curves are likely to eventually see some bear-steepening pressure on the back of this week's ECB meeting. The story is similar for Peripheral European government bonds and Euro Area investment grade corporate credit. In Chart 9, we show the same growth rates of the ECB monetary base with our scenario projections versus the 10-year Italy-Germany spread, 10-year Spain-Germany spread, 10-year Portugal-Germany spread and the Barclays Bloomberg Euro Area Investment Grade corporate spread. While the correlations are not as clear as that for German yields, a slower pace of ECB asset purchases would be consistent with some spread widening in Peripheral European and in corporate credit. Chart 8ECB Bond Buying:##BR##Watch The Pace, Not The Level ECB Bond Buying: Watch The Pace, Not The Level ECB Bond Buying: Watch The Pace, Not The Level Chart 9European Credit Spreads##BR##Set To Widen Post-ECB? European Credit Spreads Set To Widen Post-ECB? European Credit Spreads Set To Widen Post-ECB? Bottom Line: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten", dated October 19th 2017, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "The Case For Steeper Yield Curves", dated October 3rd 2017, available at gfis.bcaresearch.com. 3 https://www.bloomberg.com/news/articles/2017-10-22/draghi-seen-going-for-ecb-bond-buying-limit-in-qe-s-last-hurrah The GFIS Recommended Portfolio Vs. The Custom Benchmark Index How To Trade The Trade-Offs How To Trade The Trade-Offs Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Yield Curve & TIPS: To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve. Treasury curve steepeners and TIPS breakeven wideners will benefit. Inflation: The current cycle looks very similar to the cycle of the late 1990s. In both cases the unemployment rate fell far below its natural level before inflation started to accelerate. Almost all of the indicators that predicted the 1999 increase in inflation are currently sending strong positive signals. Credit Spreads: Spreads are tight across the entire credit spectrum, but risk-adjusted value is most attractive in the Caa, B and Baa credit tiers. Feature Chart 1Low Inflation + Flat Curve = Policy Mistake Low Inflation + Flat Curve = Policy Mistake Low Inflation + Flat Curve = Policy Mistake In the 12 months leading up to August, headline PCE inflation came in at 1.43% and core PCE inflation was a mere 1.29%. Both readings are well short of the Fed's 2% target. At the same time, the 2/10 Treasury curve is only 79 basis points away from inversion (Chart 1). The combination of low inflation and a flat yield curve suggests that, despite below-target inflation, the market views Fed policy as relatively restrictive. This situation is not sustainable. The Fed must, and will, fall behind the curve. An inverted yield curve represents the market's expectation that the Fed will be forced to cut interest rates in the future. As such, it has an excellent track record as a recession indicator. Now consider a situation where the yield curve inverts with inflation never having re-gained the Fed's target. The Fed would have tightened the yield curve into inversion, and the economy into recession, without having achieved its inflation goal. This is the most striking example of monetary policy failure that we can dream up, and unless we witness a trend change in either inflation or the slope of the curve, it is an outcome we are likely to face. Of course we do not think the above scenario will actually come to pass. In fact, our investment strategy hinges on the premise that the Fed would never abide such an outcome. This means that one of two things will occur in the coming months: Inflation will rebound and the Fed will be able to fall behind the curve while still delivering a pace of rate hikes similar to its median expectation - one more hike this year and three more next year. Inflation will remain low and the Fed will be forced to fall behind the curve by reneging on its forecasted rate hike path. These two possibilities are illustrated by looking at the real fed funds rate (deflated by core PCE inflation) alongside the popular Laubach-Williams estimate of its equilibrium level (Chart 2). In the Fed's policy framework the real interest rate must stay below equilibrium for inflation to rise. Likewise, if the Fed lifts the real interest rate above equilibrium it is because it wants inflation to fall. What is clear from Chart 2 is that one more rate hike with no improvement in inflation will move monetary policy into restrictive territory. Our contention is that the Fed will ensure that monetary policy remains accommodative (i.e. it will remain behind the curve) until inflation returns to the 2% target. Chart 2Too Close To Neutral Too Close To Neutral Too Close To Neutral Investment Implications Chart 3Yield Curve & Breakevens Move Together Yield Curve & Breakevens Move Together Yield Curve & Breakevens Move Together The first corollary of the above proposition is that the Fed will need strong conviction that inflation is poised to move higher before it delivers another rate hike. Chair Yellen is clinging to this notion for now: My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year. Most of my colleagues on the FOMC agree.1 We would also agree that inflation will be strong enough going forward for the Fed to justify a rate increase in December and several more next year (see section titled "Party Like It's 1999?" below). This is the main reason we continue to advocate a below-benchmark duration stance. But while our duration call will suffer if inflation does not rise as we expect, our recommendations to position for a steeper yield curve and wider long-maturity TIPS breakeven rates will pan out as long as the Fed falls behind the curve. If we accept the premise that the Fed must hit its inflation target before inverting the yield curve, then it will keep rates low enough for long enough to achieve that goal. This means that long-dated TIPS breakevens will necessarily return to their target range between 2.4% and 2.5% by the time that core inflation returns to target, and that the yield curve will steepen alongside the widening in breakevens (Chart 3). If the deflationary pressure in the economy turns out to be stronger than we anticipate, then it simply means that a slower pace of rate hikes will be required to get inflation back to target. The way to position for this outcome on a medium-term horizon is via lower real yields (Chart 3, panel 2), not tighter TIPS breakevens or a flatter yield curve. A Fed that is behind the curve is also a key support for our overweight allocation to investment grade and high-yield corporate bonds. Even though valuations have become very expensive (see section titled "Risk-Adjusted Value In Corporate Credit" below), a sustained period of spread widening would likely require a more restrictive monetary policy, one more concerned with dragging inflation lower than with propping it up. Chart 4Tax Cuts Would Steepen The Curve Tax Cuts Would Steepen The Curve Tax Cuts Would Steepen The Curve Political Risk There are two looming political decisions that will impact both our view on how quickly inflation will trend higher and our view on whether the Fed will indeed fall behind the curve. On the inflation front, if President Trump's tax cut plan becomes law, then the resulting fiscal stimulus will almost certainly speed up the return of inflation to target. The market has figured this out and already we observe a correlation between the slope of the yield curve, long-maturity TIPS breakevens and the relative performance of a basket of highly-taxed stocks (Chart 4). Our geopolitical strategists remain optimistic that stimulative tax legislation will be passed early next year, but note that if the Democratic party wins the upcoming Alabama senate election (to be held December 12), then there may not be enough votes in the Senate to push a tax plan through.2 The second important political decision will be the appointment of a new Fed Chair. President Trump will announce his pick within the next two weeks, and the President has suggested that the race has been winnowed down to three candidates - current Fed Chair Janet Yellen, current Fed Governor Jerome Powell and Stanford University economist John Taylor. Ex-Fed Governor Kevin Warsh could also still be in the running, although he was not specifically named by the President last week (Table 1). Table 1Top 4 Fed Chair Candidates The Fed Will Fall Behind The Curve The Fed Will Fall Behind The Curve Of those four candidates, both Yellen and Powell would maintain the status quo at the Fed. Neither would threaten our view that the Fed will fall behind the curve on inflation. Taylor or Warsh, on the other hand, could both push for a faster pace of tightening. As Fed Chairman, Professor Taylor - of Taylor Rule fame - would certainly look to adopt a more rules-based monetary policy. In all likelihood this would involve structuring policy decisions around a chosen policy rule, with the Fed justifying any deviations from that rule. His views on the current speed of Fed tightening are not as well known, but he has been critical of the Fed's zero interest rate policy in the past and has spoken favorably about several policy rules that all suggest higher interest rates than are currently observed. Similarly, Kevin Warsh has suggested that the Fed should target inflation between 1% and 2%, rather than the current symmetric 2% target. Taken at face value, this change in target would suggest a more hawkish reaction function. A John Taylor or Kevin Warsh chairmanship would call into question our key premise that the Fed will fall behind the curve, and would likely cause the Treasury curve to bear-flatten in the immediate aftermath of the appointment. Bottom Line: To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve. Treasury curve steepeners and TIPS breakeven wideners will benefit. Party Like It's 1999? This year's downtrend in core inflation has caused many to question whether it will ever rise again. Many are questioning whether the Phillips curve relationship between tighter labor markets and rising wage growth still holds, and even Janet Yellen is starting to wonder if the Fed is missing something: [O]ur framework for understanding inflation dynamics could be misspecified in some way. For example, global developments - perhaps technological in nature, such as the tremendous growth of online shopping - could be helping to hold down inflation in a persistent way in many countries.3 We would note, however, that this is not the first time it has taken longer than expected for cyclical inflation pressures to emerge despite a tight labor market. Consider that in the late 1990s the unemployment rate fell below its natural rate in April 1997, but inflation did not move meaningfully higher until mid-1999 (Chart 5). Chart 5The Current Cycle Looks Very Much Like The 1990s The Current Cycle Looks Very Much Like The 1990s The Current Cycle Looks Very Much Like The 1990s A strong dollar and negative import price shock certainly contributed to low inflation in the late 1990s, and this has also been true in the current cycle. The de-synchronized nature of the global recovery caused the dollar to surge in 2014 and 2015, much like in 1997 (Chart 6). In the late 1990s, it was only after the global recovery became more synchronized in 1999 that U.S. inflation started to respond to tight labor markets. In the current cycle, the synchronized global recovery only started in the middle of last year. Chart 6An Import Price Shock Kept Inflation Low In The 1990s And Today An Import Price Shock Kept Inflation Low In The 1990s And Today An Import Price Shock Kept Inflation Low In The 1990s And Today We identified several variables that led inflation higher in 1999. Chart 7 shows these variables from the late 1990s lined up with their readings from the current cycle. The cycles are aligned to when the unemployment rate fell below its natural level, and the vertical line shows when prices started to accelerate in 1999. The variables that led inflation higher in the 1990s were: Chart 7Pipeline Measures Led Inflation In 1999 Pipeline Measures Led Inflation In 1999 Pipeline Measures Led Inflation In 1999 PPI Finished Goods inflation BCA Pipeline Inflation Indicator The New York Fed's Underlying Inflation Gauge4 Corporate Price Deflator With the possible exception of the corporate price deflator, all of these variables are currently sending a strong signal that inflation is poised to rebound. Similar to 1999, we would expect the initial move higher in inflation to be met with wider long-maturity TIPS breakevens and a steeper yield curve. Notice that the 2/10 Treasury slope troughed at -5 bps in 1998, but steepened to +40 bps in early 1999 before starting to flatten again as the Fed ramped up its pace of tightening (Chart 5, panel 3). In the current cycle, we await that final steepening surge before the Fed gets more aggressive and flattens the curve once more. Bottom Line: The current cycle looks very similar to the cycle of the late 1990s. In both cases the unemployment rate fell far below its natural level before inflation started to accelerate. Almost all of the indicators that predicted the 1999 increase in inflation are currently sending strong positive signals. Risk-Adjusted Value In Corporate Credit In a recent report we noted that high-yield bond valuations were approaching all-time expensive levels.5 We concluded that with limited room for spread compression, but equally with no obvious catalyst for sustained spread widening, the high-yield market has essentially become a carry trade. This week we extend that analysis to consider each credit tier in both investment grade and high-yield bonds. Our goal is to see if any credit tiers have room for spread compression, or alternatively, which credit tiers offer the best risk-adjusted value. Unfortunately, the quick answer is that no credit tiers look cheap. In Chart 8 and Chart 9 we show 12-month breakeven spreads for each credit tier, scaled by their percentile rank relative to history. In other words, each chart shows the percentage of time that breakeven spreads for each credit tier have been lower than they are currently. The Aa-rated breakeven spread has been lower than it is today 15% of the time (Chart 8, panel 2), while the Aaa-rated breakeven spread has been lower than it is today only 1% of the time (Chart 8, panel 1). We use the breakeven spread - the spread widening required to earn zero excess return on a 12-month horizon - because it adjusts for the changing average duration of each bond index.6 For example, the average duration of the investment grade corporate bond index has increased during the past fifteen years. This means that a given spread level today looks less attractive than when the duration risk was lower. Chart 8 shows that there is very little room for investment grade spread compression. At the 15th percentile the Aa credit tier looks most attractive, while all other credit tiers rank below the 10th percentile. In Chart 9 we see that valuations get somewhat more compelling as we move down in quality. Ba-rated breakeven spreads have been lower 19% of the time, B-rated spreads have been lower 32% of the time and Caa-rated spreads have been lower 43% of the time. Chart 8Investment Grade Breakeven Spreads Investment Grade Breakeven Spreads Investment Grade Breakeven Spreads Chart 9High-Yield Breakeven Spreads High-Yield Breakeven Spreads High-Yield Breakeven Spreads The results in Table 2 generally confirm that the lowest credit tiers offer the best risk-adjusted value. That table shows a measure we call Days-To-Breakeven. This is a measure of the number of days of average spread widening required for each credit tier to earn zero excess return on a 12-month horizon. It is calculated as the 12-month breakeven spread divided by each sector's historical average daily spread change. It is an attempt to measure each sector's value after adjusting for differences in both duration and spread volatility. According to this measure, Caa-rated and B-rated junk offer the best risk-adjusted value, while Baa-rated corporates offer slightly better value than Ba-rated junk bonds. Table 2 also shows the amount of option-adjusted-spread (OAS) tightening required by each credit tier (at current duration levels) to reach all-time expensive valuations. For example, the Baa-rated index can undergo another 35 bps of OAS tightening before it reaches all-time lows according to its 12-month breakeven spread. We also scale this measure by each sector's historical average daily spread change to calculate a Days-To-Minimum measure, and once again the message is the same. The Caa-rated, B-rated and Baa-rated credit tiers offer the most compelling risk-adjusted value. Table 2Risk-Adjusted Value By Credit Tier The Fed Will Fall Behind The Curve The Fed Will Fall Behind The Curve It is unfortunate, though not surprising, that low quality sectors offer the best risk-adjusted value at this late stage of the credit cycle. Most fund managers have probably already started to scale back credit risk in preparation for the next recession. This is probably a prudent strategy given that even in the lower credit tiers excess returns will not be exceptional. We forecast excess returns between 2% and 5% for the overall High-Yield index. However, we also think that investors are relatively safe taking credit risk until inflationary pressures start to mount and the Fed's reaction function becomes less supportive. If inflation recovers as we expect, then we will likely start scaling back the credit risk in our recommended portfolio sometime next year in preparation for a recession in 2019. Bottom Line: Spreads are tight across the entire credit spectrum, but risk-adjusted value is most attractive in the Caa, B and Baa credit tiers. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Speech by Janet Yellen delivered October 15, 2017. https://www.federalreserve.gov/newsevents/speech/yellen20171015a.htm 2 Please see Geopolitical Strategy Weekly Report, "Why So Serious?", dated October 11, 2017, available at gps.bcaresearch.com 3 Speech by Janet Yellen delivered October 15, 2017. https://www.federalreserve.gov/newsevents/speech/yellen20171015a.htm 4 The Underlying Inflation Gauge captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data. https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 5 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 6 We calculate the breakeven spread as option-adjusted spread divided by duration. For simplicity we ignore the impact of convexity. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Oil Breakout: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. Trump Trade: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Taper: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Feature A More "Normal" Bond Market Chart of the WeekLike Deja Vu All Over Again Like Déjà Vu All Over Again Like Déjà Vu All Over Again Global bond yields have bounced very sharply off the September lows. The benchmark 10-year U.S. Treasury yield hit a 3-month intraday high of 2.37% yesterday, while the 10-year German Bund yield touched 0.5% last week. Bond markets have returned to focusing on traditional fundamentals, like growth and inflation, after spending a few weeks worrying about nuclear tensions with North Korea and other political matters. On that note, the global economic news continues to point towards continued solid growth, rising inflation pressures and, in response, less accommodative monetary policy. There is scope for additional increases in bond yields, as markets are still pricing in too much pessimism on inflation and too little hawkishness from central bankers. The latter is especially true in the U.S. where the Federal Reserve is sticking with its plans to deliver another 100bps of rate hikes by the end of 2018 if its growth and inflation forecasts are realized. The odds of that happening would increase substantially if the Trump Administration can successfully deliver tax cuts, which would represent a very rare occurrence of a fiscal stimulus coming at a time of full employment in the U.S. The announcement last week of the Trump tax cut proposals did send a whiff of the old "Trump trade" dynamic through financial markets. The U.S. Treasury curve bear-steepened, the U.S. dollar rallied, inflation expectations rose and the S&P 500 blasted through the 2500 level to hit a new all-time high. Stocks of companies that pay higher tax rates outperformed, just like they did after the election of President Trump nearly one year ago (Chart of the Week). Add in some additional reflationary pressure from Brent oil prices approaching $60/bbl, and it is no surprise that yield curves in most Developed Markets (not just the U.S.) steepened. With this reflationary backdrop, amid tight labor markets and a solid pace of coordinated global growth, we continue to recommend fixed income investors maintain a defensive duration posture, while favoring spread product over government bonds. Yields will continue to rise in the next 6-12 months, but led more by the long-end initially. In particular, we expect government bond yield curves to extend the recent trend of bear-steepening, for three reasons: rising inflation expectations, increased optimism on U.S. fiscal policy and what it means for the Fed, and the upcoming announcement of a tapering of bond purchases by the European Central Bank (ECB). Are Bond Investors Too Complacent On The Inflationary Impact Of Higher Oil Prices? We have received a surprisingly small amount of criticism from the BCA client base about our bearish strategic view on global government bonds in recent months. Perhaps that is because our clients also have a negative opinion on duration risk. At our annual investment conference in New York last week, we conducted polls which showed that a majority of the attendees expect the 10-year U.S. Treasury yield to rise to between 2.5% & 3% by this time next year. At the same time, only 1 in 4 respondents felt that being short duration in U.S. Treasuries was the "contrarian" trade that was most likely to succeed over next 12 months - perhaps because betting on higher yields is not really a contrarian opinion right now! Yet we wonder how aggressively investors in aggregate, and not just BCA clients, are positioned for a rising yield environment. The market is only discounting 40bps of Fed rate hikes over the next twelve months, even as the U.S. economic data flow continues to improve and the Trump Trade is coming back in style (Chart 2). Survey data shows that professional bond managers are running only small duration underweights, yet speculators are still running very net long positions in Treasury futures. In other Developed Markets, there are not a lot of rate hikes priced outside of Canada - where the central bank actually is tightening policy - despite our Central Bank Monitors all calling for policymakers to become less dovish, if not more outright hawkish, as we discussed last week.1 In their defense, bond investors have had a lot of non-economic factors to digest in the past couple of months - not the least of which is judging how much of an "apocalypse premium" to price into bond yields given the nuclear saber rattling between D.C. and Pyongyang. Yet when stepping back away from the headlines and tweets, bond markets have been noting the implications of rising oil prices in a typical manner - higher inflation expectations and steeper yield curves. Oil prices have risen over $10/bbl since the June lows, led by a combination of rising demand on the back of an expanding global economy and a diminished supply response that has seen excessive inventories start to be wound down (Chart 3). BCA's commodity strategists have been expecting such a move to unfold, and prices have already risen into the $55-60/bbl range (on Brent crude) that they were calling for towards year-end. While a move beyond $60/bbl is not currently expected, any additional upside surprises in global growth can only tighten the supply/demand balance in an oil-bullish direction. At a minimum, oil prices can consolidate recent gains, providing a floor to inflation expectations. Already, the breakeven rate on 10-year TIPS in the U.S. have risen 18bps off the June lows, which has prevented the slope of the Treasury curve from flattening even as the 2-year Treasury yield hit an 9-year high last week (Chart 4). We expect to see more bear-steepening of the Treasury curve in the next few months as realized inflation rates begin to grind higher and the Fed will be relatively slow to respond - they'll need to see the inflation pick up first before delivering more rate hikes. This will result in higher market-based inflation expectations (i.e. wider TIPS breakevens) as investors price in a greater chance that inflation will sustainably return to the Fed's 2% target. While oil is not the only factor that matters for U.S. inflation, it is a lot harder for investors to believe that core PCE inflation can rise to 2% without higher oil prices. Chart 2A Revival Of The Trump Trade? A Revival Of The Trump Trade? A Revival Of The Trump Trade? Chart 3A Bullish Supply/Demand Backdrop For Oil A Bullish Supply/Demand Backdrop For Oil A Bullish Supply/Demand Backdrop For Oil Chart 4Oil Vs. The U.S. Yield Curve Oil vs The U.S. Yield Curve Oil vs The U.S. Yield Curve A similar dynamic is taking place in other countries. Inflation expectations (linkers or CPI swaps) are rising alongside rising energy prices in the Euro Area (Chart 5), U.K. (Chart 6), Canada (Chart 7) and Australia (Chart 8). The moves in expectations are largest in countries experiencing stronger growth (the Euro Area and Canada), and more modest where growth is mixed (the U.K.) and where realized inflation is still very low (Australia). Yield curves have generally steepened in response to the reflationary rise in oil prices except for Canada, where the central bank has already delivered two surprise rate hikes over the summer and markets have priced in nearly three more hikes over the next year. Yet even there, global reflation will put steepening pressure on the Canadian yield curve without additional hawkishness from the Bank of Canada. Chart 5Oil Vs. The German Yield Curve Oil vs The German Yield Curve Oil vs The German Yield Curve Chart 6Oil Vs. The U.K. Yield Curve Oil vs The U.K. Yield Curve Oil vs The U.K. Yield Curve Chart 7Oil Vs. The Canada Yield Curve Oil vs The Canada Yield Curve Oil vs The Canada Yield Curve Chart 8Oil Vs. The Australia Yield Curve Oil vs The Australia Yield Curve Oil vs The Australia Yield Curve Japan, as always, remains the outlier to global trends. While oil prices have been rising even in yen terms, inflation expectations have remained subdued and the JGB yield curve has stayed flat (Chart 9). With the Bank of Japan targeting a 0% yield on the benchmark 10-year JGB as part of its current monetary policy framework, the link between energy prices, inflation expectations and the slope of the yield curve will remain broken in Japan. This makes JGBs a very low-beta government bond market, and we continue to recommend an overweight stance on Japan given our bias toward a defensive portfolio duration posture. Chart 9Oil Vs. The Japan Yield Curve Oil vs The Japan Yield Curve Oil vs The Japan Yield Curve Net-net, we see oil as continuing to provide a steepening, reflationary bias to global bond yields in the next few months, as the impact of the rise in energy prices feeds through into faster rates of headline inflation. How central banks respond will determine what curves do beyond that but, for now, the bias is towards steeper curves. Bottom Line: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. How Will The Trump Tax Plan Impact The Treasury Curve? Ask The Fed Another factor that will put steepening pressure on global yield curves, especially in the U.S., is the likelihood of the Trump fiscal stimulus coming to fruition. The White House has chosen to refocus its policy efforts on getting aggressive tax cuts implemented. This is low-hanging fruit for a president that needs a legislative victory after fighting a losing battle on health care reform. Last week, the latest Trump tax plan was unveiled, which is centered on delivering large cuts on corporate taxes, reducing the number of personal income tax brackets, eliminating many large tax deductions, allowing companies to fully expense investment spending at an accelerated rate, and introducing a territorial tax system that would exempt U.S. corporate taxes on the foreign earnings of U.S. companies. The Tax Policy Center unveiled its initial assessment of the Trump tax plan last Friday, which is expected to reduce U.S. federal tax revenue by $2.4 trillion over the next ten years and another $3.2 trillion in the following decade.2 The White House is betting on so-called "dynamic scoring" of the tax plan to recoup some of that lost revenue via higher economic growth, although that is filled with unrealistic expectations to prevent an unwanted surge in federal deficits. More likely, the Trump plan would result in a major increase in federal budget deficits over the next decade, similar to the levels estimated by Moody's last year in its own analysis of the Trump fiscal platform.3 In Chart 10, we show how periods of widening federal budget deficits typically coincide with periods of U.S. Treasury curve steepening. Usually, this is merely the business cycle at work, with deficits widening during economic downturns as tax revenues plunge and counter-cyclical government expenditure increases. What is also at work is the monetary policy cycle, with the Fed delivering rate cuts during recessions when the output gap is widening and inflation pressures are diminishing, thus bull-steepening the yield curve. Chart 10Forwards Pricing Too Much UST Curve Flattening Forwards Pricing Too Much UST Curve Flattening Forwards Pricing Too Much UST Curve Flattening Yet the current Trump tax proposal comes at a time when the U.S. economy is operating close to full employment with the output gap essentially closed (middle panel). This means that any impetus to U.S. economic growth from the fiscal easing can cause inflation pressures to build up in a manner different than typical periods of widening budget deficits. This should initially impart steepening pressures on the Treasury curve, but in a bearish fashion via higher longer-term inflation expectations. However, the eventual path for the Treasury curve will be determined by how much the Fed responds to the fiscal easing via tighter monetary policy. Typically, the slope of the Treasury curve is highly negatively correlated to the real fed funds rate (adjusted by headline inflation), with a higher real rate coinciding with a flatter curve and vice versa (bottom panel). Right now, the market is discounting only a modest rise in real U.S. policy rates, looking at the difference between forward Overnight Index Swap (OIS) rates and forward CPI swap rates. That market-implied "real rate" is expected to stay in a modest range between 0% and 1% until well into the next decade. The Fed is also forecasting a rise in the real funds rate to 0.75%, but over a much faster time horizon - within two years - than the market. This is in the context of U.S. core inflation sustainably returning to the Fed's 2% target, which will allow the Fed to eventually raise rates to its current "terminal" rate projection of 2.75%. Thus, when simply eyeballing the relationship between real rates and the slope of the curve in Chart 10, the risk is that real rates will be higher than the market expects over time, and the Treasury curve will be flatter, all else equal. Yet when looking at the slope of the Treasury curve that is currently priced into the forwards, as shown in the bottom panel of Chart 10, a substantial flattening is already discounted over the next decade. Admittedly, the correlation between the real funds rate and the slope of the curve has changed over past decades, and the curve can likely be flatter for a lower level of real yields than in years past. Yet, even allowing for that, the market does seem to be discounting a very aggressive rise in real interest rates over the coming decade - one that is unlikely to be realized unless the Fed delivers a much higher path of interest rates then they are currently projecting. Which brings us back to the Trump fiscal stimulus. If the corporate tax cuts do provide a boost to economic growth next year via increased investment spending and hiring activity, in a way that also overheats the U.S. economy and boosts core inflation, then the Fed may be forced to raise rates at a faster pace than planned. This would result in a much flatter yield curve and would raise the risks of a recession in 2019, which is a scenario we think is highly plausible, especially if there is a change at the top of the FOMC. Late last week, it was revealed that President Trump had interviewed several candidates for the position of Fed Chair. Former Fed governor Kevin Warsh and current governor Jerome Powell were the names that caught the market's attention. Warsh has been a vocal critic of the Fed's slow unwind from the unusual post-crisis monetary policies, and is thus considered a monetary hawk who would want to raise rates higher, and faster, than the current FOMC. Powell is more pragmatic and would likely maintain the status quo at the Fed. The possibility of a more hawkish Fed chair has shown up in online prediction markets, where the "prices" of candidates that are perceived to be more hawkish (Warsh, John Taylor) rose while the prices of the more dovish candidates (Janet Yellen, Gary Cohn) fell (Chart 11). Right now, the online punters have Warsh in the lead, but the intraday "trading" has been volatile. The intersection of U.S. fiscal policy and monetary policy will be critical to determine the future path of U.S. bond yields over the next year. Right now, it appears that there is too much flattening priced into the Treasury curve relative to the expected path of the funds rate and inflation, as the Fed is unlikely to raise real rates much beyond their current projections. That could change if the Trump tax cuts can deliver a faster pace of productivity growth and higher equilibrium real interest rates. Although the post-war history of the U.S. shows that tax cuts by themselves do not raise the potential growth rate of the economy unless they lead to a major increase in investment spending, and even then the impact takes years to be seen (Chart 12). Chart 11Will The Next Fed Chair Be A Hawk? Will The Next Fed Chair Be A Hawk? Will The Next Fed Chair Be A Hawk? Chart 12Tax Cuts Do Not Always Boost Growth Tax Cuts Do Not Always Boost Growth Tax Cuts Do Not Always Boost Growth For now, we think it makes more sense to bet against the substantial flattening in the forwards by positioning for a steeper Treasury curve. Bottom Line: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Tapering: Steepening Yield Curves Through The Term Premium The other major factor that should steepen global yield curves in the next several months is the expectation of a change in policy from the ECB. The central bank has been gently preparing the market since the early summer for a shift to a less accommodative policy stance, in response to robust economic growth and slowly rising core inflation (Chart 13). A decision on the changes to the asset purchase program will take place at the October 26th ECB policy meeting. This will involve a reduction in the monthly pace of bond buying and, likely, some guidance as to when the asset purchase program will end. A change in short-term interest rates is highly unlikely before the bond purchases have been fully tapered, as this would go against the current forward guidance from the ECB that states that interest rates will remain at low levels well after the purchases have stopped. As we have discussed throughout this year, we see the ECB having no choice but to begin tapering its asset purchase program. The deflationary tail risks from 2014/15 have faded and, perhaps more importantly, the ECB is running into operational constraints on which bonds it can continue to buy. A likely outcome will be an announcement that the pace of bond buying will slow from the current €60bn/month to least ½ of that pace starting in January 2018. At mid-year, the policy will likely be reevaluated and, if the economy has not slowed materially and/or inflation rolled over, a full tapering of the bond buying would be announced, ending at the end of 2018 or in the first quarter of 2019. A rate hike would not take place until late 2019, which is where the market is currently priced. In the absence of rate hikes, most of the impact on Euro Area bond yields from the tapering will come from a widening of the term premium on longer-maturity bonds. If the pace of growth slows to zero, this could result in the benchmark 10-year German Bund yield returning all the way back to 1% (bottom two panels). This would still be a very low yield by historical standards, in line with structurally lower growth rates and high government debt levels in Europe. But the path to that 1% yield would be very damaging for bond returns as Euro Area yield curves bear-steepen. While the link between our estimates of the term premiums in the major developed markets is not airtight, there has been a loose correlation between them during the post-crisis "quantitative easing" era (Chart 14). If recent history is any guide, a slower pace of ECB bond buying should coincide with steeper global yield curves, all else equal. All else is likely NOT equal, as an unruly response of risk assets and currency markets to a tapering could alter the likely path of growth and inflation expectations and, eventually, interest rates. But, at this moment, an ECB taper is more likely to result in steeper global yield curves. Chart 13An ECB Taper Will Result In##BR##Higher Term Premia In Europe... An ECB Taper Will Result In Higher Term Premia In Europe... An ECB Taper Will Result In Higher Term Premia In Europe... Chart 14...And Perhaps In Other##BR##Bond Markets, As Well ...And Perhaps In Other Bond Markets, As Well ...And Perhaps In Other Bond Markets, As Well Bottom Line: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified", dated September 26th 2017, available at gfis.bcaresearch.com. 2 http://www.taxpolicycenter.org/sites/default/files/publication/144971/a_preliminary_analysis_of_the_unified_framework_0.pdf 3 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf The Case For Steeper Yield Curves The Case For Steeper Yield Curves Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Tax Reform Is A Bear-Steepener Tax Reform Is A Bear-Steepener Tax Reform Is A Bear-Steepener The federal government provided some details about its tax reform proposal last week. Markets reacted immediately, once again starting to price-in the possibility of lower tax rates. A basket of high tax-rate stocks outperformed the S&P 500, although the relative price remains well below the highs reached in the immediate aftermath of the election (Chart 1). Bond markets have also been influenced by the "will they, won't they" tax reform drama. Since tax cuts at this relatively late stage of the economic cycle are widely expected to be inflationary, the slope of the yield curve steepens and long-dated TIPS breakevens widen whenever the passage of a tax bill seems more likely. Our political strategists expect that a tax bill will be passed by the end of Q1 2008, or by early Q2 at the latest.1 All else equal, this will bias TIPS breakevens wider and cause the Treasury curve to steepen. Even in the absence of significant tax legislation we think that TIPS breakevens will widen and the yield curve will steepen as inflation starts to pick up during the next few months. But any fiscal stimulus related to tax reform would certainly expedite the process. 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 87 basis points in September, bringing year-to-date excess returns up to 234 bps. The average index option-adjusted spread tightened 9 bps on the month to reach 101 bps. Valuation looks increasingly stretched across much of the corporate bond universe. The 12-month breakeven spread for A-rated corporate bonds has dipped well below its mid-2014 trough and is approaching the minimum value witnessed in the early stages of prior Fed tightening cycles. The same measure for Baa-rated credits fell to 17 bps last month, almost exactly equal to its mid-2014 low. While spreads are somewhat expensive, recent data on profit and debt growth have been positive. We noted in last week's report2 that net leverage declined in the second quarter, breaking a streak of two consecutive increases (Chart 2). In addition, other credit cycle indicators such as the slope of the yield curve and C&I bank lending standards do not yet signal wider spreads. Further declines in leverage will depend on whether profit growth can sustain its recent strength (bottom panel). While some moderation is likely, as of now, our leading profit indicators - particularly the weak dollar and surging manufacturing PMI - suggest that growth will stay firm for the remainder of the year (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Return Of The Trump Trade Return Of The Trump Trade Table 3BCorporate Sector Risk Vs. Reward* Return Of The Trump Trade Return Of The Trump Trade 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 143 basis points in September, bringing year-to-date excess returns up to 526 bps. The index option-adjusted spread tightened 31 bps to end the month at 347 bps, 24 bps above the mid-2014 cycle low. After adjusting for expected default losses, we calculate that the junk index currently offers an excess spread of 213 bps. We would expect a default-adjusted spread at this level to translate into low, but positive, excess returns during the next year. A simple linear regression suggests those excess returns will be on the order of 100 to 200 bps (Chart 3), but with a fairly wide margin for error. The default-adjusted spread incorporates our estimate of default losses for the next 12 months. This estimate currently sits at 1.3%. The estimate is derived from the Moody's baseline forecast of a 2.7% default rate and our own estimate of a 51% recovery rate (bottom panel). The relatively benign default outlook is reinforced by the persistent environment of steady growth and low inflation. Last week's third estimate showed that second quarter GDP growth was 3.1%, well above most estimates of trend. Meanwhile, the St. Louis Fed Price Pressures Measure predicts only a 2% chance that inflation will rise above 2.5% during the next year (panel 3). This combo of steady growth and low inflation will ensure that Fed policy remains sufficiently accommodative to support high-yield bond returns. MBS: Upgrade To Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 35 basis points in September, bringing year-to-date excess returns up to 26 bps. The conventional 30-year MBS yield rose 10 bps in September, driven by a 19 bps increase in the rate component. This was partially offset by an 8 bps tightening of the option-adjusted spread (OAS), while the compensation for prepayment risk (option cost) narrowed 1 bp. OAS have widened considerably during the past few months. In all likelihood this has been in anticipation of the Fed starting to unwind its MBS portfolio. The result is that MBS no longer look expensive compared to Aaa-rated credit (Chart 4). With more attractive valuations and the Fed's schedule for balance sheet runoff now well known, we think the time is right to edge MBS exposure higher. After having sold the rumor of Fed balance sheet runoff, it is time to buy the news. Arbitrage between MBS and credit should limit how much MBS OAS can widen during the next 6-12 months, even in the face of higher MBS supply. Further, recent spread widening has been helped along by falling mortgage rates and rising refinancings. With Treasury yields and mortgage rates now poised to put in a bottom, refis will also roll over and lend support to the MBS trade (bottom panel). Government-Related: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to 181 bps. Sovereign bonds outperformed the Treasury benchmark by 93 bps on the month. Foreign Agencies and Local Authority bonds outperformed by 25 bps and 46 bps, respectively. Domestic Agency bonds outperformed by 1 bp and Supranationals outperformed by 3 bps. Year-to-date Sovereign bond outperformance has been spurred by dollar weakness, even though spread differentials are tilted firmly in favor of domestic U.S. credit (Chart 5). But with U.S. economic data just now starting to surprise to the upside, we think the tailwind from a weakening dollar is about to fade. Mexico is the single largest issuer in the Sovereign index, and appreciation in the peso versus the U.S. dollar has been a particularly important driver of Sovereign outperformance this year. However, our Emerging Markets Strategy team now believes that peso appreciation is overdone.3 Mexican growth has been supported by strong exports and a weak currency while domestic demand has been soft. Without a solid foundation from domestic demand, this year's currency appreciation will soon cause inflation to roll over and Mexican interest rates to fall. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 62 basis points in September (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 207 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged up from 84% to 86% in September, but it remains extremely tight relative to its post-crisis trading range (Chart 6). State & local government budgets dodged a bullet when the Graham-Cassidy healthcare reform bill was defeated last month. The bill included a block-grant provision for Medicaid that would have reduced federal government transfer payments, a significant source of state & local government revenue. Last week we also learned more specifics about the federal government's proposed tax reform legislation. While the lower tax rates in the proposal are obviously negative for M/T yield ratios, the impact should be somewhat offset by the elimination of tax deductions, the state & local income tax deduction in particular. Eliminating deductions makes the tax advantage in municipal bonds appear more attractive, irrespective of the tax rate. Most importantly, the municipal bond tax exemption itself appears safe. Of course, it will still be some time before we know the final details of tax reform, which our political strategists expect will be passed by the end of Q1 2018. With the plan still not finalized, M/T yield ratios near post-crisis lows look too complacent. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted higher in September and steepened out to the 5-year maturity point. The 2/10 Treasury slope steepened 7 bps and the 5/30 slope flattened 9 bps. The market brought a December rate hike back into focus last month following a somewhat stronger CPI inflation report and Fed Chair Janet Yellen's insistence that low inflation will prove transitory. Our 12-month fed funds discounter, which shows the market's expected change in the fed funds rate during the next 12 months, moved up to 40 bps from 19 bps. As discussed in last week's report,4 we tend to agree with Chair Yellen that inflation will soon follow growth indicators higher. The market implication of this thesis is that wider TIPS breakevens will lead to one last bout of curve steepening this cycle. We continue to position for curve steepening via a trade long the 5-year bullet and short a duration-matched 2/10 barbell. This trade has returned 16 bps since inception last December. At present, our fair value model shows that the 5-year bullet is slightly expensive on the curve (Chart 7). Or put differently, that the 2/5/10 butterfly spread is fairly priced for 2 bps of 2/10 curve steepening during the next 6 months.5 We think curve steepening will easily surpass this threshold and maintain our long 5-year, short 2/10 position. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in September, bringing year-to-date excess returns up to -131 bps. The 10-year TIPS breakeven inflation rate rose 8 bps on the month but, at 1.84%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. CPI beat expectations in August for the first time in several months and, as was discussed in a recent report,6 the bond market was quick to react to even a tentative sign that inflation might have troughed. The market's sensitivity should not be surprising. Leading pipeline indicators of inflation, such as the prices paid and supplier deliveries components of the ISM manufacturing index, suggest that inflation and TIPS breakevens are biased higher (Chart 8). Counter-acting some of the optimism on inflation was the slightly weaker-than-expected August PCE report. While trimmed mean PCE inflation did perk up on a month-over-month basis, the 6-month and 12-month rates of change continue to fall (bottom panel). The 2% inflation target is of utmost importance to the Fed. In our base case scenario there is sufficient inflationary pressure for this target to be achieved with a pace of rate hikes similar to the Fed's median projection. But if that turns out not to be the case, then the Fed will respond with a slower pace of hikes. Either way, long-maturity TIPS breakevens must move higher before the end of the cycle or the Fed will have failed. ABS: Cut To Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in September, dragging year-to-date excess returns down to 68 bps. Credit card and auto loan ABS both underperformed the duration-equivalent Treasury benchmark by 2 bps in September, pulling year-to-date excess returns down to 67 bps and 69 bps, respectively. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month to reach 39 bps. It remains well below its average pre-crisis level (Chart 9). At 39 bps, the Aaa-rated ABS spread is still 11 bps wider than the average option-adjusted spread for conventional 30-year agency MBS. However, as we observed in last week's report,7 delinquency rates for consumer credit (credit cards, auto loans and student loans) are rising, while mortgage delinquency rates continue to fall. This squares with the message from the Fed's Senior Loan Officer Survey which shows that lending standards are tightening for both credit cards and auto loans (bottom panel). While delinquencies appear to have bottomed, the charge-off rate in credit card ABS collateral pools remains near all-time lows. Meanwhile, net losses in auto loan ABS collateral pools are in a clear uptrend. We continue to prefer Aaa-rated credit card ABS over Aaa-rated auto loan ABS, but are wary that credit card charge-offs will also start to increase in the near future, albeit from very low levels. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in September, dragging year-to-date excess returns down to 110 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, but it remains well below its average pre-crisis level. Fundamentally, the commercial real estate space continues to be characterized by tightening lending standards and falling demand (Chart 10) and, outside of the multi-family sector, CMBS delinquencies are trending higher (panel 5). Against this back-drop, spreads are not wide enough to entice us. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to 62 bps. The average index option-adjusted spread for the Agency CMBS index widened 3 bps on the month to reach 51 bps. This compares favorably to the 39 bps offered by Aaa-rated consumer ABS and the 28 bps offered by conventional 30-year Agency MBS. Especially since multi-family delinquency rates remain very low. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.65% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.62%. The Global Manufacturing PMI held flat at 53.2 in September, while bullish sentiment toward the dollar crept higher. This caused our model's fair value to edge lower to 2.65% from 2.67%. The U.S., Eurozone and Japan all saw stronger PMIs in September. While China's PMI dipped slightly (from 51.6 to 51), it remains firmly above the 50 boom/bust line. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?", dated September 20, 2017, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, avail-able at usbs.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017, available at ems.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For further details on our fair value model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Monetary Policy: A prominent Fed Governor has acknowledged that inflation expectations have become un-anchored to the downside. This is an important signal and suggests that the Fed will keep policy easy enough for inflation expectations to recover. TIPS: The combination of a Fed that communicates a desire for higher inflation expectations and an end to the current downtrend in realized core inflation will send TIPS breakevens wider. Yield Curve: Higher inflation expectations will cause the yield curve to steepen on a 6-12 month horizon. Although steepener trades no longer appear cheap on our model, we remain overweight the 5-year bullet versus a duration-matched 2/10 barbell. Feature Chart 1Flight To Safety Focused In Real Yields Flight To Safety Focused In Real Yields Flight To Safety Focused In Real Yields Bond markets digested two important events last week. The first was a politically driven flight to safety. The 10-year yield fell 10 bps (Chart 1) and the average junk spread widened 8 bps as the daily U.S. Policy Uncertainty index1 averaged 121 for the week, its second-highest reading since February. As we have noted in past reports,2 historically the best strategy has been to fade politically driven flights to safety. The second, and more significant, event was a speech3 given by Fed Governor Lael Brainard in which she suggested that inflation expectations have become un-anchored to the downside. As is explained below, this acknowledgement represents an important change in tone from the Fed. One that reinforces our outlook for higher Treasury yields, a steeper yield curve and wider TIPS breakevens on a 6-12 month horizon. You Had One Job The key passage from Governor Brainard's speech is the following: Nonetheless, a variety of measures suggest underlying trend inflation may be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective. To understand the significance of this statement we need some background on how the Fed thinks about inflation. FOMC members tend to apply an expectations-augmented Phillips curve framework to the task of forecasting inflation (Chart 2). Fed Chair Janet Yellen explained this approach in a September 2015 speech.4 In Yellen's words: ...economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations. [...] An important feature of this model of inflation dynamics is that the overall effect that variations in resource utilization, import prices, and other factors will have on inflation depends crucially on whether these influences also affect long-run inflation expectations. In other words, the Fed's model distinguishes between core inflation's long-run trend and its cyclical fluctuations. Cyclical fluctuations are driven by: Resource utilization (usually measured as the unemployment rate minus its estimated natural rate) Non-oil import prices Idiosyncratic shocks In contrast, core inflation's long-run trend is purely a function of long-term inflation expectations. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. In a sense, the worst possible outcome would be if inflation expectations became un-anchored to the downside. Once again, in Janet Yellen's own words: Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation's "normal" behavior, and, furthermore, that a persistent failure to keep inflation under control - by letting it drift either too high or too low for too long - could cause expectations to once again become unmoored. This describes precisely the conventional wisdom as to why the Japanese economy has experienced two decades of deflation despite reasonably high levels of resource utilization. Policymakers did not act quickly or strongly enough following the burst stock market bubble of 1989-91, and this allowed deflationary expectations to become entrenched. In this sense the Japanese experience provides a roadmap for what could happen in the U.S. if the Fed doesn't act quickly to bring inflation expectations back up to target levels. It is true that not all measures of U.S. inflation expectations currently display weakness. For example, the measure we used in our expectations-augmented Phillips curve in Chart 2 - median 10-year PCE expectations from the Survey of Professional Forecasters - appears stable in recent years. However, Governor Brainard pointed to several measures that suggest inflation expectations have already declined (Chart 3). Chart 2The Fed's Inflation Model The Fed's Inflation Model The Fed's Inflation Model Chart 3Still Well Anchored? Still Well Anchored? Still Well Anchored? Comparing the three-year period ending in the second quarter of this year with the three-year period ended just before the financial crisis, 10-year-ahead inflation compensation based on TIPS [...] yields is ¾ percentage point lower. Survey-based measures of inflation expectations are also lower. The Michigan survey measure of median household expectations of inflation over the next five to 10 years suggests a ¼ percentage point downward shift over the most recent three-year period compared with the pre-crisis years, similar to the five-year, five-year forward forecast for the consumer price index from the Survey of Professional Forecasters.5 Investment Implications In our view, there are two important facts to keep in mind: In the Fed's model of inflation it is crucial that long-term inflation expectations do not fall. Otherwise, the odds of replicating the Japanese scenario start to increase. A prominent Fed Governor has now suggested that U.S. inflation expectations have become un-anchored to the downside. Chart 4The Market's Rate Hike Expectations The Market's Rate Hike Expectations The Market's Rate Hike Expectations Taken together, these two facts have important investment implications. First, the two facts suggest that TIPS breakevens will move wider. While the Japanese experience has taught us that "open mouth operations" become less effective once deflationary expectations are entrenched, they should still have some impact in the States. Notice that the decline in Treasury yields that followed Brainard's comments last week was concentrated in the real component. The 10-year TIPS breakeven inflation rate actually rose 2 bps (Chart 1). The combination of a Fed that communicates a desire for higher inflation expectations and an end to the current downtrend in realized core inflation (see "Economy & Inflation" section below) will be enough to send long-dated TIPS breakevens wider on a 6-12 month horizon. Second, a Fed that is committed to staying accommodative for as long as is necessary to ensure that inflation expectations move higher will cause the yield curve to steepen (see section titled "Inflation Expectations Drive The Curve" below). Third, a Fed that is more committed to fighting deflation should bias Treasury yields lower. However, inflationary pressures in the U.S. economy are strong enough that the Fed will be able to move inflation expectations higher while still delivering more rate hikes than are currently priced into the curve. At present, the overnight index swap curve is discounting that the next 25 basis point rate hike will not occur until November 2018 (Chart 4)! Bottom Line: A prominent Fed Governor has acknowledged that inflation expectations have become un-anchored to the downside. This represents an important signal about the future path of policy and reinforces our view that the Treasury curve will bear-steepen during the next 6-12 months, led by wider TIPS breakevens. Inflation Expectations Drive The Curve Our research6 shows that inflation expectations are the most important driver of changes in the slope of the yield curve. This runs counter to the conventional wisdom which states that the curve flattens when the Fed hikes rates, and steepens when it cuts rates. While the correlation between Fed rate moves and the slope of the curve is undeniable, the relationship results purely from the fact that the Fed responds to changes in inflation. The link between inflation expectations and the yield curve is the dominant relationship. To see this we look at Charts 5 and 6. Both charts show monthly changes in the 5-year, 5-year forward TIPS breakeven inflation rate plotted against monthly changes in the nominal 2/10 slope. Chart 5 shows all available historical data, and we observe a strong positive correlation. In fact, 63% of monthly observations fall into either the top-right or bottom-left quadrants indicating that wider breakevens correlate with a steeper curve and vice-versa. Chart 52/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year / ##br##5-Year Forward (February 1999-Present) Open Mouth Operations Open Mouth Operations Chart 62/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year / 5-Year Forward ##br##During Fed Tightening Cycles (June 1999 To May 2000 & June 2004 To June 2006) Open Mouth Operations Open Mouth Operations The more important question, however, is whether this correlation still holds when the Fed is raising rates. Chart 6 focuses only on prior rate hike cycles and still shows a strong positive correlation. 73% of the monthly observations fall into either the top-right or bottom-left quadrants, although in this case there are more observations in the bottom-left quadrant because typically the Fed lifts rates with the goal of sending inflation and inflation expectations lower. In this respect the current rate hike cycle is unique. The Fed is in the process of lifting rates, but as Brainard's speech shows, it still critically needs inflation expectations to rise. We conclude that the Fed will stay easy enough, long enough, for long-dated TIPS breakevens to return to their pre-crisis trading range between 2.4% and 2.5%. An upward adjustment to this range will occur alongside a steeper 2/10 curve. Unit Labor Costs And The Yield Curve The logic presented above also suggests an inverse relationship between the slope of the curve and wage growth. In a world where inflation expectations are well anchored, stronger wage growth encourages the Fed to tighten policy more quickly, this causes the yield curve to flatten. Conversely, softer wage growth leads to a steeper curve. Our research shows that unit labor costs are the measure of wage growth that correlates most closely with the slope of the curve. The reason is that unit labor costs actually measure both wage growth (compensation per hour) and labor productivity (output per hour). Put differently, the yield curve can flatten because labor compensation is rising and the Fed is tightening policy (bear flattening) or it can flatten because productivity is falling and investors are discounting a slower pace of potential growth and a lower terminal fed funds rate (bull flattening). Unit labor costs capture both of these dynamics. Last week saw second quarter productivity growth revised higher from 0.9% to 1.5% and unit labor cost growth revised down from 0.6% to 0.2% (Chart 7). We expect that productivity will continue to experience a modest late-cycle bounce. Usually, payroll growth starts to moderate late in the business cycle as the labor market tightens. The cost of labor typically rises and encourages firms to substitute capital for workers. This late-cycle boost in capital spending tends to correlate with stronger productivity growth (Chart 8), and this dynamic looks to be in full swing at the moment. Payroll growth has been decelerating since early 2015, and durable goods orders have picked up sharply since the end of last year (Chart 8, bottom panel). Chart 7Weakness In Unit Labor Costs Weakness In Unit Labor Costs Weakness In Unit Labor Costs Chart 8Productivity: Look For A Late-Cycle Rebound Productivity: Look For A Late-Cycle Rebound Productivity: Look For A Late-Cycle Rebound A modest late-cycle upswing in productivity growth will put downward pressure on unit labor costs and lead to curve steepening. How To Position For Steepening We have been expressing our yield curve view via a long position in the 5-year bullet and a short position in a duration-matched 2/10 barbell since last December.7 So far that trade has returned +28 bps, even though the 2/10 slope has flattened more than 50 bps since its inception. The reason our curve steepener has outperformed even as the curve has flattened is that, when we initiated our trade, the 2/5/10 butterfly spread was discounting an even larger curve flattening. Put differently, the 5-year bullet looked extremely cheap on the curve (Chart 9).8 Chart 92/5/10 Butterfly Spread Fair Value Model 2/5/10 Butterfly Spread Fair Value Model 2/5/10 Butterfly Spread Fair Value Model This state of affairs has now changed. Our fair value model shows that the 5-year bullet appears slightly expensive compared to the barbell, or alternatively, that the 2/5/10 butterfly spread is priced for a 20 bps steepening of the 2/10 slope during the next six months. According to our model, the 2/10 slope will have to steepen by more than 20 bps during the next six months for our trade to outperform from current levels. Bottom Line: Higher inflation expectations will cause the yield curve to steepen on a 6-12 month horizon. Although steepener trades no longer appear cheap on our model, we remain overweight the 5-year bullet versus a duration-matched 2/10 barbell for now. Economy & Inflation Updates received during the past few weeks indicate that U.S. growth is running solidly above trend, and may even be accelerating. Real second-quarter GDP growth was revised higher from 2.6% to 3%. Second quarter labor productivity growth was also revised higher, as was discussed above. Even following a lackluster August employment report, our back-of-the-envelope tracking estimate for U.S. growth - the sum of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 - is running at 2.7%, well above the Fed's 1.8% estimate of trend (Chart 10). Survey measures also suggest that growth has further upside in the second half of the year, at least according to a simple growth model based on the ISM non-manufacturing survey, our own BCA Beige Book Monitor and a composite of new orders surveys (Chart 11). Chart 10Growth Tracking Above-Trend... Growth Tracking Above-Trend... Growth Tracking Above-Trend... Chart 11...And Surveys Suggest Further Upside ...And Surveys Suggest Further Upside ...And Surveys Suggest Further Upside But bond markets are not getting the message. The 10-year yield is stuck at 2.12%, and the markets seem to be saying that the link between stronger growth and rising inflation has been permanently broken. We disagree and think that investors are simply underestimating the often long and variable lags between economic growth and inflation. Chart 12Inflation Lags Growth Inflation Lags Growth Inflation Lags Growth Chart 12 shows that real GDP growth has tended to lead core inflation by about 18 months, while changes in year-over-year core CPI (the second derivative of prices) have tended to follow the ISM Manufacturing index with a lag of about 12 months. All signs suggest that the recent downtrend in inflation is nothing more than a reaction to the growth deceleration seen between mid-2015 and mid-2016. Now that growth has re-accelerated, inflation is poised to move higher. Bottom Line: Bond markets are priced as though the link between growth and inflation is broken. We expect they will be proven wrong as inflation regains its uptrend during the next few months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 The daily policy uncertainty index measures the number of news items related to economic uncertainty. For further details please see www.policyuncertainty.com 2 Please see U.S. Bond Strategy Weekly Report, "What We Know About Uncertainty", dated July 12, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/brainard20170905a.htm 4 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 5 https://www.federalreserve.gov/newsevents/speech/brainard20170905a.htm 6 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 8 For further details on how butterfly trades respond to changes in the yield curve, and on how we use our fair value yield curve models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1"Trump Trade" Progress Report "Trump Trade" Progress Report "Trump Trade" Progress Report One of our seven investment themes for 2017, published in a Special Report last December, is that the combination of strong U.S. growth and accommodative Fed policy creates a cyclical sweet spot in which risk assets will outperform. After last week's GDP revisions we now know that real growth averaged 2.1% in the first half of the year, solidly above the Fed's 1.8% estimate of trend. Meanwhile, weak inflation has caused markets to discount an exceptionally shallow path for Fed rate hikes - only 19 bps of rate hikes are priced for the next 12 months. This divergence between growth and inflation is reflected in Treasury yields. The real 10-year yield is 24 bps above its pre-election level, while the compensation for inflation protection is only 5 bps higher (Chart 1). Not surprisingly, the cyclical sweet spot has led corporate bonds to outperform duration-matched Treasuries by 296 bps since the election. The persistence of the cyclical sweet spot leads us to believe that last month's politically-driven spread widening should be seen as an opportunity to increase exposure to corporate bonds. Remain at below-benchmark duration and overweight spread product in U.S. fixed income portfolios. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in August, dragging year-to-date excess returns down to 146 bps. The average index option-adjusted spread widened 8 bps on the month to reach 110 bps. In last week's report,1 we demonstrated that to properly assess corporate bond valuations it is not sufficient to simply look at the average index spread. We need to adjust for the fact that both the average credit rating and duration of the index change over time. We also need to consider corporate spreads relative to other similar stages of the economic cycle, not relative to long-run averages. In this respect, considering the breakeven spread2 for each credit tier relative to where it traded in the early stages of prior Fed tightening cycles gives us the best sense of the value proposition in corporate bonds. At present, this analysis shows that while Aaa corporate spreads are expensive, the other investment grade credit tiers all appear fairly valued (Chart 2). Corporate profit data for the second quarter was released last week and showed a big jump in our measure of EBITD (panel 4). This makes it extremely likely that net corporate leverage declined in Q2. All else equal, this lengthens the window for corporate bond outperformance Table 3.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Cyclical Sweet Spot Rolls On The Cyclical Sweet Spot Rolls On Table 3BCorporate Sector Risk Vs. Reward* The Cyclical Sweet Spot Rolls On The Cyclical Sweet Spot Rolls On 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 67 basis points in August, dragging year-to-date excess returns down to 378 bps. The index option adjusted spread widened 26 bps to end the month at 378 bps, 55 bps above the mid-2014 cycle low. Back in March4 we tested a strategy of buying the High-Yield index relative to Treasuries whenever spreads widened by more than 20 bps in a single month, and then holding the trade for a period of one, two or three months. We found that this "buy the dips" strategy works very well when inflationary pressures are low, but performs poorly when inflation is high and rising. When inflation is low the Fed needs to support the recovery by adopting a more dovish posture whenever financial conditions tighten. With the St. Louis Fed Price Pressures Measure5 at only 6% (Chart 3), we expect a "buy the dips" strategy will continue to work for some time. In terms of valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6%, and an expected recovery rate of 49%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -9 bps. The conventional 30-year MBS yield fell 13 bps in August, driven by an 18 bps decline in the rate component. This was partially offset by a 4 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening of the option-adjusted spread (OAS). The Fed is likely to announce the run-off of its balance sheet when it meets later this month. For its part, the market has been pricing-in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments (Chart 4). In this sense, the Fed's commitment to proceed with balance sheet normalization no matter the outlook for the future pace of rate hikes is doubly negative for MBS spreads. OAS are biased wider as Fed buying exits the market, while low rates encourage faster prepayments and a higher option cost component of spreads. Going forward, the option cost component of spreads will decline as mortgage rates cease their downtrend, but OAS still appear too tight relative to trends in net issuance. Despite robust issuance so far this year and the Fed backing away as a buyer, the conventional 30-year MBS OAS remains well below its pre-crisis mean (panel 2). While MBS are starting to look more attractive, especially relative to Aaa credit (panel 3), we think it is still too soon to buy. 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 5 basis points in August, bringing year-to-date excess returns up to 154 bps. The Foreign Agency and Local Authority sectors drove the index outperformance in August. Both beat the duration-matched Treasury benchmark by 12 bps. Sovereigns outperformed the benchmark by 3 bps, Supranationals outperformed by 1 bp, and Domestic Agency bonds underperformed by 2 bps. We took a detailed look at the Sovereign index in a recent report,6 both at the aggregate and individual country levels. At the aggregate level, the two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the U.S. dollar (Chart 5). At present, relative valuation is skewed heavily in favor of domestic U.S. credit (panel 2). Added to that, given downbeat Fed rate hike expectations, we view further dollar weakness as unlikely on a 6-12 month horizon. Taken together, we continue to favor U.S. credit over USD-denominated Sovereign debt. At the country level, we identified several countries where USD-backed debt appears attractive. We found that Finland, Mexico and Colombia all offer attractive spreads. However, the spread pick-up available in Mexican and Colombian debt is compensation for heightened exchange rate volatility. Finnish debt appears the most attractive on a risk/reward basis. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 40 basis points in August (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 144 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio held flat in August, and it remains extremely tight relative to its post-crisis trading range (Chart 6). The M/T yield ratio remains very low despite the fact that state & local government net borrowing continues to rise. Net borrowing increased to $209 billion in Q2, the highest level since the second quarter of last year. Further, the Trump administration appears to be finally tackling the issue of tax reform. While comprehensive tax reform is probably too ambitious, some form of corporate and personal tax cuts seems likely, probably in the first half of next year. Lower tax rates are obviously a negative for municipal bonds, but some of the negative impact could be offset if current tax deductions (such as the deduction of state & local income tax) are removed. All else equal, fewer available tax deductions elsewhere makes the tax exemption of municipal bonds look more attractive. Of course, the municipal bond tax exemption itself could also be threatened, but at least so far this appears less likely. The bottom line is that current M/T yield ratios are far too low given the looming risks of rising state & local government borrowing and looming federal tax cuts. Remain underweight. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull flattened in August. The 2/10 slope flattened 17 bps and the 5/30 slope flattened 2 bps. The market moved to discount an even shallower path for Fed rate hikes in August. At the end of July the market had expected 27 bps of rate hikes during the next 12 months, and that number has now fallen to 19 bps (Chart 7). Consequently, our recommendation to short the July 2018 fed funds futures contract has suffered. The position is now 17 bps in the red, but we continue to believe that the market's expected rate hike path is too benign. From current levels, a position short the July 2018 fed funds futures contract will return 35 bps if there are two hikes between now and next July and 61 bps if there are 3 hikes. We also continue to recommend a position long the 5-year bullet versus a duration-matched 2/10 barbell on the view that the Treasury curve will steepen as inflation and TIPS breakevens move higher. This position has earned 28 bps since initiation last December, but valuation is starting to look less attractive. Our butterfly spread model7 suggests that the 5-year bullet is now slightly expensive compared to the 2/10 barbell (panel 3). Or put differently, that the 2/10 Treasury slope will have to steepen by more than 20 bps during the next 6 months for our trade to earn a positive return. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 36 basis points in August, dragging year-to-date excess returns down to -169 bps. The 10-year TIPS breakeven inflation rate fell 6 bps on the month and, at 1.76%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Despite robust growth, extremely weak realized inflation has caused breakevens to tighten this year. Last week's July PCE release was yet another disappointment. The year-over-year core inflation rate fell from 1.51% to 1.41% and the year-over-year trimmed mean rate fell from 1.68% to 1.64% (Chart 8). However, measures of pipeline inflation pressure such as the supplier deliveries and prices paid components of the ISM Manufacturing survey point towards higher inflation. The supplier deliveries component increased from 55.4 to 57.1 in August (panel 4) while the prices paid component held firm at an elevated 62 (panel 3). Adding it all up, and incorporating the fact that employment growth should stay strong enough to maintain downward pressure on the unemployment rate, we think it is very likely that core inflation will soon reverse course and resume the steady uptrend that began in early 2015. TIPS breakevens will widen alongside. At present, our TIPS Financial model suggests that breakevens are trading in line with other financial market instruments (panel 2). In other words, there is no apparent mis-valuation in breakevens relative to other financial markets, and higher realized inflation is likely required before breakevens move sustainably wider. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in August, bringing year-to-date excess returns up to 71 bps. Aaa-rated ABS outperformed the benchmark by 10 bps in August, bringing year-to-date excess returns up to 63 bps. Meanwhile, non-Aaa ABS outperformed by 26 bps in August, bringing year-to-date excess returns up to 147 bps. Credit card ABS outperformed the Treasury benchmark by 10 bps in August, bringing year-to-date excess returns up to 69 bps. Auto loan ABS outperformed by 12 bps, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month, and remains well below its average pre-crisis level (Chart 9). At 36 bps, the option-adjusted spread for Aaa-rated ABS is now the same as the option-adjusted spread for conventional 30-year Agency MBS. Meanwhile, lending standards are now tightening for both auto loans and credit cards. Further, the New York Fed's Household Debt and Credit Report for the second quarter revealed that "flows of credit card balances into both early and serious delinquencies climbed for the third straight quarter - a trend not seen since 2009."8 While overall credit card charge-offs in ABS collateral pools remain low (panel 4), it is clear that the cyclical winds are shifting against consumer ABS. If the trends of tightening lending standards and rising delinquencies continue, then it will soon be time to reduce consumer ABS exposure, possibly shifting into Agency MBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in August, bringing year-to-date excess returns up to 116 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month, and is approaching one standard deviation below its average pre-crisis level (Chart 10). The combination of tightening lending standards and weaker demand for commercial real estate (CRE) loans (as evidenced by the Fed's Senior Loan Officer Survey) suggests that credit concerns are starting to mount in the CRE space. Meanwhile, CMBS delinquency rates have leveled-off during the past few months and remain much lower in the multi-family space (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to 79 bps. The average index option-adjusted spread for the Agency CMBS index held flat at 48 bps on the month. This compares favorably to the 36 bps offered by both Aaa-rated consumer ABS and conventional 30-year Agency MBS. Not only does the Agency CMBS sector continue to offer an attractive spread relative to both consumer ABS and Agency MBS, but its agency guarantee and concentration in the multi-family space (where delinquencies are still low) makes it look particularly attractive. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.67% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.68%. The Global Manufacturing PMI rose to 53.1 in August, from 52.7 in July, reaching a 75-month high (panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (bottom panel). Taken together, these two factors suggest that not only is global growth accelerating but that the global economic recovery is increasingly broad based. This is an extremely bond-bearish development. A broad based global recovery means that when U.S. data finally start surprising positively, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.16%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Policy Reflections", dated August 29, 2017, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the basis point widening required over a 12-month period before a corporate bond delivers losses relative to a duration-matched Treasury security. We assume no impact from convexity and calculate the breakeven spread as OAS divided by duration. 3 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 The Price Pressures Measure is a composite indicator which shows the percent chance that PCE inflation will exceed 2.5% during the next 12 months. 6 Please see U.S. Bond Strategy Weekly Report, "The Upside Of A Weaker Dollar", dated August 15, 2017, available at usbs.bcaresearch.com 7 For further details on our models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 8 https://www.newyorkfed.org/microeconomics/hhdc Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Financial markets have slipped into a 'risk off' phase. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events. Equity bear markets are usually associated with recessions. On that score, we do not see any warning signs of an economic downturn. However, geopolitical risks are rising at a time when valuation measures suggest that risk assets are vulnerable. We do not see the debt ceiling or the failure of movement on U.S. tax reform as posing large risks for financial markets. However, trade protectionism and, especially, North Korea are major wildcards. We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. BCA Strategists debated trimming equity exposure to neutral. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. On a positive note, we have upgraded our EPS growth forecasts, except in the Eurozone where currency strength will be a significant drag in the near term. The Fed faced a similar low inflation/tight labor market environment in 1999. Policymakers acted pre-emptively and began to tighten before inflation turned up. This time, the FOMC will want to see at least a small increase in inflation just to be sure. Wages may be a lagging indicator for inflation in this cycle. Watch a handful of other indicators we identify that led inflection points in inflation in previous long economic expansions. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook, which has led to very lopsided rate expectations. Keep duration short. Feature Chart I-1Trump Popularity Headwind For Tax Reform September 2017 September 2017 A 'risk off' flavor swept over financial markets in August. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to North Korean tensions to the Texas flood and the terror attack in Spain. Trump's popularity rating is steadily declining, even now among Republican voters (Chart I-1). This has raised concerns that none of his business-friendly policies, tax cuts or initiatives to boost growth will be successfully enacted. It is even possible that the debt ceiling will be used as a bargaining chip among the various Republican factions. The political risks are multiplying at a time when the equity and corporate bond markets are pricey. Valuation measures do not help with timing, but they do inform on the potential downside risk if things head south. At the moment, we do not see any single risk as justifying a full retreat into safe havens and a cut in risk asset allocation to neutral or below. Nonetheless, there is certainly a case to be cautious and hold some traditional safe haven assets. Timing The Next Equity Bear Market It is rare to have an equity bear market without a recession in the U.S. There have been plenty of market setbacks that did not quite meet the 20% bear-market threshold, but were nonetheless painful even in the absence of recession (Black Monday, LTCM crisis, U.S. debt ceiling showdown and euro crises). Unfortunately, these corrections are very difficult to predict. At least with recessions, investors have a fighting chance in timing the exit from risk exposure. The slope of the yield curve and the Leading Economic Indicator (LEI) are classic recession indicators, and for good reason (Chart I-2). Over the past 50 years they have both successfully called all seven recessions with just one false positive. We can eliminate the false positive signals by combining the two indicators and follow a rule that both must be in the red to herald a recession.1 Chart I-2The Traditional Recession Indicators Have Worked Well The Traditional Recession Indicators Have Worked Well The Traditional Recession Indicators Have Worked Well It will be almost impossible for the yield curve to invert until the fed funds rate is significantly higher than it is today. Thus, it may be the case that a negative reading on the LEI, together with a flattening (but not yet inverted) yield curve, will be a powerful signal that a recession is on the way. Neither of these two indicators are warning of a recession. Global PMIs are hovering at a level that is consistent with robust growth. The erosion in the Global ZEW and the drop in the diffusion index of the Global LEI are worrying signs, but at the moment are consistent with a growth slowdown at worst (Chart I-3). Financial conditions remain growth-friendly and subdued inflation is allowing central banks to proceed cautiously when tightening (in the case of the Fed and Bank of Canada) or tapering (ECB). As highlighted in last month's Overview, the global economy has entered a synchronized upturn that should persist for the next year. The U.S. will be the first major economy to enter the next recession, but that should not occur until 2019 or 2020, barring any shocks in the near term. That said, risk asset prices have been bid up sharply and are therefore vulnerable to a correction. Below, we discuss five key risks to the equity bull market. (1) Is All Lost For U.S. Tax Cuts? Our recent client meetings highlight that investors are skeptical that any fiscal stimulus or tax cuts will see the light of day in the U.S. Tax cuts and infrastructure spending appear to have been priced out of the equity market, according to the index ratios shown in Chart I-4. We still expect a modest package to eventually be passed, although time is running out for this year. Tax reform is a major component of Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart I-3Some Worrying Signs On Growth Some Worrying Signs On Growth Some Worrying Signs On Growth Chart I-4Fiscal Stimulus Largely Priced Out Fiscal Stimulus Largely Priced Out Fiscal Stimulus Largely Priced Out One implication of Tropical Storm Harvey is that it might force Democrats and Republicans to cooperate on an infrastructure bill for rebuilding. Even a modest spending boost or tax reduction would be equity-market positive given that so little is currently discounted. The dollar should also receive a lift, especially given that the Fed might respond to any fiscally-driven growth impulse with higher interest rates. (2) Who Will Lead The Fed? There is a significant chance that either Yellen will refuse to stay on when her term expires next February or that Trump will appoint someone else anyway. In this case, we would expect the President to do everything he can to ensure that the Fed retains its dovish bias. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. Cohn could not arrive at the Fed and change the course of monetary policy on day one. The FOMC votes on rate changes, but in reality decisions are formed by consensus (with one or two dissents). The only way Cohn could implement an abrupt change in policy is if the Administration stacks the Fed Governors with appointees that are prepared to "toe the line" (the Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. Nonetheless, it is not clear why President Trump would take a heavy hand in monetary policy when the current FOMC has been very cautious in tightening policy. The bottom line is that we would not see Cohn's appointment to the Fed Chair as signaling a major shift in monetary policy one way or the other. (3) The Debt Ceiling A more immediate threat is the debt ceiling. Recent fights over Obamacare and tax reform have pit fiscally conservative Republicans against the moderates, and it is possible that the debt ceiling is used as a bargaining chip in this battle. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors or a halt to other entitlement programs. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is considerably divided on the issue. This augurs well for a clean bill to raise the debt ceiling as the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown in the first half of October, just before the debt ceiling is hit. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. That said, the risk of even a shutdown has been diminished by events in Houston. It would be very difficult and damaging politically to shut down the government during a humanitarian emergency. (4) Trade And Protectionism The removal of White House Chief Strategist Stephen Bannon signals a shift in power toward the Goldman clique within the Trump Administration. National Economic Council President Gary Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. The mainstream media has interpreted this shift within the Administration as reducing the risk of trade friction. We do not see it that way. President Trump still sounds hawkish on trade, particularly with respect to China. Our geopolitical experts point out that there are few constraints on the President to imposing trade sanctions on China or other countries. He could use such action to boost his popularity among his base heading into next year's midterm elections. On NAFTA, the Administration took a hard line as negotiations kicked off in August. This could be no more than a negotiating tactic. Our base case is that it will be some time before investors find out if negotiations are going off the rails. That said, the situation is volatile for both NAFTA and China, and we can't rule out a trade-related risk-off phase in financial markets over the next year. (5) North Korea North Korea's missile launch over Japan highlights that the tense situation is a long way from a resolution. The U.S. is unlikely to use military force to resolve the standoff. There are long-standing constraints to war, including the likelihood of a high death toll in Seoul. Moreover, China is unlikely to remain neutral in any conflict. However, the U.S. will attempt to establish a credible threat in order to contain Kim Jong-un. From an investor's perspective, it will be difficult to gauge whether the brinkmanship and military displays are simply posturing or evidence of real preparations for war.2 We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. Adding it all up, there is no shortage of things to keep investors awake at night. We would be de-risking our recommended portfolio were it not for the favorable earnings backdrop in the major advanced economies. Profit Outlook Update Chart I-5EPS Growth Outlook EPS Growth Outlook EPS Growth Outlook Second quarter earnings season came in even stronger than our upbeat models suggested in the U.S., Eurozone and Japan. This led to upward revisions to our EPS growth forecast, except in the Eurozone where currency strength will be a significant drag in the near term. The U.S. equity market enjoyed another quarter of margin expansion in Q2 2017 and the good news was broadly based. Earnings per share were higher versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Looking ahead, an update of our top-down model suggests the EPS growth will peak just under 20% late this year on a 4-quarter moving average basis, before falling to mid-single digits by the end of 2018 (Chart I-5). The peak is predicted to be a little higher than we previously forecast largely due to the feed-through of this year's pullback in the dollar. In Japan, a solid 70% of reporting firms beat estimates. Chart I-6 shows that Japan led all other major stock markets in positive earnings surprises in the second quarter. Manufacturing sectors, such as iron & steel, chemicals and machinery & electronics, were particularly impressive in the quarter, reflecting yen weakness and robust overseas demand. Japanese earnings are highly geared to the rebound in global industrial production. Moreover, Japan's nominal GDP growth accelerated in the second quarter and the latest PPI report suggested that corporate pricing power has improved. Twelve-month forward EPS estimates have risen to fresh all times highs, and have outperformed the U.S. in local currencies so far this year. Corporate governance reform - a key element of Abenomics - can take some credit for the good news on earnings. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. We expect trailing EPS growth to peak at about 25% in the first half of 2018 on a 4-quarter moving total basis, before edging lower by the end of the year. This is one reason why we like the Japanese market over the U.S. in local currency terms. Second quarter results in the Eurozone were solid, although not as impressive as in the U.S. and Japan. The 6% rise in the trade-weighted euro this year has resulted in a drop in the earnings revisions ratio into negative territory. Our previous forecast pointed to a continued rise in the 4-quarter moving average growth rate into the first half of 2018. However, we now expect the growth rate to dip by year end, before picking up somewhat next year. If the euro is flat from today's level, our model suggests that the drag on EPS growth will hover at 3-4 percentage points through the first half of next year as the negative impact feeds through (Chart I-7, bottom panel). Chart I-6Japan Led In Q2 Earning Surprises September 2017 September 2017 Chart I-7Currency Effects On Eurozone EPS Currency Effects On Eurozone EPS Currency Effects On Eurozone EPS Our top-down EPS model highlights that Eurozone earnings are quite sensitive to swings in the currency. In Chart I-7, we present alternative scenarios based on the euro weakening to EUR/USD 1.10 and strengthening to EUR/USD 1.30. For demonstration purposes we make the extreme assumption that the trade-weighted value of the euro rises and falls by the same amount in percentage terms. Profit growth decelerates by the end of 2017 in all three scenarios because of the lagged effect of currency swings. The projections begin to diverge only in 2018. EPS growth surges to around 20% by the end of next year in the euro-bear case, as the tailwind from the weakening currency combines with continuing robust economic growth. Conversely, trailing earnings growth hovers in the 5-8% range in the euro bull scenario, which is substantially less than we expect in the U.S. and Japan over the next year. EPS growth remains in positive territory because the assumed strength in European and global growth dominates the drag from the euro. The strong euro scenario would be negative for Eurozone equity relative performance versus global stocks in local currencies, although Europe might outperform on a common currency basis. The bottom line is that 12-month forward earnings estimates should remain in an uptrend in the three major economies. This means that, absent a negative political shock, the equity bull phase should resume in the coming months. Monetary policy is unlikely to spoil the party for risk assets, although the bond market is a source of risk because investors seem unprepared for even a modest rise in inflation. FOMC Has Seen This Before The Minutes from the July FOMC meeting highlighted that the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike and how policy should adjust to changing financial conditions. Chart I-8The FOMC Has Been Here Before The FOMC Has Been Here Before The FOMC Has Been Here Before The majority of policymakers are willing for now to believe that this year's soft inflation readings are driven largely by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excess risk taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. The hawks are thus anxious to resume tightening, despite current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. In this month's Special Report beginning on page 18, we have a close look at the impact of "Amazonification" in holding down overall inflation. We do not find the evidence regarding e-commerce compelling, but the jury is still out on the impact of other technologies. If robots and new business strategies are indeed weighing on inflation, it would mean that the Phillips curve is very flat or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. The last time the Fed was perplexed by a low level of inflation despite a tight labor market was in the late 1990s (Chart I-8). The FOMC cut rates following the LTCM financial crisis in late 1998, and then held the fed funds rate unchanged at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period at 1% to 1½%, even as the unemployment rate steadily declined and various measures pointed to growing labor shortages. The FOMC 's internal debate in the first half of 1999 sounded very familiar. The minutes from meetings at that time noted that some policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. Some argued that significant cost saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite the absence of any clear indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, exactly the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation/tight labor market environment before, but in the end patience ran out and policymakers acted pre-emptively. Inflation Warning Signs During Long-Expansions We have noted in previous research that inflation pressures are slower to emerge in 'slow burn' recoveries, such as the 1980s and 1990s. In Chart I-9, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth was a lagging indicator. Economic commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. This is not to say that we should totally disregard wage information. But it does mean that we must keep an eye on a wider set of data. Indicators that provided some leading information in the previous two long cycles are shown in Chart I-10. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart I-10 because it does not have enough history. At the moment, the headline PPI, ISM Prices Paid and BCA's pipeline inflation pressure index are all warning that inflation pressures are gradually building. However, this message is not confirmed by the St. Louis Fed's index and corporate selling prices. We are also watching the velocity of money, which has been a reasonably good leading indicator for U.S. inflation since 2000 (Chart I-11). Chart I-9In The 80s & 90s Wage Growth ##br##Gave No Early Warning On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On Inflation Chart I-10Leading Indicators Of Inflation ##br##In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Chart I-11Money Velocity And Inflation Money Velocity And Inflation Money Velocity And Inflation Our Fed view remains unchanged from last month; the FOMC will announce its balance sheet diet plan in September and the next rate hike will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation edges higher in the coming months. Some indicators are pointing in that direction and recent dollar weakness will help. Wake Me When Inflation Picks Up Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook. They also believe that persistent economic headwinds mean that monetary policy will need to stay highly accommodative for a very long time. Only one Fed rate hike is discounted between now and the end of 2018, and implied forward real short-term rates are negative until 2022. While we do not foresee surging inflation, the risks for market expectations appear quite lopsided. We expect one rate hike by year end, followed by at least another 50 basis points of tightening in 2018. The U.S. 10-year yield is also about almost 50 basis points below our short-term fair value estimate (Chart I-12). Moreover, over the medium- and long-term, reduced central bank bond purchases will impart gentle upward pressure on equilibrium bond yields. Twenty-eighteen will be the first time in four years in which the net supply of government bonds available to private investors will rise, taking the U.S., U.K., Eurozone and Japanese markets as a group. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. The currency appreciation will keep a lid on inflation in the near term. However, we see the euro's ascent as reflective of the booming economy, rather than a major headwind that will derail the growth story. Overall financial conditions have tightened this year, but only back to levels that persisted through 2016 (Chart I-13). Chart I-12U.S. 10-year Yield Is Below Fair Value U.S. 10-year Yield Is Below Fair Value U.S. 10-year Yield Is Below Fair Value Chart I-13Financial Conditions Financial Conditions Financial Conditions It will take clear signs that the economy is being negatively affected by currency strength for the ECB to back away from tapering. Indeed, the central bank has little choice because the bond buying program is approaching important technical limits. European corporate and peripheral bond spreads are likely to widen versus bunds as a result. The implication is that global yields have significant upside potential relative to forward rates, especially in the U.S. market. Duration should be kept short. JGBs are the only safe place to hide if global yields shift up because the Bank of Japan is a long way from abandoning its 10-year yield peg. Treasury yields should lead the way higher, which will finally place a bottom under the beleaguered dollar. Nonetheless, we are tactically at neutral on the greenback. Conclusions Chart I-14Gold Loves Geopolitical Crises September 2017 September 2017 In light of rising geopolitical risk, the BCA Strategists recently debated trimming equity exposure to neutral. Some argued that the risk/reward balance has deteriorated; the upside is limited by poor valuation, while there is significant downside potential if the North Korean situation deteriorates alarmingly. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasurys, Swiss bonds and JGBs have been the best performers in times of crisis (Chart I-14).3 The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Gold has tended to perform well in geopolitical events and recessions, although not in financial crises. We continue to prefer Japanese to U.S. stocks in local currency terms, given that EPS growth will likely peak in the U.S. first. Japanese stocks are also better valued. Europe is a tough call because this year's currency strength will weigh on earnings in the next quarter or two. However, the negative impact on earnings will reverse if the euro retraces as we expect. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. Our dollar and duration positions have been disappointing so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the idea that structural headwinds to inflation will forever dominate the cyclical pressures. This means that the bond market is totally unprepared for any upside surprises on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to us to be predominantly to the upside. Lastly, crude oil inventories are shrinking as our commodity strategists predicted. They remain bullish, with a price target of USD60/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst August 31, 2017 Next Report: September 28, 2017 1 Please see BCA Global ETF Strategy, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com 3 Please see BCA Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com II. Did Amazon Kill The Phillips Curve? A "culture of profound cost reduction" has gripped the business sector since the GFC according to one school of thought, permanently changing the relationship between labor market slack and wages or inflation. If true, it could mean that central banks are almost powerless to reach their inflation targets. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. In theory, positive supply shocks should not have more than a temporary impact on inflation if the price level is indeed a monetary phenomenon in the long term. But a series of positive supply shocks could make it appear for quite a while that low inflation is structural in nature. We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence at the macro level. The admittedly inadequate measures of online prices available today do not suggest that e-commerce sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points. Moreover, it does not appear that the disinflationary impact of competition in the retail sector has intensified over the years. Today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. However, the fact that retail margins are near secular highs outside of department stores argues against this thesis. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High profit margins for the overall corporate sector and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. Anecdotal evidence is all around us. The global economy is evolving and it seems that all of the major changes are deflationary. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. Central banks in the major advanced economies are having difficulty meeting their inflation targets, even in the U.S. where the labor market is tight by historical standards. Based on the depressed level of bond yields, it appears that the majority of investors believe that inflation headwinds will remain formidable for a long time. One school of thought is that low inflation reflects a lack of demand growth in the post-Great Financial Crisis (GFC) period. Another school points to the supply side of the economy. A recent report by Prudential Financial highlights "...obvious examples of ... new business models and new organizational structures, whereby higher-cost traditional methods of production, transportation, and distribution are displaced by more nontraditional cost-effective ways of conducting business."1 A "culture of profound cost reduction" has gripped the business sector since the GFC according to this school, permanently changing the relationship between labor market slack and wages or inflation (i.e., the Phillips Curve). Employees are less aggressive in their wage demands in a world where robots are threatening humans in a broadening array of industrial categories. Many feel lucky just to have a job. In a highly sensationalized article called "How The Internet Economy Killed Inflation," Forbes argued that "the internet has reduced many of the traditional barriers to entry that protect companies from competition and created a race to the bottom for prices in a number of categories." Forbes believes that new technologies are placing downward pressure on inflation by depressing wages, increasing productivity and encouraging competition. There are many factors that have the potential to weigh on prices, but analysts are mainly focusing on e-commerce, robotics, artificial intelligence, and the gig economy. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. The latter refers to the advent of new business models that cut out layers of middlemen between producers and consumers. Amazonification E-commerce has grown at a compound annual rate of more than 9% over the past 15 years, and now accounts for about 8½% of total U.S. retail sales (Chart II-1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart II-2). Amazon's business model not only cuts costs by eliminating middlemen and (until recently) avoiding expensive showrooms, but it also provides a platform for improved price discovery on an extremely broad array of goods. In 2013, Amazon carried 230 million items for sale in the United States, nearly 30 times the number sold by Walmart, one of the largest retailers in the world. Chart II-1E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share Chart II-2Amazon Dominates September 2017 September 2017 With the use of a smartphone, consumers can check the price of an item on Amazon while shopping in a physical store. Studies show that it does not require a large price gap for shoppers to buy online rather than in-store. Amazon appears to be impacting other retailers' ability to pass though cost increases, leading to a rash of retail outlet closings. Sears alone announced the closure of 300 retail outlets this year. The devastation that Amazon inflicted on the book industry is well known. It is no wonder then, that Amazon's purchase of Whole Foods Market, a grocery chain, sent shivers down the spines of CEOs not only in the food industry, but in the broader retail industry as well. What would prevent Amazon from applying its model to furniture and appliances, electronics or drugstores? It seems that no retail space is safe. A Little Theory Before we turn to the evidence, let's review the macro theory related to positive supply shocks. The internet could be lowering prices by moving product markets toward the "perfect competition" model. The internet trims search costs, improves price transparency and reduces barriers to entry. The internet also allows for shorter supply chains, as layers of wholesalers and other intermediaries are removed and e-commerce companies allow more direct contact between consumers and producers. Fewer inventories and a smaller "brick and mortar" infrastructure take additional costs out of the system. Economic theory suggests that the result of this positive supply shock will be greater product market competition, increased productivity and reduced profitability. In the long run, workers should benefit from the productivity boost via real wage gains (even if nominal wage growth is lackluster). Workers may lower their reservation wage if they feel that increased competitive pressures or technology threaten their jobs. The internet is also likely to improve job matching between the unemployed and available vacancies, which should lead to a fall in the full-employment level of unemployment (NAIRU). Nonetheless, the internet should not have a permanent impact on inflation. The lower level of NAIRU and the direct effects of the internet on consumer prices discussed above allow inflation to fall below the central bank's target. The bank responds by lowering interest rates, stimulating demand and thereby driving unemployment down to the new lower level of NAIRU. Over time, inflation will drift back up toward target. In other words, a greater degree of the competition should boost the supply side of the economy and lower NAIRU, but it should not result in a permanently lower rate of inflation if inflation is indeed a monetary phenomenon and central banks strive to meet their targets. Still, one could imagine a series of supply shocks that are spread out over time, with each having a temporary negative impact on prices such that it appears for a while that inflation has been permanently depressed. This could be an accurate description of the current situation in the U.S. and some of the other major countries. We have sympathy for the view that the internet and new business models are increasing competition, cutting costs and thereby limiting price increases in some areas. But is there any hard evidence? Is the competitive effect that large, and is it any more intense than in the past? There are a number of reasons to be skeptical because most of the evidence does not support Forbes' claim that the internet has killed inflation. (1) E-commerce affects only a small part of the Consumer Price Index As mentioned above, online shopping for goods represents 8.5% of total retail sales in the U.S. E-commerce is concentrated in four kinds of businesses (Table II-1): Furniture & Home Furnishings (7% of total retail sales), Electronics & Appliances (20%), Health & Personal Care (15%), and Clothing (10%). Since goods make up 40% of the CPI, then 3.2% (8% times 40%) is a ballpark estimate for the size of goods e-commerce in the CPI. Table II-1E-Commerce Market Share Of Goods Sector (2015) September 2017 September 2017 Table II-2 shows the relative size of e-commerce in the service sector. The analysis is complicated by the fact that the data on services includes B-to-B sales in addition to B-to-C.2 However, e-commerce represents almost 4% of total sales for the service categories tracked by the BLS. Services make up 60% of the CPI, but the size drops to 26% if we exclude shelter (which is probably not affected by online shopping). Thus, e-commerce in the service sector likely affects 1% (3.9% times 26%) of the CPI. Table II-2E-Commerce Market Share Of Service Sector (2015) September 2017 September 2017 Adding goods and services, online shopping affects about 4.2% of the CPI index at most. The bottom line is that the relatively small size of e-commerce at the consumer level limits any estimate of the impact of online sales on the broad inflation rate. (2) Most of the deceleration in inflation since 2007 has been in areas unaffected by e-commerce Table II-3 compares the average contribution to annual average CPI inflation during 2000-2007 with that of 2007-2016. Average annual inflation fell from 2.9% in the seven years before the Great Recession to 1.8% after, for a total decline of just over 1 percentage point. The deceleration is almost fully explained by Energy, Food and Owners' Equivalent Rent. The bottom part of Table II-3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table II-3Comparison Of Pre- and Post-Lehman Inflation Rates September 2017 September 2017 (3) The cost advantages for online sellers are overstated Bain & Company, a U.S. consultancy, argues that e-commerce will not grow in importance indefinitely and come to dominate consumer spending.3 E-commerce sales are already slowing. Market share is following a classic S-shaped curve that, Bain estimates, will top out at under 30% by 2030. First, not everyone wants to buy everything online. Products that are well known to consumers and purchased on a regular basis are well suited to online shopping. But for many other products, consumers need to see and feel the product in person before making a purchase. Second, the cost savings of online selling versus traditional brick and mortar stores is not as great as many believe. Bain claims that many e-commerce businesses struggle to make a profit. The information technology, distribution centers, shipping, and returns processing required by e-commerce companies can cost as much as running physical stores in some cases. E-tailers often cannot ship directly from manufacturers to consumers; they need large and expensive fulfillment centers and a very generous returns policy. Moreover, online and offline sales models are becoming blurred. Retailers with physical stores are growing their e-commerce operations, while previously pure e-commerce plays are adding stores or negotiating space in other retailers' stores. Even Amazon now has storefronts. The shift toward an "multichannel" selling model underscores that there are benefits to traditional brick-and-mortar stores that will ensure that they will not completely disappear. (4) E-commerce is not the first revolution in the retail sector The retail sector has changed significantly over the decades and it is not clear that the disinflationary effect of the latest revolution, e-commerce, is any more intense than in the past. Economists at Goldman Sachs point out that the growth of Amazon's market share in recent years still lags that of Walmart and other "big box" stores in the 1990s (Chart II-3).4 This fact suggests that "Amazonification" may not be as disinflationary as the previous big-box revolution. (5) Weak productivity growth and high profit margins are inconsistent with a large supply-side benefit from e-commerce As discussed above, economic theory suggests that a positive supply shock that cuts costs and boosts competition should trim profit margins and lift productivity. The problem is that the margins and productivity have moved in the opposite direction that economic theory would suggest (Chart II-4). Chart II-3Amazon Vs. Walmart: ##br##Who's More Deflationary? September 2017 September 2017 Chart II-4Incompatible With A Supply Shock Incompatible With A Supply Shock Incompatible With A Supply Shock By definition, productivity rises when firms can produce the same output with fewer or cheaper inputs. However, it is well documented that productivity growth has been in a downtrend since the 1990s, and has been dismally low since the Great Recession. A Special Report from BCA's Global Investment Strategy5 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, in many industries it appears that productivity is over-estimated. If e-commerce is big enough to "move the dial" on overall inflation, it should be big enough to see in the aggregate productivity figures. Chart II-5Retail Margin Squeeze ##br##Only In Department Stores Retail Margin Squeeze Only In Department Stores Retail Margin Squeeze Only In Department Stores One would also expect to see a margin squeeze across industries if e-commerce is indeed generating a lot of deflationary competitive pressure. Despite dismally depressed productivity, however, corporate profit margins are at the high end of the historical range across most of the sectors of the S&P 500. This is the case even in the retailing sector outside of department stores (Chart II-5). These facts argue against the idea that the internet has moved the economy further toward a disinflationary "perfect competition" model. (6) Online price setting is characterized by frictions comparable to traditional retail We would expect to observe a low price dispersion across online vendors since the internet has apparently lowered the cost of monitoring competitors' prices and the cost of searching for the lowest price. We would also expect to see fairly synchronized price adjustments; if one vendor adjusts its price due to changing market conditions, then the rest should quickly follow to avoid suffering a massive loss of market share. However, a recent study of price-setting practices in the U.S. and U.K. found that this is not the case.6 The dataset covered a broad spectrum of consumer goods and sellers over a two-year period, comparing online with offline prices. The researchers found that market pricing "frictions" are surprisingly elevated in the online world. Price dispersion is high in absolute terms and on par with offline pricing. Academics for years have puzzled over high price rigidities and dispersion in retail stores in the context of an apparently stiff competitive environment, and it appears that online pricing is not much better. The study did not cover a long enough period to see if frictions were even worse in the past. Nonetheless, the evidence available suggests that the lower cost of monitoring prices afforded by the internet has not led to significant price convergence across sellers online or offline. Another study compared online and offline prices for multichannel retailers, using the massive database provided by the Billion Prices Project at MIT.7 The database covers prices across 10 countries. The study found that retailers charged the same price online as in-store in 72% of cases. The average discount was 4% for those cases in which there was a markdown online. If the observations with identical prices are included, the average online/offline price difference was just 1%. (7) Some measures of online prices have grown at about the same pace as the CPI index The U.S. Bureau of Labor Statistics does include online sales when constructing the Consumer Price Index. It even includes peer-to-peer sales by companies such as Airbnb and Uber. However, the BLS admits that its sample lags the popularity of such services by a few years. Moreover, while the BLS is trying to capture the rising proportion of sales done via e-commerce, "outlet bias" means that the CPI does not capture the price effect in cases where consumers are finding cheaper prices online. This is because the BLS weights the growth rate of online and offline prices, not the price levels. While there may be level differences, there is no reason to believe that the inflation rates for similar goods sold online and offline differ significantly. If the inflation rates are close, then the growing share of online sales will not affect overall inflation based on the BLS methodology. The BLS argues that any bias in the CPI due to outlet bias is mitigated to the extent that physical stores offer a higher level of service. Thus, price differences may not be that great after quality-adjustment. All this suggests that the actual consumer price inflation rate could be somewhat lower than the official rate. Nonetheless, it does not necessarily mean that inflation, properly measured, is being depressed by e-commerce to a meaningful extent. Indeed, Chart II-6 highlights that the U.S. component of the Billion Prices Index rose at a faster pace than the overall CPI between 2009 and 2014. The Online Price Index fell in absolute and relative terms from 2014 to mid-2016, but rose sharply toward the end of 2016. Applying our guesstimate of the weight of e-commerce in the CPI (3.2% for goods), online price inflation added to overall annual CPI inflation by about 0.3 percentage points in 2016 (bottom panel of Chart II-6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart II-7). Online prices fell relative to the overall CPI for most of the time since the early 1990s, with the relative price decline accelerating since the GFC. However, our estimate of the contribution to overall annual CPI inflation is only about -0.15 percentage points in June 2017, and has never been more than -0.3 percentage points. This could be an underestimate because it does not include the impact of services, although the service e-commerce share of the CPI is very small. Chart II-6Online Price Index Online Price Index Online Price Index Chart II-7Electronic Shopping Price Index Electronic Shopping Price Index Electronic Shopping Price Index Another way to approach this question is to focus on the parts of the CPI that are most exposed to e-commerce. It is impossible to separate the effect of e-commerce on inflation from other drivers of productivity. Nonetheless, if online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. We combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure according to the BLS' annual Retail Survey (Chart II-8). The sectors in our aggregate e-commerce price proxy include hotels/motels, taxicabs, books & magazines, clothing, computer hardware, drugs, health & beauty aids, electronics & appliances, alcoholic beverages, furniture & home furnishings, sporting goods, air transportation, travel arrangement and reservation services, educational services and other merchandise. The sectors are weighted based on their respective weights in the CPI. Our e-commerce price proxy has generally fallen relative to the overall CPI index since 2000. However, while the average contribution of these sectors to the overall annual CPI inflation rate has fallen in the post GFC period relative to the 2000-2007 period, the average difference is only 0.2 percentage points. The contribution has hovered around the zero mark for the past 2½ years. Surprisingly, price indexes have increased by more than the overall CPI since 2000 in some sectors where one would have expected to see significant relative price deflation, such as taxis, hotels, travel arrangement and even books. One could argue that significant measurement error must be a factor. How could the price of books have gone up faster than the CPI? Sectors displaying the most relative price declines are clothing, computers, electronics, furniture, sporting goods, air travel and other goods. We recalculated our e-commerce proxy using only these deflating sectors, but we boosted their weights such that the overall weight of the proxy in the CPI is kept the same as our full e-commerce proxy discussed above. In other words, this approach implicitly assumes that the excluded sectors (taxis, books, hotels and travel arrangement) actually deflated at the average pace of the sectors that remain in the index. Our adjusted e-commerce proxy suggests that online pricing reduced overall CPI inflation by about 0.1-to-0.2 percentage points in recent years (Chart II-9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart II-8BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index Chart II-9BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index Admittedly, data limitations mean that all of the above estimates of the impact of e-commerce are ballpark figures. Conclusions We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence. The available data are admittedly far from ideal for confirming or disproving the "Amazonification" thesis. Perhaps better measures of e-commerce pricing will emerge in the future. Nonetheless, the measures available today do not suggest that online sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points, and it does not appear that the disinflationary impact has intensified by much. One could argue that lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. Nonetheless, if this were the case, then we would expect to see significant margin compression in the retail sector. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High corporate profit margins and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Finally, today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. Rising online activity means that we need fewer shopping malls and big box outlets to support a given level of consumer spending. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. To the extent that central banks were slow to recognize that equilibrium rates had fallen to extremely low levels, then policy was behind the curve and this might have contributed to the current low inflation environment. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Robert F. DeLucia, "Economic Perspective: A Nontraditional Analysis Of Inflation," Prudential Capital Group (August 21, 2017). 2 Business to business, and business to consumer. 3 Aaron Cheris, Darrell Rigby and Suzanne Tager, "The Power Of Omnichannel Stores," Bain & Company Insights: Retail Holiday Newsletter 2016-2017 (December 19, 2016). 4 "US Daily: The Internet And Inflation: How Big Is The Amazon Effect?" Goldman Sachs Economic Research (August 2, 2017). 5 Please see Global Investment Strategy Weekly Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 6 Yuriy Gorodnichenko, Viacheslav Sheremirov, and Oleksandr Talavera, "Price Setting In Online Markets: Does IT Click?" Journal of the European Economic Association (July 2016). 7 Alberto Cavallo, "Are Online And Offline Prices Similar? Evidence From Large Multi-Channel Retailers," NBER Working Paper No. 22142 (March 2016). III. Indicators And Reference Charts Stocks struggled in August on the back of intensifying geopolitical risks, such that equity returns slipped versus bonds in the month. The earnings backdrop remains constructive for global stocks. In the U.S., 12-month forward EPS estimates continue to climb, in line with upbeat net revisions and earnings surprises. Nonetheless, the risk/reward balance has deteriorated due to escalating risks inside and outside of the U.S. Allocation to risk assets should still exceed benchmark, but should be shy of maximum settings. It is prudent to hold some of the traditional safe haven assets, including gold. Our new Revealed Preference Indicator (RPI) remained at 100% in August, sending a bullish message for equities. We introduced the RPI in the July report. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. WTP topped out in June and the same occurred in August for the Japan and the Eurozone indexes. While the indicators are still bullish, they highlight that flows into the equity markets in the major countries are beginning to moderate. These indicators would have to clearly turn lower to provide a bearish signal for stocks. The VIX increased last month, but remains depressed by historical standards. This implies that the equity market is vulnerable to bad news. However, investor sentiment is close to neutral and our speculation index has pulled back from previously elevated levels. These suggest that investors are not overly long at the moment. Our monetary indicator is only slightly negative, but the equity technical indicator is close to breaking below the 9-month moving average (a negative technical sign). Bond valuation continues to hover near fair value, according to our long-standing model that is based on a simple regression of the nominal 10-year yield on short-term real interest rates and a moving average of inflation. Another model, presented in the Overview section, estimates fair value based on dollar sentiment, a measure of policy uncertainty and the global PMI. This model suggests that the 10-year yield is almost 50 basis points on the expensive side. We think that Fed rate expectations are far too benign, suggesting that bond yields will rise. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights Chart 1Too Close For Comfort Too Close For Comfort Too Close For Comfort The Fed is in the midst of tightening policy, but with inflation still below target it wants to ensure that overall policy settings remain accommodative. In the language of central bankers, the Fed wants to keep the real fed funds rate below its equilibrium level, the level that applies neither upward nor downward pressure to price growth. The equilibrium fed funds rate cannot be calculated with precision, but one popular estimate shows that policy settings are dangerously close to turning restrictive (Chart 1). While an announcement of balance sheet reduction is almost certain to occur next month, with the real fed funds rate so close to neutral, rate hikes are probably on hold until the gap widens. Higher inflation will widen the gap by causing the real fed funds rate to fall, and we are confident that core inflation will rise in the coming months (see page 11 for further details). This will permit the Fed to deliver more than the currently discounted 28 bps of rate increases during the next 12 months. 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 60 basis points in July, bringing year-to-date excess returns up to 209 bps. The financial press is littered with stories highlighting extremely unattractive corporate bond valuations, but we think this storyline is exaggerated. In fact, the average spread on the Bloomberg Barclays corporate bond index is somewhat wider than is typically observed in the early stages of a Fed tightening cycle (Chart 2). We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 86 bps and traded in a range between 66 bps and 104 bps.1 Viewed in this context, the current spread of 102 bps looks somewhat cheap. That being said, corporate balance sheet health is worse than is typically seen during the early stages of a tightening cycle and this will limit spread compression from current levels. But all in all, excess returns to corporate bonds should be consistent with carry during the next 6-12 months, with higher inflation and tighter Fed policy being pre-conditions for material spread widening. In a recent report2 we showed that bank bonds (both senior and subordinate) still offer a spread advantage compared to other similarly risky sectors (Table 3). Banks also continue to make progress shoring up their balance sheets and the outlook for bank profits is starting to brighten. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* On Hold, But Not For Long On Hold, But Not For Long Table 3BCorporate Sector Risk Vs. Reward* On Hold, But Not For Long On Hold, But Not For Long 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 83 basis points in July, bringing year-to-date excess returns up to 448 bps. The index option-adjusted spread tightened 12 bps to end the month at 352 bps, 8 bps above the 2017 low. We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread almost in line with the average witnessed during other similar monetary environments. In contrast, the VIX index, which co-moves with junk spreads (Chart 3), is well below levels seen during the early stages of the prior two tightening cycles. The VIX currently sits at 10, and its historical range in similar monetary environments is between 11 and 17, with an average of 13.3 In this way, there would appear to be more room for investment grade corporate bond spreads to tighten than junk spreads, especially on a volatility-adjusted basis. Despite somewhat more stretched valuations than in investment grade, high-yield still offers reasonable compensation relative to expected defaults. At present, our estimated default-adjusted spread is 206 bps, only slightly below its historical average (panel 3). This is based on an expected default rate of 2.8% during the next 12 months and an expected recovery rate of 48% (bottom panel). MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in July, bringing year-to-date excess returns up to 4 bps. The conventional 30-year MBS yield declined 3 bps in July, as a small 1 bp increase in the rate component was offset by a 4 bps tightening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. Index OAS has been in a widening trend since bottoming at 15 bps last September (Chart 4). Since then, MBS have returned 43 bps less than duration-equivalent Treasury securities. The Bloomberg Barclays Aaa-rated Credit index has outperformed Treasuries by 71 bps during that same timeframe. The back-up in OAS reflects, in large part, the market pricing in the upcoming wind-down of the Fed's balance sheet, set to be announced next month. However, we think OAS still have further to widen to catch up with the rising trend in net issuance. According to Flow of Funds data, net MBS issuance totaled $83 billion in the first quarter. If that pace continues for the rest of the year, then 2017 will be the strongest year for MBS issuance since 2009. While higher mortgage rates since the end of 2016 present a drag, at least so far, home sales have not shown much weakness (bottom panel). This is unlike the 2013 taper tantrum when home sales fell sharply following the surge in rates. We are underweight MBS on the expectation that the housing market will remain resilient in the face of higher rates, allowing issuance to continue its uptrend. However, we are closely tracking the spread advantage in MBS compared to Aaa-rated credit which is finally starting to look attractive (panel 3). Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to 149 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 81 bps and 112 bps, respectively. The low-beta Supranational and Domestic Agency sectors each outperformed by 5 bps. The Foreign Agency sector outperformed the duration-matched Treasury index by 56 bps. USD-denominated sovereign bonds have underperformed the Baa-rated U.S. Corporate index (their closest comparable in terms of risk) during the past three months even though the U.S. dollar has continued its trend lower (Chart 5). But despite this recent underperformance, the Sovereign index still does not offer a spread advantage over the Baa-rated U.S. Corporate index (panel 3). Further, while our Emerging Markets Strategy service still looks favorably upon the Mexican peso relative to other emerging market currencies, it does not expect the peso to continue its recent appreciation versus the U.S. dollar.4 We share this opinion, and expect the broad trade-weighted dollar to appreciate as U.S. growth rebounds in the back-half of the year.5 In our cross-sectional model, which adjusts spreads for credit rating and duration. Local Authorities and Foreign Agencies continue to look attractive compared to most U.S. corporate sectors. In contrast, the Sovereign and Supranational sectors appear expensive. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 38 basis points in July (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 186 bps year-to-date. The average Municipal / Treasury (M/T) yield ratio fell 2% in July, breaking below 85%. The average yield ratio remains extremely tight relative to its post-crisis trading range (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. Our early estimate, based on the recently released second quarter National Accounts data, shows that state & local government net borrowing probably moved higher in Q2 (panel 3), making the recent decline in yield ratios appear even more tenuous. The increase in net borrowing stems largely from a $21 billion drop in income tax revenues and a $20 billion decline in transfer receipts from the federal government. Income tax revenue should recover in the next two quarters,6 and we expect net borrowing will also start to decline. However, it is unlikely that net borrowing will fall by enough to justify current muni valuations. On July 6, the state House of Illinois overrode Governor Bruce Rauner's veto to finally pass a $36 billion budget. The move was sufficient for Moody's and S&P to both subsequently affirm the state's investment grade rating. The 10-year Illinois General Obligation bond yield declined 102 bps on the month, despite only a 1 bp drop in the 10-year Treasury yield. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull steepened in July. The 2/10 slope steepened 3 bps and the 5/30 slope steepened 10 bps. We currently recommend two tactical trades designed to profit from movements in the Treasury curve. First, we have been recommending a short position in the July 2018 fed funds futures contract since July 11.7 From current levels, we calculate this trade will deliver an un-levered return of 28 bps if there are two hikes between now and then, and 53 bps if there are three hikes. Our second recommendation is a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell, a trade designed to profit from a steepening of the 2/10 yield curve. It remains our view that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve. We expect the 2/10 slope to steepen as inflation rebounds during the next few months. Two weeks ago we published a Special Report 8 that explained our rationale for taking views on the slope of the curve using butterfly trades. It also explained our butterfly spread valuation model, and how we use that model to determine how much steepening/flattening is currently discounted in the yield curve. According to our model, the curve is priced for 9 bps of 2/10 steepening during the next six months (Chart 7). Our recommended butterfly trade will earn positive returns if the curve steepens by more than that. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in July. The 10-year TIPS breakeven inflation rate rose 9 bps on the month and, at 1.8%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Core inflation has moved sharply lower since February, but the fact that our Phillips Curve model of core inflation has not rolled over makes us inclined to view the downtrend as transitory. Also, during the past few weeks we have seen some preliminary signs that inflation is on the cusp of rebounding. Year-over-year core PCE inflation ticked higher in June for the first time since January. The PCE diffusion index, which has a good track record capturing near-term swings in core PCE, moved sharply higher (Chart 8). The prices paid components of the ISM manufacturing and non-manufacturing surveys increased from 55 to 62 and from 52.1 to 52.7, respectively, in July. We expect stronger realized inflation will lead TIPS breakevens higher during the next few months. However, even in a scenario where core inflation fails to rebound, the downside in breakevens from current levels is limited. The reason is that if inflation remains very low, the Fed will most likely refrain from hiking rates in December. Such a dovish capitulation from the Fed would put upward pressure on breakevens at the long-end of the curve. We discussed this possible scenario in more detail in a recent report.9 ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in July, bringing year-to-date excess returns up to 59 bps. The index option-adjusted spread for Aaa-rated ABS held flat on the month, and remains well below its average pre-crisis level. The Federal Reserve released its Q2 Senior Loan Officer Survey last week. It showed that credit card lending standards moved back into "net tightening" territory after having eased the previous quarter (Chart 9). Auto loan lending standards tightened on net for the fifth consecutive quarter. Tightening lending standards are usually a response to deteriorating credit quality, and thus tend to correlate with higher losses and wider spreads. In that regard, net loss rates for auto loans continue to trend higher, and Moody's data show that the cumulative loss rate for prime auto loans originated in 2017 is worse than for any vintage since 2009, for loans with the same age. Conversely, the mild tightening in credit card lending standards has so far not translated into rising charge-offs (Chart 9), but the situation bears close monitoring. For now, we are content to remain overweight ABS given the attractive spread pick-up compared to other similarly risky sectors. However, we also recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans, even though auto loans now once again offer an attractive spread differential, after adjusting for differences in duration and spread volatility (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 39 basis points in July, bringing year-to-date excess returns up to 96 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month, and remains below its average pre-crisis level. The Fed's Q2 Senior Loan Officer Survey showed that lending standards for all classes of commercial real estate (CRE) loans tightened, on net, for the eighth consecutive quarter. The survey also reported that demand for CRE loans is on the decline (Chart 10). The combination of tighter lending standards and weak loan demand suggests that credit concerns continue to mount in the private CMBS space. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 11 basis points in July, bringing year-to-date excess returns up to 65 bps. The average option-adjusted spread for the Agency CMBS index held flat on the month but, at 49 bps, the sector continues to look attractive compared to other similarly risky alternatives.10 Not only does the sector offer attractive spreads, but the agency guarantee and the lower delinquency rate in multi-family loans compared to other CRE loans (panel 5) makes its risk/reward profile particularly appealing. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.62% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.63%. The U.S. PMI bounced back in July, after having trended lower for most of this year. The Chinese PMI also increased last month, while the Eurozone reading moderated somewhat from a very high level (panel 4). Overall, the Global PMI came in at 52.7 in July, up from 52.6 in June. Bullish sentiment toward the U.S. dollar has also fallen sharply in recent weeks (bottom panel). Bearish dollar sentiment in an environment of expanding global growth sends a very bond-bearish signal. It means that the entire world is participating in the global expansion and any increase in Treasury yields is less likely to be met with an influx of foreign buying. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.26%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Range calculated using monthly data, specifically the final day of each month. 2 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 3 Ranges for junk spread and VIX calculated using monthly data, specifically the final day of each month. 4 Please see Emerging Markets Strategy Weekly Report, "The Case For A Major Top In EM", dated July 12, 2017, available at ems.bcaresearch.com 5 Mexico carries the largest weight in the Sovereign index, accounting for 23% of market cap. 6 Please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)