Fixed Income
Executive Summary Onshore Equity Market Outflow Pressures Remain, At Least In The Near Term China’s foreign exchange (FX) reserves fell in the first three months of 2022. The reduction was the largest quarterly fall since 2016, but it is minor in absolute terms given China’s massive FX reserves. However, the underlying drivers of the decline in the FX reserves are cause for concern. The current drawdown in FX reserves reflects losses in China’s official FX asset portfolio and increased capital outflows, which differs from in 2H20 when Chinese banks increased their FX purchases to slow the pace of the RMB appreciation. Onshore equity market net outflows will likely continue in the near term. Even though Beijing has stepped up stimulus measures, private sector sentiment and domestic demand remain subdued. The country’s zero-tolerance COVID policy will also continue to weigh down the effectiveness of the stimulus. Pressure on the bond market’s outflow will be sustained in the next 6 to 12 months as policy cycles between the US and China continue to diverge. The RMB will modestly devalue relative to the USD in the next few month. In the longer term, the RMB should be underpinned by fundamentals such as a current account surplus, positive real interest rates and a valuation cushion. Bottom Line: The drop in the first quarter FX reserves reflects losses in China’s official FX asset portfolio and increased capital outflows. Feature Chart 1The Quarterly Drop In China's FX Reserves This Year Was Largest Since 2016 Newly released data shows that China’s FX reserves dropped by US$25.8 billion to US$3.188 trillion in March. This represented a US$62 billion decrease from December 2021 and it was the largest quarterly drop since 2016 (Chart 1). The RMB also weakened slightly in March from February. The reduction in China’s FX reserves in Q1 is due to several factors, including fluctuations in the dollar versus other major currencies and the drop in market prices of foreign asset holdings. The country’s current account surplus also narrowed in the first three months of the year compared with Q4 last year. Notably, foreign holdings of Chinese local currency bonds posted a record decline in Q1 and onshore equity market outflows also accelerated. The illicit movement of capital via import over-invoicing has also picked up. We expect that the bond market outflow pressure will continue for the year and perhaps beyond as economic, inflation and monetary policy cycles in China and the US continue to diverge. Equity outflow pressures will also be sustained, at least through the next few months, while China’s COVID-induced lockdown measures in major cities significantly weaken the economic outlook. Furthermore, the country’s zero-tolerance toward COVID will continue restraining mobility in 2H22. Anticipated lockdowns will severely disrupt the local economy and weigh down the effectiveness of Chinese stimulus, which policymakers had pledged to boost. As such, we maintain our neutral position on Chinese onshore stocks and an underweight stance on Chinese investable stocks in a global portfolio. A Drawdown In FX Reserves Chart 2The Size Of Capital Outflows In Q1 Is Comparable To That In 2H20 Capital outflows intensified in Q1, with the magnitude similar to 2H20 (Chart 2). However, the underlying drivers of the depletion have changed. In 2H20, China’s state-owned banks strategically accumulated FX assets to slow the pace of a rising RMB, whereas the Q1 loss this year was mainly driven by fluctuations in global financial markets and weak domestic economic fundamentals. The reduction in China’s official FX reserves in the past three months was partly due to a stronger dollar versus other major currencies and price declines in China’s holdings of foreign currency assets. China's official FX reserves are marked-to-market and converted into US dollars. The value of China’s official reserves has been significantly impacted by two factors: the dollar’s increase of more than 4% in trade-weighted terms since its trough in May last year and the simultaneous decline in prices of both global stocks and bonds in Q1 2022 (Chart 3). In addition, China’s trade surplus narrowed in the first two months of the year from Q4 2021 and has likely dipped further in March (data has not yet been released) (Chart 4). Slower growth in China’s exports, coupled with rising global commodity prices that boosted China’s commodity import costs, has probably contributed to a smaller current account surplus, which was insufficient to offset the increased capital outflows. Chart 3The Dollar Exchange Rate And The Value Of China's Official FX Reserves Chart 4China's Trade Surplus Narrowed In Q1 This Year Meanwhile, the acceleration in capital outflows does not seem to be driven by an increase in China’s domestic banks and companies’ foreign currency holdings. It does not appear that banks have been buying foreign currencies to slow down the pace of the RMB appreciation against other currencies. As noted in a previous report since 2018 net FX purchases by China’s banks have been more tightly correlated with the spread between the CNY/USD exchange rate and the CFETS index (Chart 5, top panel). When the RMB falls relative to the USD, but not by enough to slow its increase against other trading partners, China’s banks would ramp up their FX purchases to push down the CNY/USD exchange rate and/or raise the value of other currencies in the CFETS basket (Chart 5, bottom panel). This occurred in 2H20 but does not seem to be the case this year. Chart 5No Sign Of Chinese Banks' Ramping Up FX Purchases This Year Chart 6FX Settlement Has Been Net Positive... Chinese companies have not increased their demands for USD either. Chart 6 shows a positive net FX settlement rate by banks on behalf of clients. This means more non-financial enterprises (such as exporters and investors) sold their foreign exchange holdings to banks than bought foreign exchange from banks. Moreover, Chart 7 highlights that the level of Chinese firms’ short-term foreign obligations (outstanding foreign currency loans, trade credit and liquid deposits) has remained steady. This implies that domestic firms have not been rushing to buy FX to pay back their dollar-denominated debts. Chart 7…And Chinese Firms Are Not Rushing To Pay Off External Debt Bottom Line: Q1’s capital outflows were not driven by Chinese banks’ strategic accumulation of FX reserves to slow the pace of the RMB’s appreciation, nor by the demand for USD by Chinese companies. Accelerated Portfolio Outflows China's recent capital drain may be grouped into two categories: reduced foreign portfolio inflows (and accelerated outflows) and the illicit seepage of capital. China’s bond market contributed largely to the acceleration in Q1’s portfolio outflows. Foreign holding of Chinese bonds posted a record depletion of US$30 billion in February and March this year and the trend likely continued through April (Chart 8). As the Fed enters its hiking cycle following the March lift-off, the US-China nominal interest rate has narrowed meaningfully (Chart 9). Despite a widening inflation gap between the US and China, China’s bond market has become less attractive to global investors compared with last year (Chart 9, bottom panel). Chart 8A Record Bond Market Outflow In Q1 This Year Chart 9Rate Differentials Between China and The US Have Narrowed Substantially, In Both Nominal And Real Terms Outflows from onshore equity market also accelerated in Q1, in part because of China’s disappointing domestic economic data, rising geopolitical tensions and risk-off sentiment among global investors. Losses of Northbound net flows reached US$7.6 billion in March, comparable to the amount in early 2020 when China was hit hard by the pandemic (Chart 10). Importantly, while service trade deficits from outbound tourism continued to narrow due to international travel restrictions, our estimate of the illicit capital seepage through import over-invoicing has gathered speed since 2H21 (Chart 11). The sharp rise in our illicit capital outflow indicator suggests that the private sector and Chinese residents may be moving capitals offshore. Chart 10Chinese Onshore Equity Market Also Saw Substantial Investment Outflows In Q1 Chart 11Illicit Capital Outflows Picked Up Bottom Line: The drain of capital escalated in Q1 through accelerated foreign portfolio outflows and perhaps illicit capital streaming out of the country. Investment Conclusions Chart 12Onshore Equity Market Outflow Pressures Remain, At Least In The Near Term Equity market net outflows will likely continue, at least for the next couple months while China struggles to contain the ongoing COVID flareups in major cities. We maintain our recommended neutral allocation to Chinese onshore stocks and an underweight stance on Chinese offshore stocks in a global equity portfolio (Chart 12). While China’s stimulus should be able to stabilize the economy over a cyclical time horizon (the next 6 to 12 months), the nation’s zero-tolerance COVID position poses significant downside risks to the effectiveness of policy easing. It will be harder for China to contain infections as the virus mutates and variants become more contagious. There may be more frequent and larger-scale lockdowns affecting the economy than there have been in the past two years. Meanwhile, outflow pressures on China’s bond market may carry on through the next 6 to 12 months while the economic, inflation and monetary policy cycles in the US and China continue to diverge. Although the RMB has not moved into outright expensive territory, reduced foreign portfolio flows into RMB assets and a smaller current account surplus will pose near-term downward stress on the RMB against the USD. A depreciation in the RMB would be a boon to China’s domestic economy since it will help the export sector pricing power. Beyond the near term and in the next 12 to 18 months, however, fundamentals, such as China’s current account surplus, positive real interest rates and a valuation cushion, will underpin strength in the RMB (Chart 13A & 13B). Chart 13AOnshore Equity Market Outflow Pressures Remain, At Least In The Near Term Chart 13B...But Is Cheap Based On Relative Prices Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations
According to BCA Research’s US Bond Strategy service, investment grade corporate bonds are quite expensive. Starting with a simple examination of the average investment grade index OAS, the team observes that the spread has widened somewhat off its pre-…
According to BCA Research’s European Investment Strategy service, German yields can rise above 2% without causing a public finance crisis in Italy. How high can yields rise in the Eurozone before Italy experiences meaningful funding stresses? The team…
Executive Summary From Net Borrower To Net Lenders Yields are rising across Europe. Peripheral spreads are unlikely to experience the same violent widening as last decade. Europe now has a buyer of last resort. Italy and Spain have moved from current account deficit to current account surplus nations. However, Italy and Spain are not conducting the kind of structural reforms necessary to cause public debt-to-GDP ratios to fall back below the Maastricht Treaty criteria. Nonetheless, based on our stress tests, Italian and Spanish yields can rise significantly more before debt-servicing costs become a major problem in these nations. Economic activity, not Spanish or Italian public finances, is the true constraint on European yields. Bottom Line: German yields can rise above 2% without causing a public finance crisis in Italy and Spain. To reach this level, however, nominal growth in Europe must remain robust. As a result, any pullback in yields caused by oversold conditions in the bond market will be temporary. Year-to-date, German 10-year yields have risen more than 80bps, while spreads have widened in the periphery. This has supercharged the interest rate moves: Italian BTP yields and Spanish Bono yields are up nearly 120bps and 110bps, respectively. As a result, Italian government bonds now offer a 2.4% yield, a level not experienced durably since the first half of 2019. Meanwhile, Spanish yields are close to 1.7%—their highest levels since 2017. Investors are increasingly concerned by the damage levied by higher yields in Southern Europe. Since 2018, Italian public debt has risen by 32% of GDP to 170% of GDP, and Spanish public debt has risen by 28% of GDP to 138% of GDP. These higher debt burdens beg the following question: How high can European yields rise before a new sovereign debt crisis engulfs the Eurozone? Private sector financial balances and the balance of payments in the periphery are now very different from what they were between 2008 and 2012. As a result, the odds of a similar crisis are much lower than last decade, which should allow German yields to rise further in the coming years. Italy and Spain have moved on from experiencing an EM-style balance of payment crisis with explosive debt market dynamics. They are now stuck in a Japanese scenario of excess private sector savings and low economic growth. “This Time Is Different” These might be the four most dangerous words in finance, but understanding the differences between the present situation and the sovereign debt crisis is essential to assessing the impact of higher yields on Italian and Spanish public finances. Chart 1From Net Borrower To Net Lenders The most important transformation in the Southern European economies is the rise in private sector savings. From 1999 to 2013, Italy’s private sector financial balance averaged 2.2% of GDP. Constant government deficits resulted in a significant national dissaving, forcing the country to borrow from abroad as expressed by a current account deficit that lasted from 2000 to 2013 (Chart 1, top panel). At the present moment, Italy’s current account is in a surplus equal to 3.5% of GDP, as private savings stand at 13% of GDP, up from 5% before COVID-19. The change is even more dramatic in Spain. The Spanish private sector financial balance was in a large deficit from 1999 to 2008, which averaged 5.6% of GDP and reached a nadir of 11.3% of GDP in 2007. As a result, Spain relied on foreign lending between 1980 and 2012, with a current account deficit that averaged 3% of GDP over that period (Chart 1, second panel). The switch from the status of foreign borrower to the status of surplus nation is fundamental. A country where excess private savings are so abundant they can finance large public deficits and still generate current account surpluses will experience more limited pressure on borrowing costs than a country that needs to borrow from abroad. Japan is a perfect example. Elevated public borrowing ends up being a vehicle to absorb private sector excess savings and does not constitute profligacy. Despite higher debt loads, Italy’s public finances seem more sustainable than those of Spain. The International Monetary Fund’s (IMF) October 2021 Fiscal Monitor forecast shows the Italian primary budget balance, both on an absolute basis and on a cyclically-adjusted basis, moving from -6% and -2.9% of GDP, respectively, closer to zero by 2026 (Chart 2). In Spain, primary budget balances, both on an absolute basis and on a cyclically-adjusted basis, are anticipated to improve from -8.9% and -3.4% of GDP, respectively, to -2.5% of GDP by 2026. Despite these deficits, the IMF also expects public debt to decrease by 10% of GDP to 146% in Italy and to remain flat at 120% of GDP in Spain (Chart 3). Importantly, in both cases, the upward pressure on public debt will be limited over the next five years because private savings are already high and unlikely to rise further. Chart 2Public Deficits Will Narrow Further Chart 3Debt Will Stay High, So Will Private Savings The role of the European Central Bank (ECB) as a backstop also contributes to creating a different environment than the one that prevailed prior to the “whatever it takes” era. Before Mario Draghi’s landmark July 2012 speech, there was no explicit buyer of last resort in the European sovereign debt market. Now, there is one, and its presence limits how rapidly private sector buyers might lose confidence in a country’s bond market and how far spreads can widen, even if the central bank buying has its own limit. In fact, Draghi’s forward guidance calmed the markets and caused a 250bps and 280bps collapse in Italian and Spanish 10-year yields before the ECB had even purchased a single BTP or Bono. The role of the ECB as a buyer of last resort remains crucial going forward. Yields in Italy and Spain are still 480bps and 600bps below their 2011-2012 peaks at a time when investors anticipate an end to the PEPP and APP purchases. Importantly, these spreads are narrower, even though the APP and the PEPP have purchased far more German and French sovereign bonds than Italian and Spanish bonds (Chart 4). As long as the ECB continues to emphasize that it maintains its optionality to support Italian and Spanish bond markets, even as its asset purchases end, peripheral spreads will not move back above 300bps, especially since Euroscepticism is not the risk it once was (Chart 5). Chart 4Germany and France, Not Spain and Italy, Dominated PEPP Buying Chart 5Euroscepticism on the Wane Bottom Line: As illustrated by the evolution of their current account balances, peripheral Eurozone economies have moved from deep savings deficits to a state of surplus savings. This makes them less vulnerable to the funding crises that prompted the European sovereign debt crisis. Moreover, the Eurozone now has a buyer of last resort for sovereign bonds: the post-Draghi ECB. Its presence, not its continued buying, creates the necessary insurance to limit buying strikes by the private sector, which also curtails how far Italian or Spanish spreads can widen. Long-Term Problems Abound In the long term, Italy and Spain will only be able to curtail government debt-to-GDP ratios meaningfully if trend growth recovers. This means more reforms are needed to boost productivity and labor participation rates (Chart 6). Chart 6Reforms, Not Austerity, Will Bring Debt Down Below Maastricht Levels Chart 7Competitiveness Problems In The Periphery For now, the picture remains bleak. Spain emerged out of the sovereign debt crisis with strong reform zeal. The Mariano Rajoy government reformed pensions and the labor market, which prompted a significant decline in unit labor costs compared to the Euro Area average. The pace of reforms has slowed, however, and the Pedro Sánchez government has eroded some of its predecessor’s efforts. As a result, since 2018, Spanish unit labor costs have increased once again relative to the rest of the Eurozone (Chart 7). Italy never implemented significant reforms, because it has long been beset by political paralysis. Unit labor costs are not outstripping the rest of the Eurozone, but productivity continues to lag. Economic growth in Italy and Spain will remain tepid in the coming years, which will prevent any meaningful decline in debt. The poor trend in relative competitiveness and productivity of the past few years is unlikely to be undone. Work by the OECD shows that prior to the pandemic, Spain and Italy had shifted away from being among the leading reformers in Europe. Instead, this role now falls to France, Greece, Austria, and Germany (Chart 8), which confirms last week’s analysis that France’s reform effort remains serious, even if it is less ambitious than what transpired over the past five years. As a consequence of slow growth, investment in Spain and Italy will trail behind the rest of the Eurozone. Thus, private sector savings will remain elevated and private nonfinancial sector debt loads are unlikely to increase meaningfully (Chart 9). As a result, the public sector will continue to absorb the private sector’s excess savings, which means that the debt-to-GDP ratio could sustain more upside pressure than what either the IMF or the OECD anticipate. Chart 8Italy And Spain As Reform Laggards Chart 9Private Debt Is Not The Problem These dynamics bear a striking resemblance to what happened in Japan. They also imply that Italy and Spain will remain a drag on European growth for years to come, as long as the fundamental reasons behind the private sector’s elevated savings rate are not addressed. Bottom Line: Italian and Spanish public debt-to-GDP ratios will continue to deteriorate as reform efforts are too tepid to lift durably trend GDP growth. Their private sectors will continue to save more than they invest, which, in turn, will push government debt higher. The Italian and Spanish economies will remain a drag on European growth for the foreseeable future. Stress Test Scenarios How high can yields rise in the Eurozone before Italy and Spain experience meaningful funding stresses? We explore two scenarios: one in which 10-year yields rise by an additional 2%, and a very aggressive scenario in which they rise a whopping 5%, bringing Italian and Spanish borrowing costs in the vicinity of the European debt crisis of 2011-2012. To conduct this experiment, we use a simple approach of regressing debt-service payments as a share of GDP on the level of yields. Modeling debt payments in euros was another alternative, but yield levels are also affected by the evolution of nominal GDP. As a result, using this approach considers both the numerator and the denominator of the debt-service payment modeling. Chart 10Private Debt Is Not The Problem Under the first scenario, Italian 10-year yields would rise to 4.4% from 2.4% today. This is still well below the 7.5% yield recorded in late 2011. In this context, government debt servicing would reach 4.5% of GDP, which is comparable to the average that prevailed prior to the Euro Area crisis (Chart 10). This suggests that Italian yields slightly above 4% are still somewhat manageable, albeit far from ideal. Under the second scenario, 10-year BTP yields would rise to 7.4% from 2.4% today. This is comparable to the level of yields observed at the apex of the European sovereign debt crisis, but it assumes that this yield level would remain in place for a year. As a result of the higher debt load today compared to a decade ago, the resulting debt-servicing costs have reached 5.4% of GDP, which is higher than those between 2012 and 2013 (Chart 10). This scenario is clearly unsustainable and suggests that yields of this magnitude would cripple the Italian government. Moving to Spain, the dynamics are slightly different. Spain’s refinancing schedule is more front-loaded than that of Italy. As a result, using the yields on 10-year Bonos as an independent variable in our regression approach does not explain well the evolution of Spanish debt-servicing costs. Instead, a simple regression model using both 3-year and 10-year yields does a much better job, because it reflects the heavier rollover of Spanish debt. Chart 11Stress Testing Spanish Public Finances In the first scenario, 3-year yields would rise by 1% to 1.7% and 10-year yields would increase from 2% to 3.7%, well below the 7% yields that prevailed in 2012. As a result, the Spanish government’s debt-servicing costs would be expected to rise to 2.8% of GDP, which is well below the levels that prevailed at the apex of the European debt crisis, but still above the level that existed in the first decade following the introduction of the euro (Chart 11). While far from ideal, this level is easily manageable for the Spanish government and is comparable to the Eurozone average prior to 2008. In the second scenario, 3-year yields are assumed to rise 2.5% to 3.2% and 10-year yields to increase an extra 5% to 6.7%, still slightly shy of the 7% yields from 2012. In this scenario, debt servicing costs are expected to jump above 3.5% of GDP (Chart 11) and are unsustainable unless nominal GDP growth remains above 7% and the primary budget balance improves to zero. As a result, an increase in Bono yields toward 7% is far too high for the Spanish government to withstand. We acknowledge that, although it points to an upper bound in yields, the second scenario is highly unlikely for several reasons. First, a 500bps increase in 10-year yields would far exceed the roughly 350bps rise experienced during the sovereign debt crisis of the previous decade. More importantly, many factors have changed since then: Spain and Italy’s shift from borrowing nations to surplus savings nations, the role of the ECB as buyer of last resort, greater support for the euro across all the Eurozone nations, and greater unity among EU countries as exemplified by the NextGenerationEU (NGEU) program. The first scenario would be painful but manageable for both Italy and Spain. It suggests that peripheral yields may rise meaningfully in the coming years, especially if nominal GDP growth remains higher than it was last decade when fiscal austerity was Europe’s mantra. However, fiscal austerity was self-defeating because, the more orthodox countries tried to be, the worse their growth was, making debt arithmetic unmanageable (Chart 12). Chart 12Counterproductive Austerity We can go one step further. Even if Italian and Spanish spreads widen another 100bps from this point on and settle between 200bps and 300bps above German yields, European public finances can withstand German yields rising to 2%. This seems surprising, but we cannot forget the context. German yields cannot reach those levels in a vacuum. If they increase that much, it is because nominal growth is strong, which makes debt arithmetic more manageable in the European periphery. Statistically, the relationship between Spanish debt servicing costs and German yields is negative, while the link between Italian debt servicing costs and German yields is statistically low, underscoring the role of growth. However, if German yields were to rise as Europe’s nominal GDP growth settled back to last decade’s range, then Italian and Spanish debt would implode. This is a far-fetched scenario; even the recent ECB’s pivot reflects stronger nominal activity. This does not mean that German yields will rise above 2% in the next five years, but rather it highlights that economic activity, not the peripheral nations’ public finances, is the true constraint on European yields. Bottom Line: The ECB’s role as a buyer of last resort, the shift to savings surpluses in Italy and Spain, as well as the greater European unity and lower Euroscepticism prevalent across the continent limit how far spreads can rise in the periphery. In this context, Spain and Italy can withstand higher yields than those of the last decade, since these higher borrowing costs reflect stronger nominal economic activity. Ultimately, the true constraint on German yields is not the finances of Southern Europe, but rather the state of economic growth in the Eurozone. Conclusions Related Report European Investment StrategyThe Lasting Bond Bear Market European yields continue to have significant upside, as we expect European growth to remain stronger than it was last decade even if Italy and Spain will continue to lag behind the rest of Europe. As we observed two weeks ago, Europe is no longer burdened by untimely fiscal austerity. Furthermore, the efforts to decrease the energy dependence on Russia and modernize the European economy will continue to support capex and aggregate demand. The upper band on German yields seems to be around 2%, assuming that Italian and Spanish spreads rise 100bps to 150bps over the coming years. Even the banking sector in the periphery can withstand significant upside in bond yields. BTPs and Bonos represent 11% and 6.8% of the Spanish and Italian financial sectors’ balance sheet, respectively (Chart 13). This is much higher than the role of OATs and Bunds in the French and German financial sectors, but Spanish and Italian banks have much lower NPLs and enjoy much more robust Tier-1 capital ratios than they did a decade ago (Chart 14). As a result, the doom-loop that plagued those economies ten years ago is not as pronounced. In fact, bank lending rates in Italy and Spain are now lower than they are in Germany, which contrasts greatly with the previous decade (Chart 14, bottom panel). Chart 13Exposure To The Home Country Chart 14Improved Bank Health In The Periphery Bottom Line: Bonds around the world and in Europe are massively oversold and are due for a countertrend rally. This pullback in yields, however, will be transitory. Higher trend nominal GDP growth around the world and in Europe indicates that yields have much further to rise over the next five years. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations
Executive Summary To understand the economy and the market we must think of them as non-linear systems which experience sudden phase-shifts. The pandemic introduced phase-shifts in our lives, which led to phase-shifts in our goods demand, which led to phase-shifts in monthly core inflation. As our lives phase-shift back to normality, goods demand will phase-shift back to low growth, and monthly core inflation prints will phase-shift from ‘high phase’ to ‘low phase’. With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, justifying a cyclical overweight position in T-bonds. Go overweight healthcare and biotech versus resources and financials. The leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Fractal trading watchlist additions: JPY/CHF, non-life insurance versus homebuilders, US homebuilders (XHB), cotton versus platinum, healthcare versus resources, and biotech versus resources. Bottom Line: With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, and the leadership of the equity market will flip back to long-duration sectors such as healthcare and biotech. Feature Inflation is a non-linear system, meaning that you cannot just dial it up or down gradually like the volume on your music system. Instead of gradual changes, non-linear systems suddenly phase-shift from quiet to loud, from cold to hot, from solid to liquid, or from stability to instability (Box I-1). Box 1: A Classic Non-Linear System – A Brick On An Elastic Band To experience the sudden phase-shift in a non-linear system, attach an elastic band to a brick and try pulling it across a table. As you start to pull, the brick doesn’t move because of the friction with the table. But as you increase your pull there comes a tipping point, at which the brick does move and the friction simultaneously decreases, self-reinforcing the brick’s acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability – the brick doesn’t move – to instability – the brick hits you in the face! Try as hard as you might, it is impossible to pull the brick across the table smoothly. In this non-linear system, the choice is either stability or instability. Back in 2017, in Mission Impossible: 2% Inflation – An Update, I posed a crucial question: “Given that price stability could phase-shift to instability, when should we worry about it?” I answered that “the risk remains low until the next severe downturn – when policymakers may be forced into desperate measures for a desperate situation.” The words proved prescient. Three years later, the desperate situation was a global pandemic, and the desperate measures were economic shutdowns combined with fiscal stimuluses of unprecedented scope and size. A Phase-Shift In Our Lives Produced A Phase-Shift In Inflation Developed economy inflation has just experienced a stark non-linearity. Since 2007, the US core month-on-month inflation rate remained consistently below 3.5 percent.1 Then came the pandemic’s shutdowns combined with policymakers’ massive response, and month-on-month inflation didn’t just rise to above 3.5 percent, it phase-shifted to well over 6 percent. Developed economy inflation has just experienced a stark non-linearity. The remarkable fact is that since 2007, there have been over a hundred monthly core inflation prints below 4 percent, and nine prints above 6 percent, but just one solitary print between 4 and 6 percent! In other words, monthly core inflation shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-1). Chart I-1Monthly Core Inflation Shows The Classic Hallmark Of A Non-Linear System So, what caused the phase-shift in core inflation? The simple answer is a phase-shift in durable goods spending, which itself was caused by the pandemic’s shutdown of services combined with massive fiscal stimulus. Again, this is supported by a remarkable fact. Since 2007, the monthly increase in US (real) spending on durables remained consistently below 3.5 percent. Then came the pandemic’s shutdowns and stimulus checks, and the growth in durables demand didn’t just rise to above 3.5 percent, it phase-shifted to well over 8 percent. In other words, the growth in durable goods demand also shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-2). Chart I-2Goods Demand Shows The Classic Hallmark Of A Non-Linear System The connection between the phase-shifts in goods demand and the phase-shifts in core inflation is staring us in the face – because the three separate phase-shifts in inflation have each been associated with a preceding or contemporaneous phase-shift in goods demand, which themselves have been associated with the separate waves of the pandemic (Chart I-3). Chart I-3Phase-Shifts In Core Inflation Have Been Associated With Phase-Shifts In Goods Demand Pulling all of this together, the pandemic introduced phase-shifts in our lives – lockdown or freedom. Which led to phase-shifts in our goods demand – above 8 percent or below 3.5 percent. Which led to phase-shifts in monthly core inflation – above 6 percent or below 4 percent. The key question is, what happens next? Bond Yields Are Close To A Peak As we learn to live with the pandemic, and assuming no imminent ‘super variant’ of the virus, our lives are phase-shifting back to a semblance of normality. Which means that our spending on goods is phase-shifting back to low growth. If anything, the recent overspend on goods implies an imminent corrective underspend. At the same time, it will be difficult to compensate a phase-shift down on goods spending with a phase-shift up on services spending. This is because the consumption of services is constrained by time and biology. There is a limit to how often you can eat out, go to the theatre, or even go on vacation. The upshot is that monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’ – even if the monthly headline inflation prints are kept up longer by the commodity price spikes that result from the Ukraine crisis. Monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’. Meanwhile central banks and markets focus on the 12-month core inflation rate – which, as an arithmetic identity, is the sum of the last twelve month-on-month inflation rates.2 To establish the 12-month core inflation rate, the crucial question is: how many of the last twelve month-on-month inflation prints will be high phase versus low phase? As just discussed, the new month-on-month core inflation prints are likely to phase-shift to low phase. At the same time, the historic high phase prints will disappear from the last twelve month window. Specifically, by June 2022, the three high phase prints of April, May, and June 2021 – 10 percent, 9 percent, and 10 percent respectively – will no longer be included in the 12-month core inflation rate, with the arithmetic impact of pulling it down sharply (Chart I-4). Chart I-4The High Phase Monthly Inflation Prints Of April, May, And June 2021 Will Disappear From The 12-Month Core US Inflation Rate, Thereby Pulling It Down. Clearly, the bond market anticipates some of this ‘base effect’ on 12-month inflation. This explains why turning points in the bond yield have led by 2-3 months the turning points in the 12-month core inflation rate (Chart I-5). With the 12-month core inflation rate likely to peak by June at the latest, this suggests that – absent some new shock – the long bond yield is likely to peak at some point in April/May. Reinforcing our cyclical overweight position in T-bonds. Chart I-5The Bond Yield Turns About 2-3 Months Before Core Inflation This also carries important implications for equity investors. Rising bond yields favour short-duration equity sectors such as resources and financials versus long-duration equity sectors such as healthcare and biotech. And vice-versa. Indeed, the recent performance of resources versus healthcare and financials versus healthcare is indistinguishable from the bond yield (Chart I-6 and Chart I-7). Chart I-6The Performance of Resources Versus Healthcare Is Indistinguishable From The Bond Yield Chart I-7The Performance of Financials Versus Healthcare Is Indistinguishable From The Bond Yield With bond yields likely to peak soon, the leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Go overweight healthcare and biotech versus resources and financials. Fractal Trading Watchlist Reinforcing the fundamental analysis in the previous section, the 130-day outperformance of resources versus healthcare and biotech has reached the point of fractal fragility that has marked previous trend exhaustions, suggesting that the recent outperformance of resources is nearing an end. Also new on our watchlist is a commodity pair, cotton versus platinum, whose strong outperformance is vulnerable to reversal. And US homebuilders (XHB), whose recent underperformance is at a potential turning point. There are two new trade recommendations. First, the massive outperformance of world non-life insurance versus homebuilders is at the point of fractal fragility that has consistently marked previous turning points (Chart I-8). Hence, go short non-life insurance versus homebuilders, setting a profit target and symmetrical stop-loss at 14 percent. Second, the strong underperformance of the Japanese yen is also at the point of fractal fragility that has marked several previous turning points (Chart I-9). Accordingly, go long JPY/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Please note that our full watchlist of 19 investments that are experiencing or approaching turning points is now available on our website: cpt.bcaresearch.com Chart I-8The Massive Outperformance Of Non-Life Insurance Is Vulnerable To Reversal Chart I-9Go Long JPY/CHF The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Cotton’s Outperformance Is Vulnerable To Reversal US Homebuilders’ Underperformance Is At A Potential Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Annualized month-on-month inflation rate. 2 Strictly speaking, the 12-month inflation rate is the geometric product of the last 12 month-on-month inflation rates. Chart I-1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-2The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-3AUD/KRW Is Vulnerable To Reversal Chart I-4Canada Versus Japan Is Vulnerable To Reversal Chart I-5Canada's TSX-60's Outperformance Might Be Over Chart I-6US Healthcare Providers Vs. Software Approaching A Reversal Chart I-7The Euro's Underperformance Could Be Approaching a Resistance Level Chart I-8A Potential Switching Point From Tobacco Into Cannabis Chart I-9Bitcoin's 65-Day Fractal Support Is Holding For Now Chart I-10Biotech Approaching A Major Buy Chart I-11CAD/SEK Reversal Has Started Chart I-12Financials Versus Industrials Is Reversing Chart I-13Norway's Outperformance Could End Chart I-14Greece's Brief Outperformance Has Ended Chart I-15BRL/NZD At A Resistance Point Chart I-16The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart I-17The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart I-18Cotton's Outperformance Is Vulnerable To Reversal Chart I-19US Homebuilders' Underperformance Is At A Potential Turning Point Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Our Global Fixed Income strategists’ Global Duration Indicator is comprised of three elements: BCA Research’s Global Leading Economic Indicator, the Global Leading Economic Indicator’s diffusion index, and economic expectations indices from the ZEW. The…
According to BCA Research’s US Bond Strategy service, current spread levels offer a good opportunity to reduce corporate bond exposure. Corporate spreads have rallied to within striking distance of their pre-COVID lows at the same time as the yield curve…
Highlights Chart 1Reduce Credit Exposure Corporate bond spreads staged a nice rally during the past month. The average index spread for investment grade corporates is only 22 bps above its pre-COVID low and 33 bps above last year’s trough. The average High-Yield index spread is 5 bps above its pre-COVID low and 49 bps above last year’s trough (Chart 1). This rally occurred even as inflation data continued to surprise to the upside and employment data confirmed that the US labor market is extremely tight. With the economic data justifying the Fed’s hawkish pivot, the Treasury curve has flattened dramatically, and both the 2-year/10-year and 3-year/10-year slopes are now inverted (Chart 1, bottom panel). An inverted yield curve is a reliable late-cycle indicator, and we think current spread levels offer a good opportunity to reduce corporate bond exposure. This week, we downgrade investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5), placing the proceeds into Treasuries. We also downgrade our recommended allocations EM Sovereigns (see page 8) and TIPS (see page 11), upgrade our recommended allocation to CMBS (see page 13) and adjust our recommended yield curve positioning (see page 10). Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 86 basis points in March, bringing year-to-date excess returns up to -154 bps. Our quality-adjusted 12-month breakeven spread shifted down to its 21st percentile since 1995 (Chart 2). As noted on the first page of this report, corporate spreads have rallied to within striking distance of their pre-COVID lows at the same time as the yield curve has become inverted beyond the 2-year maturity. We showed in last week’s report that an inversion of the 2-year/10-year Treasury slope is not necessarily a harbinger of imminent recession, but it does typically coincide with very low (and often negative) excess corporate bond returns.1 The combination of reasonably tight spreads and an inverted yield curve causes us to recommend downgrading investment grade corporate bond allocations from neutral (3 out of 5) to underweight (2 out of 5). It’s important to note that corporate balance sheets remain healthy (bottom panel) and we see no indication that a recession or default cycle will unfold during the next 6-12 months. That said, we must acknowledge that an inverted yield curve signals that the economic recovery is entering its late stages. Economic growth will be slower going forward and corporate spreads are unlikely to tighten much, especially from current depressed levels. Against this backdrop it makes sense to be more cautious on credit, sacrificing small positive excess returns in the near-term to ensure that we aren’t invested when the next downturn hits. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 119 basis points in March, bringing year-to-date excess returns up to -96 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – shifted down to 3.7% (Chart 3). An inverted yield curve sends the same negative signal for high-yield excess returns as it does for investment grade. However, high-yield valuation is currently more attractive. The option-adjusted spread differential between Ba-rated bonds and Baa-rated bonds remains elevated at 86 bps, 41 bps above its pre-COVID low (panel 3). It is also likely that economic growth will remain sufficiently strong for defaults to come in below the spread-implied threshold of 3.7% during the next 12 months (bottom panel). The greater attractiveness of high-yield valuations relative to investment grade causes us to maintain a higher allocation to the sector, even as we downgrade our portfolio’s overall credit risk exposure. We therefore recommend a neutral (3 out of 5) allocation to high-yield corporates. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in March, dragging year-to-date excess returns down to -74 bps. The zero-volatility spread for conventional 30-year agency MBS tightened 3 bps on the month as a 4 bps tightening of the option-adjusted spread (OAS) was partially offset by a 1 bp increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.2 This valuation picture is starting to change. The option cost is now up to 40 bps, its highest level since 2016, and refi activity is slowing as the Fed lifts rates. At 28 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market bonds underperformed the duration-equivalent Treasury index by 23 basis points in March, dragging year-to-date excess returns down to -505 bps. EM Sovereigns outperformed the Treasury benchmark by 40 bps on the month, bringing year-to-date excess returns up to -609 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 62 bps, dragging year-to-date excess returns down to -439 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 7 bps in March. This comes on the heels of a sharp underperformance in February that was driven by Russian bonds which have since been removed from the index. Russian bonds have also been purged from the EM Corporate & Quasi-Sovereign Index, and this index underperformed duration-matched US corporates by 11 bps in March (Chart 5). The yield differential between EM sovereigns and duration-matched US corporates remains negative. As such, we downgrade our recommended allocation to EM sovereigns from underweight (2 out of 5) to maximum underweight (1 out of 5). In sharp contrast, the EM Corporate & Quasi-Sovereign Index continuous to offer a significant yield advantage (panel 4). We retain our neutral (3 out of 5) recommendation for EM Corporates & Quasi-Sovereigns. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 5 basis points in March, bringing year-to-date excess returns up to -122 bps (before adjusting for the tax advantage). While the war in Ukraine has introduced a great deal of uncertainty into the economic outlook, the municipal bond sector should be better placed than most to deal with the fallout. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will continue to support state & local government coffers for some time. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past two months. The 10-year Aaa Muni / Treasury yield ratio is currently at 94%, up significantly from its 2021 trough of 55%. The yield ratios between 12-17 year munis and duration-matched corporate bonds are also up significantly off their lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched corporates is 93%. The same measure for 17-year+ Revenue bonds stands at 101%, meaning that Revenue bonds carry a before-tax yield advantage versus duration-matched corporates. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve’s bear-flattening trend continued through March. The 2-year/10-year Treasury slope flattened 35 bps on the month and the 5-year/30-year Treasury slope flattened 44 bps. These slopes are now both inverted, sitting at -6 bps and -12 bps respectively. In last week’s report we noted the unusually wide divergence between very flat slopes at the long end of the yield curve and very steep slopes at the front end.3 For example, the 5-year/10-year Treasury slope is -18 bps but the 3-month/5-year slope is 204 bps. This divergence is happening because the market has moved quickly to price-in a rapid near-term pace of rate hikes that will end in roughly one year. However, so far, the Fed has only delivered 25 bps of those hikes and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. This trade looks attractive on our model (Chart 7) and will profit if the rate hike cycle moves more slowly than what is currently priced in the market but lasts longer, as is our expectation. By entering our new 5-year bullet over 2-year/10-year barbell trade we also close our previous 2-year bullet over cash/10-year barbell trade at a loss. We continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade. TIPS: Underweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 143 basis points in March, bringing year-to-date excess returns up to +271 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate rose 21 bps. Since last May we have been recommending that clients maintain a neutral allocation to TIPS versus nominal Treasuries at the long end of the curve and an underweight allocation to TIPS at the front end. This recommendation was premised on the view that the breakeven curve would steepen as falling inflation put downward pressure on short-maturity TIPS breakevens and long-dated breakevens remained at levels close to the Fed’s target. Recently, the 10-year TIPS breakeven inflation rate has shot up to levels well above the Fed’s 2.3%-2.5% target range (Chart 8) and our TIPS Breakeven Valuation Indictor has shifted into “expensive” territory (panel 2). Further, while inflation has remained high for longer than we expected, it still seems more likely than not that it will roll over between now and the end of the year as pandemic fears fade and consumers shift their spending patterns away from goods and toward services. As such, we think investors should take this opportunity to further reduce exposure to TIPS versus nominal Treasuries at both the short and long ends of the curve. That is, within our overall underweight allocation to TIPS we continue to recommend positioning in breakeven curve steepeners and in real yield curve flatteners. We also continue to recommend an outright short position in 2-year TIPS. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in March, dragging year-to-date excess returns down to -31 bps. Aaa-rated ABS underperformed by 21 bps on the month, dragging year-to-date excess returns down to -27 bps. Non-Aaa ABS underperformed by 49 bps on the month, dragging year-to-date excess returns down to -51 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). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. This also indicates that while surging gasoline prices will weigh on consumer activity in the coming months, household balance sheets are starting from such a good place that we don’t expect a meaningful increase in consumer credit delinquencies. 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: Overweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in March, bringing year-to-date excess returns up to -78 bps. Aaa Non-Agency CMBS outperformed Treasuries by 25 bps on the month, bringing year-to-date excess returns up to -67 bps. Non-Aaa Non-Agency CMBS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -110 bps. CMBS spreads remain wide compared to other similarly risky spread products. Further, commercial real estate (CRE) lending standards have recently shifted into “net easing” territory and demand for CRE loans is strengthening (Chart 10). In light of today’s downgrade of corporate credit, non-agency CMBS look like an attractive alternative to add some spread to a portfolio. Increase exposure from neutral (3 out of 5) to overweight (4 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 17 basis points in March, dragging year-to-date excess returns down to -39 bps. The average index option-adjusted spread widened 5 bps on the month. It currently sits at 48 bps, not that far from its average pre-COVID level (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 255 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31, 2022) 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 March 31, 2022) 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 -55 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 55 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 C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of March 31, 2022) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 2 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 3 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
Executive Summary Our recommended model bond portfolio outperformed its custom index by a robust +48bps in Q1/2022 – an impressive performance given the significant uncertainties stemming from the Ukraine war, surging commodity prices and hawkish central banks. This outperformance came entirely from the rates side of the portfolio (+52bps) as global government bond yields surged, driven by a large underweight to US Treasuries. The credit side of the portfolio was largely unchanged versus the benchmark (-4bps). Looking ahead, we see global bond yields as being more rangebound over the next six months. A lot of rate hikes in 2022 are already discounted (most notably in the US) and global inflation is likely to decelerate in Q2 & Q3. As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Bottom Line: In our model bond portfolio, we are downgrading US investment grade corporates to underweight, and reducing high-yield exposure in the US and Europe to neutral. We are also reducing inflation-linked bond allocations in the US and euro area to underweight versus nominals. Feature The first three months were horrific for global bond markets. The Bloomberg Global Aggregate index delivered a total return of -6.2%, the second worst quarter since 1990. No sector, from government bonds to corporate debt to emerging market spread product, was immune to the pressures from soaring energy prices, war-driven uncertainty and hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report Global Fixed Income StrategyOur Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely That toxic cocktail for bond returns may lose some potency in the coming months if a de-escalation of the Ukraine tensions can be reached. However, the bigger drivers of bond market volatility – high global inflation and the monetary tightening necessary to combat it – are more likely to linger for longer than expected. Government bond yields are unlikely to fall much in this environment. Increasingly, global credit spreads, especially for corporate debt in the US, will face intensifying widening pressure as central banks rapidly dial back pandemic-era monetary accommodation, led by the US Federal Reserve. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the first quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2022 Model Bond Portfolio Performance: Regional Allocation Drives Outperformance Chart 1Q1/2022 Performance: Big Gains From Rising Bond Yields The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was -4.6%, outperforming the custom benchmark index by +48bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +52bps of outperformance versus our custom benchmark index while the latter underperformed by -4bps. In an extremely negative quarter for fixed income both in terms of the breadth and depth of losses, our regional allocation choices helped us continue generating outperformance after we transitioned to a neutral overall portfolio duration stance in mid-February. Throughout the quarter, we maintained a significant underweight on US Treasuries in the portfolio, even after we tactically upgraded our duration tilt. We expected US government debt to still underperform that of other developed markets, even in an environment where the rise in global bond yields was due for a breather. Our rationale worked – admittedly helped by the inflationary shock of the Russian invasion of Ukraine - with the US Treasury part of our portfolio generating a whopping +63bps of outperformance (Table 1). Table 1GFIS Model Bond Portfolio Q1/2022 Overall Return Attribution Meanwhile, our biggest government bond overweights were in Europe, a market we expected to perform defensively in a portfolio context. We were obviously caught offside on this call as energy prices and inflation expectations in Europe surged in response to the Ukraine conflict. In total, our portfolio lost -30bps in active return terms in euro area government bonds, with the losses spread evenly between the core and periphery. We did staunch the bleeding somewhat by reducing our allocation to the periphery in the last two weeks of the quarter and using the proceeds to fund an increased allocation to European investment grade corporates. The European corporate index spread has tightened -23bps since that switch. Turning to the credit side of the portfolio, the most successful position was our underweight tilt on emerging market (EM) USD-denominated corporates (+10bps) and sovereigns (+9bps) during a catastrophic quarter for EM risky assets driven by the conflict as well as weakness in the Chinese economy. We sustained losses from our overweight on US CMBS (-11bps) which was broadly offset by gains from our underweight on US MBS (+10bps). Lastly, while we were hurt by the sell-off in euro area high-yield (-13bps), where we were overweight to start 2022, we did scale back some of that exposure towards the end of the quarter when markets started to discount the risk of a “worst case” scenario of direct NATO intervention in Ukraine. The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2022 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2022 Spread Product Performance Attribution By Sector Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+23bps) Underweight UK Gilts with a maturity greater than 10 years (+14bps) Underweight US treasuries with a maturity between 3 and 5 years (+12bps) Biggest Underperformers: Overweight euro area high-yield corporates (-13bps) Overweight US CMBS (-11bps) Overweight Spanish Bonos (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2022 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q1/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers. Notably, we were underweight UK Gilts (-1280bps) and EM Sovereigns (-1103bps) on the extreme right side of the chart. We were also underweight US Treasuries (-531bps) which, despite being in the middle of Chart 4, contributed hugely to our portfolio outperformance due to their large market cap weighting in the benchmark index. Broadly, this means that, except for Europe and Australia, our highest conviction calls worked in our favor during the quarter. Bottom Line: Our model bond portfolio outperformed its benchmark index in the third quarter of the year by +48bps – a positive result coming largely from underweight positions in US Treasuries, UK Gilts, and EM credit. Changes To Our Model Bond Portfolio Allocations The uncertainty stemming from the Russia/Ukraine conflict led us to temporarily neutralize many of the recommended exposures in the model bond portfolio. We not only moved to neutral on overall portfolio duration, we also neutralized individual country yield curve tilts and inflation-linked bond allocations. While the situation remains fluid, the worst-case scenarios of the conflict expanding beyond the borders of Ukraine appear to have been avoided. This leads us to reconsider where to once again take active risks on the rates side of the portfolio. Chart 5Our Duration Indicator Calling For Slowing Global Yield Momentum Duration On overall portfolio duration, we are maintaining a neutral (“at benchmark”) stance in the portfolio. Our Global Duration Indicator is currently signaling that the strong upward momentum of global bond yields should fade over the next few months (Chart 5). Slowing global growth expectations – a trend that was already in place prior to the Ukraine conflict - are the major reason why our Duration Indicator has turned lower. The war-fueled surge in energy prices has helped push global bond yields higher through rising inflation breakevens, which also prompted central banks – most notably the Fed and the Bank of England (BoE)- to signal a need for a faster pace of interest rate hikes in 2022 despite softening growth momentum. Looking ahead, that strong link between oil prices and bond yields will not be broken until there is some sort of de-escalation of the Ukraine conflict, which does not appear imminent. This supports a near-term neutral overall duration stance. Yield Curve Allocations In terms of yield curve exposure, we see some opportunities to adjust allocations (Chart 6). US curves have inverted and UK curves are flirting with inversion as markets are pricing in more Fed/BoE tightening, while curves in Germany and France have bear-steepened with longer-term inflation expectations going up faster than shorter-term interest rate expectations. In the US and UK, the yield curve flattening also reflects the “front loading” of Fed/BoE rate hike expectations. Overnight index swap (OIS) curves are pricing in 190bps of rate hikes in the US, and 134bps in the UK, by the end of 2022. This is followed quickly by rate cuts discounted in H2/2023 and 2024 in both countries. We see it as more likely that both central banks will deliver fewer hikes than discounted in 2022 and but will push rates to higher levels than priced by the end of 2024. That leads us to add a mild steepening bias into our US and UK government bond allocations in the model bond portfolio. We offset that by inserting a flattening bias in the German and French yield curve allocations to keep the overall portfolio duration at 7.5 years, matching that of the custom benchmark index (Chart 7). Chart 6Curve Flattening In The US & UK Is Overdone Chart 7Overall Portfolio Duration: Stay Neutral Chart 8No Change To Our Country Allocations To Begin Q2/22 Country Allocations Turning to our country allocations, we see no need to make major changes right now (Chart 8). We still prefer to maintain an underweight stance on countries that are more likely to see multiple central bank rate hikes in 2022 (the US, UK, Canada) versus those that are less likely (Germany, France, Japan, Australia). We are also staying neutral on Italian and Spanish government bonds with the ECB set to taper the pace of its asset purchases in Q2. Less ECB buying raises the risk that higher yields will be required to entice private sector buyers to buy Italian and Spanish debt with a smaller central bank backstop. Inflation-Linked Bonds Our Comprehensive Breakeven Inflation (CBI) indicators assess the potential for a significant move in 10-year breakeven inflation rates, based on deviations from variables that typically correlate with breakevens like oil prices or survey-based measures of inflation expectations. At the moment, none of the CBIs for the eight countries in our model bond portfolio are below zero (Chart 9), which would be a signal that breakevens are too low and can move higher. Chart 9Inflation-Linked Bond Exposure: Reduce Europe & The US, Increase Canada Canada has the lowest CBI, and last week, we added a tactical trade to go long 10-year Canadian inflation breakevens. We will add that position to our model bond portfolio this week, moving the Canadian “linkers” allocation to overweight versus nominal Canadian government bonds (within an overall underweight allocation to Canada in the model bond portfolio). On the other side of our CBI rankings are countries where the CBIs are well above zero and breakevens are more stretched: Germany, Italy, France and the US. We are currently neutral inflation-linked bonds in those four countries, but strictly as a hedge against the war-fueled risks of further increases in oil prices. Now, however, 10-year breakevens have widened to levels that already factor in more expensive oil, even with oil prices struggling to break out to new highs. As a result, we are downgrading the allocation to linkers in Germany, Italy, France and the US to underweight within the model bond portfolio (Chart 10). Corporate Bonds The most meaningful changes we are making to our model bond portfolio, and in our strategic investment recommendations, are to our corporate bond allocations: We are downgrading US investment grade corporate bond exposure from neutral to underweight (2 out of 5) We are downgrading US high-yield corporate bond exposure from overweight to neutral (3 out of 5) We are also downgrading euro area high-yield exposure from overweight to neutral (3 out of 5) Credit spreads across the developed market and EM space have fully unwound the surge seen after Russia invaded Ukraine on February 24 (Chart 11). We had turned more cautious on global spread product exposure in early March because of the war-fueled shock to energy prices and investor sentiment. We viewed this as a bigger issue for European and EM credit, with Europe heavily reliant on Russian energy supplies and EM market liquidity impacted by bans on trading of Russian assets. We therefore reduced exposures to European high-yield and EM hard currency debt in the model bond portfolio. Chart 10Our Inflation-Linked Bond Country Allocations Now, while markets have become more sanguine about the prospects of a long war that can more directly draw in Western forces, a bigger threat to financial market stability has emerged – more aggressive tightening of global monetary policy led by the Fed. Chart 11Global Credit Spreads Have Returned To Pre-Invasion Levels Chart 12Global Monetary Backdrop Turning More Negative For Credit Already, the move away from quantitative easing by the Fed, ECB and BoE has led to a negative impulse for global credit returns (Chart 12). Excess returns for the Bloomberg Global Corporate and High-Yield indices are now essentially flat on a year-over-year basis, and the riskiest credit tiers of both indices are seeing the greater spread widening (bottom panel). Another indicator of tightening monetary policy, the flat US Treasury curve, is also signaling a poor environment for US credit market returns. Our colleagues at our sister service, BCA Research US Bond Strategy, have noted that when the 2-year/10-year US Treasury curve flattens below +25bps, the odds of US investment grade credit outperforming duration-matched Treasuries decline sharply. Dating back to 1973, the average excess return (over Treasuries) for the Bloomberg US investment grade index over the twelve months after the 2/10 curve flattens below +25bps is -0.56%. The 2/10 US Treasury curve is now inverted at -3bps, even with the Fed having only delivered a single +25bp rate hike so far in the current cycle. This is a highly unusual occurrence, as the Treasury curve typically inverts after the Fed has delivered multiple rate hikes in a tightening cycle. Bond investors are clearly “front-running” the Fed in discounting aggressive rate hikes in 2022 in response to US inflation near 8%. We think the Fed will deliver fewer hikes than markets are discounting this year, but will do more in 2023 and 2024. Yet the message from the now-inverted yield curve, and what it means for corporate bond performance, is too powerful to ignore. This underpins our decision to downgrade our recommended allocation to US investment grade to underweight. We do not, however, see a need to move the allocations for other corporate bond markets as aggressively. The credit spread widening seen so far in 2022 in the US and Europe – a trend that was already in place before the start of the Ukraine war – has restored more value to European corporate spreads compared to US equivalents. That can be seen when looking at our preferred measure of spread valuations, 12-month breakeven spreads.2 The historical percentile ranking of the 12-month breakeven spread is 63% for euro area investment grade and a much lower 23% for US investment grade (Chart 13). The absolute level of the euro area ranking justifies maintaining an overweight stance on euro area investment grade, both in absolute terms and relative to US investment grade. A smaller gap exists for high-yield, where the euro area 12-month breakeven spread percentile ranking is 50% versus 33% in the US. Those lower percentile rankings justify no higher than a neutral allocation to high-yield on either side of the Atlantic. On the surface, maintaining a higher allocation to US high-yield over US investment grade does appear counter-intuitive in an environment where the US Treasury curve is inverted and investors are growing increasingly worried that the Fed will need to engineer a major growth slowdown to cool inflation. However, that same high inflation helps to maintain a fast enough pace of nominal economic growth to limit the default risk for riskier borrowers. Moody’s estimates that the default rate for high-yield corporates will reach 3.1% in the US and 2.6% in Europe by year-end. Using those estimates, we can calculate a default-adjusted spread, or the current high-yield spread minus one-year-ahead expected default losses. That spread is currently 134bps in the US and 206bps in Europe, both well above the low end of the long-run range and closer to the long-run average (Chart 14). Those are levels that are consistent with a neutral allocation to high-yield in both regions, as current spreads offer a decent cushion in an environment of relatively low default risk. Chart 13More Attractive Spread Levels In Europe Vs. US Chart 14Low Default Risk Helps Support High-Yield Valuations Chart 15Persistent Headwinds To EM Credit Performance Emerging Markets Finally, we continue to see more reasons to be cautious on EM USD-denominated credit, given the lack of support from typical fundamental drivers (Chart 15). Weak Chinese growth, slowing commodity price momentum (on a year-over-year basis), and a firm US dollar are all factors that weigh on EM economic growth and the ability to service hard-currency debt. We are maintaining an underweight allocation to EM USD-denominated sovereign and corporate debt in our model bond portfolio. Indications that China is ready to introduce more fiscal and monetary stimulus, and/or if the Fed’s messaging turned less hawkish – and less US dollar bullish – would be the signals necessary for us to consider an EM upgrade. Summing It All Up The full list of our recommended portfolio allocations after making all of the above changes can be seen in Table 2. The changes leave the portfolio with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Chart 16Overall Portfolio Allocation: Underweight Spread Product Vs Governments the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has now flipped to an underweight stance on the exposure of spread product to government bonds, equal to four percentage points of the portfolio (Chart 16) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 80bps – a level similar to that before the changes were made and still well below our self-imposed 100bps tracking error limit (Chart 17) the portfolio now has a yield below that of the custom benchmark index, equal to 2.51% (Chart 18). Chart 17Overall Portfolio Risk: Moderate Chart 18Overall Portfolio Yield: Below-Benchmark The changes leave the portfolio much more exposed to a widening of global credit spreads than a rise in government bond yields – a desired outcome with bond yields already discounting a lot of tightening but credit spreads still at historically tight levels. Bottom Line: As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. We are expressing that by cutting the exposure to corporate bonds in our model bond portfolio. Portfolio Scenario Analysis For The Next Six Months After making all the specific changes to our model portfolio weightings, which can be seen in the tables on pages 23-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes Table 3BEstimated Government Bond Yield Betas To US Treasuries For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around developments in the Ukraine/Russia conflict and the impacts on uncertainty and commodity-fueled inflation. Base Case There is no further escalation of the Ukraine/Russia conflict, possibly resulting in a temporary ceasefire. Oil prices pull back on a lower war risk premium, helping lower inflation expectations. Global realized inflation peaks during Q2/2022, alongside some moderation of global growth in lagged response to high energy prices. Within that slower pace of global growth, the US outperforms Europe while Chinese growth remains weak because of COVID lockdowns (although that will eventually lead to more stimulus from Chinese policymakers). The Fed delivers 100bps of rate hikes by July, starting with a 50bp increase at the May meeting, before pausing at the September meeting in response to slowing US inflation and growth. There is a mild bear flattening of the US Treasury curve, but yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 20 and the fed funds rate reaches 1.5%. Escalation Scenario The is no reduction in Ukraine war tensions, with increased Russian aggression resulting in greater NATO military involvement. The risk premium in oil prices increases, delaying the expected peak in global inflation until the second half of 2022. Inflation expectations remain elevated. Global growth weakens more than in the base case scenario because of higher energy prices, but with US growth still outperforming Europe. China’s economy remains weighed down by COVID lockdowns and an inadequate fiscal/monetary/credit policy response. The Fed is forced to be more aggressive because of high inflation expectations, delivering 150bps of hikes by September. The US Treasury curve bear-flattens, but with Treasury yields rising across the curve through wider TIPS breakevens and greater-than-expected rate hikes keeping real yields stable. The Brent oil price rises +25%, the VIX index climbs to 30, the US dollar appreciates by +5% thanks to slowing global growth and a more aggressive move by the Fed to push the funds rate to 2%. De-Escalation Scenario There is a full and lasting ceasefire between Russia and Ukraine. The war risk premium in oil prices collapses, allowing global inflation to peak in Q2 and then decline rapidly. Global growth sentiment improves because of lower energy prices and diminished worries about a wider world war. European growth outperforms US growth (relative to expectations) as European natural gas prices decline. China responds faster than expected to the latest COVID wave with more aggressive policy stimulus. Lower inflation allows the Fed to be more patient on rate hikes, delivering only 75bps of hikes by July before pausing. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is fairly small as lower TIPS breakevens are partially offset by higher real yields (as growth sentiment improves). The Brent oil price falls -20%, the VIX index drifts down to 18, and the US dollar depreciates by -3% as global growth improves and the Fed pushes the funds rate to a less-than-expected 1.25% by July. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 19 and Chart 20, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 19Risk Factor Assumptions For The Scenario Analysis Chart 20US Treasury Yield Assumptions For The Scenario Analysis Given our neutral overall portfolio duration stance, and the mild changes in nominal bond yields implied by our forecasts, it should not be surprising that the rates side of the portfolio is expected to not contribute any excess return in Q2 and Q3. However, Fed rate hikes – which push up yields on spread product in the forecasting regressions – result in negative credit returns in all scenarios (especially in the cases where the VIX is expected to rise). Thus, the return on the credit side of the model portfolio, where we are now underweight credit risk, will be the main driver of performance, delivering a range of excess return outcomes between +29bps and +53bps. Bottom Line: The next six months will be about locking in the significant gains in our model bond portfolio performance from rising bond yields, and transitioning to outperforming via wider credit spreads in US investment grade and EM hard currency debt. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 12-month breakeven spreads compare the option-adjusted spread (OAS) of a credit market or sector to its duration, using Bloomberg bond index data. The breakeven spread is the amount of spread widening that must occur over a one-year horizon to make the total return of a credit instrument equal to that of duration-matched risk-free government debt. 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 Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months)