Corporate Bonds
Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022 Chart 2Strong Fundamental Support For US Growth Chart 3China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022 Chart 5Lower Inflation Will Help Boost Consumer Confidence The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns Chart 11Stay Underweight US Interest Rate Exposure Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure Chart 14Expect More US-Europe Spread Widening In 2022 Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure Chart 18Our Recommended DM Government Bond Country Allocations In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling Chart 27Euro Area Corporate Spread Valuations Are Also Stretched Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022 When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 31Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Chart 1Curve Flattening Is Overdone Fed Chair Jay Powell made big news last month. During Senate testimony, Powell not only signaled that the Fed is likely to accelerate the pace of asset purchase tapering when it meets in December, he also suggested that the Fed won’t necessarily wait until “maximum employment” is achieved before lifting rates. Powell’s comments suggest that the first Fed rate hike could come as early as June 2022 and as late as December 2022, and the exact timing will depend on how inflation and inflation expectations move during the next few months. The front-end of the Treasury curve is fairly priced for either scenario. The 2-year Treasury yield is currently 0.60%. If we assume that the Fed eventually lifts rates at a pace of 100 bps per year until reaching a 2.08% terminal rate, we calculate a fair value range for the 2-year yield of 0.39% to 0.74%, depending on whether Fed liftoff occurs in June or December. In contrast, the same assumptions give us a fair value range of 1.69% to 1.79% for the 10-year Treasury yield, well above its current level of 1.40% (Chart 1). The investment implications are clear. Investors should maintain below-benchmark portfolio duration and put on Treasury curve steepeners, overweight the 2-year note and underweight the 10-year. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 89 basis points in November, dragging year-to-date excess returns down to +102 bps. The index option-adjusted spread widened 12 bps on the month and our quality-adjusted 12-month breakeven spread is now at its 7th percentile since 1995. This indicates that valuations remain stretched even after the recent widening (Chart 2). The back-up in spreads was driven by the combination of the Fed’s shift toward a more hawkish policy stance and concerns about the new omicron COVID variant. This led to a large flattening of the yield curve in addition to wider corporate bond spreads. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable owning corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 – 50 bps.1 The 3-year/10-year Treasury slope currently sits at 49 bps, just below our 50 bps threshold. However, our range of fair value estimates suggests that the 3/10 slope should be between 63 bps and 86 bps today, and that it should only break below 50 bps between March and September of next year (bottom panel). All in all, we expect the pace of Treasury curve flattening to abate during the next couple of months and this will allow spreads to tighten back to their recent lows. We will turn more cyclically defensive on corporate bonds next year when the break below 50 bps in the 3/10 slope is confirmed by our fair value readings. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 121 basis points in November, dragging year-to-date excess returns down to +444 bps. The index option-adjusted spread widened 50 bps on the month, leading to a significant rise in the spread-implied default rate. The spread-implied default rate is the 12-month default rate that is priced into the junk index, assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps. At present, the spread-implied default rate sits at 3.8% (Chart 3). For context, defaults have come in at an annualized rate of 1.6% so far this year and we showed in a recent report that corporate balance sheets are in excellent shape.2 Specifically, the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We conclude that the default rate will be comfortably below 3.8% during the next 12 months, allowing high-yield bonds to outperform duration-matched Treasuries. We recommend that investors favor high-yield over investment grade corporate bonds, and we expect that last month’s spread widening will reverse in relatively short order. However, as noted on page 3, we will turn more defensive on credit risk (including high-yield bonds) next year once we are confident that the 3/10 Treasury curve has sustainably moved into a flatter regime (0 – 50 bps). MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 46 basis points in November, dragging year-to-date excess returns down to -90 bps. The zero-volatility spread for conventional 30-year agency MBS widened 13 bps on the month, driven by an 11 bps widening of the option-adjusted spread and a 2 bps increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in last week’s report that MBS’ recent poor performance is attributable to an option cost that is too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index has been slow to fall this year despite the back-up in yields.3 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refi activity will remain sticky going forward. This will put upward pressure on MBS spreads. We recommend adopting an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-neutral Treasury index by 35 basis points in November, dragging year-to-date excess returns down to +33 bps. Sovereign debt underperformed duration-equivalent Treasuries by 157 basis points in November, dragging year-to-date excess returns down to -220 bps. Foreign Agencies underperformed the Treasury benchmark by 9 bps on the month, dragging year-to-date excess returns down to +36 bps. Local Authority bonds underperformed by 16 bps in November, dragging year-to-date excess returns down to +406 bps. Supranationals outperformed by 2 bps, bringing year-to-date excess returns up to +18 bps. The investment grade Emerging Market Sovereign bond index outperformed the equivalent-duration US corporate bond index by 42 bps in November. The Emerging Market Corporate & Quasi-Sovereign index underperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.4 Within EM sovereigns, attractive countries include: Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in November, bringing year-to-date excess returns up to +371 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuation.5 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue Munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 22% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve flattened dramatically in November. Increasingly hawkish rhetoric from the Fed pushed front-end yields higher as news about the omicron COVID strain pressured long-dated yields lower. The 2-year/10-year Treasury slope flattened 16 bps on the month, it currently sits at 75 bps. The 5-year/30-year Treasury slope flattened 11 bps on the month, it currently sits at 56 bps. As noted on the front page, long-dated Treasury yields have fallen to well below levels consistent with a reasonable Fed rate hike cycle. This drop in long-maturity yields has pushed the 2/5/10 butterfly spread to extremely high levels, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that 2/10 yield curve steepeners are incredibly cheap. Indeed, we observe that the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4). A trade long the 5-year bullet and short a duration-matched 2/10 barbell does indeed look attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen during the next 6-12 months, and we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. This leads us to recommend a position long the 2-year note and short a duration-matched barbell consisting of cash and the 10-year note. We also advise investors to own a position long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This latter position offers a very attractive duration-neutral yield advantage of 24 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in November, leaving year-to-date excess returns unchanged at +739 bps. The 10-year TIPS breakeven inflation rate fell 8 bps on the month while the 2-year TIPS breakeven inflation rate rose 17 bps. The 10-year and 2-year rates currently sit at 2.44% and 3.24%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 8 bps on the month. It currently sits at 2.16%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve, where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long-end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect it will. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 9 basis points in November, dragging year-to-date excess returns down to +26 bps. Aaa-rated ABS underperformed by 11 bps on the month, dragging year-to-date excess returns down to +13 bps. Non-Aaa ABS performed in line with Treasuries in November, keeping year-to-date excess returns steady at +93 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). The result is that the collateral quality backing consumer ABS is exceptionally high. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in November, dragging year-to-date excess returns down to +155 bps. Aaa Non-Agency CMBS underperformed Treasuries by 30 bps in November, dragging year-to-date excess returns down to +63 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 70 bps, dragging year-to-date excess returns down to +469 bps (Chart 10). Though returns have been strong this year and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 47 basis points in November, dragging year-to-date excess returns down to +58 bps. The average index option-adjusted spread widened 9 bps on the month. It currently sits at 40 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -62 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 62 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 30th, 2021) Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 30th, 2021) Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Footnotes 1 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4 Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 5 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.
Highlights Fed: Until more is learned about the omicron variant, our base case view remains that the Fed will lift rates later than what is currently priced in the market. We think a September or December 2022 liftoff date is reasonable. Treasuries: Our main Treasury curve investment recommendations: below-benchmark portfolio duration and 2/10 curve steepeners, are not that sensitive to the timing of Fed liftoff. Both positions should be profitable whether the first rate hike occurs in June 2022 or December 2022. Corporates: Investors should remain overweight spread product versus Treasuries in US bond portfolios, maintaining a preference for high-yield corporates over investment grade. The recent bout of spread widening caused by expectations of more restrictive monetary policy and news about the omicron variant will reverse in the coming months. MBS: Agency MBS are unattractive relative to other US spread products, and current MBS valuations may understate the future pace of mortgage refi activity. Remain underweight Agency MBS within US bond portfolios. Feature Chart 1Curve Flattening Is Overdone Up until Friday, the bear-flattening of the Treasury curve was a well-established trend, one that even accelerated early last week before revelations about the new omicron COVID variant sent yields sharply lower (Chart 1). Large swings in expectations about the timing of Fed liftoff have been responsible for the recent volatility in Treasury yields. Back in September, the market was priced for no rate hikes at all until 2023. Just two months later we find the fed fund futures market pricing Fed liftoff in July 2022 with 75% odds of three rate hikes before the end of next year (Chart 2A). At one point early last week the market was priced for Fed liftoff in June 2022, with 32% chance of liftoff in March 2022 (Chart 2B). Chart 2ALiftoff Expectations: H2 2022 Chart 2BLiftoff Expectations: H1 2022 Pre-Omicron Market Moves June and March liftoff dates came into play early last week because of mounting evidence that the Fed is considering accelerating the pace of its asset purchase tapering. As it stands now, the current pace of tapering gets net asset purchases to zero by June of next year. Given the Fed’s stated preference for lifting rates only after tapering is finished, the current pace means that Fed liftoff is only possible in H2 2022 or later. However, if the pace of tapering is increased it would make earlier liftoff dates possible. It was speculation about an announcement of accelerated tapering at the December FOMC meeting that caused the market to bring June and March 2022 liftoff dates into play last week. Speculation about an accelerated taper really got going after an interview by San Francisco Fed President Mary Daly. Daly is widely regarded as one of the most dovish members of the FOMC, and indeed in last week’s report we highlighted her November 16th speech that called for patience in the face of high inflation.1 But last week, Daly said in an interview that “if things continue to do what they’ve been doing, then I would completely support an accelerated pace of tapering.”2 With one of the most dovish FOMC members seemingly on board, we see a good chance that the committee will announce an accelerated taper at the next meeting. As of today, we’d put the odds of an accelerated taper announcement in December at 50%, with still one more CPI report and one more employment report that will tip the scales in one direction or the other before the Fed meets. An accelerated taper doesn’t necessarily mean that the Fed will move toward earlier rate hikes, it simply gives the committee the option to hike sooner if inflation remains stubbornly high. In fact, we’ve been expecting a later liftoff date (December 2022) on the view that inflationary pressures will wane between now and the middle of next year. We continue to think that a September 2022 or December 2022 liftoff date is the most likely outcome, as we expect that falling inflation during the next six months will allow the Fed to focus more on the employment side of its mandate. However, if inflation doesn’t fall as we expect, then the Fed may move more quickly. The Impact Of The Omicron Variant Chart 3Households Have Ample Savings Friday’s revelation that a new COVID variant (the omicron variant) has been identified sent yields lower and caused the market to push out its liftoff expectations. As of today, available evidence suggests that the omicron variant will out-compete the delta variant and quickly become the world’s dominant COVID strain. There is some evidence to suggest that current vaccines will offer less protection against omicron. However, it is still unknown whether the omicron variant causes more (or less) severe illness than prior strains. Even in a severe scenario where the new strain leads to the re-imposition of lockdown measures, we are puzzled by Friday’s bond market moves. The market seems to be saying that a prolonged pandemic will be deflationary and lead to a later Fed liftoff date. We aren’t so sure that’s the case. US households continue to enjoy a large buffer of accumulated savings compared to the pre-COVID trend (Chart 3) and they have ample room to increase consumer debt (Chart 3, bottom panel). This suggests that aggregate demand will stay well supported next year, even in the face of greater pandemic concerns. The re-imposition of lockdown measures, however, will hamper the supply side of the economy and prolong the economy’s issues with supply chain bottlenecks and labor shortages. It will also prevent consumers from shifting demand away from over-heating goods sectors and towards services. All of this will only keep inflation higher for longer, a development that could actually encourage the Fed to act more quickly. Bottom Line: Until more is learned about the omicron variant, our base case view remains that the Fed will lift rates later than what is currently priced in the market. We think a September or December 2022 liftoff date is reasonable. However, if inflation refuses to fall during the next 3-6 months there is a risk that the Fed will be tempted to move earlier. The Treasury Market Implications Of Earlier Liftoff Tables 1A – 1C show expected 12-month returns for different Treasury maturities. Each table assumes that the market moves to fully price-in a specific expected path for the fed funds rate during the 12-month investment horizon. The scenario presented in Table 1A assumes that the Fed starts to lift rates in June 2022. It then proceeds with rate increases at a pace of 100 bps per year before the fed funds rate levels-off at 2.08%, 8 bps above the lower-end of a 2.0% - 2.25% target range.3 The scenarios presented in Tables 1B and 1C use the same rate hike pace and terminal rate as in Table 1A. However, we vary the expected liftoff dates. Table 1B assumes that liftoff occurs at the September 2022 FOMC meeting and Table 1C assumes that liftoff occurs at the December 2022 FOMC meeting. The first big conclusion we draw is that expected Treasury returns are negative for most maturities in all three scenarios. This justifies sticking with below-benchmark portfolio duration. Second, expected returns are better at the short-end of the curve (2yr) than at the long-end (10yr) in all three scenarios. This justifies sticking with our recommended 2/10 yield curve steepener. Specifically, we advise clients to buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Finally, the 20-year bond continues to offer greater expected returns than the 10-year and 30-year maturities. We view this as an attractive carry trade opportunity and advise clients to buy the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. Bottom Line: Our main Treasury curve investment recommendations: below-benchmark portfolio duration and 2/10 curve steepeners, are not that sensitive to the timing of Fed liftoff. Both positions should be profitable whether the first rate hike occurs in June 2022 or December 2022. Corporate Spreads: Just A Tremor, Not The Big One Chart 4IG Spreads Troughed In September Corporate bond spreads had already been widening before Friday’s news sent them even higher (Chart 4). Prior to Friday, the most likely reason for spread widening was a concern about a quicker pace of Fed tightening. As we highlighted in last week’s report, corporate balance sheet health is sublime and all signs point to default risk remaining low for some time.4 In fact, up until Friday, investment grade corporates were performing worse than high-yield as spreads widened. This suggests that the widening had more to do with perceptions of monetary accommodation than with perceptions of default risk. Then, on Friday, spreads widened sharply and high-yield underperformed investment grade. This is consistent with the market pricing-in an increase in expected default risk due to the emergence of the omicron variant. Our view is that the recent bout of spread widening will reverse in the near-term. Spreads will tighten back down to their recent lows giving investors an opportunity to reduce exposure sometime next year. We posit three possible scenarios: In the first scenario, the omicron COVID variant turns out to be less economically impactful than the recent delta strain. In this case, the recent spike in default expectations will reverse and inflation will moderate during the next six months as pandemic fears recede. In this scenario, the Fed will be able to wait until September or December 2022 – when its “maximum employment” target will be met – before lifting rates. Spreads will tighten on expectations of more accommodative monetary policy. Chart 5Pace Of Curve Flattening Will Moderate In the second scenario, the omicron COVID variant turns out to be inflationary. US consumer demand is not curbed significantly, but supply chains remain under pressure and labor shortages persist. This will encourage the Fed to move more quickly, possibly lifting rates as early as June. However, even this scenario would only see the 3-year/10-year Treasury slope dip below 50 bps in March of next year (Chart 5). Our prior research has shown that excess corporate bond returns tend to be strong when the 3-year/10-year Treasury slope is above 50 bps, as this suggests a highly accommodative monetary environment.5 We would likely see another period of spread tightening between now and March, even in this worst-case scenario for corporate spreads. The final possible scenario is one where the omicron COVID variant turns out to be deflationary. Growth and inflation both slow and the Fed significantly delays tightening, possibly into 2023. Given the robust health of corporate balance sheets, this scenario would be excellent for corporate bond returns. The deflationary shock would have to be very severe, much worse than the delta wave, to push the default rate meaningfully higher. Further, a shift toward more accommodative Fed policy would lengthen the runway for strong corporate bond returns. That is, it would be some time before the 3-year/10-year slope dips below 50 bps. Bottom Line: Investors should remain overweight spread product versus Treasuries in US bond portfolios, maintaining a preference for high-yield corporates over investment grade. The recent bout of spread widening caused by expectations of more restrictive monetary policy and news about the omicron variant will reverse in the coming months. Investors will be able to reduce cyclical corporate bond exposure at more attractive levels sometime next year. Stay Negative On Agency MBS We have been recommending an underweight allocation to Agency MBS in US bond portfolios for quite some time, and that is not likely to change anytime soon. Since the March 23rd 2020 peak in credit spreads, conventional 30-year Agency MBS have outperformed a duration-matched position in Treasuries by 0.59% while Aaa and Aa-rated corporate bonds have outperformed by 16% and 15%, respectively (Chart 6). MBS performance has been particularly poor since the spring. A big reason why is that MBS spreads did not adequately compensate investors for the magnitude of mortgage refinancings. Chart 7 shows that the compensation for prepayment risk embedded in MBS spreads (the option cost) plunged in mid-2020 as interest rates were cut to zero and mortgage refis spiked. In fact, the option cost embedded in MBS spreads was the lowest it had been in several years (Chart 7, panel 2), signaling that the market was priced for a big drop in refi activity. However, that big drop in refi activity never materialized. The MBA Refinance Index has remained elevated in 2021 (Chart 7, bottom panel), despite the back-up in bond yields. Chart 6MBS Returns Have Lagged Corporates Chart 7Option Cost Must Rise An increase in cash-out refinancings is a big reason for the stickiness in refi activity this year. Home prices have been on a tear and households have an increasing incentive to tap the equity in their homes (Chart 8). Freddie Mac recently noted an increase in both the share of refinancings that are for “cash-out” and the aggregate dollars of equity that borrowers are extracting from their homes.6 They also noted, however, that the amount of equity extraction as a percent of property values has trended down. This suggests that this trend toward cash-out refinancings is not yet exhausted. In fact, we expect refi activity will remain elevated during the next 6-12 months, even as bond yields move modestly higher. Chart 8Households Can Tap Their Home Equity Against this back-drop, our sense is that the compensation for prepayment risk embedded in MBS spreads remains too low. But, even if we assume that the MBS option cost is exactly right, it still wouldn’t make Agency MBS look attractive compared to alternative investments. The option-adjusted spread (OAS) offered by conventional 30-year Agency MBS is below the OAS offered by Aaa and Aa-rated corporate bonds (Chart 9). It is only slightly above the OAS offered by Agency CMBS and Aaa-rated consumer ABS. Chart 9OAS Differentials Bottom Line: Agency MBS are unattractive relative to other US spread products, and current MBS valuations may understate the future pace of mortgage refi activity. Remain underweight Agency MBS within US bond portfolios. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 2 https://news.yahoo.com/san-francisco-fed-mary-daly-certainly-see-a-case-for-speeding-up-taper-142328227.html 3 The effective fed funds rate currently trades 8 bps above the lower-end of its target range, and we assume that this will continue to be the case. 4 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 5 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 6 http://www.freddiemac.com/research/insight/20211029_refinance_trends.page Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
Highlights Fed: The Fed is embroiled in a debate about whether to move more quickly toward rate hikes. Our expectation is that the Fed will remain relatively dovish unless 5-year/5-year forward inflation expectations show signs of breaking out. We continue to expect liftoff in December 2022. TIPS: We recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Investors should short 2-year TIPS outright, enter 2/10 inflation curve steepeners and 2/10 real (TIPS) curve flatteners. Corporate Bonds: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios. Should The Fed Take Out Some Insurance? Inflation has arrived much earlier in the cycle than usual and it has put the Fed in a tough spot. The so-called Misery Index – the sum of the unemployment and inflation rates – has moved in the wrong direction this year (Chart 1), and there is increasing disagreement about how the Fed should respond. Chart 1A Setback For The Fed The Case For Buying Insurance On the one hand, some people – both inside and outside the FOMC – are calling for the Fed to move more quickly toward tightening. One notable external voice is the former Chair of the Council of Economic Advisers Jason Furman who just published a report calling for the Fed to speed up the pace of tapering so that it can prepare markets for rate hikes starting in the first half of 2022.1 Such a policy shift would significantly impact bond markets, which are currently priced for Fed liftoff to occur at the July 2022 FOMC meeting and for 69 bps of rate hikes in total by the end of 2022 (Chart 2). This equates to 100% odds of two 25 basis point rate hikes in 2022, with a 92% chance of a third. Chart 22022 Rate Expectations Furman makes the point that the Fed has already achieved its new Flexible Average Inflation Target (FAIT). The PCE deflator has averaged more than 2% annual growth since the target was adopted in August 2020 and even since just before the pandemic (Chart 3). Inflation has still averaged only 1.7% annual growth during the post-Great Financial Crisis period, but FOMC participants have generally focused on shorter look-back periods when discussing the FAIT framework. Chart 3The Fed's Flexible Average Inflation Target In Action In addition to its FAIT framework, the Fed has articulated a three-pronged test for when it will lift rates. The Fed has promised to only lift rates once (i) PCE inflation is above 2%, (ii) PCE inflation is expected to remain above 2% for some time and (iii) labor market conditions have reached levels consistent with “maximum employment”. Furman argues that the Fed should abandon this three-pronged liftoff test on the grounds that it leaves no room for assessing how far inflation is from its goal. For example, Furman says that if we take the Fed’s guidance literally then “it would not lift rates in the face of a 10 percent inflation rate if the unemployment rate was even 0.2 percentage points above its full employment level.” Chart 4Short-term Inflation Expectations Effectively, Furman is arguing for the Fed to take out some insurance against the risk of long-lasting inflationary pressures. Inflation is high right now. It may come back down naturally, but it may not. Furman argues that it makes sense for the Fed to marginally tighten policy in the meantime to lessen the risk of falling behind the curve and having to play catch-up. Fed Governor Christopher Waller seems to agree with most of Furman’s arguments. Waller also argued for speeding up the pace of tapering in a recent speech, and while he didn’t go so far as to say that the Fed should abandon its maximum employment test for liftoff, he implied that his personal definition of “maximum employment” could be achieved very soon.2 Waller said that after “adjusting for early retirements, we are only 2 million jobs short of where we were in February 2020”. This would suggest that just four more months of +500k employment gains, like we saw in October, would be enough for Waller to argue for rate increases. In his speech, Waller also mentioned the risk he sees from rising inflation expectations. He specifically pointed to elevated readings from the 5-year TIPS breakeven inflation rate, the New York Fed Survey of Consumers’ 3-year expectation, and the University of Michigan Survey’s 1-year expectation (Chart 4). Waller cautioned that: [I]f these measures were to continue moving upward, I would become concerned that expectations would lead households to demand higher wages to compensate for expected inflation, which could raise inflation in the near term and keep it elevated for some time. This possibility is a risk to the inflation outlook that I’m watching carefully. The Case Against Insurance San Francisco Fed President Mary Daly sits on the other side of the argument. She argued against the Fed taking preemptive action to tame inflation in a recent speech.3 Her main argument is that rate hikes would do little to lower inflation in the near-term and may end up harming the economy down the road: Chart 5Long-term Inflation Expectations Monetary policy is a blunt tool that acts with a considerable lag. So, raising rates today would do little to increase production, fix supply chains, or stop consumers from spending more on goods than on services. But it would curb demand 12 to 18 months from now. Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers. Like Waller, Daly also pointed to possible risks from rising inflation expectations. If the high readings on inflation last long enough, they could seep into our psychology and change our expectations about future inflation. Households would then expect prices to keep rising and ask for higher wages to offset that. Businesses, of course, would pass those increases on to consumers in the form of higher prices, causing workers to ask for even higher wages. And on it would go, in a vicious wage-price spiral that would end well for no one. However, unlike Waller, Daly said that “there is little evidence” that such an expectations-driven spiral is starting to take hold. To make her point, Daly stressed that long-term inflation expectations remain well-anchored near levels consistent with the Fed’s target. This is certainly true. Five-to-ten year ahead inflation expectations, whether from survey responses or derived from TIPS prices, have been remarkably stable during inflation’s recent surge (Chart 5). This would seem to suggest that people generally believe that current high inflation will fade over time, and that the Fed’s medium-term inflation target is not at risk. The BCA View Our sense is that there are a number of FOMC participants in both the hawkish and dovish camps. But for the time being, the fact that 5-year/5-year forward inflation expectations remain well-anchored tips the scale in favor of the doves. As a result, the Fed will watch the incoming data as it tapers asset purchases between now and June. If 5-year/5-year forward inflation expectations remain stable during that period, the Fed will wait until its “maximum employment” goal is met before lifting rates. However, if the 5-year/5-year forward TIPS breakeven inflation rate rises above 2.5%, the doves will capitulate and abandon the “maximum employment” liftoff target. The committee will move quickly toward tightening to stave off the sort of wage/price spiral described by both Waller and Daly. Our own view is that realized inflation will trend lower between now and next June. This will prevent 5-year/5-year forward inflation expectations from rising and will push down shorter-dated inflation expectations. As a result, the Fed will wait until its “maximum employment” target is met before lifting rates. We continue to think the first rate hike is most likely to occur at the December 2022 FOMC meeting, slightly later than what is currently priced in the market. On Inflation And TIPS Valuation We continue to recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries. While there is a risk that a lengthy period of high inflation will eventually lead to a break-out in long-maturity TIPS breakeven inflation rates, that risk must be weighed against the fact that our TIPS Breakeven Valuation Indicator shows that the 10-year TIPS breakeven inflation rate is too high relative to different measures of underlying inflation (Chart 6). Chart 6TIPS Are Expensive Relative To Nominals Our TIPS Breakeven Valuation Indicator has a strong track record, with readings between -1 and -0.5 usually coinciding with a subsequent drop in the 10-year TIPS breakeven inflation rate (Table 1). Table 1TIPS Valuation Indicator Track Record Moreover, we continue to think that inflation is very likely to trend down during the next 6-12 months. The most important driver of today’s high inflation rate has been a remarkable surge in core goods inflation, from near 0% prior to the pandemic to 8.5% today (Chart 7). This jump in core goods prices is explained by a shift in the composition of consumer spending away from services and toward goods (Chart 8). This shift started during the worst of the pandemic when spending on services was not an option. Households diverted their spending toward goods at a time when COVID prevented factories from running at full capacity. Chart 7Goods Inflation Chart 8Consumer Spending: Goods v. Services Our sense is that as the impact of the pandemic fades, we will see the composition of spending shift back toward services and firms will also be able to increase capacity. The result will be a drop in core goods inflation during the next 6-12 months, one that is significant enough to send the overall inflation rate lower. In fact, there are already signs that inflation is close to peaking. The Baltic Dry Index – an index that measures the cost of transporting raw materials – has plunged (Chart 9), and other measures of the price of shipping containers are starting to top out (Chart 9, bottom 2 panels). All of these indicators tracked inflation’s recent rise and are now signaling an easing of bottlenecks in the goods supply chain. The upshot from an investment perspective is that falling inflation will keep a lid on long-maturity TIPS breakeven inflation rates during the next 6-12 months. It will also send short-maturity TIPS breakeven inflation rates lower, and we recommend an underweight allocation to TIPS versus nominal Treasuries at the front-end of the curve. The top panel of Chart 10 shows that the 2-year TIPS breakeven inflation rate has greatly exceeded the Fed’s target range. In contrast, the 10-year TIPS breakeven inflation rate is only slightly above target. If we assume a base case scenario where both rates trend toward the middle of the Fed’s target range during the next 12 months, and a base case scenario for nominal yields consistent with the Fed lifting rates in December 2022 and then hiking at a pace of 100 bps per year until reaching a 2.08% terminal rate (Chart 10, bottom panel), we see that the 2-year real yield has a lot of upside during the next 12 months (Chart 10, panel 2). This is true both in absolute terms and relative to the 10-year real yield. Chart 9Peak Shipping Costs Chart 10The Upside In Real Yields As a result, our view that inflationary pressures will ease during the next 6-12 months leads to the following investment recommendations: Short 2-year TIPS outright Enter 2/10 TIPS breakeven inflation curve steepeners Enter 2/10 real (TIPS) yield curve flatteners Corporate Balance Sheets Are In Great Shape Gross corporate leverage – the ratio of total corporate debt to pre-tax profits – has plunged during the past few quarters. This indicator is the backbone of our macro default rate model and, as such, its drop explains why there have been so few corporate defaults this year.4 Digging beneath the surface, we see that a great deal of leverage’s decline is explained by soaring profit growth, but a sharp drop in debt growth is also partly to blame (Chart 11). If we broaden our scope of corporate balance sheet indicators, the evidence further points to the fact that balance sheets are in great shape. Our Corporate Health Monitor – a composite indicator consisting of six different balance sheet metrics – is deep in “improving health” territory, aided by extremely high readings from the Free Cash Flow-to-Total Debt and Interest Coverage ratios (Chart 12). Chart 11Gross Leverage Is Falling Chart 12Corporate Health Monitor One thing that seems certain is that corporate profits will not continue to grow by more than 50%, as they did during the past four quarters. As such, we hesitate to make too big a deal out of balance sheet ratios that are directly tied to profit growth. However, even if we look at different measures of the amount of debt versus equity on corporate balance sheets, we arrive at the same conclusion that balance sheets are extremely healthy. The top panel of Chart 13 shows the ratio between total corporate debt and the market value of equity. This ratio is at its all-time low, but one could argue that it is being inappropriately flattered by elevated stock valuations. If we look at the ratio of total debt-to-net worth, where net worth is the difference between assets and liabilities with real estate assets valued at market value and non-real estate assets valued at replacement value, we also see a significant improvement and the lowest ratio since 2010 (Chart 13, panel 2). Finally, we also find the lowest ratio of debt-to-net worth since 2013 even if we value all non-financial corporate assets at historical cost (Chart 13, bottom panel). In other words, the message is clear. Corporate balance sheets have repaired themselves considerably since the pandemic and leverage ratios are the lowest they’ve been in years. This fact has not gone unnoticed by ratings agencies who’ve announced far more upgrades than downgrades so far this year (Chart 14). Chart 13Leverage Ratios Chart 14Upgrades Much Higher Than Downgrades What about the path forward for balance sheets? Our view is that balance sheet health will stop improving at the margin, but that it still has a long way to go before it poses a risk for defaults or corporate bond spreads. The recent spike in profit growth will recede in the coming quarters. This sort of large jump in profits following a recession is fairly typical, but it also tends to be short-lived (Chart 11, panel 2). Further, while corporate debt growth probably won’t surge next year it is likely that it will start to increase. At present, slow corporate debt growth is explained by the fact that company earnings have far outpaced capital investment requirements (Chart 15). This is partly because earnings have been strong and partly because capex requirements have been low. This is about to change. Inventory-to-sales ratios are near record lows and we have already seen a jump in core durable goods orders. All of this points to a capex resurgence in 2022 that will be partially financed by rising corporate debt. Chart 15Debt Growth Will Rise In 2022 Bottom Line: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.piie.com/sites/default/files/documents/furman-2021-11-17.pdf 2 https://www.federalreserve.gov/newsevents/speech/waller20211119a.htm 3 https://www.frbsf.org/our-district/press/presidents-speeches/mary-c-daly/2021/november/policymaking-in-a-time-of-uncertainty/ 4 For more details on our Default Rate Model please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
Highlights Chart 1Buy The 2-Year, Sell The 10-Year Treasury yields have been volatile of late, but the biggest move has been a flattening of the yield curve led by a sell-off at the front-end. Our recommended yield curve positioning (short the 5-year bullet / long a duration-matched 2/10 barbell) was well suited to profit from this move but has now run its course. The solid lines in the bottom panel of Chart 1 show the paths discounted in the forward curve for the 2-year and 10-year yields. The dashed lines show the fair value paths for each yield in a scenario where the Fed starts hiking in December 2022 and proceeds at a pace of 100 bps per year until reaching a 2.08% terminal rate. We can see that the 2-year yield looks a bit too high relative to fair value and the 10-year looks too low. Taken together, our fair value estimates show that the 2/10 Treasury slope should flatten during the next 12 months, but not by as much as is currently discounted in the forward curve (Chart 1, top panel). Investors should maintain below-benchmark portfolio duration but should shift out of 2/10 flatteners and into steepeners. Specifically, we close our prior yield curve trade and open a new one: Long the 2-year note, short a duration-matched barbell consisting of cash and the 10-year note. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds performed in line with the duration-equivalent Treasury index in October, leaving year-to-date excess returns unchanged at +193 bps (Chart 2). The combination of above-trend economic growth and accommodative monetary policy continues to support positive excess returns for spread product versus Treasuries. The recent flattening of the yield curve is a strong reminder that the window of outperformance for corporate bonds will eventually close, but the curve will need to be a lot flatter before we start to worry. Specifically, we are targeting a level of 50 bps for the 3-year/10-year Treasury slope as a level where we will turn more cautious on spread product relative to Treasuries. This slope currently sits at 80 bps and the pace of flattening should moderate during the next few months. A recent report presented the results of a scenario analysis for investment grade corporate bond returns during the next 12 months.1 We concluded that investment grade corporate bond total returns will be close to zero or negative during the next 12 months and that excess returns versus duration-matched Treasuries are capped at 85 bps. With that in mind, we advise investors to seek out higher returns in junk bonds, municipal bonds and USD-denominated Emerging Market sovereign and corporate bonds. We also recommend favoring long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 14 basis points in October, bringing year-to-date excess returns up to +572 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.1% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first nine months of the year, well below the estimate generated by our model. Another recent report considered different plausible scenarios for junk bond returns during the next 12 months.4 We concluded that junk bond total returns will fall into a range of -0.29% to +1.80% during the next 12 months and that excess returns versus duration-matched Treasuries will be between +0.94% and +1.84%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in October, dragging year-to-date excess returns down to -44 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 16 bps in October. The spread looks tight relative to levels seen during the past year and relative to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) tightened 3 bps in October to reach 29 bps (panel 3). This is only just above the 28 bps offered by Aaa-rated consumer ABS but below the 54 bps offered by Aa-rated corporate bonds and the 30 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index performed in-line with the duration-equivalent Treasury index in October, leaving year-to-date excess returns unchanged at 68 bps. Sovereign debt outperformed duration-equivalent Treasuries by 23 basis points October, bringing year-to-date excess returns up to -65 bps. Foreign Agencies underperformed the Treasury benchmark by 5 bps on the month, dragging year-to-date excess returns down to +44 bps. Local Authority bonds outperformed by 16 bps in October, bringing year-to-date excess returns up to +423 bps. Domestic Agency bonds underperformed by 15 bps, dragging year-to-date excess returns down to +9 bps. Supranationals underperformed by 11 bps, dragging year-to-date excess returns down to +16 bps. The investment grade Emerging Market Sovereign bond index outperformed the equivalent-duration US corporate bond index by 35 bps in October. The Emerging Market Corporate & Quasi-Sovereign index delivered 8 bps of outperformance versus duration-matched US corporates (Chart 5). Despite this outperformance, both indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.6 Within EM sovereigns, attractive countries include: Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 48 basis points in October, bringing year-to-date excess returns up to +341 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and individual tax hikes will only increase the attractiveness of tax-exempt munis if they are included in the upcoming reconciliation bill. Last week’s report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuation.7 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity municipal bonds are especially compelling. We calculate that 17-year+ maturity General Obligation Munis offer a before-tax yield pick-up relative to credit rating and duration-matched corporate credit. The same goes for 17-year+ Revenue bonds. High-yield muni spreads are reasonably attractive relative to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened dramatically in October. The 2-year/10-year Treasury slope flattened 17 bps to end the month at 107 bps. The 5-year/30-year slope flattened 35 bps to end the month at 75 bps. As is mentioned on the first page of this report, the large flattening of the yield curve has led us to take profits on our prior 2/10 flattener (short 5-year bullet versus 2/10 barbell) and to initiate a 2/10 curve steepener (long 2-year bullet versus cash/10 barbell). We also noted on the front page that we still expect the 2/10 slope to flatten during the next 12 months, just not by as much as what is currently priced into the forward curve. The 2/5/10 butterfly spread has risen a lot during the past few weeks and it now looks extremely high, both in absolute terms and relative to our fair value model (Chart 7). The 2/5/10 butterfly spread can rise because of either 2/5 steepening or 5/10 flattening. We contend that the current elevated 2/5/10 butterfly is mostly the result of a 5/10 slope that is too flat, not a 2/5 slope that is too steep. The bottom two panels of Chart 7 show the 2/5 and 5/10 slopes along with dashed lines indicating where those slopes were on prior Fed liftoff dates in 2015 and 2004. We see that the 2/5 slope is not unusually steep compared to those prior liftoff dates, but the 5/10 slope is unusually flat. For this reason, we want long exposure to the 2-year note and short exposure to the 10-year note between now and Fed liftoff in late-2022. The best way to achieve this exposure is to buy the 2-year note and short a duration-matched barbell consisting of the 10-year note and cash. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 106 basis points in October, bringing year-to-date excess returns up to +740 bps. The 10-year TIPS breakeven inflation rate rose 15 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate fell 10 bps. At 2.54%, the 10-year TIPS breakeven inflation rate is now slightly above the 2.3% to 2.5% range that is consistent with inflation expectations being well-anchored around the Fed’s target (Chart 8). Meanwhile, at 2.14%, the 5-year/5-year forward TIPS breakeven inflation rate has dipped below the Fed’s target range (panel 3). The divergence between 10-year and 5-year/5-year breakeven rates underscores the flatness of the inflation curve (bottom panel). Near-term inflation expectations are extremely high, but they decline sharply further out the curve. Our view is that inflationary pressures will wane during the next 6-12 months and this will lead to a steep decline in short-maturity TIPS breakeven inflation rates.8 Breakeven rates at the long-end should remain relatively close to the Fed’s target range. We recommend positioning for this outcome by entering inflation curve steepeners or real yield curve (aka TIPS curve) flatteners. We also advise entering an outright short position in 2-year TIPS. The 2-year TIPS yield has a lot of room to rise as the cost of 2-year inflation compensation falls and the 2-year nominal yield remains close to its fair value. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in October, dragging year-to-date excess returns down to +35 bps. Aaa-rated ABS underperformed by 8 bps on the month, dragging year-to-date excess returns down to +25 bps. Non-Aaa ABS underperformed by 5 bps, dragging year-to-date excess returns down to +93 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in October, bringing year-to-date excess returns up to +196 bps. Aaa Non-Agency CMBS underperformed Treasuries by 3 bps in October, dragging year-to-date excess returns down to +93 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 17 bps, bringing year-to-date excess returns up to +543 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to +105 bps. The average index option-adjusted spread tightened 3 bps on the month. It currently sits at 30 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 29th, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of October 29th, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -60 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 flattens by less than 60 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 For more details please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 7 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 8 Please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021.
Highlights The market pricing of the ECB is too aggressive. More so than in the US, temporary factors explain the European inflation surge. Energy, taxes, and base effects account for the bulk of the price increases. In contrast to supply shortages, European labor shortages are small and slack will limit wage growth. Despite the lack of near-term inflation risks, European growth prospects are significantly stronger than last decade. As a result, European inflation will settle at a higher level than in the 2010s and will increase durably in the second half of the 2020s. The inflation curve will steepen, as will the yield curve. Banks will continue to outperform, especially compared to the insurance sector. A tactical opportunity to buy European high-yield corporates has emerged. In France, Macron remains the favorite for the 2022 presidential election. Feature Last week’s ECB meeting did nothing to curb the impression among traders that the ECB will start removing monetary accommodation in 2022. The implied policy rate stands at -0.25% one year from now and -0.08% in two years. Meanwhile, Italian 10-year spreads over Germany have increased to 127bps, their highest level since November 2020. This market action rests on the perception that inflationary pressures in the Euro Area are durable. While this line of reasoning may have credence in the US, it is weaker across the Atlantic where the economy shows fewer signs of genuine inflationary pressure. Moreover, the deterioration in peripheral financial conditions further limits the ability of the ECB to withdraw accommodation without a financial accident. Meanwhile, the NGEU program has created a climate where the likelihood of a premature and excessive fiscal tightening is low. Thus, the weak European growth of the past decade will not be repeated. When considering these inflationary and fiscal views, it becomes apparent that the European yield curve has room to steepen further. Consequently, European banks remain attractive and should be bought on dips, especially relative to insurance companies. The EONIA Curve Is Too Aggressive The sudden increase in interest rate hikes priced in the EONIA curve is a consequence of the rapid acceleration in European realized inflation and CPI swaps. Neither are durable. Headline HICP has surged to 4.1% and core CPI towers at 2.1%, their highest reading in 13 and 19 years, respectively. These surges are the reflection of transitory factors: Chart 1The Energy Path-Through Energy prices are lifting HICP and are sipping through to core CPI. Inflation for electricity, gas, and fuel has reached 14.7% and the energy CPI is at 23.5%. Both are moving in line with headline and core CPI (Chart 1). Now that Brent oil and natural gas have increased four and twenty folds since Q2 2020, respectively, their ability to contribute as much to overall inflation has decreased because they are unlikely to appreciate as much again. While oil prices may rise again here, European natural gas will decline meaningfully in the coming months. Tax increases are another important driver of core CPI. Core inflation with constant taxes stand at 1.37%, which is 0.67% below core CPI. In other words, while core CPI is high by the standard of the past decade, once we adjust for tax increases, it stands at normal levels (Chart 2). Base-effects are another dominant ingredient of the surge in European core CPI. The annualized two-year rate of change of the Eurozone’s core CPI stands at 1.11%, which is within the norm of the past seven years and below the rates experienced prior to 2014. In comparison, the annualized two-year core inflation in the US is 2.87%, well outside the range of the past decade (Chart 3). Chart 2Death And Taxes Chart 3Controlling For The Base Effect Inflation remains narrowly based. The Euro Area trimmed-mean CPI stands at 0.22%, or 1.82% below core CPI. Meanwhile, in the US, trimmed-mean CPI has reached 3.5% or 0.5% below core CPI (Chart 4). These figures confirm that the Eurozone inflation increase is more muted and narrower than that of the US. Wages are not experiencing any meaningful shock so far. Negotiated wages are growing at a 1.7% annual rate; meanwhile, the Atlanta Fed Wage Tracker is expanding at 3.6% and is rising even more steadily for low-skill jobs (Chart 5). Chart 4Much More Narrow Than In The US Chart 5Limited Wage Pressures Continental Europe’s more limited inflationary pressures compared to the US are a consequence of policy decisions during the crisis. The Euro Area fiscal stimulus in 2020 and 2021 amounted to 11% of 2019 GDP, but output declined by 15% in Q2 2020 and suffered a second dip in Q1 2021. Meanwhile, US fiscal packages amounted to 25% of 2019 GDP, while GDP declined by 10% in Q2 2020. Consequently, the Eurozone’s output gap is -4.1% of GDP, while that of the US has essentially closed. The contrasting nature of the stimuli accentuated the different outcomes created by their respective size. In Europe, governmental support focused on keeping people at work, which left aggregate supply unchanged. In the US, public programs allowed jobs to disappear, but they placed money directly in the pockets of consumers, which caused aggregate demand to rise relative to aggregate supply. In this context, a wage-price spiral is unlikely to develop in Europe as long as the energy crisis does not continue through 2022. First, the labor shortage problems are less acute in the Eurozone than in the US or the UK. Chart 6 highlights the factors limiting production in various industries. In the industrial sector, the “labor shortages” category has grown, but pale compared to the role of “material and equipment shortages” as a problem. In the services sector, the “weak demand” and “other” categories are greater obstacles to production than the “labor” factor, which remains at Q1 2020 levels (Chart 6, middle panel). Only in the construction sector are “labor shortages” the chief problem, but they still hurt production less than “insufficient demand” did in February 2021, when real estate prices were already strong (Chart 6, bottom panel). Second, labor market slack remains comparable to 2011 levels, when the ECB erroneously increased interest rates to fight energy-driven inflation (Chart 7). Additionally, the rise in persons available to work but not currently seeking employment represent 75% of the increase in labor market slack since Q4 2019. At the crisis peak in Q2 2020, this category accounted for 105% of the increase in labor market slack. This suggests that, as the vaccination campaign continues to progress across the continent; as households use up their savings; and as government supports ebb across Europe, a large share of those who are a part of the labor market slack will start looking for jobs again, which will increase the supply of workers and limit wage pressures. If traders are overly worried about realized inflation remaining high in Europe, they are also over-emphasizing some CPI swap measures that trade above 2%. CPI swaps only tell one part of the inflation expectations story, because they are one and the same as energy prices. Elevated energy prices sap spending power in the rest of the economy, if other inflation expectation measures remain well anchored; thus, rising energy inflation rarely translates into broad-based pricing pressure. For now, our Common Inflation Expectation measure for the Eurozone, based on the New York Fed’s method for the US, is still toward the low-end of its distribution, even though it includes CPI swaps (Chart 8). This confirms that the energy crisis remains a relative-price shock and that it is unlikely to lead to a generalized inflation outburst in the Euro Area. Chart 8Different Inflation Expectations Bottom Line: Markets expect a first 10bps ECB rate hike by June 2022 and the deposit rate to be 25bps higher by September 2023. However, unlike in the US, there are few signs that European inflation reflects anything more than higher energy prices, rising taxes, and base effects. Moreover, the stories in the press of labor shortages are exaggerated, while broad-based inflation expectations are not unmoored. In this context, we lean against the EONIA pricing and expect the ECB to increase rates in 2024, at the earliest. Fiscal Policy Unlike Last Decade The 2010s were a lost decade for Europe. GDP only overtook its 2008 peak in 2015. Today, GDP is recovering much faster from the recession than it did twelve years ago, and it is unlikely to relapse as it did back then. Chart 9A Lost Decade The European economic underperformance last decade was rooted in fiscal policy. As the top panel of Chart 9 highlights, the fiscal thrust during the GFC was minimal, at 1.3% of GDP, and was rapidly followed by a negative fiscal thrust. Moreover, the ECB unduly tightened policy in 2011 and left peripheral spreads fester at elevated levels between 2011 and 2014. This combination substantially hurt demand, especially in the European periphery. Capex proved particularly vulnerable. It is derived demand and therefore adds considerable variance to GDP. Faced with strong policy headwinds, its share of GDP plunged for most of the decade, which greatly contributed to the European economic malaise (Chart 9, bottom panel). According to the IMF, the Eurozone fiscal thrust will not exert the same drag as it did last decade; hence, capex is also unlikely to repeat its mediocre performance. Instead, the poorer Eastern and Central European economies as well as the weaker peripheral nations will receive a significant fillip from the NGEU program (Chart 10). When the NGEU grants and loans as well as the EU’s Multiannual Financial Framework funds are aggregated together, the EU will provide EUR1.9 trillion funding (adjusted for inflation) to member states over the next five years (Table 1). These sums will prevent any meaningful fiscal retrenchment from taking place. Table 1Bigger Spending The NGEU funds will be particularly supportive for capex. The Recovery and Resilience Facility (RRF), which will be the main instrument to deliver funds across Europe, is heavily weighted toward green transition, reskilling, and digital transformation (Chart 11, top panel). Practically, this spending focuses on electrical, power, water, and broadband infrastructures, as well as renovation and modernization projects (Chart 11, bottom panel). This reinforces the notion that capex is unlikely to follow the same trajectory it did last decade. The implication of more accommodative fiscal policy and more robust capex is that the European output gap will close much faster than it did after the GFC. Hence, even if we expect the current inflation spike to pass next year, inflation will ultimately settle higher than it did last decade. Moreover, in the second half of the 2020s, European inflation will trend higher as full employment will be achieved. Bottom Line: The Euro Area is unlikely to experience another lost decade like the previous one. European trend growth remains low, but fiscal policy will not be as tight. Consequently, capex will not be as depressed, especially because the NGEU grants will greatly incentivize investments in certain sectors of the economy. As a result, the output gap will close much faster than it did in the 2010s. Moreover, once the current pandemic-driven inflation surge passes, CPI will settle at a higher level than it did last decade and will trend higher durably in the second half of the 2020s. Investment Implications Three main conclusions can be derived from our expectation on European inflation and growth dynamics over the coming decade. First, the inflation yield curve will steepen meaningfully. Today, near-term CPI swaps are lifted by energy markets and 2-year CPI swaps are 20bps above 20-year CPI swaps (Chart 12). From 2012 to 2020, 20-year CPI swaps stood between 30 bps and 150 bps above short maturity ones. Second, a steeper inflation curve, along with greater inflation risk toward the end of the decade will cause the European term premium to normalize from its -1.21% level. This will allow German 10-year yields to rise and the European yield curve to steepen (Chart 13). Chart 12Long-Term Inflation Expectations Have Upside Chart 13A Steeper German Yield Curve Third, higher German yields and a steeper curve will greatly benefit European banks (Chart 14, top panel). This pattern will be especially evident against insurance firms, which have massively outperformed deposit-taking institutions over the past seven years as yields fell (Chart 14, bottom panel). Additionally, banks’ balance sheets have become more robust than they once were and NPLs are unlikely to rise meaningfully as a result of government guarantees and easy fiscal policy (Chart 15). Investors should go long bank/short insurance on a cyclical basis. Chart 14Long Bank / Short Insurance Chart 15Imporving Balance Sheets A Tactical Buying Opportunity In European High-Yield Corporate Bond Market Chart 16Tactical Buying Opportunity The 40 basis points widening in European high-yield spreads has created a tactical buying opportunity. Inflation fears spurred by rising energy prices and by input prices are the likely culprit behind the recent spread widening (Chart 16). Although US junk spreads have already narrowed significantly, European high-yield corporate bond spreads are still 40 bps wider than at the beginning of September. The 12-month breakeven spread, which measures the degree of spread widening required over a 12-month period for corporate bond returns to break even with a duration-matched position in government bond securities, now ranks at its 20th percentile, from 10th (Chart 16, second panel). Spreads will narrow back to near post-crisis lows before year-end on both an absolute and breakeven basis: First, monetary and fiscal policy remain very accommodative. Importantly, Spain and Italy will receive large shares of the NGEU funds until 2026. Second, growth will remain above trend despite recent inflation worries. Third, the European default rate is still falling, leaving the worst of the default cycle behind (Chart 16, third panel). Finally, our bottom-up Corporate Health Monitor signals improving corporate health, which historically coincides with narrowing spreads (Chart 16, bottom panel). Bottom Line: The recent widening in European high-yield spreads represents a short window of opportunity to buy the dip. Beyond this timeframe, a more cautious approach toward European credit is appropriate, as the ECB will become less active in the bond market. A French Update Last month, French President Emmanuel Macron unveiled a EUR30 billion investment plan aimed at supporting and fostering industrial and tech “champions of the future.” This new plan comes on top of the EUR100 billion recovery package that was announced in September 2020 to face the pandemic. While these investments will be made across many sectors of the French economy, the focus will be the French tech and energy sectors (Chart 17, top panel). This announcement comes six months before the next presidential election and amid the emergence of Eric Zemmour as a potential far-right candidate. However, Zemmour’s candidacy is unlikely to alter our expectation that Macron will be re-elected in 2022. Recent polls that include Zemmour as a potential candidate in the first-round show that he is appealing to Marine Le Pen’s voter base (Chart 17, bottom panel). Meanwhile, former Prime Minister Edouard Philippe—who would have made a formidable opponent to Macron had he decided to run—announced the creation of his own party with the objective of supporting Macron’s re-election campaign. Chart 18Recent Developments Support These Trades These political developments come as the French health and economic picture keeps improving. Although the vaccination pace has slowed in France, 68% of the population is fully vaccinated and 76% of the population has received at least one dose. Thus, the healthcare system continues to weather well recent COVID waves. Moreover, business confidence remains robust and reached its highest reading since July 2007, despite supply issues holding back production. The French jobs market is also recovering, with the unemployment rate expected to fall to 7.6% in Q3 from 8% in Q2. The introduction of a new investment plan, the emergence of a far-right candidate and Edouard Philippe’s newfound support, and the COVID-19 and economic developments bode well for President Macron’s chances at re-election. This implies additional French reforms over the next five years that aim to suppress unit labor costs and to make French exports more competitive vis-à-vis their main competitor, Germany. As a result, investors should overweight French industrial stocks relative to German ones (Chart 18, top panel). Meantime, additional investment in the French tech is bullish for a sector that is inexpensive relative to its European peers. Overweight French tech equities relative to European ones (Chart 18, panel 2 and 3). Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
Highlights Energy Prices & Bond Yields: Surging energy prices are lifting inflation expectations in the US and Europe, while at the same time dampening consumer confidence amid diminished perceptions of real purchasing power. These conflicting trends are putting central banks in a tricky spot in the near-term, but tightening labor markets will force a more enduring need for dialing back global monetary accommodation in 2022, led by the Fed and the Bank of England. Stay below-benchmark on global duration exposure, favoring euro area government debt over US Treasuries and UK Gilts. High-Yield: Trans-Atlantic junk bond performance has diverged of late, with euro area spreads widening versus the US. This is a temporary distortion created by the pop in oil prices, with the Energy sector that benefits from higher oil prices representing a far greater share of the high-yield universe in the US compared to Europe. Maintain an overweight stance on European high-yield corporates. Feature Chart of the WeekGlobal Bond Yield Breakout? It is not easy being an inflation-targeting central bank these days. Soaring energy prices, with the Brent crude benchmark price climbing to a 3-year high of $86/bbl last week and natural gas prices up nearly four-fold year-to-date in Europe. These moves are adding upward pressure to inflation rates already elevated because of disrupted supply chains and rising labor costs. Government bond yields in the developed markets are moving higher in response, driven by rising inflation breakevens and increasing central bank hawkishness that is causing a stir in negative real yields (Chart of the Week). Among the three most important developed economy central banks - the Fed, the ECB and the Bank of England (BoE) – the most forceful signaling of a need for tighter policy is surprisingly coming from Threadneedle Street in London, home to one of the most dovish central banks since the 2008 crisis. Numerous BoE officials, including Governor Andrew Bailey, have strongly hinted that UK rate hikes could begin as soon as next month’s policy meeting. Fed officials have suggested a similar timetable for the start of the QE taper. By contrast, members of the ECB Governing Council have paid lip service to the recent sharp pickup in euro area inflation but, for the most part, have stuck to the view that it will not last long enough to justify a policy response. The relative hawkishness among “The Big Three” central banks fits with our current recommended strategy on global duration exposure, staying below-benchmark, and country allocation, with the largest underweights to US Treasuries and UK Gilts. Should Central Banks Focus More On Inflation Or Growth? Monetary policymakers are in a difficult spot at the moment. Rising energy prices have breathed new life into inflation, and inflation expectations, even as global growth momentum has cooled off somewhat. Given the magnitude and breadth of the global energy price surge – even coal prices in China have shot up 120% since late August - it will be difficult for central bankers to “see through” the inflationary implications and worry more about growth (Chart 2). Rising energy prices are likely to extend the current global inflation upturn that has already gone on for longer than expected because of supply-chain disruptions. This raises the risk that consumers could turn more cautious on spending behavior if they have to devote more of their incomes just to fuel their cars or heat their homes. In the US, this dynamic already appears to be playing out. The acceleration of inflation has broadened out, with the Cleveland Fed’s trimmed mean CPI inflation measure (which removes the most volatile components of the CPI) rising to 3.5% in September (Chart 3, top panel). With US consumers seeing higher prices on a wider range of goods and services, they have raised their inflation expectations. The preliminary October University of Michigan US consumer confidence survey showed that 1-year-ahead inflation expectations rose to a 13-year high of 4.8% (middle panel). Chart 2Pouring Gas On Global Inflation The New York Fed’s consumer survey showed a similar 1-year-ahead inflation forecast (5.3%), which is well above the forecast for income growth in 2022 (2.9%). Combining those two measures shows that US consumers implicitly see a contraction in their real incomes over the next 12 months. Chart 3US Consumers Expect A Sharp Decline In Real Purchasing Power This has likely played a big role in the sharp fall in the University of Michigan consumer confidence index since the peak back in June (bottom panel), despite favorable US labor market conditions. US consumer perceptions of inflation appear much greater than the reality of inflation evident in the official price indices. The New York Fed survey also asks US consumers what their 1-year-ahead expectations are for major spending categories, like food or rent (Chart 4). Consumers expect somewhat slower inflation for food (7.0%) and gasoline (5.9%) over the next year, yet they also expect much higher medical care costs (9.4%) and rent (9.7%). For the latter two, those are considerably higher than the latest actual inflation rates seen in the US CPI (2.4% for rent, 0.4% for medical care) or PCE deflator (2.1% for rent, 2.4% for medical care). Taking these survey results at face value, it is likely that US consumers are overestimating how much their real incomes will suffer next year from higher inflation. This is especially true as US household income growth will likely surpass the 2.9% estimate seen in the New York Fed survey. Yet that does not preclude the Fed from starting to turn more hawkish. Central bankers are always on the lookout for signs that higher realized inflation is feeding through into rising inflation expectations, which could require a policy tightening response to prevent an overshoot of inflation targets. The Fed has given itself a bit more leeway in that regard by altering their policy framework to allow temporary deviations of inflation from the central bank targets. The BoE, however, has not given itself the same sort of flexibility, which is why it is now signaling an imminent rate hike in response to survey-based inflation expectations, and breakeven inflation rates on longer-dated index-linked Gilts, climbing to close to 4% (Chart 5). Yet even the Fed, with its Average Inflation Targeting framework, has signaled that a tapering of its bond purchases will likely begin by year-end. Chart 4US Consumer Inflation Expectations Well Above Actual Inflation Markets are looking at the persistence of high inflation and have priced in a more hawkish trajectory for interest rates in the US, UK and even Europe over the next 12-24 months (Chart 6, bottom panel). Chart 5Inflation Weighing On UK & European Consumer Confidence Real bond yields in those regions are also starting to move higher in response to rising rate expectations (third panel) - a bond-bearish dynamic that we have discussed at length in recent reports.1 Between those three, the BoE’s hawkish turn has hammered the Gilt market the hardest. Yet there has definitely been a spillover into rate expectations and bond yields in other countries on the back of the BoE guidance. We have already seen rate hikes from smaller developed market central banks, Norway and New Zealand, over the past month. If a major central bank like the BoE soon follows suit because of overshooting inflation expectations, then markets are justified in thinking that the Fed or even the ECB could be next. Of those “Big 3” central banks, we see the ECB as being the least likely to respond to the current inflation upturn with rate hikes in 2022. There is simply not enough evidence suggesting that the energy/supply-chain driven inflation in the euro area is broadening out into other parts of the economy on a sustainable basis. Furthermore, there is already some degree of monetary tightening “scheduled” in 2022 when the ECB’s pandemic bond purchase program expires in March. The ECB will not want to compound that by moving into rate hiking mode soon after. On the other hand, the Fed will likely see enough further tightening of US labor market conditions to begin hiking rates in the fourth quarter of 2022 (Chart 7). In the UK, After next month’s likely rate hike, the BoE will need to deliver at least another 50-75bps of additional hikes in 2022 and likely more in 2023 with real policy rates already well below neutral before the latest spike in energy prices. Chart 6Expect Higher Real Yields As Central Banks Turn More Hawkish Chart 7Labor Markets, Not Commodities, Will Dictate Monetary Policy In 2022 With the Fed and BoE set to be far more hawkish than the ECB next year, we see greater risks of government bond yields rising faster, and higher than current forward rates, in the US and UK compared to the euro area (Chart 8). This justifies an overall cautious strategic stance on duration exposure in global bond portfolios. With regards to inflation-linked bonds, however, we recommend only a neutral overall stance. Elevated inflation breakevens have converged to, or even above, central bank inflation targets in all developed market economies (excluding Japan). 10-year UK breakevens, in particular, look very expensive on our fair value model (Chart 9). Chart 8Our Recommended "Big 3" Country Allocations Chart 9Maintain An Overall Neutral Stance On Inflation-Linked Bonds Bottom Line: Our view on the policy decisions of the Big 3 central banks in 2022 informs our strategic (6-18 months) investment strategy within those markets. Stay below-benchmark on overall global duration exposure, favoring euro area government debt over US Treasuries and UK Gilts. Fade The Recent Backup In European High Yield Spreads Chart 10A Slight Pickup In European Junk Spreads Corporate credit markets in the US and Europe have calmed down since the July/August “Delta fueled” selloff with one notable exception – European high-yield (HY). The Bloomberg European HY index spread now sits 39bps above the September low, noticeably diverging from the US HY index spread (Chart 10). We view those wider spreads as a tactical buying opportunity for European junk bonds, both in absolute terms and versus US junk bonds. The recent underperformance appears rooted in soaring European energy prices. The spread widening has been concentrated in European consumer sectors (both cyclicals and non-cyclicals) that would be more exposed to the drain on real incomes from booming natural gas prices. Energy is also a smaller part of the European high-yield index (2%) compared to the US HY index (13%), which helps explain the performance gap with the US – the US index is more exposed to companies that benefit from higher energy prices (Chart 11). Chart 11Sectoral Breakdown Of US & Euro Area High-Yield Indices Over a more medium-term perspective, there is little reason why there should be a meaningful performance difference between US and European HY. The path of spreads and excess returns (versus duration-matched government debt) for the two markets have been highly correlated in recent years (Chart 12). When adjusting European HY returns to allow a proper apples-to-apples comparison to US HY – by hedging European returns into US dollars and controlling for duration differences between the two markets – there has been little sustained difference in returns dating back to 2018. Chart 12Euro Area HY Has Closed The Gap Vs. The US Chart 13Junk Default Rates Will Stay Low In 2022 More fundamentally, there is little difference in default rates that would justify a major divergence of HY spreads on both sides of the Atlantic. Moody’s is forecasting a HY default rate for a rate of 2% in both the US and Europe for 2022 (Chart 13). Such similar default rate expectations make sense with economic growth likely to remain well above trend in 2022 in both the US and Europe. Higher inflation will also boost nominal GDP growth, helping lift corporate revenues and the ability to service debt. From a valuation perspective, there is also little to choose from between European and US HY: The default-adjusted spread, which takes the current HY index spread and subtracts expected default losses over the next twelve months, is 196bps in Europe and 166bps in the US (Chart 14). While those spreads are below the post-2000 mean in both markets, they are still above past valuation extremes. The percentile ranking of 12-month breakeven spreads (the amount of spread widening over one year that would eliminate the yield advantage of HY over duration-matched government bonds) are also similar, 25% for European HY and 26% for US HY (Chart 15). These suggest HY spreads are not particularly “cheap”, from a historical perspective, in either market, but they could move lower to reach previous historical extremes. Chart 14Low Expected Default Losses Supporting HY Valuations Chart 15Overall HY Spreads Are Tight In The US & Europe Chart 16Euro Area Ba-Rated HY Spreads Look More Attractive Summing it all up, there is no discernable reason why European HY should trade at a sustainably wider spread to US HY, outside of the compositional issue related to the weight of the Energy sector in both markets. When breaking down the two markets by credit rating buckets, European Ba-rated corporates even look more attractive versus similarly-rated US corporates, based on 12-month breakeven spread percentile rankings (Chart 16). Bottom Line: Maintain a strategic overweight stance on European high-yield corporates, and tactically position for some relatively better performance of European junk bonds versus US equivalents. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "What If Higher Inflation Is Not Transitory?", dated September 23, 2021, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Spread Product: Investors should stay overweight spread product versus Treasuries for now (with a preference for high-yield corporates over investment grade). But recent shifts in the yield/spread correlation suggest that the credit cycle is getting a bit long in the tooth. We will be quick to recommend a reduction in spread product exposure once the monetary tightening cycle is more advanced and the 3-year/10-year Treasury slope flattens to below 50 bps. We expect this could occur in the first half of 2022. Labor Market & Fed: September’s employment report likely doesn’t alter the Fed’s timeline. The Fed is still on track to announce a tapering of its asset purchases next month and we expect employment growth will be sufficiently strong for the Fed to start hiking rates in December 2022. The Treasury curve will bear-flatten as that outcome is priced in. Duration: Investors should maintain below-benchmark portfolio duration with an expectation that the 10-year Treasury yield will reach a range of 2%-2.25% by the time of Fed liftoff in December 2022. Feature Chart 1A December Debt Ceiling Debate The creditors of the United States government can breathe a little easier, at least for a couple of months, as Congress reached an agreement last week to punt debt ceiling negotiations until December. T-bills maturing this month reacted sharply to price-out the risk of technical default, though December bill yields have already started to push higher in anticipation of more turmoil (Chart 1). Of course, the political incentives to lift the debt ceiling will be the same in December as they are today, and Congress will ultimately act to avert economic disaster.1 Financial markets seem to realize this, and Treasury note and bond yields have been unphased by the drama. Instead, Treasury yields have moved higher in recent weeks alongside other indicators of optimism surrounding economic reflation and re-opening (Chart 2). However, there is one troubling signal from financial markets that warrants further investigation. Corporate bonds (both investment grade and high-yield) have underperformed duration-matched Treasuries so far in October, even as Treasury yields have moved higher (Chart 3). Typically, Treasury yields and corporate bond spreads are negatively correlated – spreads tighten as Treasury yields rise, and vice-versa – so it is notable when the correlation flips. Chart 2The Reflation Trade Is Back Chart 3Bad Times For Bonds The next section of this report explores the economic drivers of the yield/spread correlation and considers whether the flip to a positive yield/spread correlation signals anything about future corporate bond performance. An Examination Of The Yield/Spread Correlation The simple economic explanation for the negative yield/spread correlation is that an improved economic outlook leads to both a better environment for credit risk (i.e. tighter corporate bond spreads) and the expectation that higher interest rates will be needed to cool the economy in the future (i.e. higher Treasury yields). With that in mind, when spreads and yields both rise at the same time it usually means that the Fed is “over-tightening”. That is, tightening monetary policy so much that the near-term credit environment is deteriorating. This could be because the Fed is making a policy mistake – tightening into an economic slowdown – or because inflation is high enough that the Fed is deliberately slowing growth in an effort to bring down prices. A Technical Examination Looking at the history of monthly changes in Treasury index yields and High-Yield index spreads since 1994, we see that it is quite unusual for yields and spreads to both rise in the same month (Chart 4). In fact, monthly yield and spread changes are negatively correlated 65% of the time and have only risen together in 15% of the months since 1994. Chart 4Monthly Junk Spread Changes Versus Monthly Treasury Yield Changes Since 1994 Second, we observe in Chart 4 that almost all months of large spread widening or tightening occur against the back-drop of a negative yield/spread correlation. This shouldn’t be too surprising. The worst months for corporate bond performance occur during economic recessions when the Fed is cutting interest rates. Conversely, the best months for corporate bond performance occur just after the recession-peak in spreads when the Fed has finished cutting rates and the economic recovery is starting up. Tables 1A and 1B delve deeper into the return numbers. Table 1A shows average High-Yield excess returns over different investment horizons following a signal from the yield/spread correlation. For example, the second row shows that after a month when both Treasury yields and junk spreads rise, high-yield bonds deliver average excess returns of 24 bps during the following 3 months, 116 bps during the following 6 months and 75 bps during the following 12 months. Table 1B provides even more detail by showing 90% confidence intervals for each number. Table 1AAverage High-Yield Excess Returns After A Signal From Yield/Spread Correlation Table 1BHigh-Yield Excess Returns After A Signal From Yield/Spread Correlation: 90% Confidence Intervals We draw two conclusions from this analysis. First, a month when spreads widen and yields fall sends the worst signal for near-term (3-month) corporate bond performance, though a month where both yields and spreads rise is a close second. Second, and most relevant for the current market, a month when yields and spreads rise together sends the worst signal for junk bond performance over the following 12 months. In fact, it is the only signal where the 90% confidence interval shows the chance of negative excess returns during the following 12 months. This second conclusion aligns with our intuition. A period of both rising Treasury yields and junk spreads likely signals that the market is pricing-in some move toward a tighter monetary policy stance, though not a severe enough move to send long-maturity Treasury yields down. This is most likely to occur in the very early stages of a monetary tightening cycle, when monetary conditions are still accommodative but recent shifts in Fed policy suggest that they will become more restrictive down the road. A Historical Examination A look back through history confirms our analysis of when yields and spreads tend to rise concurrently. The solid line in the third panel of Chart 5 shows the number of months when both junk spreads and Treasury yields rose out of the most recent trailing 12-month period. The dashed line shows the same measure over the trailing 3-month period, multiplied by 4 to put it on the same scale as the solid line. A spike in these lines indicates that Treasury yields and junk spreads were rising at the same time. Chart 5Rising Yields And Spreads Is A Warning Signal For Monetary Tightening We identify four relevant historical periods. First, yields and spreads rose concurrently during the 1999/2000 Fed tightening cycle. Specifically, yields and spreads rose together in the early stages of the tightening cycle, then spreads continued to widen as yields fell during the 2001 recession. Second, our indicator showed a couple blips higher during the 2004/06 tightening cycle, though corporate bond returns were solid during this period, at least until after the tightening cycle ended and the recession began. Third, the 2013 taper tantrum coincided with a temporary increase in both yields and spreads as investors worried that the Fed was moving too quickly toward rate hikes. Fourth, yields and spreads both moved higher in 2015 as the Fed was heading toward a December 2015 rate hike against a back-drop of slowing economic growth. Turning to today, we view the recent jump in our indicator as similar to the jump seen during the 2013 taper tantrum. Not only is the Fed once again about to taper asset purchases, but the tapering of asset purchases suggests that the Fed’s next move will be a rate hike at some point down the road. We view this as an early warning sign for corporate bond spreads. While the monetary environment remains supportive for positive corporate bond returns for now, this may not be true by this time next year when the Fed is that much closer to liftoff. Bottom Line: Investors should stay overweight spread product versus Treasuries for now (with a preference for high-yield corporates over investment grade). But recent shifts in the yield/spread correlation suggest that the credit cycle is getting a bit long in the tooth. We will be quick to recommend a reduction in spread product exposure once the monetary tightening cycle is more advanced and the 3-year/10-year Treasury slope flattens to below 50 bps. We expect this could occur in the first half of 2022. Labor Market Update: Still On Track For November Taper And December 2022 Liftoff Chart 6Employment Growth Slowed in September September’s employment report delivered a disappointing headline number, with nonfarm payrolls growing only 194 thousand on the month compared to a consensus estimate of 500k (Chart 6). The details of the report were slightly better: August’s nonfarm payroll growth number was revised higher, our measure of the unemployment rate adjusted for distortions in the number of people employed but absent from work fell from 5.5% to 4.9% (Chart A1) and average hourly earnings rose at an annualized monthly rate of 7.7% (Chart 6, bottom panel). Expect A November Taper For bond investors, the most pressing question is whether the report is bad enough to delay the Fed’s tapering announcement past November. We doubt it. The Fed’s test for when to taper asset purchases, that it gave itself last December, is “substantial further progress” back to pre-COVID levels of employment. Since December 2020, total nonfarm payroll employment is 50% of the way back to its February 2020 level (Chart 7) and there are several good reasons to believe that employment growth will be much stronger in October and November. First, the delta wave of COVID cases clearly weighed on employment growth in September, much like it did in August. The Leisure & Hospitality sector only added 74 thousand jobs in September, compared to an average monthly pace of 349 thousand jobs between February and July of this year before the delta wave struck. With a shortfall of almost 1.6 million Leisure & Hospitality jobs compared to pre-COVID levels (Table 2), job growth in this sector will bounce back sharply during the next few months now that new COVID cases are receding (Chart 8). Chart 7"Substantial Further Progress" Has Been Made Chart 8Delta Wave Has Crested Second, the last column of Table 2 shows that the government sector accounted for net job loss of 123 thousand in September. This negative number was driven by state & local government education jobs and is almost certainly a statistical artifact. According to the Bureau of Labor Statistics’ release notes: Recent employment changes [in state & local government education] are challenging to interpret, as pandemic-related staffing fluctuations in public and private education have distorted the normal seasonal hiring and layoff patterns. Table 2Employment By Industry Expect December 2022 Liftoff As for what this labor market report means for when the Fed will start lifting rates, we believe that we are still on track for liftoff in December 2022. The Appendix to this report updates our scenarios that show the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and labor force participation rates by specific future dates. If we use the median assumption from the New York Fed’s Survey of Market Participants that the Fed will lift rates when the unemployment rate is 3.5% and the participation rate is 63%, we calculate that average monthly nonfarm payroll growth of +453k is required to reach those targets by the end of 2022. We see that threshold as eminently achievable.2 Bottom Line: September’s employment report likely doesn’t alter the Fed’s timeline. The Fed is still on track to announce a tapering of its asset purchases next month and we expect employment growth will be sufficiently strong for the Fed to start hiking rates in December 2022. Investors should maintain below-benchmark portfolio duration and hold Treasury curve flatteners in anticipation of that outcome. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a significant increase in the labor force participation rate (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.8% and a participation rate of 62.8%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +453k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth prints +400k per month going forward, we would expect Fed liftoff between December 2022 and June 2023. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Footnotes 1 For more details on the politics of the debt ceiling please see US Political Strategy Weekly Report, “The House Ways And Means Tax Plan”, dated September 15, 2021. 2 For a discussion about what unemployment and participation rate targets to use in this analysis please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns