Yield Curve

Highlights Reflation Trade: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. New Zealand: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean government bond market. Feature "I know it makes no difference to what you're going through; but I see the tip of the iceberg, and I worry about you." - Rush Is The Liquidity Party Starting To Wind Down? Global financial markets continue to enjoy the "sweet spot" of a solidly expanding global economy, but without enough inflation pressure to force central banks to slam on the monetary brakes. That backdrop is starting to change, though. Odds are rising that the European Central Bank (ECB) will begin tapering its bond buying next year, with some hints of that possibly being announced as soon as next week's monetary policy meeting. At the same time, the Bank of Japan (BoJ) - faced with the operational constraints of buying an ever-increasing share of Japanese financial assets - is focused on targeting long-term interest rates rather than increasing liquidity. Even the Federal Reserve is now talking about reducing its massive balance sheet later this year. The liquidity tailwind to global growth and risk assets is now at risk of becoming a headwind. Already, the growth rate of the major central bank balance sheets has rolled over and is on course to decelerate further over the next year (Chart of the Week). Importantly, this downshift in global liquidity momentum is happening as signs of slowing growth have appeared in some major economies like China and the U.S. (Chart 2). Chart of the WeekLiquidity Tailwind To Risk##BR##Assets Is Fading Liquidity Tailwind To Risk Assets Is Fading Liquidity Tailwind To Risk Assets Is Fading Chart 2Growth Momentum##BR##Already Starting To Cool Off Growth Momentum Already Starting To Cool Off Growth Momentum Already Starting To Cool Off We remain concerned that the Chinese economy will see a policy-induced deceleration in the 2nd half of the year. However, we still expect the U.S. to rebound after the soft patch of growth in the first quarter, and we see nothing in the Euro Area data to suggest that the current solid expansion is at risk of fading quickly. This should allow inflation expectations to drift upward toward the central bank targets given the apparent lack of spare capacity on both sides of the Atlantic (Chart 3). Chart 3Fed & ECB Facing##BR##Economic Capacity Constraints Fed & ECB Facing Economic Capacity Constraints Fed & ECB Facing Economic Capacity Constraints We still expect the Fed to deliver another two rate hikes before year-end and the ECB to begin its exit strategy from the current extraordinary monetary policies by slowing the pace of asset purchases starting early next year. For now, the backdrop will remain supportive for the outperformance of growth-sensitive assets like corporate credit and equities over government bonds in the U.S. and Europe over the balance of 2017. However, the early signals sent by "leading leading" indicators such as our Global Leading Economic Indicator diffusion index (Chart 2, top panel) suggests that liquidity and growth trends will become far more challenging for the markets in 2018. Bottom Line: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. Maintain a below-benchmark duration exposure and an overweight allocation to corporate debt in global fixed income portfolios. New Zealand: Safety From A Global Bond Apocalypse? A growing number of the world's most wealthiest (and, arguably, most paranoid) people are reportedly buying real estate in New Zealand as a safe haven place to live if modern civilization collapses.1 While the immediate need for taking such precautions can be debated, there is sound logic in treating New Zealand as a location far removed from the current geopolitical and socio-economic problems of the world. We now see a case for treating New Zealand bonds as a potential "safe haven" market for global fixed income investors. The Economic Backdrop Has Become More Muddled We have been running a SHORT position in New Zealand (paying 12-month OIS rates) in our Tactical Overlay portfolio since last November. Our view then was that the New Zealand economy would surprise to the upside in 2017 and inflation was likely to start drifting upward. This would pressure the Reserve Bank of New Zealand (RBNZ) to raise the Official Cash Rate (OCR) from the highly accommodative level of 1.75%. So far, that expectation has not panned out as the RBNZ has held rates steady amid a more uncertain outlook for the New Zealand economy. Growth indicators have been a bit mixed over the past few months, but the current uptick in the manufacturing purchasing managers' index (PMI) is pointing to real GDP expanding around 3% on a year-over-year basis (Chart 4). If maintained for the full year, this would be slightly above the RBNZ's estimate of potential growth at 2.8%. There are some downside risks, however, given that consumer and business confidence are both below previous cyclical peaks and fiscal policy is expected to be mildly restrictive in 2017 (bottom three panels). The housing market remains a key cyclical wild card. Residential construction has been a significant source of growth over the past few years, driven by a surge in net immigration into New Zealand and declining interest rates (Chart 5). However, the RBNZ is projecting immigration inflows to slow from the current high level, largely due to improving labor market conditions in the developed economies (most notably, Australia, which is the largest source of New Zealand immigrants). Chart 4Stable NZ Growth...For Now Stable NZ Growth...For Now Stable NZ Growth...For Now Chart 5NZ Housing Activity Starting To Peak Out NZ Housing Activity Starting To Peak Out NZ Housing Activity Starting To Peak Out Slower immigration would reduce the demand for New Zealand housing at a time when mortgage rates have already been rising off the record lows seen in 2016 (bottom panel). This has occurred without any rate hikes from the RBNZ, as rising global bond yields have put upward pressure on New Zealand bank funding costs, which have been passed through to higher mortgage rates. The RBNZ is currently projecting growth in house prices to slow sharply from last year's robust 15% pace to just 5% in 2017. The main drivers are higher borrowing costs and the ongoing impact of macro-prudential regulations against high loan-to-value ratio mortgage lending. Importantly, slower housing activity will not only have a direct impact on GDP growth through softer construction, but will also indirectly dampen consumer spending growth via wealth effects. Yet even with this expected drag on growth from housing, the New Zealand economy is still expected to face capacity constraints over the rest of the year. Higher Uncertainty Over Price Pressures Both the RBNZ and the International Monetary Fund estimate that the output gap has fully closed and is projected to move into positive territory this year (Chart 6). At the same time, the current unemployment rate of 4.9% is below the OECD's estimate of the full employment level and the RBNZ projects a further decline in joblessness in 2017 (third panel). Despite this evidence of the economy reaching capacity constraints, both wage growth and price inflation remain subdued and inflation expectations remain well-anchored around 2% - the midpoint of the RBNZ's 1-3% target range. Wage costs are particularly depressed, growing only 1% on a year-over-year basis in Q1. This may be related to the rise in the labor force participation rate - up to an all-time high of 70.6% in Q1 from a cyclical low of 68.2% at the end of 2015 - that has increased the available supply of labor. The most recent headline inflation print for Q1 was quite strong, taking the year-over-year growth rate up to 2.2%. Yet in the RBNZ's April Monetary Policy Statement (MPS), the central bank took a surprisingly dovish tone, citing uncertainty over the true degree of slack in the economy and downside risks to growth that would prevent a further acceleration of inflation.2 The RBNZ now forecasts inflation to not rise above 2.2% this year and to fall back to 1.1% in both 2018, led by a sharp decline in growth for tradeables, mostly energy and food inflation (Chart 7). Importantly, this forecast includes the recent decline in the trade-weighted New Zealand Dollar (NZD). Non-tradeables inflation is also expected to stabilize on the back of slower housing-related items in the consumer price index. Chart 6RBNZ Not Expecting A Big Rise In Inflation... RBNZ Not Expecting A Big Rise In Inflation... RBNZ Not Expecting A Big Rise In Inflation... Chart 7...As Growth In Tradeables Prices Cools ...As Growth In Tradeables Prices Cools ...As Growth In Tradeables Prices Cools A Weaker Case For Tighter Monetary Policy The official RBNZ projection is that the OCR will stay unchanged at 1.75% until September 2019. The market expectation priced into the NZD OIS curve calls for 27bps of hikes over the next twelve months (Chart 8). Our New Zealand Central Bank Monitor has been suggesting the need for tighter monetary policy since mid-2016, but appears to be rolling over (2nd panel). The diminished rate hike expectations have coincided with a decline in the NZD and a sharp underperformance of New Zealand equities. The markets are giving a consistent signal on softening growth prospects in New Zealand, confirming the central bank's more recent dovish turn. Chart 8Market Expectations Of##BR##RBNZ Hikes Are Fading Market Expectations Of RBNZ Hikes Are Fading Market Expectations Of RBNZ Hikes Are Fading Given the newfound uncertainties over the New Zealand growth and inflation outlook, the case for owning New Zealand interest rate exposure has grown a little bit stronger. Admittedly, we do not envision a major pullback in growth, and inflation may not fall by as much as the RBNZ is expecting given how little spare capacity there appears to be in the economy. Yet there is now just enough uncertainty to keep the central bank on hold for longer than expected, as was noted in the "scenario analysis" section of the April MPS.3 The RBNZ noted that if the level of spare capacity is smaller than currently assumed, then the latest growth forecast will result in inflation eventually moving to 2.0% in 2018 and 2.3% in 2019, resulting in the OCR needing to rise to 2.25% in two years. Alternatively, if housing demand slows even faster than current projections, inflation would be below the 2% target during the next two years and the OCR would need to fall to 1.25% by the end of 2018. Our takeaway from this is that, even in the more positive scenario, interest rates are not expected to rise by much more than the markets are currently discounting. Position For Tighter New Zealand Spreads Versus Treasuries & Bunds The economic risks in New Zealand now appear evenly balanced. This argues for stable monetary policy and diminished bond volatility. Current market forwards for both government bonds and NZD swaps shows that very little movement in interest rates is expected over the next year (Chart 9). We generally agree with this pricing, although the uncertainty over the degree of spare capacity, and underlying inflation pressures, make a directional view on interest rates or the shape of the yield curve an unattractive risk proposition. A more interesting opportunity presents itself in looking at spread trades between New Zealand government bonds versus other developed market sovereign debt. The yield betas for New Zealand versus the U.S. and Germany have fallen steadily over the past year (Chart 10), indicating that New Zealand bonds can be more insulated from the rise in yields that we expect for U.S. Treasuries and German Bunds over the latter half of 2017. Given the competitively high yields on offer in New Zealand, even on a currency-hedged basis (bottom panel), we see a case for going long New Zealand interest rate exposure versus U.S. and Germany. Chart 9Higher NZ Bond Yields##BR##Priced Into Forwards Higher NZ Bond Yields Priced Into Forwards Higher NZ Bond Yields Priced Into Forwards Chart 10NZ Bonds: Now Lower Beta##BR##With Higher Hedged Yields NZ Bonds: Now Lower Beta With Higher Hedged Yields NZ Bonds: Now Lower Beta With Higher Hedged Yields At current yield levels, going long New Zealand versus Germany looks more compelling relative to spread compression trades versus U.S. Treasuries. We see strong potential for New Zealand-Germany spreads to tighten faster than the forwards over the next six months (Chart 11), largely through rising German yields as the ECB signals that a tapering of bond purchases is set to begin next year. The downside potential for New Zealand-U.S. spread compression looks less likely from current tight levels, although if Treasury yields rise by as much as we expect in the coming months, some spread tightening should occur here, as well. Chart 11Go Long 5Yr NZ Bonds Vs##BR##USTs and German OBLs Go Long 5yr NZ Bonds vs USTs and German OBLs Go Long 5yr NZ Bonds vs USTs and German OBLs Based on our analysis, we are closing our current NZD rates trade in our Tactical Overlay portfolio with a tiny profit of +3bps , and entering two new trades: long 5-year NZD government bonds versus 5-year U.S. Treasuries, on a currency-hedged basis; and long 5yr NZD government bonds versus 5-year German government debt, on a currency-unhedged basis.4 We are choosing to hedge the currency exposure back into USD for the former given the view of BCA's currency strategists that the EUR/USD exchange rate is now stretched too far to the upside and is at risk of declining as the Fed delivers on additional rate hikes in the coming months.5 In other words, we see a greater potential for a decline in NZD/USD than NZD/EUR in the next 3-6 months. Bottom Line: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation, in contrast to the strong likelihood of additional Fed rate hikes and an ECB taper announcement in the next few months. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: A Bad Moon Rising For Bond Yields Chart 12Markets Not Worried##BR##About The New President Markets Not Worried About The New President Markets Not Worried About The New President The new South Korean president, Moon Jae-In was elected on May 9th, ending a year of political turmoil after the previous president's scandal and impeachment. Our colleagues at BCA Geopolitical Strategy view Moon and his Democratic Party as a major shift to the political left.6 The new president's policy agenda is aimed at economic stimulus for the working class alongside reforms of the country's chaebol industrial giants. Korean financial markets have greeted the election result positively, with the benchmark KOSPI equity index up 2.7%, and the Korean won up 1% versus the U.S. dollar, from the pre-election levels on May 8th. (Chart 12). This is consistent with past market behavior, as the won tends to be less reactive toward domestic events (i.e. after the previous president's impeachment, the won actually strengthened) and more sensitive to international uncertainties (i.e. North Korea-U.S. military tensions, as occurred in mid-March). Korean interest rates, however, have shown little response to the change in leadership in Seoul, with bond yields unchanged since the election. We see this as presenting an opportunity for fixed income investors. Clearly, the new regime in Seoul represents a real change for the Korean people, but it also represents a potential shift in the economic backdrop - namely, through an expected large fiscal stimulus from the new government - that will impart a steepening bias to the Korean interest rate curve. A Sluggish Economy Greets The New President While the steady, if unspectacular, pace of global growth in the past few years has been enough to absorb spare capacity in many countries, South Korea's sub-par economic performance has left the country with a widening output gap (Chart 13). Policymakers are well aware that consumer spending, which contributes about 60% of GDP, has been steadily weakening alongside slowing credit growth. Chart 13Sluggish Growth In South Korea Sluggish Growth In South Korea Sluggish Growth In South Korea The new government will attempt to boost domestic consumption, and thus overall growth, by increasing social welfare spending. Moon's economic agenda calls for raising the minimum wage by 55% by 2020, increasing subsidies for education costs and parental leave, and doubling the basic pension payment for the elderly regardless of their income level. It might prove to be very effective in the short term at boosting consumer spending, but this may not prove to be a sustainable driver of growth in South Korea, where the marginal swings in the economy have historically been driven more by exports. Youth joblessness is another problem that Moon will attempt to tackle with his ambitious economic program. While the labor market may appear healthy, with an overall unemployment rate of only 3.7%, the situation is far more challenging for young adults in South Korea - the jobless rate for those aged 20-29 is 11.3%. One of the reasons for such a high unemployment rate among young South Koreans is that university graduates, of which there are many in this highly-educated nation, expect (and look for) high-paying jobs, but cannot find enough of them.7 The labor market has become more competitive in recent years as weak economic growth has limited the ability of private sector, especially large corporations, to hire as much. To solve this problem, the new government has promised to create 810,000 jobs in the public sector. Creating public sector jobs may temporarily solve the high unemployment rate, but in the long run, this will also cause larger fiscal burdens for taxpayers. Position For A Steeper South Korean Yield Curve Headline CPI inflation in South Korea is currently hovering around the 2% target of the Bank of Korea (BoK), while core CPI growth is lower at 1.3%. The BoK has maintain the policy rate at 1.25% since June 2016, with a bias towards additional easing given the lack of sustained inflationary pressure amid weak domestic demand. The BoK did sound a slightly more upbeat tone on the economy at last week's monetary policy meeting, led by the spillover effects from improving global growth rather than a more bullish expectation on the Korean consumer. Importantly, the central bank still expects inflation pressures to remain subdued - no surprise given the large output gap. The BoK did note that it is monitoring several factors in judging future policy decisions: the pace of rate hikes by the Fed, trends in global trade, geopolitical tensions, the pace of household debt accumulation and "the directions of the new government's fiscal policies." The latter may end up being the most important factor, as President Moon is proposing an increase in government spending equal to 0.7% of GDP - an amount equal to ½ of the estimated output gap coming after a 2016 budget surplus of 1% of GDP. This increase in fiscal spending could directly drive up the longer-end of Korean yield curve, as this would result in a narrower budget surpluses and greater KGB issuance. At the same time, the lack of domestic inflation pressures, even with the fiscal stimulus, will keep the BoK on an easing bias that will keep short dated yields well anchored. Therefore, we see the potential for the Korean yield curve to eventually steepen and break the downward-sloping trendline in place since 2014 (Chart 14). We recommend positioning for this move by entering a 2-year/10-year steepening trade in the Korean yield curve. Admittedly, this trade is more structural than tactical in nature, as the Moon stimulus policies will take time to unfold. Importantly, a flattening of the 2-year/10-year KGB curve is currently priced into the forwards, meaning that positioning now for a steepener does not incur negative carry (Chart 15). Chart 14More Fiscal Stimulus =##BR##Steeper Korea Curve More Fiscal Stimulus = Steeper Korea Curve More Fiscal Stimulus = Steeper Korea Curve Chart 15Enter A 2Yr/10Yr##BR##Korean Bond Curve Steepener Enter a 2yr/10yr Korean Bond Curve Steepener Enter a 2yr/10yr Korean Bond Curve Steepener Also, Korean 10-year bond yields are currently exhibiting a strong correlation to similar maturity U.S. Treasuries with a yield beta around 1.0 (bottom panel). Given our view that longer-dated U.S. yields have upside risk from both additional Fed rate increases and higher U.S. inflation expectations, that high yield beta suggests that the Korean yield curve could suffer some of the same cyclical bear-steepening pressures that we expect for U.S. Treasuries in the next 3-6 months. Bottom Line: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end curve of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean bond curve. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 https://www.theguardian.com/technology/2017/jan/29/silicon-valley-new-zealand-apocalypse-escape 2 The central bank noted that its "suite" of output gap estimates, using varying methodologies, have an unusually wide range at the moment between -1.5% and +2%. 3 http://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement 4 These trades can be done using interest rate swaps as well (receiving NZD rates vs paying USD & EUR rates), as swap spreads are expected to remain broadly stable in all three regions. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Bloody Potomac", dated May 19 2017, available at fes.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets" dated May 24 2017, available at gps.bcaresearch.com. 7 According to the OECD, Korea's college enrollment rate was a whopping 87% as recently as 2014. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Distant Early Warning Distant Early Warning Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist Global Recovery Will Persist Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Labor Market Still Strong Labor Market Still Strong Chart 3Look For Above 2% Growth Look For Above 2% Growth Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve Stronger Productivity = Steeper Curve Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Surprise Indexes Will Converge Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Look To China To Trade UST / Bund Spread Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative Monetary Conditions Still Fairly Stimulative Monetary Conditions Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Higher Yields Via Currency Hedging Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Hedging Costs & Bond Returns: Germany Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan Hedging Costs & Bond Returns: Japan Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Rate Hikes Lagging Wage Growth Rate Hikes Lagging Wage Growth Rate Hikes Lagging Wage Growth Last Friday's GDP report showed that the U.S. economy grew a meagre 0.7% (annualized) in the first quarter of 2017, well below levels necessary to sustain an uptrend in inflation. However, our forward looking indicators still point to U.S. growth of around 2% during the next few quarters. It is likely that faulty seasonal adjustments suppressed Q1 GDP growth. Q1 growth has averaged -0.1% during the past 10 years, while Q2 growth has averaged more than 2%. Q2 growth has also exceeded Q1 growth in 8 of the last 10 years. For its part, the Bloomberg Barclays Treasury index has provided an average return of close to 1% during the past 10 Q1s and an average return of 0.4% during the past 10 Q2s. Treasury returns have been greater in the first quarter than in the second quarter in 6 out of the past 10 years. Investors would be wise to ignore Q1 GDP and stay focused on the uptrends in wage growth and inflation that are likely to persist (Chart 1). With the market priced for only 38 bps of rate hikes between now and the end of the year, there is scope for the Fed to send a hawkish surprise. Stay at below-benchmark duration and short January 2018 Fed Funds Futures. 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 23 basis points in April. The index option-adjusted spread tightened 2 bps on the month and, at 116 bps, it remains well below its historical average (134 bps). While supportive monetary policy will ensure excess returns consistent with carry, investors should not bank on further spread compression as spreads have already discounted a substantial improvement in leverage (Chart 2). In a recent report,1 we noted that net leverage (defined as: total debt minus cash, as a percent of EBITD) is positively correlated with spreads, and also that it has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. We conclude that debt growth will likely continue to outpace profit growth (panel 4), even as profits rebound over the course of this year. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018, when inflationary pressures are more pronounced and the Fed steps up the pace of tightening. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3). Further, our commodity strategists expect OPEC production cuts will be extended through to the end of the year, and that $60/bbl remains a reasonable target for oil prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Time Of The Season Time Of The Season Table 3BCorporate Sector Risk Vs. Reward* Time Of The Season Time Of The Season High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in April. The index option-adjusted spread tightened 12 bps on the month and, at 371 bps, it is currently 27 bps above its 2017-low. Wider junk spreads in recent months appear to be largely related to flight-to-safety flows driven by elevated global political uncertainty. We find it notable that spreads tightened following the market-friendly result of the first round of the French election. While political uncertainty remains, we view current spreads as attractive on a 6-12 month horizon. In a recent report,2 we tested a strategy of "buying dips" in the junk bond market and found that it produced favorable results in a low-inflation environment. With the St. Louis Fed's Price Pressures Measure still suggesting only a 6% chance of PCE inflation above 2.5% during the next 12 months, we think this strategy will continue to work. Moody's recorded 21 defaults in Q1 (globally) down from 41 in the first quarter of 2016, with the improvement attributable to recovery in the commodity sectors. While commodity sectors still accounted for half of the defaults in Q1, Moody's predicts that the retail sector will soon assume the mantle of "most troubled sector." According to Moody's, nearly 14% of retail issuers are trading at distressed levels. Moody's still expects the U.S. speculative grade default rate to be 3% for the next 12 months, down from 4.7% for the prior 12 months. Based on this forecast we calculate the High-Yield default-adjusted spread to be 207 bps (Chart 3), a level consistent with positive excess returns on a 12-month horizon more than 70% of the time. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in April. The conventional 30-year MBS yield fell 10 bps on the month, driven by an 11 bps decline in the rate component. The compensation for prepayment risk (option cost) rose by 2 bps, but this was partially offset by a 1 bp tightening in the option-adjusted spread (OAS). Since the middle of last year the MBS OAS has widened alongside rising net issuance, but this has been offset by a falling option cost (Chart 4). This is exactly the price behavior we would expect to see in an environment where mortgage rates are moving higher and the market is starting to discount the Fed's eventual exit from the MBS market. Higher mortgage rates suppress refinancings, and this will ensure that the option cost component of spreads remains low. However, higher mortgage rates are also unlikely to halt the uptrend in net MBS issuance, since the main constraint on housing demand this cycle has been insufficient household savings, not un-affordable mortgage payments.3 This means that OAS still have room to widen alongside greater net issuance. The winding down of the Fed's mortgage portfolio - a process that is likely to begin later this year - will only add to the supply that the market needs to absorb. How will the opposing forces of low option cost and widening OAS net out? The option cost component of spreads is already close to its all-time low, while the OAS is still 16 bps below its pre-crisis mean. We think it is unlikely that a lower option cost can fully offset OAS widening. 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 2 basis points in April, bringing year-to-date excess returns up to 75 bps. The high-beta Sovereign and Foreign Agency sectors outperformed by 8 bps and 1 bp, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 7 bps each. Local Authorities underperformed the Treasury benchmark by 23 bps. Since the beginning of the year, excess returns from the Sovereign sector have been supported by a weakening U.S. dollar (Chart 5). Mexican debt, in particular, has benefited from a 10% appreciation of the peso relative to the U.S. dollar (panel 3). A stronger peso obviously makes Mexico's USD-denominated debt easier to service and has led to year-to-date excess returns of 402 bps for Mexican sovereign debt relative to U.S. Treasuries. Mexican debt accounts for 21% of the Sovereign index. Our Emerging Markets Strategy service thinks that Mexico's central bank could deliver another 50 bps of rate hikes, because inflation is above target, but also maintains that further rate hikes will soon start to squeeze consumer spending.4 Conversely, the Fed has scope to hike rates much further. Sovereigns no longer appear expensive on our model, relative to domestic U.S. corporate sectors. But we still expect them to underperform as the dollar resumes its bull market. Local authorities and Foreign Agencies still offer lucrative spreads on our model, and we remain overweight those spaces within an overall underweight allocation to the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in April (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio was flat on the month, but has fallen 15% since peaking shortly after the U.S. election (Chart 6). The sparse details of the Trump administration's proposed tax reform plan, released last week, did not include any specific mention of the municipal bond tax exemption, but did call for the elimination of "targeted tax breaks" leaving some to wonder if the tax exemption is in play. It is too soon to tell whether repealing the tax exemption will be part of the final tax reform plan, although its repeal would be at odds with the President's stated desire to spur infrastructure spending. For this reason, we suspect the tax exemption will ultimately survive. Assuming the tax exemption survives, the proposed repeal of the Alternative Minimum Tax and of the state & local government income tax deduction should both increase demand for tax-exempt municipal bonds. However, this positive impact will be offset by lower tax rates. All in all, it is too soon to know how this will all shake out, but the considerable uncertainty makes us reluctant to take strong directional bets in the municipal bond market for now. Meanwhile, Muni mutual fund inflows have totaled more than $9 billion since the beginning of the year, while total issuance is at a 12-month low. Strong inflows and low supply likely explain why yield ratios are testing the low-end of their post-crisis trading range. 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 lower in April, with the 2/10 slope flattening by 12 basis points and the 5/30 slope steepening by 6 bps. The 5-year Treasury yield declined 12 bps on the month, while the 10-year yield fell 11 bps. The 2-year yield actually ticked 1 bp higher. Significant outperformance in the 5-year part of the curve means that our recommendation to favor the 5-year bullet over a duration-matched 2/10 barbell has returned 27 bps since inception on December 20, 2016. This 5-year bullet over duration-matched 2/10 barbell trade is designed to profit from 2/10 curve steepening, which has not yet materialized. Instead, the trade has performed well because the 2/5/10 butterfly spread has moved much closer to our estimate of fair value (Chart 7). The 5-year bullet still looks moderately cheap on the curve, but no longer offers an exceptional valuation cushion. For our trade to outperform from here we will likely need to see some 2/10 curve steepening. We continue to hold the 5-year bullet over duration-matched 2/10 barbell trade, because we still expect the 2/10 slope to steepen. This steepening will be driven by wider long-maturity TIPS breakevens which should eventually catch up to leading pipeline inflation measures (see next page). In a recent report,5 we outlined the main drivers of the slope of the yield curve on a cyclical horizon and concluded that wider breakevens can cause the nominal curve to steepen even with the Fed in the midst of hiking rates. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 25 basis points in April. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.92%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Our Financial Model of TIPS breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline in breakevens to weakness in the stock-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to fair value (Chart 8). Both core and trimmed mean PCE inflation dropped sharply in March, and are now running at 1.6% and 1.8% year-over-year, respectively (bottom panel). This decline is likely to reverse in the coming months. Crucially, pipeline inflation measures, such as the ISM prices paid index, are holding firm at high levels (panel 4). We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. In that environment, TIPS breakevens should eventually return to their pre-crisis range. In last week's report,6 we considered the possibility that TIPS breakevens might not return to their pre-crisis trading range, even if measures of core inflation remain strong. The most likely reason relates to structural rigidities in the repo market that have made it more costly to arbitrage the difference between real and nominal rates. For now, we consider this simply a risk to our overweight view. 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 April, bringing year-to-date excess returns up to +33 bps. Aaa-rated issuers outperformed the Treasury benchmark by 10 bps on the month, while non-Aaa issues outperformed by 13 bps. The index option-adjusted spread for Aaa-rated ABS tightened 1 bp on the month, and remains well below its average pre-crisis level. Banks are now tightening lending standards on both auto loans and credit cards. While we do not expect this recent development to have much of an impact on consumer spending,7 it is usually an indication that there is growing concern about ABS collateral credit quality. This concern is echoed by the fact that net losses on auto loans are trending sharply higher (Chart 9). Credit card charge-offs remain subdued for now - and we continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans - but even in the credit card space quality concerns are starting to mount. Capital One reported a 20% drop in earnings in Q1 versus the same quarter in 2016, and noted that it has been tightening underwriting standards against a back-drop of credit card loans growing faster than income. We remain overweight ABS for now, as the securities still offer attractive spreads compared to other high-quality spread product, but we are closely monitoring credit quality metrics for signs of rising stress. 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 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, and is fast approaching its average pre-crisis level. Apartment and office building prices are growing strongly, but as in the corporate space, the retail sector is a major drag (Chart 10). Tighter lending standards and falling demand also suggest that credit stress is starting to mount, but while office and retail delinquencies are rising multi-family delinquencies remain low (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for Agency CMBS widened 1 bp on the month, and currently sits at 54 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 35 bps, Aaa consumer ABS = 46 bps, Agency bonds = 17 bps and Supranationals = 20 bps. We continue to recommend an overweight position in Agency CMBS. 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 2.59% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.43%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we are inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. It should also be noted that the fair value readings from both the 2-factor and 3-factor models are calculated using FLASH PMI estimates for April. These estimates will be revised later today when the actual PMI data are released. 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 2.32%. 1 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 4 Please see Emerging Markets Strategy Weekly Report, "A Time To Be Contrarian", dated April 5, 2017, available at ems.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Chart 1Is Inflation Heating Up? Is Inflation Heating Up? Is Inflation Heating Up? In past reports we have argued that as long as inflation (and inflation expectations) are below the Fed's target, then the "reflation trade" will remain in vogue. In other words, with inflation still too low, the Fed has an incentive to back away from its hawkish rhetoric whenever risk assets sell off and financial conditions tighten. But with inflation heating up - the last two monthly increases in core PCE are close to the highest seen in this recovery (Chart 1) - will the Fed become less responsive? Not yet! Year-over-year core PCE is still only 1.75% (the Fed's target is 2%) and the cost of inflation protection embedded in long-dated TIPS remains too low (panel 2). In fact, the uptrend in TIPS breakevens lost some of its momentum last month alongside wider credit spreads and the S&P 500's first monthly decline since October. In this environment, we are inclined to add credit risk as spreads widen and believe a "buy the dips" strategy will work until inflation pressures are more pronounced. On a 6-12 month horizon we continue to recommend: below-benchmark duration, overweight spread product, curve steepeners and TIPS breakeven wideners. 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 15 basis points in March. The index option-adjusted spread widened 3 bps on the month and, at 118 bps, it remains well below its historical average (134 bps). While supportive monetary policy will ensure excess returns consistent with carry, investors should not bank on further spread compression as spreads have already discounted a substantial improvement in leverage (Chart 2). In fact, leverage showed a marked increase in Q4 2016 even though spreads moved tighter. The measure of gross leverage (total debt divided by EBITD) shown in Chart 2 increased in the fourth quarter even though total debt grew at an annualized rate of only 0.3%. However, EBITD actually contracted at an annualized rate of 7% in Q4 causing leverage to rise. The quarterly decline in EBITD looks anomalous, and the year-over-year trend is improving (panel 4). In fact, we would not be surprised to see leverage stabilize this year as profits rebound.1 But similarly, we also expect that the recent plunge in debt growth will reverse. Historically, it has been very rare for leverage to fall unless prompted by a recession. We will take up this issue in more detail in next week's report. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3), and we remain overweight. This week we also downgrade the Retailers and Packaging sectors, which have become expensive, and upgrade Cable & Satellite, which appears cheap. Table 3A Reflation Window Still Open Reflation Window Still Open Table 3B Reflation Window Still Open Reflation Window Still Open 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 25 basis points in March. The index option-adjusted spread widened 20 bps on the month and, at 383 bps, it is currently 136 bps below its historical average. Given the favorable policy back-drop described on page 1, we view the recent widening in junk spreads (Chart 3) as an opportunity to increase exposure to the sector. In fact, in a recent report2 we tested a strategy of "buying dips" in the junk bond market in different inflationary regimes. The strategy involved buying the High-Yield index whenever spreads widened by 20 bps or more in a month and then holding that position for 3 months. We defined the different inflationary regimes based on the St. Louis Fed's Price Pressures Measure (PPM).3 We found that our "buy the dips" strategy yielded positive excess returns 65% of the time in a very low inflation regime (PPM < 15%), 59% of the time in a low inflation regime (15% < PPM < 30%), 44% of the time in a moderate inflation regime (30% < PPM < 50%) and only 25% of the time in a high inflation regime (50% < PPM < 70%). Currently, the reading from the PPM is 13%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in March. The conventional 30-year MBS yield rose 6 bps on the month, driven entirely by a 6 bps increase in the rate component. The compensation for prepayment risk (option cost) declined by 6 bps, but this was exactly offset by a 6 bps widening in the option-adjusted spread. As a result, the zero-volatility spread was flat on the month. The option-adjusted spread represents expected excess returns to MBS assuming that prepayments fall in line with expectations. On this basis, MBS look more attractive than they have for some time (Chart 4). However, net MBS issuance also surged in Q4 2016 (panel 4) and should remain robust this year despite higher mortgage rates.4 Interest rates have not been a deterrent to mortgage demand since the financial crisis. The limiting factors have been a lack of household savings and restrictive bank lending standards. Both of these headwinds continue to gradually fade. The option-adjusted spread still appears too low relative to issuance. Nominal MBS spreads are linked to rate volatility (bottom panel), and volatility should increase as the fed funds rate moves further off its zero-bound.5 The wind-down of the Fed's MBS portfolio - which we expect will begin in 2018 - should also pressure implied volatility higher as the private sector is forced to absorb the increased supply, some of which will be convexity-hedged. 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 22 basis points in March. The high-beta Sovereign and Foreign Agency sectors outperformed by 71 bps and 41 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 9 bps and 15 bps, respectively. Local Authorities underperformed the Treasury benchmark by 17 bps. The performance of Sovereigns has been stellar this year, as the sector has benefited from a 3% depreciation in the trade-weighted dollar (Chart 5). However, the downtrend in the dollar looks more like a temporary reversal than an end to the bull market. With U.S. growth on a strong footing, there is still scope for global interest rate differentials to move in favor of the dollar. Potential fiscal policy measures - such as lower tax rates and a border-adjusted corporate tax - would also lead to a stronger dollar, if enacted. As such, we do not believe the current outperformance of Sovereigns can be sustained. We continue to recommend overweight allocations to Foreign Agencies and Local Authorities, alongside underweight allocations to the rest of the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 24 basis points in March (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio declined 2% on the month and remains firmly anchored below its post-crisis average. This year's decline in M/T yield ratios has been concentrated at the short-end of the curve (Chart 6), and long maturities now offer a significant valuation advantage. This week we recommend favoring the long-end of the Aaa Muni curve (10-year maturities and beyond) versus the short-end (maturities up to 5 years). Overall, M/T yield ratios appear fairly valued on a tactical basis. While fund inflows have ebbed in recent weeks (panel 4), this has occurred alongside a plunge in gross issuance (bottom panel). The more concerning near-term risk for Munis is that yield ratios have already discounted a substantial improvement in state & local government net borrowing (panel 3). However, we expect net borrowing to decline during the next couple of quarters on the back of rising tax revenues. State & local government tax receipts decelerated throughout most of 2015 and 2016 alongside falling personal income growth and disappointing retail sales. However, both income growth and retail sales have moved higher in recent months, and this should soon translate into accelerating tax receipts and lower net borrowing. Longer term, significant risks remain for the Muni market.6 Chief among them is that state & local government budgets now finally look healthy enough to increase investment spending. Not to mention the significant uncertainty surrounding the potential for lower federal tax rates and plans to invest in infrastructure. 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 underwent a small parallel shift upward in March, roughly split between a bear-steepening leading up to the FOMC meeting on March 15 and a bull-flattening from the meeting until the end of the month. Overall, the 2/10 Treasury slope flattened 1 basis point on the month and the 5/30 slope ended the month 1 bp steeper. Our recommended position long the 5-year bullet and short the 2/10 barbell - designed to profit from a steeper yield curve - returned +3 bps in March and is up 7 bps since inception on December 20. In addition, we also entered a short January 2018 fed funds futures trade on March 21.7 The performance of this trade has so far been flat. In a recent report,7 we identified the main cyclical drivers of the slope of the yield curve as: The fed funds rate (higher fed funds rate = flatter curve) Inflation expectations (higher inflation expectations = steeper curve) Interest rate volatility (higher volatility = steeper curve) Unit labor costs (higher unit labor costs = flatter curve) We concluded that even though the Fed is in the process of lifting the funds rate, the yield curve likely has room to steepen as long-maturity TIPS breakevens recover to levels more consistent with the Fed's inflation target (Chart 7). In addition, interest rate volatility has likely bottomed for the cycle and the uptrend in unit labor costs could level-off if productivity growth continues to rebound. The recent decline in bullish sentiment toward the dollar has also not yet been matched by a steeper 5/30 slope (bottom panel). TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in March. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.97%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. While the catalyst for the recent softening in TIPS outperformance seems to be the hawkish re-rating of Fed rate hike expectations, the uptrend in TIPS breakevens was probably due for a pause in any case. Breakevens had become stretched relative to our TIPS Financial Model - based on the dollar, oil prices and the stock-to-bond total return ratio. However, measures of pipeline inflation pressure - such as the ISM prices paid survey (Chart 8) - still point toward wider breakevens and, as was noted on the front page of this report, recent core inflation prints have been quite strong. All in all, growth appears strong enough that core inflation should continue its gradual uptrend and, more importantly, the Fed will be keen to accommodate an increase in both realized core inflation and TIPS breakevens, which remain below target. This means that in the absence of a material growth slowdown, long-maturity TIPS breakevens should continue to trend higher until they reach the 2.4% to 2.5% range that historically has been consistent with the Fed's inflation target. In a baseline scenario where the unemployment rate is 4.7% at the end of the year and the dollar remains flat, our Phillips curve model8 predicts that year-over-year core PCE inflation will be 2.02% at the end of this year. ABS: Maximum Overweight Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +22 bps. Aaa-rated issues outperformed the Treasury benchmark by 16 bps on the month, and non-Aaa issues outperformed by 26 bps. The index option-adjusted spread for Aaa-rated ABS tightened 5 bps on the month. At 48 bps, the spread remains well below its average pre-crisis level (Chart 9). Banks are now tightening lending standards on both auto loans and credit cards. While we do not expect this recent development to have much of an impact on consumer spending, it is usually an indication that there is growing concern about ABS collateral credit quality. As such, this week we scale back our recommended allocation to ABS from maximum overweight (5 out of 5) to overweight (4 out of 5). While credit card charge-offs remain well below pre-crisis levels, net losses on auto loans have started to trend higher (bottom panel). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, despite the modest spread advantage in autos (panel 3). Further, the spread advantage in Aaa consumer ABS relative to other high-quality spread product is becoming less compelling. Aaa ABS now only provide a 12 bps option-adjusted spread cushion relative to conventional 30-year Agency MBS and offer a slightly lower spread than Agency CMBS. 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 10 basis points in March, dragging year-to-date excess returns down to +16 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month, but remains below its average pre-crisis level. Commercial real estate prices are still growing strongly, and prices in both major and non-major markets have re-gained their pre-crisis peaks (Chart 10). However, lending standards are tightening and, more recently, loan demand has rolled over (panel 4). This suggests that credit risk is starting to increase in commercial real estate, as do CMBS delinquencies which have put in a bottom (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in March, bringing year-to-date excess returns up to +16 bps. The index option-adjusted spread for Agency CMBS tightened 2 bps on the month, and currently sits at 53 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 36 bps, Aaa consumer ABS = 48 bps, Agency bonds = 18 bps and Supranationals = 22 bps. We continue to recommend an overweight position in Agency CMBS. 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 2.54% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.28%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we are inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.35%. 1 For further detail on the medium-term profit outlook please see The Bank Credit Analyst, February 207, dated January 26, 2017, available at bca.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 8, 2017, available at usbs.bcaresearch.com 3 A composite of 104 economic indicators designed to capture the probability of PCE inflation exceeding 2.5% during the subsequent 12 months. https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Duration & Fed Policy: The longer risk assets can withstand rising rates, the higher will be the ultimate resting place for Treasury yields. Maintain below-benchmark duration on a 6-12 month horizon and add a short fed funds futures trade to profit from increased Fed hawkishness in the near-term. Yield Curve: While the long-run trend will be for the yield curve to flatten as the Fed hiking cycle progresses, rising inflation expectations will cause the curve to steepen between now and the end of the year. Maintain a position long the 5-year bullet, short a duration-matched 2/10 barbell to profit from a steeper curve on a 6-9 month horizon. Feature Say Uncle Chart 1More Tightening To Come More Tightening To Come More Tightening To Come The Fed lifted rates last week but kept its median projected path for future rate hikes unchanged. Judging from the market's reaction, this was a more dovish outcome than was anticipated. Since last Wednesday's meeting the dollar is down 0.5%, junk spreads have tightened 10 basis points and the 2/10 yield curve has steepened 1 bp. In other words, financial conditions have continued to ease even as the Fed took another step toward more restrictive policy. All in all, money markets are now discounting only a slightly slower pace of rate hikes than the Fed's median forecast (Chart 1) and financial conditions suggest that further incremental tightening is in store. The financial conditions component of our Fed Monitor1 is above zero, meaning that financial conditions are more accommodative than the long-run average, and the Chicago Fed's Adjusted Financial Conditions Index also shows that conditions are easy relative to the strength of the economy (Chart 1, bottom panel). New York Fed President William Dudley has previously described how the Fed incorporates financial conditions into its decision making:2 Chart 2The Fed Policy Loop The Yield Curve On A Cyclical Horizon The Yield Curve On A Cyclical Horizon All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. We have also described this process in the context of our Fed Policy Loop3 (Chart 2). In essence, the Fed will continue to nudge rate hike expectations higher until financial conditions tighten excessively. At that point - because with inflation below target the Fed still has an interest in supporting the recovery - it will quickly shift to a more dovish stance. Chart 3Short Jan 2018 Fed Funds Futures Short Jan 2018 Fed Funds Futures Short Jan 2018 Fed Funds Futures One implication of the Fed Policy Loop is that the longer risk assets can withstand rising rates, the higher will be the ultimate resting place for the fed funds rate and Treasury yields. As such, we continue to recommend a below-benchmark duration allocation on a 6-12 month horizon. Another implication is that because markets shrugged off the latest rate increase, Fed policy is likely to turn more hawkish in the very near term. We therefore recommend investors add a tactical trade: short the January 2018 fed funds futures contract (Chart 3). We calculate that this trade will return 11 bps in a scenario where the Fed lifts rates twice more before the end of the year and 37 bps in a scenario where the funds rate is raised three times. However, we do not expect to hold this trade until the end of the year. Rather, we expect the Fed will nudge rate expectations higher in the next month or two and that these gains will be realized over a much shorter horizon. We also add a caveat that, in the present environment, it is safer to implement any "hawkish Fed trades" in either fed funds futures or the overnight index swap market. The Eurodollar market does not provide the same potential for gains because the LIBOR / OIS spread is currently elevated and could tighten to offset the profits from rising fed funds rate expectations (Chart 3, bottom panel). Fed hawkishness also argues for a flatter yield curve in the very near term. While this could materialize, we continue to hold our position in the 5-year bullet over a duration-matched 2/10 barbell - a trade designed to profit from a steeper 2/10 slope. For reasons described in the next section we believe the yield curve will steepen between now and the end of the year, although the risks are tilted toward flattening in the very near term and in 2018 and beyond. What Drives The Yield Curve? In this week's report we present an overview of the main drivers of the slope of the Treasury yield curve. Specifically, we identify (i) the fed funds rate, (ii) inflation expectations, (iii) implied volatility and (iv) unit labor costs as factors that correlate strongly with the slope of the yield curve on a cyclical horizon. We review the outlook for each of these factors and conclude that the Treasury yield curve has room to steepen between now and the end of the year. Beyond that, the curve will likely resume flattening as inflationary pressures start to bite and the Fed's rate hike cycle picks up steam. Chart 4Fed Rate Hikes Flatten The Curve Fed Rate Hikes Flatten The Curve Fed Rate Hikes Flatten The Curve 1. The Fed Funds Rate Not surprisingly, the slope of the Treasury curve correlates very strongly with the level of short rates (Chart 4). Typically, short-maturity yields are much more influenced by the expected path of Fed rate hikes than long-maturity yields. As such, when the Fed is lifting rates the yield curve tends to bear-flatten - both the 2-year and 10-year Treasury yields rise, but the 2-year rises more quickly. In contrast, when the Fed is cutting rates the yield curve tends to bull-steepen - both the 2-year and 10-year Treasury yields fall, but the 2-year falls more quickly. In a typical cycle the yield curve will start to flatten as the Fed lifts rates and will eventually become completely flat when the end of the rate hike cycle is reached and the fed funds rate is at its "equilibrium" or "terminal" level. Usually, at that point in the cycle, the Fed will keep policy too tight in an effort to rein in inflation. This causes the economy to slow and the yield curve to invert, signaling the start of the next recession. A recent BCA Special Report4 speculates that if the federal government succeeds in delivering sizeable fiscal stimulus, inflationary pressures could start to build next year, leading to a more rapid pace of Fed rate hikes and a flat or inverted yield curve by the end of 2018. This would be consistent with a recession in 2019. In terms of the behavior of the yield curve, this is not far off from the Fed's own projections. At present, the median FOMC projection calls for the fed funds rate to reach its equilibrium level of 3% by the end of 2019. If this forecast plays out, it means that the 2/10 Treasury slope must flatten by roughly 117 bps between now and then. Turning back to Chart 4, we see that the Treasury curve has already flattened considerably even though the Fed has only raised rates three times. This means that either the equilibrium fed funds rate is much lower than the Fed's 3% projection and the 2/10 slope will reach zero with a much lower fed funds rate, or that the curve flattening is overdone and the curve has room to steepen before it resumes its cyclical flattening trend. As is explained below, we favor the latter interpretation. 2. Inflation Expectations The 5-year/5-year forward TIPS breakeven inflation rate is also highly correlated with the slope of the yield curve (Chart 5). As long-dated inflation expectations increase the yield curve tends to steepen, and vice-versa. Interestingly, the positive correlation between long-dated inflation expectations and the slope of the Treasury curve persists even when the Fed is hiking rates. Notice that in the 1999 rate hike cycle, the yield curve did not start to flatten until the 5-year/5-year breakeven fell. Also, in the 2004-06 hike cycle, curve flattening ebbed just as the breakeven started to widen. Chart 5Rising TIPS Breakevens Steepen The Curve Rising TIPS Breakevens Steepen The Curve Rising TIPS Breakevens Steepen The Curve Charts 6 and 7 show the relationship between the 2/10 Treasury slope and the 5-year/5-year breakeven in more detail. Chart 6 shows the correlation between monthly changes in the 2/10 Treasury slope and the 5-year/5-year breakeven using all available data back to January 1999. We see that a positive correlation between the slope and the breakeven prevailed in 64% of monthly observations, while only 36% of months displayed a negative correlation. Chart 62/10 Nominal Treasury Slope Vs. TIPS Breakeven ##br##Inflation Rate 5-Year/5-Year Forward (February 1999 - Present) The Yield Curve On A Cyclical Horizon The Yield Curve On A Cyclical Horizon Chart 72/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year/5-Year ##br##Forward During Fed Tightening Cycles (June 1999 To May 2000 & June 2004 To June 2006) The Yield Curve On A Cyclical Horizon The Yield Curve On A Cyclical Horizon In Chart 7, we focus exclusively on the past two Fed tightening cycles (1999-2000 & 2004-2006). Not only does a linear regression show an even stronger correlation than was achieved with the full sample, but we also see that a positive correlation between the slope and the breakeven existed in 73% of monthly observations, while only 27% of months displayed a negative correlation. At present, core PCE inflation is still below the Fed's 2% target and different measures of inflation expectations are all well below levels that prevailed during prior rate hike cycles (Chart 8). In other words, the Fed must proceed slowly enough with rate hikes to ensure that long-dated inflation expectations continue to trend higher, which argues for a steeper yield curve until inflation and inflation expectations are more firmly anchored around the Fed's target. For the 5-year/5-year forward TIPS breakeven inflation rate we think a range of 2.4% to 2.5% would signal that inflation expectations are well anchored around the Fed's target. 3. Volatility Implied interest rate volatility - as measured by the MOVE volatility index - is another factor that correlates with the yield curve on a cyclical horizon (Chart 9). In theory, higher rate volatility should coincide with a steeper yield curve, all else equal, and this is exactly the correlation we observe. Chart 8Fed Wants Inflation Expectations To Rise Fed Wants Inflation Expectations To Rise Fed Wants Inflation Expectations To Rise Chart 9Higher Vol Steepens The Curve Higher Vol Steepens The Curve Higher Vol Steepens The Curve Let's consider that there is a risk premium applied to taking a unit of duration risk (usually called the term premium) and that said risk premium is larger for longer-maturity bonds that carry more duration risk. All else equal, the risk premium applied to one unit of duration risk should be larger when rate volatility is higher. This should also coincide with a steeper yield curve, since there is more duration risk at the long-end of the curve. In a recent report,5 we concluded that the level of disagreement among forecasters about future GDP growth and T-bill rates were the two most important drivers of cyclical swings in implied rate volatility, the Global Economic Policy Uncertainty Index has at times also played a role (Chart 9, bottom 3 panels). Chart 10Higher Unit Labor Costs Flatten The Curve Higher Unit Labor Costs Flatten The Curve Higher Unit Labor Costs Flatten The Curve At the moment, the amount of forecaster disagreement about future GDP growth is near its lows since 1990 and T-bill forecast disagreement has, until recently, been suppressed by the zero lower bound on interest rates. All this implies that the balance of risks favors higher implied interest rate volatility in the months ahead, which will apply steepening pressure to the yield curve. 4. Unit Labor Costs Unit labor costs are the final yield curve indicator we discuss in this report. Since faster wage growth tends to coincide with Fed tightening and slowing wage growth tends to correlate with Fed easing, it makes sense for wage indicators to be inversely correlated with the slope of the yield curve. While it is broadly true that all wage indicators show a reasonable inverse correlation with the slope of the curve, unit labor costs are the best. The reason is that unit labor costs (compensation per unit produced) actually measure both wage growth (compensation per hour) and labor productivity (output per hour) (Chart 10). It turns out that the yield curve can flatten in the traditional way - a bear-flattening driven by rising wages and Fed tightening - but occasionally it can also bull-flatten if the market starts to discount a lower equilibrium (or terminal) fed funds rate. We might expect this sort of curve behavior in an environment of extremely low productivity growth, and this is exactly what has occurred during the past few years. Notice in Chart 10 that compensation per hour does not explain the curve flattening that started in 2014, but unit labor costs do because they also factor in incredibly low productivity growth. In the longer-run, we would strongly expect unit labor costs to remain in an uptrend. Wage growth is accelerating and there are structural headwinds that will prevent productivity growth from returning to the levels seen at the height of the IT revolution in the late 1990s and early 2000s. As was discussed last year in a Special Report from our Global Investment Strategy service,6 the rate of human capital accumulation is in a secular downtrend as is the share of workers in their 40s - the age cohort when people are most productive. However, there has also been a cyclical component to the productivity slowdown and it is possible that productivity growth could accelerate somewhat in the near-term as the cycle matures. The capital stock per worker correlates strongly with productivity growth (Chart 11), and while capital investment has been depressed for most of the recovery there are finally some signs that it may return (Chart 12). Chart 11Productivity Held Back By Lack Of Investment Productivity Held Back By Lack Of Investment Productivity Held Back By Lack Of Investment Chart 12Getting Optimistic About Capex Getting Optimistic About Capex Getting Optimistic About Capex In fact, it is even conceivable that more rapid wage growth itself might encourage firms to replace labor with capital, causing traditional measures of wage growth to accelerate relative to unit labor costs. Also, the prospect of tax reform and regulatory relief could give capital spending a boost - it has already led to a jump higher in small business optimism (Chart 12, bottom panel). Unit labor costs will likely continue to accelerate on a cyclical investment horizon, applying flattening pressure to the yield curve. But this flattening pressure would be mitigated to the extent that there is any cyclical rebound in productivity growth. Yield Curve Strategy Upon consideration of the four factors described above, we conclude that while the slope of the yield curve will likely be close to zero sometime in late 2018, curve flattening won't start in earnest until late this year or early next year when inflation expectations are higher (2.4% to 2.5% on long-dated TIPS breakevens) and core PCE inflation is firmly anchored around the Fed's 2% target. This conclusion is based on our observations that: TIPS breakevens and the slope of the curve tend to be positively correlated, even during rate hike cycles. Interest rate volatility is more likely to rise than fall. Unit labor costs are likely to remain in an uptrend on a cyclical horizon, but there is scope for them to level-off if we see a modest late-cycle rebound in productivity growth. To position for a steeper yield curve between now and the end of this year we continue to recommend that investors favor the 5-year Treasury note relative to a duration-matched position in a 2-year/10-year barbell. Long bullet/short barbell trades tend to outperform when the yield curve steepens, and our model suggests that the 5-year yield is currently very cheap relative to the 2/10 slope (Chart 13). We have been recommending this trade since December 20, 2016 and it has so far returned +2 bps even though the 2/10 slope has flattened 13 bps during that time. The strong positive carry means that not much curve steepening is required for the trade to realize strong positive gains. Chart 13The 5-Year Bullet Is Cheap On The Curve The 5-Year Bullet Is Cheap On The Curve The 5-Year Bullet Is Cheap On The Curve Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 For further details on our Fed Monitor please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 4 Please see BCA Special Report, "Beware The 2019 Trump Recession", dated March 7, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians", dated March 25, 2016, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Keep A Close Eye On Financial Conditions Keep A Close Eye On Financial Conditions Keep A Close Eye On Financial Conditions The market's rate hike expectations moved sharply higher during the past two weeks as a string of Fed speeches, including one by Chair Yellen, all but confirmed a March rate hike. The market is now priced for 75 basis points of hikes during the next 12 months, compared to 50 bps at the end of January. At least so far, broad indicators of financial conditions have not tightened in response to this re-rating of the Fed (Chart 1). However, there are some preliminary indications that the reflation trade is fraying at the edges. The trade-weighted dollar has appreciated +0.2% since the end of January, the 2/10 Treasury slope has flattened 9 bps and the 10-year TIPS breakeven inflation rate has declined 1 bp. The Fed is currently testing the markets with hawkish rhetoric but, with inflation and TIPS breakevens still below target, will ultimately support the reflation trade if it comes under threat. In this environment investors with 6-12 month investment horizons should maintain below-benchmark duration, remain overweight spread product and continue to position for a steeper curve and wider TIPS breakevens. Feature Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 48 basis points in February. The index option-adjusted spread tightened 6 bps on the month and, at 112 bps, it remains well below its historical average (134 bps). Our research1 shows that when core PCE inflation is between 1.5% and 2%2 investment grade corporate bonds produce an average monthly excess return of close to zero. A 90% confidence interval places monthly excess returns between -19 bps and +17 bps with inflation in this range and excess returns do not turn decisively negative until core PCE is above 2%. Given the Fed's desire to nurture a continued recovery in inflation, we are not worried about significant spread widening until inflation is sustainably above 2%. In the meantime we expect corporate bond excess returns to be low, but positive. While supportive monetary policy should ensure excess returns consistent with carry, investors should not bank on further spread compression as corporate spreads have already discounted a substantial improvement in leverage (Chart 2). Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3), and our commodity strategists expect oil prices to remain firm even in the face of a stronger U.S. dollar. This week we upgrade the Wireless and Packaging sectors from underweight to neutral and downgrade the Consumer Cyclical Services sector from neutral to underweight. The former two sectors now appear cheap on our model, while the latter has become expensive. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* How Much Can Markets Take? How Much Can Markets Take? Table 3BCorporate Sector Risk Vs. Reward* How Much Can Markets Take? How Much Can Markets Take? High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 112 basis points in February. The index option-adjusted spread tightened 25 bps on the month and, at 349 bps, it is currently 170 bps below its historical average. One of our key investment themes3 for this year is that the uptrend in defaults is likely to reverse (Chart 3), mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Despite the positive outlook for defaults, we retain only a neutral allocation to High-Yield because of very tight valuations. The index option-adjusted spread is now within a hair of the average level of 340 bps that prevailed during the 2004 - 2006 Fed tightening cycle, when indicators of corporate balance sheet health were in much better shape. In fact, the index spread is now only 116 bps wider than its all-time low of 233 bps, reached in 2007. Our preferred measure of High-Yield valuation is the default-adjusted spread - the average spread of the junk index less our forecast of 12-month default losses. At present, the default-adjusted spread is 142 bps. Historically, a default-adjusted spread between 100 bps and 150 bps is consistent with positive excess returns during the subsequent 12 months 64% of the time. It is only when the default-adjusted spread falls below 100 bps that positive excess returns become unlikely. Junk has provided positive excess returns over a 12-month horizon only 13% of the time when the starting default-adjusted spread is between 50 bps and 100 bps. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in February. The conventional 30-year MBS yield fell 5 bps on the month, driven by a 7 bps decline in the rate component. The compensation for prepayment risk (option cost) increased by 1 bp, as did the option-adjusted spread. MBS spreads remain extremely tight relative both to history and Aaa-rated credit, although they have begun to widen somewhat relative to credit in recent weeks (Chart 4). More distressing is that the nominal MBS spread appears too tight relative to interest rate volatility (bottom panel). As we noted in a recent report,4 the long-run trend in interest rate volatility tends to be driven by uncertainty about the macroeconomic and political environment. In fact, rate volatility can be modeled using forecaster disagreement about GDP growth and T-bill rates. While the Fed's policy of forward guidance and a fed funds rate pinned at zero limited the amount of forecaster disagreement in recent years, this disagreement will re-emerge the further the fed funds rate moves off its lower bound. Another medium-term risk for MBS comes from the Fed ending the reinvestment of its MBS portfolio. As we described in a recent Special Report,5 the Fed is likely to allow its MBS portfolio to shrink at some point in 2018, putting further upward pressure on MBS spreads. 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 30 basis points in February, bringing year-to-date excess returns up to +51 bps. The high-beta Sovereign and Foreign Agency sectors outperformed the Treasury benchmark by 90 bps and 59 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors each outperformed by 4 bps. Local Authorities returned 24 bps in excess of duration-matched Treasuries. Sovereigns have outperformed Baa-rated corporate bonds year-to-date, a trend consistent with the rise in commodity prices and a trade-weighted dollar that has weakened by 1.5% (Chart 5). However, the dollar has started to appreciate in recent weeks and probably has further upside in the medium-term, especially if the Fed maintains its hawkish posture. Historically, it has been very rare for Sovereigns to outperform U.S. corporate bonds when the dollar is appreciating. After adjusting for credit rating and duration, the Foreign Agency and Local Authority sectors continue to appear cheap relative to U.S. corporate credit. In contrast, Sovereigns, Supranationals and Domestic Agencies all appear expensive. We continue to recommend overweight allocations to Foreign Agencies and Local Authorities, alongside underweight allocations to the rest of the government-related index. In a television interview last month Treasury Secretary Steven Mnuchin confirmed that GSE reform is still a priority for the new administration but that tax reform is much higher on the agenda. This means that agency spreads will likely remain insulated from any "reform risk" until next year at the earliest. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 13 basis points in February (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio has fallen 4% since the end of January and remains firmly anchored below its post-crisis average. The decline in the average M/T yield ratio was concentrated in short maturities, while ratios at the long-end of the curve actually rose (Chart 6). Accelerating fund flows and falling issuance will continue to support yield ratios in the near term. In fact, our tactical yield ratio model - based on issuance, fund flows and ratings migration - shows that yield ratios are presently very close to fair value. Although the average M/T yield ratio still appears expensive if we include the global economic policy uncertainty index as an additional explanatory variable.6 One risk to Munis is that yield ratios have already discounted a substantial reduction in state and local government net borrowing in Q1 (panel 3). While we expect this improvement will materialize in the next few quarters, net borrowing is biased upward beyond this year based on the lagged relationship between corporate sector and state and local government health.7 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 has bear-flattened since the end of January as the market revised its Fed rate hike expectations sharply higher. Both the 2/10 and 5/30 Treasury slopes have flattened by 9 basis points since January 31. As such, our recommended position long the 5-year bullet and short the 2/10 barbell - designed to profit from a steeper yield curve - has returned -26 bps since the end of January, although it has returned close to 0 bps since it was initiated on December 20.8 As was stated on the front page of this report, the Fed's increasingly hawkish rhetoric has already caused the uptrend in TIPS breakevens to pause and the nominal Treasury slope to flatten (Chart 7). With inflation still below target these trends are not sustainable from the point of view of Fed policymakers. If the trend of decreasing TIPS breakevens and a flattening curve persists, we would expect the Fed to back away from its hawkish rhetoric. This dynamic will support a steeper yield curve at least until core PCE inflation is back to the Fed's 2% target and long-dated TIPS breakevens are anchored in a range between 2.4% and 2.5% (a range that is typically consistent with core PCE inflation at 2%). The persistent attractiveness of the 5-year bullet relative to the rest of the curve makes a position long the 5-year bullet and short a duration-matched 2/10 barbell the most attractive way to position for a steeper yield curve (panel 3). The carry buffer in the 5-year helps mitigate some of the risk of curve flattening. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent Treasury index by 18 basis points in February. The 10-year TIPS breakeven rate declined 3 bps on the month and, at 2.04%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. While the catalyst for the recent softening in TIPS outperformance seems to be the hawkish re-rating of Fed rate hike expectations, the uptrend in TIPS breakevens was probably due for a pause in any case. Breakevens had become stretched relative to our TIPS Financial Model - based on the dollar, oil prices and the stock-to-bond total return ratio (Chart 8). Diffusion indexes for both PCE and CPI inflation have also shifted into negative territory, suggesting that realized inflation readings will soften during the next couple of months. On a cyclical horizon, however, the Fed will be keen to allow breakevens to rise toward levels more consistent with its inflation target and will quickly adopt a more dovish stance if breakevens fall significantly. This "Fed put" should remain in place at least until core PCE inflation is firmly anchored around 2% and long-dated TIPS breakevens return to a range between 2.4% and 2.5%. As we detailed in a recent report,9 while accelerating wage growth will ensure that inflation remains in a long-run uptrend, the impact from wages will be mitigated by deflating import prices meaning that the uptrend will be slow. We continue to expect that year-over-year core PCE inflation will not attain the Fed's 2% target until the end of this year. ABS: Maximum Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities performed in-line with the duration-equivalent Treasury index in February. Aaa-rated issues underperformed the Treasury benchmark by 2 basis points, while non-Aaa issues outperformed by 12 bps. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month. At 50 bps, the spread remains well below its average pre-crisis level. Banks are now tightening lending standards on both auto loans and credit cards (Chart 9). While we do not think this will have much of an impact on consumer spending,10 it is usually an indication that there is growing concern about ABS collateral credit quality. While credit card charge-offs remain well below their pre-crisis levels, net losses on auto loans have in fact started to trend higher (bottom panel). We continue to recommend Aaa-rated credit cards over Aaa-rated auto loans, despite the spread advantage in autos. We will closely monitor the evolving credit quality situation, but for now continue to view consumer ABS as a very attractive alternative to other short-duration Aaa-rated spread product such as MBS and Agency bonds. The main reason being the sizeable spread advantage that has persisted in ABS for some time. At present, Aaa-rated consumer ABS offer an option-adjusted spread of 50 bps, compared to 31 bps for 30-year conventional Agency MBS and 18 bps for Agency bonds. 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 34 basis points in February. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps on the month, but remains below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are firmly entrenched below their pre-crisis average. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 20 basis points in February. The index option-adjusted spread for Agency CMBS widened 5 bps on the month, and currently sits at 53 bps. The spread offered on Agency CMBS is similar to what is offered by Aaa-rated consumer ABS (50 bps) and greater than what is offered by conventional 30-year MBS (31 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. 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 2.42% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.21%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.49%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2016, available at usbs.bcaresearch.com 2 Year-over-year core PCE inflation is currently 1.74%. 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 For further details on the linkage between corporate sector health and state & local government health please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 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) Current Recommendation

Highlights Monetary Policy: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Economy: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. High-Yield: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Feature Chat 1A Hawkish Market Reaction A Hawkish Market Reaction A Hawkish Market Reaction After having been relatively subdued in the two months since the Fed's last rate increase, rate hike expectations priced into money market curves awakened last week following Janet Yellen's semi-annual Congressional testimony. Expectations priced into the overnight index swap curve have returned close to levels last seen on the day of the December 2016 FOMC meeting (Chart 1). As of last Friday's close, the market was priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. The implied probability of a March hike peaked at 34% last Wednesday.1 In this week's report we discuss why a March rate hike is unlikely. We also consider the outlook for U.S. economic growth in 2017, which we expect will remain decidedly above trend. Above-trend growth will allow the gradual increase in core inflation to persist, reaching the Fed's target by the end of the year. As a result, the Treasury curve will bear-steepen during this timeframe. To position for this outcome, investors should maintain below-benchmark duration and favor the belly (5-year bullet) of the curve relative to the wings (2/10 barbell) in duration-matched terms.2 Yellen's Hawkish Turn? Most news reports of Janet Yellen's testimony last week perceived a hawkish tone in her remarks and focused specifically on the following sentence: As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.3 However, more important than the above boilerplate is the simple fact that inflation remains below target and the Fed has an incentive to tread cautiously to support its eventual recovery. There is no pressing need to move quickly on rate hikes and we expect that the next rate increase will not occur until June. One reason is that, in the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in Chart 2, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming "meetings". Chart 2Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Second, as was alluded to above, core PCE inflation is running at 1.7% year-over-year, still below the Fed's 2% target. What's more, long-dated TIPS breakeven inflation rates are also below levels that are consistent with inflation being anchored near the Fed's target (Chart 3). At present, the 5-year/5-year forward TIPS breakeven rate is 2.17%. Historically, a range of 2.4% to 2.5% is consistent with inflation at the Fed's target. Further, even though a strong January core CPI print, released last week, seemed to strengthen the case for a March hike, the details of the report show that only a few components (new cars +0.9% m/m, apparel +1.4% m/m, and airline fares +2.0% m/m) accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in contractionary territory (Chart 4), it is very likely that inflation will soften in the coming months. Chart 3Inflation Still Too Low Inflation Still Too Low Inflation Still Too Low Chart 4Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Both our own and the Fed's forecasts for continued inflation increases are contingent on the view that tight labor markets are causing wage pressures to mount, and certainly wages have accelerated during the past few years. However, wage growth in both real and nominal terms is still below where the Fed would like it to be, and there has been scant evidence of wage acceleration during the past few months. While the Atlanta Fed's Wage Growth Tracker remains strong in nominal terms, it has leveled off in real terms, and both the Employment Cost Index and Average Hourly Earnings have recently been flat (Chart 5). A final factor that will prevent the Fed from lifting rates in March is the extremely high degree of policy uncertainty. As shown in Chart 6, economic policy uncertainty traditionally correlates with financial conditions. With financial markets having already discounted a very positive fiscal policy outcome, there is a heightened risk that some disappointing news on the fiscal front will lead to a sharp tightening of financial conditions in the near term. Such an event would definitely put the Fed on hold until financial markets recovered. Chart 5Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Chart 6Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Bottom Line: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Policy Aside, U.S. Growth Is Heating Up Chart 7ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth Most recent economic discussion has focused on when President Trump will get around to enacting some of the more stimulative parts of his policy agenda, and whether or not the impact of these policies (tax cuts, infrastructure spending) will ultimately be offset by other spending cuts. But in the meantime, leading indicators of GDP growth have been picking up steam. Both the manufacturing and non-manufacturing ISM surveys point to an increase in GDP growth in the first quarter (Chart 7), and consistently, the New York Fed's tracking model suggests Q1 GDP will grow by 3.1%. The Atlanta Fed's GDP tracking model pegs Q1 growth slightly lower at 2.4%. Our own sense is that GDP growth will remain solidly above trend this year, in the range of 2.5% to 3%, even in the absence of major fiscal stimulus. This forecast hinges on the view that both residential and non-residential investment will rebound from the depressed levels seen last year and that consumer spending will remain strong. Residential Investment Chart 8Residential & Non-Residential Investment Residential & Non-Residential Investment Residential & Non-Residential Investment Residential investment was actually a drag on GDP growth for two quarters in 2016, even though leading indicators such as the months supply of new homes and homebuilder confidence remained supportive (Chart 8, panels 1 & 2). The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s,4 meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.5 While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates (Chart 8, panel 3). Non-Residential Investment Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector (Chart 8, panel 4). Now that the oil price has recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of New Orders surveys also suggests that non-residential investment will trend higher this year (Chart 8, bottom panel). While there is some concern that the optimism displayed in these survey measures may not filter through to the "hard" economic data, a Special Report from our Bank Credit Analyst publication that will be published on Thursday concludes that a tangible growth acceleration is indeed underway throughout the G7. Consumer Spending As always, the consumer is the main driver of U.S. growth and we expect consumer spending will remain firm in 2017. Our U.S. Investment Strategy service recently undertook a detailed analysis of consumer spending,6 focusing on its two main drivers - income growth and the savings rate (Chart 9). A look at past cycles suggests that income growth can remain strong even after the economy reaches full employment as rising wages compensate for decelerating payroll growth (Chart 10). The recent spike in consumer income expectations suggests that the impact from rising wages might be particularly important in the current cycle (Chart 10, panel 1). Chart 9Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Chart 10Wages Can Drive Income Growth Wages Can Drive Income Growth Wages Can Drive Income Growth Another benefit of the economy reaching full employment is that increased job security can translate into greater consumer confidence and a lower savings rate (Chart 9, bottom panel). Confidence trends suggest that the savings rate has scope to decline during the next few months. One possible headwind to consumer spending is the recent tightening of consumer lending standards. The Fed's Senior Loan Officer Survey for the fourth quarter of 2016 shows that lending standards on auto loans have tightened for three consecutive quarters and that credit card lending standards also recently spiked into "net tightening" territory. In other words, more banks are now tightening lending standards on consumer loans than easing them. Prior to the financial crisis, consumer lending standards were strongly correlated with the savings rate (Chart 11). More stringent lending standards slowed the pace of consumer credit growth and led to reduced consumer spending. But this relationship broke down following the financial crisis. After the housing bust, households were no longer eager to supplement their consumption with as much credit as possible. Their chief concern became repairing their own balance sheets. As such, the supply of credit is no longer the most important driver of the savings rate. In the data, we observe that the savings rate did not fall by as much as would have been predicted by easing lending standards in the early years of the recovery. As a result, we do not think that modestly tighter lending standards will have much of an impact either. The Fed's latest Senior Loan Officer Survey also showed that demand for consumer credit declined sharply in 2016 Q4. This is potentially more worrisome for the savings rate since lower credit demand may still suggest a reduced appetite for spending, even in the wake of the Great Recession. However, a look back at prior cycles shows that loan demand from the Senior Loan Officer Survey tends to decline several years prior to the next recession, but the savings rate has tended to stay low until the next recession actually hits (Chart 11, bottom panel). We would not be surprised to see the same dynamic play out again. Bottom Line: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. Chart 11Lending Standards Less Of A Risk Lending Standards Less Of A Risk Lending Standards Less Of A Risk Chart 12Default-Adjusted Spread Default-Adjusted Spread Default-Adjusted Spread A High-Yield Valuation Update With the release of the Moody's default report for January we are able to update our forecast for High-Yield default losses during the next 12 months, and also our High-Yield default-adjusted spread. The default-adjusted spread is our preferred valuation indicator for both High-Yield and Investment Grade corporate bonds. It is calculated by taking the option-adjusted spread from the Bloomberg Barclays High-Yield index and subtracting an estimate of expected default losses during the next twelve months (Chart 12). Default loss expectations are calculated using the Moody's baseline forecast for the 12-month High-Yield default rate and our own forecast of the recovery rate based on its historical relationship with the default rate (Chart 12, bottom two panels). The current reading from our default-adjusted spread is 152 basis points. Most of the time, a reading of 152 bps on the default-adjusted spread is consistent with small positive excess returns for both High-Yield and Investment Grade corporate bonds (Chart 13 & Chart 14). This is also consistent with the excess returns we expect from corporate credit this year. Chart 1312-Month Excess High-Yield Returns Vs. Ex-Ante ##br##Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March Chart 1412-Month Excess Investment Grade Returns Vs. Ex-Ante High-Yield##br## Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March In fact, when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns to High-Yield have been positive in 65% of cases, with a 90% confidence interval placing 12-month excess returns in a range between -5.0% and +1.7%. Given the favorable economic back-drop of strong economic growth and accommodative Fed policy, we would expect High-Yield excess returns to be positive during the next 12 months. But given the tight starting valuation, probably not above +1.7%. Bottom Line: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculations of rate hike probabilities implied by fed funds futures are lower than those shown on Bloomberg terminals. Our measure differs because we use the actual data for the effective fed funds rate and also adjust for the well-known fact that the effective fed funds rate tends to fall by approximately 10 basis points on the last day of the month. 2 For further details on our recommended yield curve trade please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/testimony/yellen20170214a.htm 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see "The State Of The Nation's Housing 2016", Joint Center for Housing Studies of Harvard University. 6 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights Chart 1Strong Growth & An Easy Fed Strong Growth & An Easy Fed Strong Growth & An Easy Fed More than a month has passed since the Fed's latest rate hike and, at least so far, the economy is displaying no ill effects. While the economic data continue to surprise to the upside, Fed rate hike expectations have moderated since mid-December (Chart 1). The combination of accelerating growth and accommodative monetary policy sets the stage for further outperformance in spread product. This message was underscored by last Friday's employment report which showed robust payroll gains of +227k alongside a slight deceleration in wage growth. This is consistent with an environment where growth remains above trend but the recovery in inflation proceeds more gradually. Against this back-drop we favor overweight positions in spread product and TIPS relative to nominal Treasuries, while also positioning for a bear-steepening of the Treasury curve. While we would not rule out a near-term correction in risk assets, due to extended positioning and elevated policy uncertainty, we would view any correction as a buying opportunity given the supportive growth and monetary policy back-drop. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 5 basis points in January (Chart 2). The index option-adjusted spread tightened 2 bps on the month and, at 121 bps, it remains well below its historical average (134 bps). In a recent report1 we examined historical excess returns to corporate bonds given different levels of core PCE inflation. We found that excess returns are best when year-over-year core PCE is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with extremely accommodative monetary policy. When inflation is between 1.5% and 2% (year-over-year core PCE is currently 1.7%), average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. Excess returns do not turn decisively negative until core PCE is above 2%. Given the Fed's desire to nurture a continued recovery in inflation, we expect corporate bond excess returns to be low, but positive. The Technology sector is relatively defensive and is close to neutrally valued according to our model (Table 3). In addition, our Geopolitical Strategy service has observed that many of the firms in this sector carry significant exposure to China, a risk as U.S. protectionism ramps up.2 We therefore downgrade our position in Technology from overweight to neutral, and upgrade our positions in Wirelines, Media & Entertainment and Other Utilities from underweight to neutral. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Cue The Reflation Trade Cue The Reflation Trade Table 3BCorporate Sector Risk Vs. Reward* Cue The Reflation Trade Cue The Reflation Trade High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 124 basis points in January. The index option-adjusted spread tightened 21 bps on the month and, at 376 bps, it is currently 144 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default outlook, last week we upgraded high-yield from underweight to neutral. Still-tight valuation is the reason we maintain a neutral allocation as opposed to overweight. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is currently 152 bps (Chart 3). This is close to one standard deviation below its long-run average. Historically, we have found that a default-adjusted spread between 150 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of -164 bps. With the spread in this range a 90% confidence interval places 12-month excess returns between -500 bps and +171 bps. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 24 basis points in January. The conventional 30-year MBS yield rose 5 bps in January, driven by a 7 bps widening of the option-adjusted spread. The rate component of the yield held flat, while the compensation for prepayment risk (option cost) declined by 2 bps. MBS spreads remain extremely tight, relative both to history and Aaa-rated credit. Historically, the option-adjusted spread is correlated with net MBS issuance and robust issuance will eventually lead this spread wider. At least so far, net MBS issuance shows no sign of slowing down. While refinancing applications declined alongside the recent spike in Treasury yields, purchase applications have remained resilient (Chart 4). The Fed ceasing the reinvestment of its MBS portfolio would also significantly add to MBS supply. As we explained in a recent report,4 we expect the Fed will not start to wind down its balance sheet until 2018. However, if growth is stronger than we expect there is a chance the process could begin near the end of this year. In that same report we also observed that nominal MBS spreads are very low relative to both the slope of the yield curve and implied rate volatility. This poses a risk to MBS in the near-term. Government-Related: Cut To Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 21 basis points in January. Sovereign bonds outperformed by 75 bps, while Foreign and Domestic Agency bonds outperformed by 6 bps and 14 bps, respectively. Local Authorities outperformed by 34 bps and Supranationals outperformed by 2 bps. This week we downgrade the government-related sector from overweight to underweight, although we recommend maintaining an overweight allocation to both the Foreign Agency and Local Authority sectors. Sovereigns are not attractive compared to corporate credit, according to our model, and will struggle to outperform if the dollar remains in a bull market, as we expect it will. A stronger dollar increases the cost of debt servicing from the perspective on non-U.S. issuers. Foreign Agencies and Local Authorities both appear attractive relative to corporate credit, after adjusting for differences in credit rating and duration. Foreign Agencies in particular will perform well if oil prices continue to trend higher. Supranationals offer very little spread, and are best thought of as a hedge in spread widening environments. Domestic Agency debt can also be thought of in this vein, but with the added risk that spreads start to widen if any progress is made toward GSE reform. While any concrete movement on GSE reform is still a long way off, the new administration has brought the topic back into the headlines and this has led to some increased volatility in Domestic Agency spreads in recent weeks (Chart 5). Municipal Bonds: Upgrade To Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 40 basis points in January (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 2% in January and currently sits just below its post-crisis average. Even though net state & local government borrowing edged higher in Q4, issuance has rolled over in recent weeks and fund flows have sharply reversed course (Chart 6). As a result, our tactical yield ratio model - based on issuance, fund flows and ratings migration - shows that yield ratios are very close to fair value. Although the average M/T ratio still appears expensive if we include the global economic policy uncertainty index as an additional explanatory variable.5 While we remain cautious on the long-term prospects for state & local government health, we expect that improving trends in fund flows and issuance will support yield ratios for the next several months. Eventually we expect that increased state & local government investment will lead to higher issuance, but this will take some time to play out. In the meantime it will be crucial to monitor the federal government's progress on tax reform, particularly if there appears to be any appetite for removing municipal bonds' tax exempt status. Our sense is that the tax exemption will remain in place due to the administration's stated preference for increased infrastructure spending. But that outcome is highly uncertain. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview After a volatile end to last year, the Treasury curve was relatively unchanged in January. The 2/10 slope steepened by 1 basis point on the month and the 5/30 slope steepened by 2 bps. In previous reports we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen this year. This steepening will be driven by a continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. However, as we posited in a recent report,6 it could take until the end of this year before TIPS breakevens return to pre-crisis levels and core inflation returns to the Fed's target. To position for a steeper Treasury curve, we recommend that investors favor the 5-year bullet versus a duration-equivalent 2/10 barbell. Not only will the bullet outperform the barbell as the curve steepens, but the 5-year bullet is currently very cheap relative to the 2/10 slope (Chart 7). This trade has so far returned +29 bps since initiation on December 20. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 58 basis points in January. The 10-year TIPS breakeven inflation rate increased 10 bps on the month and, at 2.05%, it remains well below its pre-crisis range of 2.4% to 2.5%. The Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly adopt a more dovish policy stance if breakevens fall. This "Fed put" is a key reason why we remain overweight TIPS relative to nominal Treasuries, although we expect the uptrend in breakevens will moderate during the next few months. As we detailed in a recent report,7 while accelerating wage growth will ensure that inflation remains in an uptrend, the impact from wages will be mitigated by deflating import prices. Diffusion indexes for both PCE and CPI have also rolled over recently, suggesting that inflation readings will soften during the next couple of months. The anchor from slowly rising inflation will prevent TIPS breakevens from increasing too quickly, and breakevens are also too high compared to the reading from our TIPS Financial model - based on the dollar, oil prices and the stock-to-bond total return ratio (Chart 8). At the moment, only pipeline measures of inflationary pressure such as the ISM prices paid index (panel 4) suggest that breakevens will move rapidly higher in the near term. Remain overweight TIPS but expect the uptrend in breakevens to moderate in the months ahead. ABS: Maximum Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in January. Aaa-rated issues outperformed by 5 bps while non-Aaa issues outperformed by 17 bps. Credit card issues outperformed by 8 bps and auto loans outperformed by 5 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. At 51 bps, the spread remains well below its average pre-crisis level. As was noted in the Appendix to our year-end Special Report,8 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except Baa-rated corporates and Caa-rated high-yield in 2016. With ABS spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. The spread on Aaa-rated credit card ABS tightened 4 bps in January, and now sits at 49 bps. Meanwhile, the spread on Aaa-rated auto loan ABS tightened 1 bp on the month, and now sits at 54 bps. In early November we recommended favoring Aaa-rated credit cards relative to Aaa-rated auto loans. Collateral credit quality between credit cards and auto loans is clearly diverging in favor of credit cards (Chart 9, bottom panel), and in early November, our measure of the volatility adjusted breakeven spread (days-to-breakeven) was displaying no discernible valuation advantage in autos. Since November, however, autos have started to look more attractive (Chart 9, panel 3). If auto loan spreads continue to widen relative to credit cards we may soon shift back into autos. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month, and is now close to one standard deviation below its pre-crisis mean (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 22 basis points in January. The index option-adjusted spread for Agency CMBS tightened 4 bps on the month, and currently sits at 51 bps. The spread offered from Agency CMBS is similar to what is offered by Aaa-rated consumer ABS (52 bps) and greater than what is offered by conventional 30-year MBS (30 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.44% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.08%. The lower fair value is the result of a large spike in the uncertainty index in November that has yet to unwind (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. It is for this reason that we recently moved back to a below-benchmark duration stance.9 For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.44%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2016, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", dated January 18, 2016, available at gps.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 5 For further details on the model please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes for 2017", dated December 20, 2016, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Inflation: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Yield Curve: With core inflation still low, the Fed will be quick to back away from its rate hike plans if there is any indication that inflation might reverse its uptrend. This supports a bear-steepening of the yield curve and the continued outperformance of TIPS versus nominal Treasuries. Spread Product: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Feature Chart 1A Sustainable Recovery A Sustainable Recovery A Sustainable Recovery After seven years of false starts and disappointments, a durable recovery in inflation is finally under way (Chart 1). The key difference between the current uptrend and prior episodes of rising inflation - such as those witnessed in 2011 and 2014 - is that this time around most labor market indicators suggest the economy is very close to full employment. For this reason the recovery in core inflation is likely to persist, and will eventually settle at a level close to the Fed's 2% target for core PCE. That being said, it is still far too soon for investors to worry about inflation, particularly as it relates to the performance of risk assets. The remainder of this report discusses why the recovery in inflation is likely to be slow moving, and also how the inflation outlook impacts our major fixed income investment calls. Some Near-Term Headwinds There are two reasons why year-over-year measures of core inflation are likely to moderate during the next three months. First, diffusion indexes for both CPI and PCE inflation have recently dipped below the zero line (Chart 2), meaning that more components of each index have decelerating prices than have accelerating prices. Historically, rising year-over-year core inflation has been associated with diffusion indexes above zero. Second, January and February of last year saw incredibly large price increases in both core CPI and core PCE (Chart 3). This means that gains in January and February of this year will also have to be very strong to overcome the large base effect and cause the year-over-year growth rates to move higher. Chart 2Diffusion Indexes Point To Deceleration Diffusion Indexes Point To Deceleration Diffusion Indexes Point To Deceleration Chart 3A Large Base Effect In Jan & Feb A Large Base Effect In Jan & Feb A Large Base Effect In Jan & Feb Now these are only very short term arguments. The base effects will be out of the way by March and diffusion indexes can reverse course very quickly. However, they do suggest that inflation readings are likely to be relatively weak during the next few months. This will be critical for the near-term path of monetary policy and, in our view, makes it likely that the Fed will keep rates steady until the June FOMC meeting. The Phillips Curve Chart 4A Phillips Curve Model Of Inflation A Phillips Curve Model Of Inflation A Phillips Curve Model Of Inflation Turning to the longer run outlook for inflation, we employ a Phillips curve model of core PCE inflation based on one that Janet Yellen referred to in a speech from September 2015.1 In this framework, the year-over-year change in core PCE inflation is modeled using: Lagged core inflation Inflation expectations (from the Survey of Professional Forecasters) Non-oil import price inflation relative to core PCE inflation Resource utilization (calculated as the difference between the unemployment rate and the Congressional Budget Office's (CBO) estimate of the natural rate of unemployment) The model does an excellent job capturing changes in core PCE inflation since 1990 (Chart 4), and is also useful because it gives us a glimpse of the mental framework that Fed policymakers apply to the task of inflation forecasting. Most importantly, the model allows us to generate inflation forecasts given estimates for inflation expectations, the unemployment rate and the U.S. dollar (which closely tracks relative import prices). For example, in a base case scenario where we assume that inflation expectations and the dollar remain flat, but that the unemployment rate declines from its current level of 4.7% to 4.5% by the end of this year, the model predicts year-over-year core PCE inflation will rise from its current level of 1.65% to 1.87% by November, still below the Fed's 2% target. If we keep the same forecast for a steadily declining unemployment rate but also incorporate a 5% increase in the value of the trade-weighted U.S. dollar, then core PCE inflation is projected to rise to 1.76% by November. The stronger dollar means that import prices exert a bit more of a drag. Conversely, if we keep the same unemployment assumption but assume that the U.S. dollar depreciates by 5%, then core PCE inflation is projected to reach 1.98% by November. In this scenario import prices actually provide a slight boost to core inflation. Overall, to create a scenario where core inflation reaches the Fed's target before the end of this year we need to make a fairly optimistic assumption about the unemployment rate and also incorporate a substantial dollar depreciation. In our view, it is more likely that the dollar remains under mild upward pressure this year as the U.S. economy continues to de-couple from the rest of the world. Fiscal policy remains the wildcard, as any protectionist measures implemented by the new U.S. government could lead to import price shocks. Although at first blush any watering-down of trade deals, imposition of tariffs, or protectionist tweaks to the tax code would seem likely to send import prices higher, much depends on how much of the adjustment to the new trade policy occurs through the exchange rate or through prices. This is incredibly hard to determine until the details of any protectionist trade measures are known. Our Global Investment Strategy service explored the potential ramifications of one such trade proposal - a border-adjusted corporate tax - in a Special Report published last week.2 A Bottom-Up Perspective An alternative to the Phillips curve approach is to split core inflation into its major sub-components: shelter, core goods and core services excluding shelter. We can then examine each sub-component separately and identify different macro drivers for each (Chart 5). Shelter has been the strongest contributor to core inflation so far in this recovery and can be modeled using home prices, the rental vacancy rate and household formation (Chart 5, panel 1). Based on these relationships, we expect shelter inflation will remain elevated for quite some time, while our model suggests it is even likely to move a bit higher during the next few months. After briefly seeming like it might rebound earlier last year, the rental vacancy rate has since fallen to new lows while home price appreciation continues at a steady rate of just above 4% per year (Chart 6). Further, the vacancy rate should remain under downward pressure and home prices under upward pressure as long as household formation continues to outpace home construction. The top panel of Chart 6 shows that the difference between housing starts and household formation closely tracks the rental vacancy rate. The vacancy rate rose throughout the 1990s and early 2000s as housing starts outpaced the creation of new households, but starts have not been sufficiently robust so far in this recovery. In addition, housing inventory as a percent of households is near the lows of the early 1990s (Chart 6, bottom panel). This inventory calculation includes the "shadow inventory" from foreclosed homes which has almost normalized back to pre-crisis levels, in any case. Chart 5The Components Of Core CPI The Components Of Core CPI The Components Of Core CPI Chart 6Drivers Of Shelter Inflation Drivers Of Shelter Inflation Drivers Of Shelter Inflation We expect that shelter inflation will remain elevated at least until housing construction starts to outpace the creation of new households, but will moderate once that supply response starts to emerge. Chart 7Atlanta Fed Wage Growth Tracker* ##br##Versus Unemployment Rate Inflation: More Fire Than Ice, But Don't Sound The Alarm Inflation: More Fire Than Ice, But Don't Sound The Alarm Core goods inflation (Chart 5, panel 2) has been, and will continue to be, the major source of deflation in this cycle. A large fraction of core goods are imported and, as such, core goods inflation tends to follow the trend in the U.S. dollar. The bull market in the U.S. dollar will continue to keep a lid on core goods prices, and will limit how quickly inflation can rise. Any meaningful increase in inflation this year is likely to come from the core services excluding shelter component, which historically tends to track fluctuations in wage growth (Chart 5, bottom panel). As we have previously highlighted, the labor market is close to full employment and the relationship between the unemployment rate and wage growth remains strong (Chart 7). In this environment, even modest further declines in the unemployment rate should exert meaningful upward pressure on wages. Bottom Line: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Investment Implications Duration & TIPS Chart 8Leading Inflation Indicators & Breakevens Leading Inflation Indicators & Breakevens Leading Inflation Indicators & Breakevens Long-maturity TIPS breakeven inflation rates still have upside, although the rate of increase is unlikely to maintain its current rapid pace. As core inflation converges with the Fed's target so should long-dated measures of inflation expectations such as TIPS breakevens. Historically, core PCE inflation close to 2% has coincided with long-dated TIPS breakevens in a range between 2.4% and 2.5%. With the 10-year breakeven currently at 2.05%, we expect it has another 35 to 45 basis points of upside. Measures of pipeline inflation pressure, such as producer prices and the prices paid and supplier deliveries components of the ISM manufacturing survey also point to rising breakevens (Chart 8). We continue to recommend an overweight allocation to TIPS versus nominal Treasury securities. With rate hike expectations still relatively depressed,3 real yields do not have much downside. Rising breakevens should therefore also pressure long-dated nominal yields higher in the months ahead. While we currently recommend a benchmark duration stance, we are actively looking for an opportunity to shift to below-benchmark duration, as was discussed in last week's report.4 Yield Curve As breakevens and nominal yields move higher the yield curve should also steepen (Chart 9). The strong positive correlation between the slope of the yield curve and TIPS breakevens is the result of the impact of Fed policy on both variables. Chart 9Wider Breakevens Correlated With A Steeper Yield Curve Inflation: More Fire Than Ice, But Don't Sound The Alarm Inflation: More Fire Than Ice, But Don't Sound The Alarm Fed policy tends to be accommodative in the early stages of a recovery, and this causes the yield curve to steepen and breakevens to widen as investors logically expect that easy money will cause both growth and inflation to move higher. In contrast, the yield curve tends to flatten and breakevens tend to fall later in the recovery once Fed policy turns more restrictive. Chart 105-Year Bullet Still Cheap 5-Year Bullet Still Cheap 5-Year Bullet Still Cheap Given that core inflation and TIPS breakevens both remain below the Fed's targets, it is too soon to expect a shift toward restrictive Fed policy. In other words, the Fed will be quick to back away from its rate hike plans if there is any indication that breakevens or inflation might reverse their uptrends. It is only once core inflation and TIPS breakevens have returned to the Fed's targets that the stated purpose of Fed policy will shift from supporting the recovery to snuffing out inflation. To profit from a steeper yield curve we entered a long 5-year bullet short duration-matched 2/10 barbell trade on December 20. So far this trade has returned 14 bps, and the 5-year bullet continues to look very cheap on the curve (Chart 10). Spread Product In prior research we considered the performance of spread product throughout the four phases of the Fed cycle (Chart 11).5 We define the four phases of the Fed cycle as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Chart 11Stylized Fed Cycle Inflation: More Fire Than Ice, But Don't Sound The Alarm Inflation: More Fire Than Ice, But Don't Sound The Alarm Using a very simple estimate of the equilibrium fed funds rate based on potential GDP and a long-run moving average of the funds rate itself, we have found that excess returns to investment grade corporate bonds are highest in phase IV and phase I, when the fed funds rate is below equilibrium (Table 1). However, the key problem with this analysis is that it is very difficult to estimate the equilibrium fed funds rate in real time. As stated above, the estimate used in Table 1 incorporates the CBO's estimate of potential GDP which is frequently revised after the fact. So while we are confident that we are currently in phase I of the Fed cycle, the challenge becomes looking for other indicators that might warn us about the transition from phase I to phase II, where excess returns are much worse. We have found that core PCE inflation is one such indicator. We calculated average monthly excess returns to investment grade corporate bonds when year-over-year core PCE inflation is below 1.5%, between 1.5% and 2%, and between 2% and 2.5% (Table 2). Table 1Investment Grade Corporate Bond Excess Returns* Under The Four Phases##br## Of The Fed Cycle (August 1988 To Present) Inflation: More Fire Than Ice, But Don't Sound The Alarm Inflation: More Fire Than Ice, But Don't Sound The Alarm Table 2Investment Grade Corporate Bond Excess Returns* Under Different Ranges##br## For Year-Over-Year Core** PCE (August 1988 To Present) Inflation: More Fire Than Ice, But Don't Sound The Alarm Inflation: More Fire Than Ice, But Don't Sound The Alarm The results show that the highest returns occur when inflation is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with phase IV of the Fed cycle. We found mixed results for when inflation is between 1.5% and 2%. In this environment average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. This environment likely encompasses phase I of the Fed cycle and the transition into phase II. It is not until core PCE inflation is above 2% that excess returns turn decisively negative. Monthly excess returns average -13 bps in this environment, with a 90% confidence interval of -35 bps to +10 bps. With inflation likely to remain between 1.5% and 2% for the balance of the year, it is too soon to turn all-out bearish on spread product. For the moment we recommend a neutral allocation, but with an underweight allocation to high-yield bonds where valuations are exceedingly tight. Given that inflation is low and Fed policy is accommodative, we would be quick to upgrade both investment grade and high-yield corporates on any near-term sell off. The current uncertainty surrounding fiscal policy also complicates the outlook for spread product. On the one hand, it raises the risk of a near-term sell off if it appears as though some of the more stimulative aspects of Trump's agenda will not be implemented. On the other hand, in addition to headline-grabbing promises of increased infrastructure spending, there are many other policy details that could also have significant market implications. One example would be the elimination of the tax deductibility of corporate interest expenses. Such a provision is currently included in the Republican's plan for corporate tax reform, and would severely diminish supply in the corporate bond market if it is implemented. Bottom Line: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 2 Please see Global Investment Strategy, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at gis.bcaresearch.com 3 The overnight index swap curve is priced for 54 basis points of rate hikes during the next twelve months. 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy / U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27, 2014, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification