Fixed Income

Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 9The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. 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Highlights So far, both the demand and supply side of the Philippine economy have been rather weak; yet there are signs that growth is set to revive. Fiscal expenditures have bottomed. Bank lending is also reviving. Acceleration in broad money supply is usually a good omen for stronger economic activity (Chart 1). Being a defensive market within EM, Philippine stocks will benefit in an impending period of weak EM stock prices. Upgrade this bourse from underweight to neutral in an EM equity portfolio. Philippine sovereign credit is also defensive in nature relative to its EM peers. Stay overweight in an EM portfolio. A deteriorating external accounts outlook makes the peso vulnerable. The central bank will also likely tolerate a weaker currency. Stay short the peso versus the US dollar. A vulnerable peso renders Philippine domestic bonds unappealing. Stay neutral in an EM domestic bonds portfolio. Feature The steep underperformance of Philippine stocks over the past several years is due for a pause. While this bourse may not see a sustainable rally in absolute terms, a period of flattish relative performance vis-à-vis the EM benchmark is likely. We recommend upgrading this market from underweight to neutral within an EM equity portfolio (Chart 2). Chart 1Accelerating Fiscal Spending And Credit Is A Good Omen For Economic Growth Chart 2Philippine Stocks' Underperformance Is Set For A Breather But It's A Risk In Absolute Terms One reason why Philippine stocks are unlikely to rally in absolute US dollar terms is a vulnerable peso. Philippine external accounts will likely deteriorate further, and therefore the peso is set to continue to trade on the weaker side. Currency investors should stick with our recommended short the peso versus US dollar trade for now. Philippine domestic bonds also remain unattractive to foreign investors. Local bond yields are not high enough relative to those of safe-haven bonds (US treasuries). As a result, the country is witnessing net debt portfolio outflows. The nation’s sovereign USD bonds, however, will likely outperform the EM benchmark going forward and merit an overweight stance in an EM sovereign bond portfolio. A Feeble Economy …   The Philippine economy, so far, continues to be soft. Demand has been sluggish: manufacturing sales remain well below pre-pandemic levels – both in value and volume terms. So are car sales (Chart 3). On the supply side, production volume gives a similar message: they are still below pre-pandemic levels. Manufacturing PMI is barely in the expansion territory (Chart 4). In other words, there is palpable weakness in both the demand and supply side of the domestic economy. Chart 3The Demand Side Of The Economy Has Been Weak... Chart 4...So Has Been The Supply Side The soft domestic demand is also evident from the import cargo throughput in the country’s ports. While exports cargo has risen well above pre-pandemic levels, import cargo has not (Chart 5). Part of the reason behind the lingering frailty is muted fiscal spending. Over the past 12 months, the latter has decelerated measurably. To be sure, Philippine fiscal outlays during the entire pandemic period have not been extraordinary; and yet this has slowed further (Chart 6, top panel). Chart 5Weak Domestic Demand Is Also Evident In Still Subdued Imports Chart 6Govt Spending Had Decelerated, Even As QE Proceeds Remained Unspent   The sharp widening seen in the country’s fiscal deficits had more to do with dwindling fiscal revenues, rather than strong spending. In fact, central bank data shows that most of its government bond purchase proceeds (‘QE’ proceeds) are unspent – still sitting in the government’s accounts with the central bank, i.e., they have not been channeled into the economy (Chart 6, bottom panel). … But Plenty Of Dry Powder Going forward, however, that picture is likely to change. The country is heading into general elections in May 2022. Lawmakers therefore have an incentive to spend the amount currently lying in the central bank. The amelioration in the number of new Covid-19 cases has enabled a re-opening of the economy, which will make stimulus spending easier. In addition, the federal budget for 2022 passed last month1 includes an 11.5% hike in government outlays. With core CPI at 3%, this translates into a robust 8.5% government expenditure growth rate in real terms. Chart 7Credit Is Finally Reviving Beyond fiscal spending, the country’s bank credit might also gain some traction: During the pandemic, banks shunned loan disbursements. Lately, however, there are signs that credit is reviving (Chart 7). Real borrowing costs (prime lending rates deflated by core CPI) from banks are low, close to only 1%. Such low cost of credit should encourage new borrowing at a time when economic activity is resuming. On their part, banks have made sizeable provisions against the rising NPLs during the pandemic, and therefore have already taken a substantial hit on their books (Chart 8, top panel). Relatively cleaner balance sheets should encourage banks to lend. Banks have also been able to materially raise their operating efficiency in the past couple of years (by way of rising net interest income). As a result, operating margins have improved measurably. This has helped absorb part of the NPL-related losses and has somewhat cushioned the blow to banks’ bottom line (Chart 8, bottom panel). Relatively better margins (than otherwise would have been the case) should prompt banks to take relatively higher risks, i.e., expand their loan books going forward. Should fiscal authorities ramp up their spending, and should banks also begin to lend again, the activity that has resumed following a lessening of Covid-19 cases will get a fillip. Higher fiscal spending and bank credit will lift money supply in the economy, usually a good omen for stronger economic activity (see Chart 1 on page 1). Incidentally, inflation in the Philippines is under control. The relatively high headline inflation print is not indicative of any genuine inflationary pressures, and is due mostly to food prices, which account for 38% of the CPI basket. Core and trimmed mean CPI are much lower at around 3% (Chart 9, top panel). Chart 8Banks Have Cleaner Books Now As They Made Sizable NPL Provisions Chart 9There Are No Genuine Inflationary Pressures In The Philippines The central bank expects the headline inflation rate to decelerate to within its target band of 2% to 4% by the end of this year and settle close to the midpoint in 2022 and 2023. At the same time, Philippine nominal wages are barely growing (Chart 9, bottom panel). This implies that businesses have little margin pressures to raise their selling prices. Genuine inflationary pressures, therefore, are unlikely to become acute in the foreseeable future. That, in turn, will help keep fiscal and monetary policies accommodative.  Domestic Bond Yields Will Stay Flattish With the resumption of economic activity, will come higher fiscal revenues. That should help the Philippine fiscal deficit to narrow.  Narrower fiscal deficit in the Philippines is usually bond bullish (i.e., bond yields go down). Yet, lower bond yields will have negative implications for Philippine capital inflows. Foreign investors are the marginal buyers of Philippine bonds. And their appetite for the latter depends on how much extra yield the Philippines offers over safe-haven bonds (US treasuries). Chart 10 shows that whenever the yield differential narrows too much (to around 200 basis points), net debt portfolio inflows into the Philippines typically stop, and often turn into outflows. This is what is happening now. On the other end, when the differential widens enough (about 400 - 500 basis points), those outflows turn into inflows again. Chart 10The Philippines Need To Offer Relatively Higher Yields To Attract Capital Inflows Given that we expect US long-term bond yields to rise, if Philippine bond yields do not rise at an even faster pace, its yield differential would stay low. Thus, the country will be hard-pressed to see any debt portfolio inflows in the near future. The absence of foreign buyers, in turn, would put a floor under bond yields. This will counterbalance any yield-suppressing forces coming from improving fiscal deficits. Thus, overall, the country will likely see flattish yields over the next six to nine months. And The Peso, Shaky Chart 11Debt Dominates The Philippines' Capital Inflows Low bond yields and short-term interest rates will have negative ramifications for the currency: It’s the foreign debt flows, rather than equity investments, that dominate Philippine capital inflows. This is true for all categories of inflows: FDI, portfolio and other investments (Chart 11). The fact that debt investors are the dominant group among foreign investors has some implications. Debt investors do not like lower interest rates while equity investors do. As such, debt inflows into the Philippines diminish when the interest rates (bond yields) are relatively low. Muted foreign capital inflows, in turn, are bearish for the peso. The country’s current account outlook is also not rosy. The trade deficit has widened significantly, and the robust current account surplus has given way to deficits – in line with our forecast in our previous report. With domestic demand reviving (government spending, household consumption and business investment), imports will now likely grow faster than exports, and therefore, will weigh down on both trade and current account deficits further in the months ahead. Notably, the country’s overseas workers’ remittances have also rolled over in recent months. All these will be a headwind for the peso (Chart 12). As noted, the central bank does not expect inflation to overshoot their target in the next two years. They have also been a net buyer of US dollars year-to-date, i.e., they have been leaning against their currency. This implies that they would not mind a weaker currency – especially when the economy is still not strong, and inflation is not a threat. Incidentally, the peso is also about 7% expensive vis-à-vis the US dollar in purchasing power terms (Chart 13). Chart 12Current Account Balance Will Deteriorate As Rising Domestic Demand Fuels Imports Chart 13The Peso Is Somewhat Expensive In PPP Terms And Is Vulnerable To A Downside Equity Underperformance Is Late An improving fiscal balance is usually bullish news for Philippine stock multiples. The connection is via bond yields/interest rates. An improving fiscal balance leads to lower bond yields, which, in turn, boost this market which is dominated by interest rate sensitive sectors (real estate, financials/banks and utilities make up 50% of market cap). Chart 14Weak EM Stock Prices Herald Outperformance by The Defensive Philippine Markets Yet, in this cycle, an improving fiscal balance may not herald a material fall in the country’s bond yields due to net debt portfolio outflows (as explained above). Thus, Philippine stocks would miss the tailwind from rising multiples. A dim outlook for the peso also calls for caution on the part of absolute-return foreign investors. That said, the resumption of economic activity will lead to rising earnings, and that should provide some tailwinds for this market. Moreover, as a defensive market within EM, Philippine stocks usually outperform the overall EM benchmark during periods of weak EM stock prices. Incidentally, we have a negative outlook on EM stock prices over the coming several months (Chart 14). Weighing all the pros and cons, we infer that Philippine stocks’ relative performance will likely be rangebound over the next six to nine months. Sovereign Credit Will Outperform Chart 15The Philippines' Sovereign Credit Outperforms During EM Risk-Off Periods, Stay Overweight A negative outlook on overall EM sovereign credit warrants overweighting Philippine sovereign credit relative to its EM brethren. The reason is the defensive nature of the Philippine sovereign bond market – just like its equity market. During periods of stress, Philippine sovereign spreads widen much less than its EM peers. Chart 15 shows that in each of the last three risk-off periods (2008-09, 2015, 2020), Philippine sovereign credit massively outperformed the EM benchmark. The basis for the defensive features of Philippine sovereign credit is that the nation’s external public debt is quite low at 18% of GDP, down from 25% ten years back. Of this, foreign bonds outstanding are 10% of GDP, down from 12% ten years back (the rest being loans and contingent liabilities). Such low debt means the defensive nature of this market is unlikely to change soon. Hence, it makes sense to overweight Philippine sovereign bonds in view of impending sovereign credit spreads widening in the broader EM universe. Investment Conclusions Stocks: The Philippine economy will likely see some traction in the months ahead as fiscal spending rises and bank credit revives. This bourse’s relative performance will also benefit in an impending risk-off period in emerging markets. Asset allocators should upgrade this market from underweight to neutral in an EM equity portfolio. Our underweight call on this market vis-à-vis an EM equity portfolio has yielded a gain of 16% since we recommended it in October 2018. The Peso: The peso remains vulnerable in the face of deteriorating external accounts. Currency investors should stay with our recommended long USD/ short PHP trade for now. This call has yielded 2.1% so far since our recommendation on March 18, 2021. Chart 16Philippine Domestic Bonds Warrants A Neutral Allocation In An EM Portfolio Domestic Bonds: Local currency bond yields in the Philippines are likely to stay flattish despite the slated improvements in the country’s fiscal balance. The peso is also set to stay weak. These call for a cautious stance on Philippine domestic bonds. Yet, they tend to do well relative to their EM counterparts during periods of EM stress – as they did in 2015 and in 2020 (Chart 16). Since another such period is around the corner, we recommend that investors maintain a neutral allocation of Philippine local currency bonds in an EM portfolio.    Sovereign Bonds: Philippine sovereign bonds are set to outperform their EM counterparts. Asset allocators should stay overweight the Philippines in a dedicated EM sovereign bonds portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 Passed in the third and final reading in the lower house and sent to the Senate, the upper house.

Highlights There is a high risk of a global demand shortfall in 2022. This is because consumer demand for services will remain well below its pre-pandemic trend… …while the recent booming demand for goods is crashing back to earth. Stay overweight 30-year T-bonds. In the equity market, underweight the ‘reflation’ sectors: specifically, underweight banks and basic resources. Stay overweight animal care. Overweight the interactive entertainment sector (look out for a Special Report on this sector coming out very soon). Fractal analysis: Overweight gas distribution. Feature Chart of the WeekSpending On Services In The US Is Still Far Below The Pre-Pandemic Trend. Will It Catch Up In 2022? With inflation surging, you would be forgiven for thinking that global demand is red-hot. Sadly, global demand is not red-hot. Two years after the pandemic began, the lynchpin of demand – consumer spending on services – remains far below its pre-pandemic trend. For example, US consumer spending on services is around $420 billion, or 5 percent, below where it should be (Chart I-1). A similar story holds true in the UK and France (Chart I-2 and Chart I-3). Chart I-2Spending On Services Is Still Far Below The Pre-Pandemic Trend In The UK... Chart I-3...And France Still, overall US consumer spending is on trend. Just. But only thanks to an unprecedented largesse of fiscal and monetary stimulus. Begging the question, what will happen when the stimulus ends? If overall stimulated spending is just on trend while spending on services is in deficit, it means that spending on goods is in a mirror-image $420 billion surplus. Which, given the smaller share of spending on goods, equates to 8 percent above where it should be. One misconception is that the surplus in goods spending is concentrated in durables. While this was true six months ago, two-thirds of the current surplus is in nondurables, dominated by clothing and shoes, food and drink at home, and games, toys and hobbies (Chart I-4). Chart I-4US Overspend On Durables Is Now $140 Bn, While Overspend On Nondurables Is $280 Bn Looking ahead, if the demand for goods crashes back to earth, as seems to be happening now, then the demand for services will have to catch up to its pre-pandemic trend. Otherwise there will be a deficit in aggregate demand. So, the crucial question for 2022 is, will services spending catch up to its pre-pandemic trend? Services Spending Will Remain Well Below Its Pre-Pandemic Trend Many people believe that the deficit in US services spending is due to the underspend in bars, restaurants, and hotels. In fact, this is another misconception. The underspending on ‘food services and accommodations’ is now a negligible $30 billion out of the $420 billion deficit. In which case, where is the deficit? Surprisingly, the biggest component is a $160 billion underspend on health care (Chart I-5). In particular, the spending on ‘outpatient physician services’ levelled off a year ago well below its pre-pandemic level (Chart I-6). A plausible explanation is that many doctor’s appointments have shifted to online, requiring much lower spending. The result is that health care consumption has slowed its convergence to the pre-pandemic trend, implying that a deficit could be persistent. Chart I-5US Underspend On Health Care ##br##Is $160 Bn Chart I-6US Spending On Physician Services Is Far Below The Pre-Pandemic Trend A second major component of the deficit is a $110 billion underspend on recreation services, as consumers have shunned the large or dense crowds in amusement parks, sports centres, spectator sports, and theatres. Some of this shunning of crowds will be long-lasting (Chart I-7). Chart I-7US Underspend On Recreation Services Is $110 Bn A third major component of the deficit is a $60 billion underspend on public transportation, as people have likewise shunned the personal proximity required in mass transit systems and aeroplanes. Some of this shunning of transport that requires personal proximity will also be long-lasting (Chart I-8). Chart I-8US Underspend On Public Transportation Is $60 Bn Worryingly, the recent spending on both recreation services and public transportation has stopped converging with the pre-pandemic trend. Admittedly, this might be a blip due to the delta wave of the pandemic, and spending could re-accelerate once this wave subsides. On the other hand, it would be prudent to assume that the delta wave was not the last wave of the pandemic and that further waves could arrive in 2022. Pulling all of this together, large parts of services spending will remain persistently below their pre-pandemic trend. Eventually, new and innovative types of services will plug this deficit, but this will take time. Therefore, we conservatively estimate that, at the end of 2022, US consumer spending on services will still be below its pre-pandemic trend by at least $200 billion, or 2.5 percent. Other major economies, like the UK and France, will suffer similar deficits. Goods Spending Will Crash Back To Earth Let’s now switch to the other side of the ledger, and assess to what extent the underspend in services can be countered by an overspend in goods. Spending on durables is already crashing back to earth. A surplus of $500 billion in March has collapsed to $140 billion now, and we fully expect it to fall back to zero. The reason is that durables, by their very definition, provide long-duration utility. Meaning that there are only so many cars, smartphones, and gadgets that any person can own. But what about the current $280 billion surplus on nondurables – can that be sustained? The biggest component of the nondurables surplus is a $85 billion, or 20 percent, overspend on clothes and shoes. Some of this overspend is justified by a wardrobe transition to the post-pandemic way of working and living. But clothes and shoes, though classified as nondurable, are in fact quite durable. Meaning that once the wardrobe transition is complete, we do not expect people to spend 20 percent more on clothes and shoes than they did before the pandemic (Chart I-9). Chart I-9US Overspend On Clothes And Shoes Is $85 Bn A second major component of the nondurables surplus is a $75 billion, or 7 percent, overspend on food and beverages at home. To a large extent, this has been a displacement of the underspending on eating and drinking out. But given that this underspend on eating and drinking out has almost normalised, we expect the overspend on eating and drinking at home to fade (Chart I-10). Chart I-10US Overspend On Food And Drink At Home Is $75 Bn A third major component of the nondurables surplus is a $45 billion, or 16 percent, overspend on recreational items: games, toys, hobbies, and pets and pet products (Chart I-11 and Chart I-12). To a large extent, this has been a displacement of the underspend on recreation services involving crowds, which will last. Hence, we expect the nondurable surplus on recreational items also to last, to the benefit of the animal care sector and the interactive (electronic) entertainment sector. Chart I-11US Overspend On Games, Toys, And Hobbies Is $45 Bn Chart I-12Spending On Pets Is ##br##Booming Pulling all of this together, we expect the $140 billion surplus on durables to disappear fully, and the $280 billion surplus on nondurables to fade to well below $200 billion. Therefore, given that the deficit on services is likely to be above $200 billion, there is a high risk of a consumer demand deficit in 2022. Four Investment Conclusions The ultra-long end of the bond market is figuring out that without sustained above-trend demand, you cannot get sustained inflation. And to repeat, if demand is barely on trend after an unprecedented largesse of fiscal and monetary stimulus, then what will happen when the stimulus ends? All of which leads to four investment conclusions: Stay overweight 30-year T-bonds. In the equity market, underweight the ‘reflation’ sectors: specifically, underweight banks and basic resources. Stay overweight animal care. Overweight the interactive entertainment sector (look out for a Special Report on this sector coming out very soon). Gas Distribution Is Oversold Finally, one of the paradoxes of skyrocketing natural gas prices is that it has badly hurt the gas distributors which, for the most part, have not been able to pass on the higher prices in full to end users. The resulting margin squeeze has caused a sharp recent underperformance, which is now fragile on its 65-day/130-day composite fractal structure (Chart I-13). Chart I-13Gas Distribution Is Oversold Given this fractal fragility combined with the recent correction in natural gas prices, a recommended trade would be to overweight global gas distribution versus banks, setting a profit target and symmetrical stop-loss at 5 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com 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 ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields ##br##- Asia Chart I-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Highlights Fed/BoE: Both the Fed and the Bank of England found ways to talk down 2022 rate hike expectations discounted in US and UK bond markets. This is only a temporary reprieve, however, as the near-term uncertainties over the persistence of cost-push inflation will eventually be overwhelmed by medium-term certainties of demand-pull inflation confirmed by tightening labor markets. Stay underweight US Treasuries and UK Gilts in global bond portfolios. US Treasury Curve: Longer-term US Treasury yields are priced too low relative to the likely peak in the fed funds rate in the next cycle. Position for a steeper US Treasury curve until Fed rate hikes are imminent, which will likely not be until Q4/2022. Feature Chart of the WeekShifting Rate Expectations Driving Bond Yields As QE Fades Bond market uncertainty about future monetary policy moves is on the rise. Bond volatility has picked up, most notably at the front end of yield curves that are most sensitive to rate hike expectations which have been intensifying. Yet last week, the Federal Reserve and Bank of England (BoE) were able to talk bond investors off the ledge – at least, temporarily - by pushing back against expectations of multiple rate hikes in the US and UK in 2022. Central bankers in those countries are stuck in a difficult spot. Inflation is high enough to warrant some tightening of monetary policy. Yet there are lingering concerns over how long the current upturn in global inflation will last. Meanwhile, there are just enough questions on the underlying pace of economic momentum to require policymakers to see more data, especially in labor markets, before feeling comfortable enough to pull the trigger on actual rate hikes. We now see that happening first in the UK early next year, and in the US in late 2022. One thing that is certain is that the ups and downs of interest rate expectations – and the central bank forward guidance that influences them – will increasingly become the more dominant driver of bond yields and yield curve shape as global pandemic bond-buying programs get wound down (Chart of the Week). On that front, we see more potential for bond-bearish steepening in the UK and US over the next several months. The BoE: Another Bad Date With The Unreliable Boyfriend The UK financial press infamously dubbed the BoE “the unreliable boyfriend”, under the leadership of former Governor Mark Carney, for hinting at interest rate increases that never materialized. At last week’s Monetary Policy Committee (MPC) meeting, rates were kept unchanged in a 7-2 vote despite some intense signaling in recent weeks that a rate hike was imminent. Under current BoE Governor Andrew Bailey, this edition of the MPC is more like an indecisive spouse than unreliable boyfriend. On the one hand, there is a clear overshoot of UK inflation (and inflation expectations) that would justify a rate hike as soon as possible (Chart 2). The BoE’s new economic forecasts presented in the November Monetary Policy Report (MPR) called for headline CPI inflation to reach a peak of 5% in April 2022 – significantly higher than the 4% late-2021 forecast from the August MPR. On the other hand, high current inflation is already having a dampening effect on economic sentiment. The GfK index of UK consumer confidence is down -10% from the peak seen in July, despite diminishing concerns over COVID seen in public opinion polls (Chart 3, middle panel). A similar divergence is evident in the BoE’s Decision Maker Panel survey of UK Chief Financial Officers, which showed that uncertainty over future sales was somewhat elevated compared to diminished concerns about COVID and Brexit (bottom panel). Chart 2Fed/BoE Cannot Stay Dovish For Much Longer Chart 3High UK Inflation Raises Growth Uncertainty The BoE highlighted these divergences in economic sentiment series in the November MPR as examples of how high inflation, fueled by global supply chain disruptions and soaring energy prices, introduced uncertainty into the central bank’s forecasts. Even more uncertainty exists in the BoE’s ability to assess the amount of spare capacity, and underlying inflationary pressure, in the UK economy. The BoE dedicated a 9-page section of the November MPR to a discussion about estimating the growth of the supply-side of the UK economy, evidence of how difficult that process has become during the COVID era. The BoE concluded that the pandemic would end up reducing the level of UK potential supply by -2% from pre-COVID levels, even though the growth rate would return to a pre-pandemic pace of around 1.5% by 2023-24. This is a combination that makes setting monetary policy tricky. Reduced supply indicates that the UK economy has a smaller output gap with more inflationary pressure that would require higher interest rates. Yet sluggish growth in potential supply implies that the UK equilibrium interest rate is likely still very low, thus the BoE would not have to raise rates much to get policy back to neutral. This uncertainty over the size of the output gap in the UK economy will force to BoE to focus more on the labor market as the best “real-time” measure of spare capacity. On that front, the evidence is also difficult to interpret. The UK unemployment rate fell to 4.5% over the three months to August, the last available data before the UK government’s COVID furlough schemes, which protected worker incomes hit by COVID job losses, ended on September 30. The UK Office of National Statistics estimates that there were between 900,000 and 1.4 million UK workers furloughed in late September, representing a significant source of labor supply to be absorbed when the government income assistance ends. Thus, the BoE would need to see at least a month or two of post-furlough employment reports – not just job growth, but labor force participation - to assess how quickly those workers were being reabsorbed into the UK labor market. By the BoE’s own estimates, the impact of the furlough schemes, combined with the compositional issues arising from pandemic job losses being borne more by lower-wage workers, boosted UK wage growth by 2.2% (Chart 4, bottom panel). “Underlying” wage growth, net of those effects, is 0.6%, above the pre-COVID peak, suggesting a tightening labor market before the return of furloughed workers to the labor force. In the end, we see the BoE’s November non-hike as nothing more than a delay of the inevitable. While a December hike is possible, this would represent a “double tightening” of monetary policy with the current BoE quantitative easing program set to expire at year-end. The more likely date for a rate hike is now February. This would give the MPC a few months of post-furlough labor data to assess the amount of spare capacity in UK labor markets. We expect the data to show enough underlying health in labor demand relative to supply for the BoE to conclude that accelerating wage growth represents a more sustainable form of UK inflation in 2022 than energy prices or supply-chain disruptions were in 2021, justifying a move to begin hiking rates. We continue to recommend positioning for a steeper UK Gilt curve, focused on longer-maturities where yields were too low relative to even a moderate future BoE rate hike cycle (Chart 5). We entered a new tactical butterfly spread trade last week, going long the 10-year Gilt bullet versus a duration-neutral 7-year/30-year barbell – we continue to like that trade as a way to play for eventual BoE rate hikes in the first half of 2022. Chart 4BoE Needs More Employment Data To Confirm Wage Uptrend Chart 5Stay In UK Long-End Gilt Curve Steepeners Bottom Line: The Bank of England is still on a path to begin rate hikes, either in December or, more likely, February of next year. Stay underweight UK Gilts. Position For A Steeper US Treasury Curve The Fed announced last week that tapering would begin right away in November, in a move that has been hinted at since the summer. The monthly pace of purchases of Treasuries and Agency MBS will decline by $10 billion and $5 billion, respectively in November and also December. The Fed declined to commit to any specific tapering amounts beyond that, although it seems likely that the same monthly pace of reduction will continue in 2022. This would take the buying of Treasuries and MBS, net of maturing debt, to zero by June of next year, clearing the first necessary hurdle before the FOMC could contemplate a hike in the funds rate. A completion of the taper by June has been hinted at in the speeches of several Fed officials in recent weeks. This is a bit faster than the expected pace of tapering seen in the most recent New York Fed Primary Dealer and Market Participant Surveys from September (Chart 6), but should not be categorized as a hawkish surprise. There were also few bond-bearish signals on future policy moves hinted at by Fed Chair Jay Powell in post post-FOMC meeting press conference. Chart 7Upside Risk To UST Yields From A Tightening Labor Market Powell did note that it was still not clear how long the current supply chain/commodity price driven surge in inflation would persist into next year. The expectation, however, was that these forces would eventually subside and allow US inflation to return back to levels much closer to the Fed’s 2% target. Given the uncertainties in the timing of that peak and decline in US inflation, the Fed has limited ability to calibrate any post-taper rate hikes by focusing solely on inflation - especially with longer-term inflation expectations still at levels consistent with the Fed’s target. The Fed will continue to look at US labor market developments to determine the timing and pace of future rate hikes. The last set of FOMC economic projections compiled for the September meeting have the US unemployment rate falling to 3.8% next year, below the median FOMC estimate of full employment at 4%, with one 25bp rate hike penciled in for 2022. We can use that as a baseline assumption on what the Fed considers to be the level of “maximum employment” that would need to be reached before rate hikes could begin. The US unemployment rate fell to 4.6% in October, thus there is still some more to go before hitting that 3.8% rate hike threshold. Yet among the FOMC members, the estimates of full employment range from 3.5%-4.5%, so the October print did knock on the door of that range (Chart 7, middle panel). With US wage growth already showing signs of breaking out – the Atlanta Fed Wage Tracker hit a 14-year high of 14% in September (bottom panel), while the Employment Cost Index rose by a record quarterly pace of 1.3% in Q3 – the Fed will likely be under a lot of pressure to begin hiking rates soon after the taper is expected to end next June. Chart 8UST Curve Forwards Too Flat Vs. Likely Fed Rate Hikes We still see December 2022 as the most likely liftoff date, although a faster decline in unemployment could move that timetable forward. The bigger issue for the US Treasury market, however, is not the timing of liftoff but how fast the pace of hikes will be afterward. On that note, future rate expectations are still far too low. For example, according to the New York Fed’s Primary Dealer Survey, the fed funds rate is expected to average only 1.7% over the next ten years (top panel), a level that has proved to be a ceiling for the 10-year Treasury yield so far in 2021. Our colleagues at BCA Research US Bond Strategy recently made the case for expecting the US Treasury curve to bearishly steepen in the coming months. In their view, longer-maturity Treasury yield forward rates were too low compared to a fair value determined by the likely path for the funds rate that assumes rate hikes start in December of next year and rise by 100bps per year to a terminal rate of 2.08% (Chart 8). Interestingly, 2-year Treasury forward rates were in line with the projections of our US Bond Strategy team’s fair value framework. We fully agree with our US Bond colleagues on the likelihood of future Treasury curve steepening. This fits with our views on many developed market countries, not just the US, where longer-maturity bond yields were pricing in too few future rate hikes relative to what was likely to occur over the next few years. Even when taking a much longer perspective, the US Treasury curve looks too flat right now. Going back to the mid-1980s, the current 2-year/10-year US Treasury curve slope of just over 100bps has never been reached (in a flattening move) in the absence of actual Fed rate hikes (Chart 9). Chart 9UST Curve Has Never Been This Flat Without Some Actual Fed Rate Hikes This week, we are adding a new trade to our Tactical Overlay table to benefit from this expected move in the US yield curve, a US Treasury 2-year/10-year curve steepener (combined with a position in cash, or US 3-month treasury bills, to make the entire trade duration-neutral). We are also taking profits on our previous Tactical US curve flattening trade, which has returned 0.84% since initiation back in June. The exact securities and weightings for our new trade can be found in the Tactical Overlay Trades table below. Bottom Line: Longer-term US Treasury yields are priced too low relative to the likely peak in the fed funds rate in the next cycle. Position for a steeper US Treasury curve until Fed rate hikes are imminent, which will likely not be until Q4/2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Overlay 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 Fed: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Nominal Treasuries: We project that Treasury securities will still deliver negative total returns, even if Fed liftoff is delayed until December 2022. Investors can protect returns by favoring the 2-year note (long 2yr over cash/10yr barbell) and 20-year bond (long 20yr over 10yr/30yr barbell). TIPS: Investors should short 2-year TIPS outright in anticipation of falling short-dated inflation expectations during the next 12 months. The Taper Is Done, Now Onto Liftoff The Fed announced a tapering of its asset purchases last week and the details of the tapering plan were consistent with what had already been signaled to the public. The Fed will purchase $70 billion of Treasuries this month (compared to $80 billion in October) and $35 billion of agency MBS (down from $40 billion in October). It will then reduce monthly Treasury and MBS purchases by $10 billion and $5 billion each month, respectively, until it reaches net zero asset purchases by June of next year (Chart 2). The Fed didn’t give specific guidance on what will happen with the balance sheet after June, but it’s highly likely that it will follow the pattern of the last tightening cycle and keep the balance sheet flat for a long time, until the fed funds rate is well above the zero bound. The Fed also gave itself the option to increase or decrease the pace of purchases if such changes are warranted by the economic outlook, but it would take a major shock to knock the Fed off its pre-set course. Chart 1The Market's Liftoff Expectations Chart 2Net Purchases Will Reach Zero By June With the tapering announcement out of the way, the Fed can now turn to the more important question of when to start lifting interest rates. Jay Powell made it clear at last week’s press conference that the committee hasn’t yet formally taken up the issue, but that didn’t stop reporters from pressing the Chairman to provide more details about when the Fed will hike. None of that should be too surprising. There’s intense market interest and a great deal of uncertainty about the timing of Fed liftoff. Two months ago, markets were pricing-in no rate hikes at all in 2022. Now, markets are looking for Fed liftoff at the September 2022 FOMC meeting and are discounting a 90% chance of 2 rate hikes by the end of next year (Chart 1). The Fed’s Thinking On Liftoff So, what did we learn from last week’s FOMC Statement and press conference about how the Fed is thinking about the liftoff date? First, we know from previous comments that the Fed would prefer to reduce net asset purchases to zero before it starts lifting rates. This means that the July 2022 FOMC meeting is the first “live meeting” where a rate hike could possibly occur, and the fed funds futures market is already pricing-in a 74% chance that liftoff will occur at that meeting (Chart 1). We aren’t so sure. In fact, we don’t see the Fed lifting rates until December 2022, and Chair Powell’s comments about inflation at last week’s press conference only increased our confidence in that view. On inflation, Powell echoed comments by Fed Governor Randal Quarles that we flagged in a recent report.1 Both Powell and Quarles put less emphasis on the length of time that inflation remains above the Fed’s target and more emphasis on the causes of that inflation and whether it’s appropriate for the Fed to lean against it. Here’s Powell from last week (emphasis added): Supply constraints have been larger and longer lasting than anticipated. Nonetheless, it remains the case that the drivers of higher inflation have been predominantly connected to dislocations caused by the pandemic, specifically the effects on supply and demand from the shutdown, the uneven reopening, and the ongoing effects of the virus itself. Our tools cannot ease supply constraints. Like most forecasters, we continue to believe that our dynamic economy will adjust to the supply and demand imbalances, and that as it does, inflation will decline to levels much closer to our 2 percent longer-run goal. Of course, it is very difficult to predict the persistence of supply constraints or their effects on inflation. Global supply chains are complex; they will return to normal function, but the timing of that is highly uncertain.2 Essentially, Powell is pointing out that it would be a mistake for the Fed to tighten policy to bring down inflation only to find out that the economy’s natural supply side response was about to do so anyways. The Fed would have dragged down aggregate demand for no reason. So what would cause the Fed to lift rates? We see two potential triggers. The first liftoff trigger would be an assessment by the FOMC that the labor market has reached “maximum employment”. This is the liftoff condition that the Fed has officially set for itself. The second liftoff trigger would be an uncomfortable increase in long-dated inflation expectations. A spike in long-dated inflation expectations would be worrying enough that the Fed would abandon its “maximum employment” goal and tighten earlier. The “Maximum Employment” Trigger Chart 3How Far From "Maximum Employment"? The concept of “maximum employment” brings a whole host of other issues along with it. How will the Fed know if the labor market is at “maximum employment”? We’ve discussed this topic at length ourselves and have come to a few helpful conclusions.3 First, we can infer from the most recent Summary of Economic Projections that the Fed views an unemployment rate of 3.8% as roughly consistent with “maximum employment”. It is therefore highly unlikely that the Fed will even consider declaring victory on its employment goal until the unemployment rate is in the vicinity of 3.8%, down from its current 4.6% (Chart 3). Second, there are good reasons to believe that the aging of the US population and the recent sharp increase in retirements will prevent the labor force participation rate from re-gaining its pre-pandemic level. However, FOMC participants seem to agree that the prime-age (25-54) labor force participation rate should be close to its February 2020 level for the “maximum employment” condition to be satisfied (Chart 3, bottom panel). Chair Powell even specifically referenced the prime-age participation rate at last week’s press conference. We think a declaration of “maximum employment” will only occur once the unemployment rate is near 3.8% and the prime-age (25-54) labor force participation rate is near its February 2020 level of 82.9%, up from its current 81.7%. It’s unlikely that these conditions will be met in time for a July 2022 rate hike. The Appendix to this report updates our scenarios for the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and participation rates by specific future dates. Our scenarios use the overall participation rate (not the prime-age one), but we think the scenarios derived from the New York Fed’s Surveys of Market Participants and Primary Dealers come close to capturing reasonable conditions for “maximum employment”. Based on those scenarios, we calculate that average monthly nonfarm payroll growth of 602k to 733k is required to reach “maximum employment” by June 2022. Conversely, average monthly payroll growth of only 379k to 455k is required to reach “maximum employment” by December 2022. We see the latter as easily achievable and the former as more of a stretch. On the topic of employment growth, it’s worth noting that both monthly nonfarm payroll growth and the prime-age labor force participation rate were dragged down by the spread of the Delta variant during the past few months (Chart 4). With new COVID cases falling, we should see stronger payroll growth and a higher prime-age part rate in the months ahead. Relatedly, falling COVID cases will also help alleviate some the constraints on labor supply as workers grow less fearful of the virus and more confident about re-entering the labor force. This will not only push prime-age participation higher, but it will also take some of the sting out of wage growth. Wage growth has been extremely high recently as the number of job openings has far outpaced the number of new hires (Chart 5). Fading COVID fears should increase the pace of hiring and slow wage growth. This will give the Fed even more confidence that it should stay the course. Chart 5Peak Wage Growth? The Inflation Expectations Trigger Chart 6Inflation Expectations Are Well-Anchored We noted above that the Fed would abandon its “maximum employment” liftoff condition if long-dated inflation expectations rose to uncomfortably high levels. Specifically, we like to track the 5-year/5-year forward TIPS breakeven inflation rate relative to a target range of 2.3% to 2.5% (Chart 6). As long as the 5-year/5-year breakeven rate stays within that range or below, the Fed will be guided by its “maximum employment” goal. However, if that rate were to break above 2.5% for a significant period of time, the Fed would be sufficiently worried about an expectations-driven inflationary spiral that it would abandon its “maximum employment” trigger and bring forward the liftoff date. We don’t expect to see a breakout above 2.5% in the 5-year/5-year forward TIPS breakeven inflation rate anytime soon. The rate has stayed well contained throughout the past few months even as inflation skyrocketed. It would be strange for it to suddenly spike after inflation has already peaked.4 Bottom Line: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Treasury Market Positioning For A December 2022 Liftoff To determine how we should position within the Treasury market, we translate our above views on the timing of Fed liftoff into fair value estimates for different segments of the Treasury curve. Specifically, we assume a scenario where the Fed starts hiking in December 2022 and then lifts rates at a pace of 100 bps per year until reaching a terminal rate of 2.08%. That 2.08% terminal rate is based on an expected target range of 2%-2.25% that is inferred from responses to the New York Fed’s Surveys of Market Participants and Primary Dealers. We assume that the effective fed funds rate will trade 8 bps above the lower-bound of its target range, as it does currently. Table 1 shows expected 12-month total returns for each Treasury maturity, assuming the market moves to fully price-in our expected funds rate path during the next year. Table 1Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.08% Terminal Rate The first observation that jumps out is that, except for the 2-year and 20-year maturities, expected Treasury returns are negative across the board. This justifies sticking with our recommended below-benchmark portfolio duration stance. Second, our expectation that liftoff will be delayed relative to current market expectations gives the 2-year note slightly better expected returns, particularly relative to the 10-year note. As a result, we advise investors to hold 2/10 yield curve steepeners. Specifically, investors should go long the 2-year note versus a duration-matched barbell consisting of the 10-year note and cash. Third, the 20-year bond looks to be priced cheaply on the curve. It offers expected 12-month returns of +79 bps while the 10-year note and 30-year bond are both projected to lose money. We recommend taking advantage of this situation by going long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This proposed trade offers positive carry of 20 bps (Chart 7). Further, the 10/20 slope is stuck in the middle of where it was on the 2015 and 2004 liftoff dates (Chart 7, panel 2). The 20/30 slope, meanwhile, is inverted and well below where it was on the 2015 and 2004 liftoff dates (Chart 7, bottom panel). Our 20 over 10/30 trade will profit as the 20/30 slope re-steepens, even if the 10/20 slope doesn’t move that much. Chart 7Buy 20s Versus 10s30s It could be argued that our recommend trades are all predicated on a fed funds rate scenario that embeds too low of a terminal rate. In fact, the median projection of FOMC participants would place the terminal rate closer to 2.5% than to 2%. If we alter our scenario by increasing the terminal rate assumption from 2.08% to 2.58%, it only improves the outlook for our recommended positions (Table 2). Table 2Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.58% Terminal Rate In the new scenario, expected Treasury returns are more negative – especially at the long-end. However, the 2-year note is still expected to earn a small profit. Our 20 over 10/30 trade performs slightly worse in this second scenario compared to the first one (+1.79% versus +1.95%), but it is still expected to make money.  TIPS Chart 8A Lot Of Upside In Short-Maturity Real Yields We have one final government bond recommendation based on our expectation that Fed liftoff will be delayed until December 2022. That trade is to go short 2-year TIPS. Alternatively, investors could enter 2/10 inflation curve steepeners or 2/10 real yield curve flatteners. Our base case economic outlook is that supply side constraints (both in global supply chains and in the labor market) will loosen during the next 12 months. This will push down short-dated inflation expectations while long-dated inflation expectations stay relatively close to the Fed’s target. If we assume that both the 2-year and 10-year TIPS breakeven inflation rates trend towards the middle of the Fed’s 2.3% to 2.5% target range during the next 12 months and that the nominal 2-year and 10-year yields follow the paths predicted by the fair value scenario presented in Table 1, then we see that the 2-year real yield has a lot of upside (Chart 8). This is true both in absolute terms and relative to the 10-year real yield. We advise investors to short 2-year TIPS outright. Alternatively, 2/10 inflation curve steepeners or 2/10 real yield curve flatteners will also perform well during the next 12 months. Bottom Line: We suggest four different ways that bond investors can profit from the Fed delaying liftoff until December 2022. Investors should keep portfolio duration low, enter 2/10 nominal curve steepeners, buy the 20-year T-bond versus a 10/30 barbell and short 2-year TIPS.  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 3.7% and a participation rate of 62.7%. 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 +455k in order to hit “maximum employment” by the end of 2022. 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. Chart A2Tracking Toward Fed Liftoff 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. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 2 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20211103.pdf 3 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 4 For more details on our inflation outlook please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns