Developed Countries

Highlights The Biden administration’s budget reconciliation bill will close the output gap, so markets will have to start thinking about upcoming tax hikes, rising wages, and eventual Fed interest rate hikes. Biden’s lax immigration policies will not have a major negative impact on wage growth. A doubling of the minimum wage, which could still make it into one of two budget reconciliation bills, would include a measure to index the post-2026 minimum wage to the average rate of wage rises. Biden’s industrial policy and support of labor unions would also increase wages. Stay long Treasury inflation-protected securities versus duration-matched Treasuries and long value stocks over growth stocks.  Feature The Senate and House of Representatives passed a concurrent resolution on the budget for FY2021, the first step in the budget reconciliation process that will enable Democratic leadership to pass President Joe Biden’s $1.9 trillion American Rescue Plan with only a simple majority in the Senate. The budget resolution is a fantasy that the ruling party uses to bypass the Senate filibuster, as was the case under George W. Bush, Barack Obama, and Donald Trump. The latest such resolution claims that the budget deficit will be smaller, not larger, after the Biden rescue plan than what is currently projected by the Congressional Budget Office (Chart 1). It envisions the entire $1.9 trillion being spent in 2021 and then a huge drop in expenditures in 2022. A fiscal cliff ahead of the 2022 midterm election will not occur. Instead the second budget reconciliation maneuver, for FY2022, will increase spending levels once again with infrastructure and green projects, as per Biden’s campaign platform. Chart 1Democrats Pass Budget Resolution The FY2021 budget resolution does not contain any tax increases, “revenue offsets,” to keep the budget in line because the COVID relief is emergency spending that is one-off, not recurring. The FY2022, however, will aim partially to repeal President Trump’s tax cuts. As such financial markets will continue to “buy the rumor” of additional fiscal spending for now but they will also sell the news given that the next reconciliation bill will push up inflation expectations even further, hasten the Federal Reserve’s policy normalization, and include tax hikes. And the current buy-the-rumor phase could be interrupted anyway by Biden’s immediate foreign policy challenges. Larry Summers And The Output Gap Democrats will err on the larger side of the $1.9 trillion stimulus because they regret erring on the smaller side back in 2009. But it is still possible for the price tag to be knocked down to around $1.5 trillion given that the economy is recovering and several moderate Democrats will balk at the enormous size. After all, $900 billion passed at the end of the year is not yet spent. Biden has already compromised by raising the eligibility requirements for households to receive $1,400 stimulus checks. Larry Summers, a frequent guest at the annual BCA conference and a veteran of the Clinton and Obama White Houses, has stirred up a firestorm over the past month by warning that too much federal money spent on short-term cash handouts today would crowd out the administration’s political capital and the amount of deficit spending that is available for long-term, productivity-enhancing investments. Summers warned that the current proposed stimulus is three times larger than required to fill the output gap. Chart 2 shows the output gap from 2009-12 and projected from 2021-24 alongside the size of the relevant stimulus packages to illustrate his point. Treasury Secretary Janet Yellen defended the $1.9 trillion price tag – like Summers, she is not normally one to worry about overheating the economy, but unlike Summers, she is now an administration official. She predicted that this size of package would bring the economy back to full employment by next year. The Congressional Budget Office, based on earlier congressional actions, had predicted employment would not return to its pre-COVID level until around 2024. The administration will look to Yellen now and in future to make the call on when enough stimulus is enough. With inflation expectations recovering rapidly, the Fed could be forced to hike rates as early as late 2022, though we think 2023 is more likely given our methodological bias as political analysts. This means the scope for overheating is quite large – a point reinforced by the comparison with the economic recovery back in 2009 (Chart 3). Summers’s criticism is not remiss and could come back to haunt the administration.1 When inflation picks up, the Fed will have to allow an overshoot according to its new policy of targeting average inflation. But once it is assured, it will have to start hiking rates. And once it starts hiking rates it could trigger a recession. Plus, even if we set recession risks aside, Summers’s critical point is that too much stimulus today will reduce the political and budgetary scope for Biden’s long-term agenda, which includes what will likely be his second major bill focused on infrastructure and renewables. The reconciliation process makes it highly likely that Democrats will drive through this initiative through the Senate but not if moderate Senate Democrats balk in the face of rising budget deficits and inflation. Chart 2How Much Is Too Much Stimulus? Our base case still holds that Democrats will pass both reconciliation bills over the next roughly 12 months but investors should keep Summers’s warning in mind. Chart 3Recovery Is Ahead Of The Previous Cycle There are tailwinds for Biden’s agenda. First, his political capital is moderate-to-strong and likely to strengthen over the coming year. It will get bumped up by improving economic conditions, including most recently a marked decline in bankruptcy filings from Q3 to Q4. Our updated Political Capital Index is shown in the  Appendix. Second, concern about budget deficits has eroded, as Republican fiscal largesse showed under Trump – the pandemic and atmosphere of crisis greatly reinforce this point. Third, divisions in the Republican Party have produced as many as five moderates who could assist Biden in winning close legislative votes – even beyond the relatively easy passage of the American Rescue Plan in his honeymoon period. This Republican Party split is the only significance of President Trump’s second impeachment. Trump’s legal woes will continue after he is acquitted in the Senate. The deeper Republicans are divided over Trump’s legacy the harder time they will have recovering in the 2022 midterms, where opposition parties are normally favored. But the Biden administration’s leftward agenda will bring Republicans together, especially once the country moves out of the crisis. One of the biggest battles looms over the southern border. Bottom Line: The $1.9 trillion American Rescue Plan will more than close the output gap and yet it is only one of two budget reconciliation bills that the Biden administration will seek to pass over the next 12 months. There are still domestic and international factors that could impede the recovery, not least China’s policy tightening, but the risk of excessively short-term stimulus at the expense of long-term public investment is clear. Republicans Will Regroup Over Immigration To Summers’s warning about Biden’s legislative window of opportunity, recall that President Trump never achieved his signature 2016 policy promise – to build a wall on the border with Mexico – because congressional Republicans led him to prioritize repealing and replacing the Affordable Care Act (which failed) and passing the Tax Cut and Jobs Act (which succeeded). There was no political capital left for a major legislative push on the border and immigration. Immigration is one of the areas where Biden has a major incentive to push his policies aggressively. Immigrants tend to skew Democratic in their party affiliations. Americans increasingly believe immigration should be increased, a trend that accelerated after Trump’s election on an avowedly anti-immigration platform (Chart 4, top panel). Today 34% believe it should be increased in addition to 36% who are comfortable with the current level. Meanwhile the number who believe it should be decreased has fallen to 28%, down from 34%-38% around the time of Trump’s election. An anti-immigration candidate may be able to win within the Republican Party (especially under the specific circumstances of 2015-16) but he or she will have trouble winning general elections. Trump himself discarded the topic in the 2020 race. For Democrats, immigration is also probably the single most effective way to drive a wedge between the populist and establishment factions of the Republican Party. For example, establishment Republican presidents oversaw huge infusions of foreigners into US society, the 1986 Immigration and Reform Control Act, which granted amnesty to three million illegal immigrants, and the 1990 Immigration Act, which increased the quota of legal immigrants. By contrast Trump rose to power by attacking the bipartisan consensus on “open borders.” As long as a substantial cohort of Republicans defends immigration on free market principles, and upholds the corporate interest in having plentiful availability of lower wage seasonal and specialized workers, the party will be divided. The above points explain why the Biden administration will pursue immigration reform more intently than public opinion would leave one to believe. Polls show that voters want to focus on the economic recovery, the pandemic response, and social and civil rights policies more than immigration. There is no question that Biden is prioritizing the pandemic, the economy, and health care (Chart 4, bottom panel). But the Democratic Party has a strategic interest in expanding immigration so Biden will continue to plow forward with executive orders and comprehensive immigration reform in Congress. The US does need immigration reform – to ensure the flow is orderly. President Trump’s “wall” proposal did not come out of nowhere. Like the “Know Nothing Party” that emerged in the 1840s and rose to prominence in the 1850s, the Trump movement arose amid a historic increase in the foreign-born share of the population (Chart 5). But Trump’s policies hardly made a dent in the flow of legal immigrants into the US. Now Biden will reverse them and encourage more incomers. Therefore immigration will persist as a bone of contention in the 2020s. Granted, immigration has amply attested positive effects on the economy – including most clearly by lifting the US’s fertility rate so that it does not suffer from as rapid of an aging process as other developed countries. Indeed, voters are primarily concerned about illegal, not legal, immigration. Still, Republicans will struggle to walk the line between tighter immigration policies and appealing to an audience beyond “old white folks.” This suggests the Biden administration has room to run. Chart 4Public Not Too Concerned About Immigration Chart 5Historically Large Foreign-Born Population It helps Biden that the post-World War II and post-Cold War booms in legal immigration are relatively measured when compared to the overall population. The inflow of migrants was around 0.3% in 2019, very far from its post-war peak of 0.7% per year (Chart 6). Thus the Biden administration will not be overly concerned about being too progressive on this issue. Chart 6Boom In Legal Immigration Less Impressive Relative To Population Chart 7Detainees On The Mexican Border Illegal immigration is the biggest factor motivating periodic public backlashes such as in 2016. Southwestern border apprehensions – the only credible way to measure the unauthorized flow of people over the Mexican border – spiked under President Obama as well as President Trump, though US agents detained nowhere near the numbers witnessed in the 1980s and 1990s (Chart 7). The stock of illegal immigrants in the US ranges from 10-11 million and has remained flat, or fallen slightly, since the financial crisis of 2008. The weakening of the US economy, in the context of tighter border security, reduced incentives to make the difficult journey (Chart 8). The fact that President Obama and Trump increased detentions suggests that the demand to get into the country recovered over the course of the last business cycle. Based on President Biden’s voting record in the Senate and statements during the 2020 campaign, he is not an ultra-dove on the border – but his party has moved to the left on the issue. This is clear from his rivals’ positions in the Democratic primary election. Even his Vice President Kamala Harris, who was not the most radical on stage, supported decriminalizing illegal border crossings and downgrading Immigration and Customs Enforcement. Still, until Democrats repeal the filibuster in the Senate, they will not have a chance of passing comprehensive immigration reform with Republicans unless they accept stronger enforcement provisions. Biden voted for the 2006 Secure Fence Act but more recently has emphasized high-tech upgrades to better monitor crossovers. Harris also accepted high-tech security funding that did not involve building a wall. Even with these compromises, it will still be a stretch to find 10 Republicans willing to cross the aisle on this issue while Trump and his faction remain active to punish them in primary elections. Chart 8Estimate Of Total Illegal Immigrants The demand to enter the US will revive once the pandemic is over. The big surge in illegal border crossings in the 1980s-90s coincided with a period in which US economic growth and wellbeing far outpaced that of Mexico and Central America (Chart 9). The gap in GDP per capita is the crudest possible measure and does not reflect the dramatic differences in quality of life that drive people to relocate. Nevertheless, the gap remains drastic, especially with Mexico. Chart 9The Grass Is Greener On The Other Side The gap in current economic activity, such as manufacturing PMIs, between the US and Mexico is as wide as ever. Even as manufacturing contracts in Mexico, the demand for workers in US service industries is soaring (Chart 10). Moreover the US economic revival will be super-charged by the gargantuan fiscal stimulus of 2020-21 whereas Mexican government support for the economy is comparatively austere (Chart 11) Chart 10Super-Charged US Recovery Opens Big Gap With Mexico Chart 11Less Government Support In Mexico Than US Bottom Line: Biden is opening up the borders at a time of economic disparity between the US and Latin America that will lead to an influx of immigration. This is positive for US labor force growth and productivity but it will be hard to pass a long-term solution through Congress. The Republican Party is deeply divided on the issue today but it is likely to become a rallying cry as numbers of newcomers increase and as Trump-style populism remains an active force within the party. Immigration, Wages, And The Minimum Wage   The macroeconomic and market impact of easier border and immigration controls boils down to the impact on wages. There is a vast literature on this subject and we will not pretend to be comprehensive. We will merely make a few observations. The foreign-to-native-born wage differential has narrowed substantially over the past twenty years. The discount to hire immigrants has shrunk from 24% to 15% (Chart 12). This is a reflection of the high demand for immigrant labor and especially the increase in high-skilled workers alongside the booming tech, legal, financial, personal care, and health care industries in the United States – the fastest growing sectors for foreign-born workers since 2003. Earnings growth for foreign workers is more cyclical than for native workers and has been rising faster in recent decades (Chart 13). Chart 12Immigrants Command A Higher Price Than They Used To Chart 13Immigrant Wages Grow In Boom Times Immigrants work the lowest-wage jobs and hence there is some correlation between the share of foreign-born workers in any given industry and the hourly wage, just as there was at the turn of the century (Chart 14). But it does not follow that an increase in immigration suppresses wages as a whole. Chart 15 shows that, over the last business cycle at least, a change in the foreign worker share of a given industry does not correlate with a change in wage growth. Of course, it stands to reason that increasing the supply of labor decreases the price. But not if demand is growing sufficiently to raise the price for all workers. As we have seen, since migrants are willing to undertake long and dangerous journeys for work, they are likely to go where the demand is strong and the price is right – and the flow drops when the jobs dry up. Chart 14Immigrants Work The Lowest Wage Jobs Chart 15More Immigration Not Necessarily A Pay Cut Academics debate the impact on wages. There could be a negative impact, especially for low-skilled native workers, but the aggregate effect is small. One study showed that wages for native workers fell by three percent cumulatively over the 20-year period from 1980-2000 due to immigration.2  This is not dramatic. We can test the connection between immigration and wage growth informally by plotting the growth of southwest border detentions and legal permanent residence admissions alongside that of real wages. There is no clear relationship either way (Chart 16). The same is true if we test it with real median wages – the surge in border apprehensions under President Trump coincided with a boom in wages across the spectrum.  Chart 16Border Influx Does Not Suppress Wages Thus we cannot rule out the possibility that the Biden administration’s relaxation of border controls will have a dampening effect on wages over the long run but we cannot endorse it either. Chances are that the rollout of COVID-19 vaccines and government spending will continue to power a recovery that tightens the labor market and lifts wages for most workers.   What about the administration’s simultaneous policy of doubling the federal minimum wage to $15 per hour by the year 2026 – and indexing wage growth after that date to the median hourly wage? The minimum wage hike might yet make it into the budget reconciliation bill under negotiation – but Biden has already signaled it can be delayed. There is a growing fear about the negative impact on small businesses struggling during the pandemic. The Congressional Budget Office estimates that anywhere from 1 million to 2.7 million jobs could be lost in 2025 if the wage hike were implemented now and businesses would pay $333 billion.3 But the proposal will return when the second budget reconciliation bill is up for consideration unless the Senate parliamentarian rules it out, in which case its passage becomes much less likely. Only about 2% of workers are paid at or below the current minimum wage of $7.25 per hour so a minimum wage hike but the CBO estimates that 10 percent of workers would be below the proposed wage level by 2025 (Chart 17). The states with higher proportions of minimum wage workers will be the ones most affected and are mostly in the south, including South Carolina, Mississippi, Kentucky, and Texas, though there are a few in the north such as New Hampshire and Pennsylvania (Chart 18). Chart 17Most Workers Earn More Than Minimum Wage Chart 18Minimum Wage Workers By State Previous minimum wage hikes did not prevent the economy from reaching full employment – nor did they lead to a lasting pickup in overall wage growth. But indexation to overall wage growth would mark a big change in favor of an eventual wage-price spiral. It cannot be ruled out given that the reconciliation option might be available to Democrats, though it would not take effect till 2026. Bottom Line: There is no firm link between immigration growth and wage growth. Increased immigration flows often coincide with higher incomes and wages as growth and productivity improve. Meanwhile a change in the minimum wage will have a limited impact from a macro point of view alone but a bigger impact if it is indexed to wage growth after 2026, which is possible. In the coming years the much greater impact of Biden’s policies will stem from the massive infusion of fiscal spending he is likely to pass through Congress, which will close the output gap quickly and put upward pressure on wages.    Investment Takeaways Easier immigration and a higher minimum wage are not the only Biden policies that will affect wages. One of the biggest developments since Biden took office is his confirmation that he will maintain a tougher trade policy than his predecessors, excluding Trump. Biden won the election among Midwestern blue collar voters at least partly by stealing Trump’s thunder on trade and globalization. Since taking office he has issued a “Buy American” executive order and declared that he will maintain “extreme” competition with China. His cabinet appointees – notably Antony Blinken at the State Department and Janet Yellen at the Treasury – have given words of warning to China over trade as well. Geopolitical risk is one reason we are cutting back on our participation in the market’s exuberance at the moment, given that critical foreign policy stances are likely to be tested early in Biden’s term. But there is also a long-term implication of the Democrats’ marginal increase in protectionism.   It was the overall policy context of hyper-globalization that led to sluggish wage growth in the United States over the previous forty years. A major factor was the decline of manufacturing and unionization as a result of a lack of competitiveness in the US as global production came online. The erosion in manufacturing jobs only stopped in recent years (Chart 19). Popular support for unions has risen to levels last seen in the late 1970s and 1990s since the Great Recession – under Trump even Republicans talked up unions. Chart 19Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Biden’s policies outlined above are reminiscent of the “third way” Democrats in the 1990s – particularly Bill Clinton, who oversaw an increase in the minimum wage and a surge in both legal and illegal immigration. But on trade Biden is shaping up to be more like Trump than Clinton, albeit directing his protectionism more at China than other trade partners. His spending bills will also use fiscal spending to promote industrial policy. Meanwhile labor protections will go up and unionization will at least stem its multi-decade decline.    For the stock market the risk of higher wages looms mostly due to the super-charging of the economy with stimulus. But shoring up domestic manufacturing, unions, labor perks and protections, and possibly indexing the minimum wage will contribute to faster wage growth and – to corporations – higher employment costs (Chart 20). This is a headwind to the corporate earnings outlook. But like the Biden administration’s tax hikes it is not yet affecting the market’s overall bullishness – and may not until the first reconciliation bill passes and the narrative shifts from stimulus to structural reform. Investors may soon find out that they will be dealing with higher wages, higher taxes, higher inflation, and a higher cost of capital. Chart 20Higher Wages, Lower Corporate Profits Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Table A1BPolitical Capital: Household And Business Sentiment Table A1CPolitical Capital: The Economy And Markets Table A2Political Risk Matrix Table A3Biden’s Cabinet Position Appointments     Footnotes 1     See BCA Global Investment Strategy, “Fiscal Stimulus: How Much Is Too Much?” January 8, 2021, bcaresearch.com. 2     George J. Borjas and Stephen J. Trejo, “The Evolution of the Mexican-Born Workforce in the United States,” in Borjas, ed, Mexican Immigration to the United States (Chicago: Chicago University Press, 2005), pp.13-55.     3    See “The Budgetary Effects of the Raise the Wage Act of 2021,” Congressional Budget Office, February 2021, cbo.gov.  

Today we close two high-conviction trades and place a stop buy order for the June 2021 expiry VIX futures as a hedge to the remaining positions. Homebuilders have proven to be more resilient than we expected, especially given the selloff in the bond market. Clearly the US consumer is not concerned about a rebound in rates, at least not yet. Moreover, the looming fiscal stimulus will only facilitate more excesses, even in the residential housing market, as a fresh wave of liquidity will likely more than offset the tightening in monetary conditions. Thus, we have lost confidence in our high-conviction underweight stance in this niche consumer discretionary group and are taking a loss of 11% since inception. The S&P consumer staples sector was a natural high-conviction underweight given our end-2021 4,000 SPX target that we arrived at on the November 9 Special Report. Now that the market is within spitting distance of our target, the risk reward is no longer as favorable as it used to be for this defensive sector. Thus, we are closing this high-conviction trade today for a gain of 8% since inception. Finally, we successfully capitalized on our long VIX futures hedge to the tune of 19% recently, but given that volatility is settling down, it pays to institute a stop buy order for the June 2021 expiry VIX futures near the 25 mark. Bottom Line: Close the S&P consumer staples and the S&P homebuilding high-conviction underweights for 8% and -11% returns, respectively since the December 7 inception; and place a stop buy order for the June 2021 VIX futures at the 25 level.

Overweight We remain on the sidelines with regard to the broad S&P technology sector, but we continue to recommend a barbell portfolio approach preferring defensive software and services stocks to aggressive hardware and equipment equities. In that light, we reiterate our overweight stance in the key S&P software sub-industry that still commands the highest market cap weight in the tech sector, just shy of 33%. While the overall capex data is sluggish, software capital outlays have recovered smartly and according to national accounts are growing at a 10%/annum pace. Stock market-reported capex confirms that software capital expenditures are on an absolute tear and remain a key pillar of our secular preference for this defensive tech group (see chart). True, there is an element of stealing revenues from the future, but as long-time readers of our publication know we do not believe that SaaS is a fad and the adoption of cloud services remains in the early innings, which will continue to underpin the S&P software index. Bottom Line: Continue to overweight the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL. For more details, please refer to this Monday’s Strategy Report. ​​​​​​​

Highlights Duration: Long-maturity Treasury yields are closing in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Ba Versus Baa Corporates: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Feature Chart 1Uptrend Intact Bond yields moved higher last week, maintaining their post-August uptrend despite a brief lull in the second half of January (Chart 1). The 30-year yield even touched 1.97%, its highest level since last February. Given the sharp up-move, the first section of this week’s report considers whether bond yields look stretched. More broadly, we discuss several factors that will help us decide when to increase portfolio duration. How Much Higher Can Yields Rise? We have maintained a recommended below-benchmark duration stance since October and have been targeting a range of 2% to 2.25% for the 5-year/5-year forward Treasury yield.1 That target range is based on median estimates of the long-run equilibrium fed funds rate from the New York Fed’s surveys of market participants and primary dealers (Chart 2). The rationale is that in an environment of global economic recovery where the Fed is expected to eventually lift the funds rate back to equilibrium, long-dated forward yields should reflect expectations of that long-run equilibrium. At present, the 5-year/5-year forward Treasury yield is 1.97% meaning that there is between 3 bps and 28 bps of upside before our target is met. Chart 2Almost At Target A 5-year/5-year forward Treasury yield between 2% and 2.25% would not automatically trigger an increase in our recommended portfolio duration, but it would mean that further increases in yields would need to be justified by upward revisions to survey estimates of the long-run equilibrium fed funds rate. In a similar vein, the 5-year/5-year forward TIPS breakeven inflation rate has risen considerably in recent months, but at 2.15%, it remains below the 2.3% to 2.5% range that the Fed would consider “well anchored” (Chart 2, bottom panel). In other words, there is still some running room for reflationary economic outcomes to be priced into bond yields. Cyclical Growth Indicators Treasury yields may be encroaching on the lower bounds of our target ranges, but cyclical economic indicators suggest further increases ahead. The CRB Raw Industrials / Gold ratio remains in a solid uptrend, and encouragingly, it is being driven by a surging CRB index and not just a falling gold price (Chart 3). Separately, the outperformance of cyclical equity sectors over defensives has moderated in recent weeks, but not yet by enough to warrant reversing our duration call (Chart 3, bottom panel). Chart 3Cyclical Bond Indicators Value Indicators Chart 4Bond Valuation Indicators While cyclical indicators point to further bond weakness ahead, a couple valuation measures show yields starting to look stretched. Two survey-derived estimates of the 10-year zero-coupon term premium have moved up sharply. The estimate derived from the New York Fed’s Survey of Market Participants has jumped into positive territory and the estimate derived from the Survey of Primary Dealers is close behind (Chart 4). These surveys ask respondents to estimate what they think the fed funds rate will average over the next ten years. By comparing the median survey response to the current spot 10-year Treasury yield we get a measure of how much term premium the median investor expects to earn. These term premium estimates have typically been negative during the past few years, though they did rise to about +50 bps before Treasury yields peaked in 2018. In other words, a positive term premium estimate, on its own, is no reason to extend duration. All it tells us is that if the median investor is correct about the future path of the fed funds rate, then there is more money to be made at the long-end of the curve than in cash. This doesn’t rule out investors revising their funds rate expectations higher, or the term premium becoming even more stretched. Another related bond valuation indicator is the difference between the market’s expected path for the fed funds rate and the path projected by the FOMC (Chart 4, bottom panel). Here we see that, for the first time since 2014, the market is priced for a faster pace of tightening over the next two years than the median FOMC participant anticipates. Again, this is not a decisive signal to buy bonds. The FOMC could revise its funds rate projections higher when it meets next month. However, the longer that market pricing remains more hawkish than the Fed, the stronger the case to increase duration becomes. The Dollar Chart 5Dollar Still Supports Higher Yields Finally, we should note that the trade-weighted dollar appreciated last week as bond yields rose (Chart 5). A stronger dollar certainly supports the case for extending duration, the only question is whether the dollar has strengthened enough to dent US economic growth and pull US yields back down. Our sense is that we haven’t reached that breaking point yet, but we could if US real yields continue to rise relative to real yields in the rest of the world (Chart 5, panels 2 & 3). We think of the relationship between US bond yields and the dollar as a feedback loop. A weaker dollar supports economic reflation, which eventually sends yields higher. However, once higher US yields de-couple too far from yields in the rest of the world, the dollar appreciates. A stronger dollar impairs the economic outlook and sends US yields back down, the dollar then depreciates and the cycle repeats. At present, we appear to be in the stage of the feedback loop where US yields are rising relative to the rest of the world, putting upward pressure on the dollar. However, we don’t think the dollar is yet strong enough to prevent US yields from climbing. Dollar bullish sentiment, for example, remains below 50% suggesting that most investors remain dollar bears. A sub-50 reading on this index also tends to coincide with rising US Treasury yields (Chart 5, bottom panel). A move above 50 in the dollar sentiment index would be another signal that the bond bear market is becoming stretched. Bottom Line: Long-maturity Treasury yields are closing-in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Comparing Baa- And Ba-Rated Corporate Bonds Chart 6The Ba Index OAS Is Unusually High We have previously written that the macro environment is extremely positive for credit risk and we recommend moving down in quality within corporate bonds. We have also pointed out that the incremental spread pick-up earned from moving out of Baa-rated bonds and into Ba-rated bonds is elevated compared to typical historical levels. As such, the Ba-rated credit tier looks like the sweet spot for corporate bond allocation from a risk/reward perspective.2 In this week’s report we delve a little deeper into the relative valuation between Baa- and Ba-rated bonds. First, we note the difference between the average option-adjusted spread (OAS) of the Ba index and the average OAS of the Baa index. The Ba index OAS is 126 bps above the Baa index OAS, a level that looks high compared to recent years (Chart 6). One problem with this simple comparison of index OAS is that the average duration of the Ba index is much lower than the average duration of the Baa index (Chart 6, bottom panel). However, after doing our best to match the duration between the two indexes, we still find that Ba offers an attractive yield advantage, particularly compared to levels seen in 2017 and 2018 (Chart 6, panel 2). Going back to our simple OAS differential, we conducted a small study looking at calendar year excess returns between 1989 and 2020. Our results show that the differential between the Default-Adjusted Ba OAS and the Baa OAS does a good job predicting relative excess returns between the two sectors (Table 1).3 The Default-Adjusted Ba OAS is the Ba index OAS at the beginning of the calendar year minus realized Ba default losses that occurred during the year in question. We also use the Baa index OAS from the beginning of the year, but don’t make any adjustments for Baa default losses. Table 1Annual Excess Return Differential & Relative Spreads: Ba Corporates Over Baa Corporates Our results show that Ba excess returns outpaced Baa excess returns in every calendar year for which the Adjusted Ba/Baa OAS differential exceeds 100 bps. The raw Ba/Baa OAS differential is currently 126 bps. This means that we should be very confident that Ba-rated bonds will outperform Baa-rated bonds in 2021, as long as Ba default losses come in below 0.26%. This seems likely. For context, Ba default losses came in at 0.09% in 2020, despite the 12-month default rate spiking to almost 9%. Fallen Angels Another interesting issue to consider when looking at the intersection between the Baa and Ba credit tiers is the presence of fallen angels – bonds that were initially rated investment grade but have been downgraded to junk. The 2020 default cycle coincided with a huge spike in ratings downgrades and the number of outstanding fallen angels jumped dramatically (Chart 7). Not only that, but fallen angels also performed exceptionally well in 2020. Fallen angels outperformed duration-matched Treasuries by 800 bps in 2020 compared to 431 bps for the Ba-rated index, -10 bps for the Baa-rated index and -13 bps for the B-rated index (Chart 7, bottom panel). All that outperformance has compressed fallen angel valuations a lot. The incremental spread pick-up in fallen angels over duration-matched Baa-rated bonds is 201 bps, about one standard deviation below its post-2010 average (Chart 8). Fallen angels look even worse compared to the Ba index, offering only a 30 bps spread advantage (Chart 8, panel 2). Chart 7Fallen Angels Dominated In 2020 Chart 8Fallen Angels No Longer Look Cheap Bottom Line: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes.   Labor Market Update Chart 9Employment Growth Has Slowed Last week’s January employment report was a disappointment with nonfarm payrolls growing only 49k after having contracted by 227k in December (Chart 9).   Two weeks ago, we calculated the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 4.5% by certain future dates.4 In our view, an unemployment rate of 4.5% would meet the Fed’s definition of maximum employment, making it an important pre-condition for monetary tightening. Revising our calculations to incorporate January’s report, a 4.5% unemployment rate by the end of 2021 still looks like a long shot. Nonfarm payroll growth would have to average between +328k and +705k per month to meet that target, depending on the path of the participation rate (Table 2). That said, we still view a 4.5% unemployment rate by the end of 2022 as achievable. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% ##br##By The Given Date Yes, even that will require average monthly payroll growth of between +210k and +411k, but we are likely to see a re-opening of certain shuttered sectors – Leisure & Hospitality, for example – during that timeframe. When it occurs, this re-opening will lead to a surge in employment growth that will push average monthly payroll growth dramatically higher. Notice that almost 40% of the 9.9 million drop in overall employment since February 2020 has come from the Leisure & Hospitality sector (Chart 10). Chart 10Waiting For The Post-COVID Snapback Bottom Line: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Excess returns are calculated relative to duration-matched Treasury securities in all cases. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification