Economy

Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Chart 6Renewables Dominate Incremental New Generation Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Chart 14     Footnotes 1     Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020.  It is available at ces.bcaresearch.com.   2     Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021.  The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3    Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Surging Covid-19 cases to unprecedented levels have unsettled India’s equity and currency markets. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential ongoing super-spreader events. Yet, the country’s medium- and longer-term outlooks remain positive. Asset allocators with less tolerance for volatility may tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Feature New COVID-19 cases in India have skyrocketed in the past few weeks – far surpassing previous peaks. The country now accounts for 40% of daily new cases globally (Charts 1 and 2). This has raised the possibility of fresh lockdowns and, as a result, Indian stocks and the currency have begun to sell off. Chart 1Daily COVID-19 Cases Have Lately Skyrocketed In India … Chart 2… Accounting For 40% Of Global Cases And 20% Of Deaths … We have been overweight India in an EM equity portfolio because of the country’s positive cyclical and structural outlook. Even though our views have not changed, we believe the parabolic surge in COVID-19 cases is likely to cause near-term volatility in Indian equity and currency markets. As such, we recommend that asset allocators who have less tolerance for volatility tactically downgrade Indian equities to neutral for the next couple of months. Below we elaborate the reasons for this near-term downgrade, as well as the reasons for our more upbeat view over the medium to long term. New Cases Might Stay High Chart 3… And Raising The Specter Of Another Stringent Lockdown Being a densely populated country with less than ideal living conditions, the attempts to control the spread of COVID-19 via social distancing measures is extremely difficult in India. Yet, the authorities tried to do exactly that last spring by imposing the most stringent lockdown measures anywhere in the world (Chart 3). The result was a complete collapse in economic activity: year-over-year industrial production fell by a half, and GDP contracted by 22% in the second quarter of 2020 from a year ago. Now facing an unprecedented surge in new cases, markets are apprehensive that even a partial lockdown will scuttle the nascent recovery in the economy. Worryingly, the number of new cases in India might stay exceptionally high for a while. The reason is that there are several potential super-spreader events going on. The country is undergoing state-level elections in five states where the candidates are canvassing in front of gatherings of tens of thousands of people. Currently, there is also a religious congregation taking place where up to three million pilgrims have assembled. Chart 4Should Morbidity And Mortality Rates Rise, A Harsh Lockdown May Become Inevitable The morbidity and mortality rates have not yet risen (Chart 4). This is a key metric and will likely determine the stringency of the authorities’ lockdown measures. Even though the Prime Minister has declared that stern lockdowns would be last-resort measures, the possibility cannot be excluded if hospitalization and mortality rates begin to rise. The following has also added to investor concerns: The fact that equity valuations are much higher now than they were last spring makes the market even more prone to a setback (Chart 5). Indian stocks have benefitted from a record amount of foreign portfolio inflows over the past 12 months – totaling $ 34 billion. The risk is therefore high that some of these flows might reverse in the near term if the threat of renewed lockdowns is realized. That will be a headwind for both stock market and the rupee (Chart 6). Finally, a rising US dollar, and a likely general underperformance of EM stocks over the next several months, will also encourage outflows from India. Chart 5Elevated Valuations Have Added To The Vulnerability Of Indian Stocks Chart 6A Reversal In Foreign Portfolio Inflows Will Cause Both Stocks And The Rupee To Fall Cyclical Outlook Remains Positive Beyond the near-term jitters, India’s cyclical outlook remains positive. The recovery has been solid as indicated by the following metrics: The number of E-way bills issued (a barometer of business activity) as part of the Goods & Services Tax (GST) collection mechanism keeps rising steadily. GST collection itself has also been strong – validating the same message (Chart 7). Manufacturing and Services PMIs printed over 55 in March – indicating robust expansion of activity. Order books of companies, as indicated by both RBI and Dun & Bradstreet surveys, look strong. These indicators herald an improvement in industrial production going forward (Chart 8). Chart 7Underlying Economic Recovery In India Has Been Robust So Far … Chart 8… Supported By Strong Order Books … In short, all of the above points to an ameliorating top lines (sales) for the corporates in the coming months, barring stringent lockdowns. Meanwhile, firms’ profits margins have also recovered meaningfully. An RBI survey of over 2600 companies shows that both gross and net profit margins had risen to above pre-pandemic levels by December 2020 (Chart 9). Given the wide margins, a recovery in sales levels will lead to accelerating profits in the quarters ahead. In a sign that profit re-acceleration is not far off, firms have begun to invest in new plants and machinery. Capital spending had already turned positive during the last quarter of 2020 versus the same period of 2019. Imports of capital goods have also begun to rise – corroborating new capex plans of the firms (Chart 10). Chart 9… And Healthy Profit Margins … Chart 10… Which Have Encouraged Firms To Resume Capital Spending New capital expenditure is undertaken only when firms are confident of strengthening demand. Besides, capex usually comes on the heels of rising profits. Higher capital goods imports and capital spending therefore indicate that the companies are optimistic of both sales and profits going forward. On its part, the central bank has ensured that the liquidity in the banking system remains abundant by engaging in plenty of open market operations. Bank credit growth, at 6.3%, is still low, but appears to have bottomed. Excluding the credit to large corporations – who have in recent years been replacing bank credit by local currency debt issuances – the credit growth rate is 9% (Chart 11). Odds are that beyond the near-term jitters due to rising COVID-19 cases, credit will accelerate in line with recovering economic activity. That will be bullish for bank stocks. Incidentally, banks make up the largest chunk of Indian equity index. Finally, Indian small caps continue to outperform their large cap counterparts (Chart 12). Smaller firms in India are much more vulnerable to a slowdown in growth and tighter credit conditions. The fact that they keep outperforming suggests that investors do not expect a major or lasting impact of the latest pandemic outbreak on the economy. Chart 11Bank Credit Will Rise As The Expansion Continues Chart 12Small Caps Outperformance Suggest Investors Are Sanguine About Growth And Credit Conditions Beyond the cyclical recovery, we are bullish on India’s longer-term outlook as well. The reason for that is India is one of the rare EM countries undertaking meaningful structural reforms. The country’s demographics are also highly favorable. We will elaborate on these and other structural issues in greater detail in our future reports. Investment Conclusions Indian stocks and the currency have entered a period of turbulence as surging COVID-19 cases prompt profit taking/selling. EM equity portfolios with low tolerance for volatility should therefore consider tactically downgrading this bourse to neutral for a couple of months. Absolute return investors (in US$ terms) should also brace for near-term volatility in Indian share prices. Over the medium-to-long term however, Indian stocks will likely outperform their EM peers as well as rally in absolute terms (Chart 13). Indian bank stocks are also suffering from the ongoing volatility. However, given Indian private banks’ higher efficiency and better balance sheets vis-à-vis banks elsewhere in the EM, long-term investors should continue to stick with our recommended trade of long Indian banks/ short EM banks (Chart 14). Chart 13Beyond The Near-Term Volatility, Indian Stocks Will Outperform Their EM Peers … Chart 14… So Will Indian Bank Stocks Vis-à-vis EM Banks Fixed income investors should continue receiving 10-year swap rates in India. With the abundant rainfall, food prices will decline. This will keep inflation under check. The rising COVID-19 cases and a potential lockdown are disinflationary in nature and will push down swap rates.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

In lieu of next week’s strategy report, I will be presenting the first Counterpoint webcast titled ‘Mega-Themes, Coming Shocks, And Top Trades’. I hope you can join. Highlights Standard economic theory assumes that money is perfectly fungible. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. This is known as ‘mental accounting bias.’ Mental accounting bias means that we are more likely to use the massive stockpile of savings accumulated during the pandemic to pay down debt than to spend. Mental accounting bias also means that we are overpaying for high-yielding equities. Long-term investors should avoid banks, and they should avoid ‘value.’ Correctly calculated, the equity risk premium is now almost non-existent. US long-term bond yields have much more scope to move down than to move up. Fractal trade shortlist: equities versus bonds, PKR, and New Zealand equities. Feature Chart of the WeekConsumption Is Explained By Wages... Chart of the Week...Not By Stimulus Checks Many economists predict that, once economies fully reopen, the massive stockpile of household savings accumulated during the pandemic will unleash a tsunami of household spending. But economists are not the right people to make this prediction. The answer to whether households will, or will not, spend their stockpile of accumulated savings does not fall into the realm of Economics. It falls into the realm of Psychology. Whether We Spend Money Depends On Which ‘Mental Account’ It Occupies In A Major Anomaly In The Bond Market we pointed out that the propensity to spend out of income is high, but the propensity to spend out of wealth is low. Meaning that whether unspent income gets spent depends on whether households categorise it as additional income or additional wealth. This raised a follow-up question. How can the decision to spend money depend on whether someone categorises it as income or wealth? The answer comes from Psychology, and a phenomenon known as ‘mental accounting bias.’ Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to draw on these accounts for spending. There is a clear hierarchy in our willingness to spend from our ‘mental accounts’. At the top of the hierarchy comes our monthly wage check, followed by the money in our current (checking) account. These ‘income’ accounts we are willing to spend. Further down the hierarchy comes our savings account and our investment portfolio. These ‘savings’ or ‘wealth’ accounts we are unwilling to spend. Standard economic theory assumes that money is perfectly fungible, so that a pound in a current account is no different to a pound in a savings account. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. When we move money from our wages or our current account into our savings account, our willingness to spend it collapses. This explains why consumption closely tracks the wages that dominate our income mental account, but has no meaningful connection with stimulus checks which largely end up in our savings mental account (Chart of the Week and Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Trends Yet while we are unwilling to spend our savings mental account, we are willing to pay down debt with it. Indeed, realising this emotional connection between our savings and our debt, many lenders offer mortgages which ‘offset’ a savings account against the mortgage debt. Pulling all of this together, the stockpile of household savings accumulated during the pandemic is unlikely to boost consumption trends. More likely, it will be used to reduce household debt. In which case, part of the recent rise in public debt will just end up paying down private debt, as happened in Japan during the 1990s (Chart I-3). Chart I-3In Japan, Public Debt Ended Up Paying Down Private Debt This spells trouble for bank asset growth. ‘Value’ Offers No Value Mental accounting bias also explains the dominant phenomenon in the financial markets of recent years – the so-called ‘search for yield’. At first glance, the search for yield makes sense, but on deeper thought the distinction between yield and capital appreciation is irrational. Just like income and wealth, the money that comes from an investment’s yield and the money that comes from its capital appreciation is perfectly fungible (assuming am equal tax treatment). Yet, in practice, many investors put yield and capital appreciation into separate mental accounts, categorising an investment’s yield as spending money, and its capital as saving money. Hence, those investors – say retirees – who want their assets to generate money for their spending mental account have an irrational bias towards investments that generate yield. Whereas those investors that want their assets to boost their saving mental account have a bias towards investments that generate capital growth. To reiterate, given that money is perfectly fungible, these mental accounts are irrational.  Under normal circumstances, these irrational biases are not a problem because there are enough investments available for both the spending and the saving mental accounts. But in recent years, the assets that would normally generate the safe income for the spending account – cash and government bonds – are no longer doing so. Hence, in the ensuing stampede for yield, income fixated investors have suffered a dangerous tunnel vision. By fixating on an equity’s yield rather than on its prospective total return, yield seeking investors are overpaying for high-yielding equities, and thereby sacrificing their long-term wealth. By fixating on an equity’s yield rather than on its prospective total return, investors are overpaying for high-yielding equities. Case in point. The 8 percent forward earnings yield on global financials appears to offer considerably more value than the 5 percent on healthcare and the 3.5 percent on technology. But what really matters is how that forward earnings yield translates into prospective total return. On this basis, the apparent value in financials turns out to be a mirage. Using the post financial crisis relationship between forward earnings yield and prospective return, high-yielding financials were, until very recently, priced to deliver a lower return than low-yielding technology. And financials are still priced to deliver a lower return than lower-yielding healthcare. To deliver the same long-term return as healthcare, the valuation of financials would have to decline by 20 percent (Chart I-4 - Chart I-6). Chart I-4Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Chart I-5Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Chart I-6Tech Is Expensive Therefore, mental accounting bias is a double whammy for banks. It spells trouble for bank asset growth, and it makes investors overpay for high-yielding equities. This creates the ultimate paradox of investment. The defining feature of ‘value’ is that it offers no value! Long-term investors should avoid banks, and they should avoid value. US Bond Yields Have More Scope To Move Down Than Up The foregoing analysis also carries important implications on the correct approach to value equities, and specifically the equity risk premium – meaning, the prospective excess return on equities versus high-quality bonds. The common incorrect approach is to take the forward earnings yield on equities and subtract the 10-year bond yield. Using a US forward earnings yield of 4.5 percent, this would suggest the equity risk premium is a comfortable 3 percent versus the nominal bond yield of 1.5 percent. Or a very comfortable 5.5 percent versus the real bond yield of -1 percent. The glaring error with this approach is that it is subtracting apples from oranges. The 10-year bond yield is the return you will receive from the bond over the next 10 years. But as you have just seen, the forward earnings yield is not the return you will receive from equities over the next 10 years. To subtract apples from apples we must first translate the forward earnings yield into a prospective 10-year total return. The current translation turns out to be a 2 percent nominal return (Chart I-7 - Chart I-8) or a 0 percent real return (Chart I-9 - Chart I-10). Comparing these with the nominal or real bond yields, we find that the equity risk premium is almost non-existent. Chart I-7Convert The Earnings Yield Into A Prospective Nominal Return... Chart I-8…To Find That The Equity Risk Premium Is Almost Non-Existent Chart I-9Convert The Earnings Yield Into A Prospective Real Return... Chart I-10...To Find That The Equity Risk Premium Is Almost Non-Existent The almost non-existent equity risk premium means that equities are richly valued, and that this rich valuation is contingent on bond yields not rising significantly. Moreover, it is not just equities that are richly valued. As we pointed out in The Road To Inflation Ends At Deflation the valuation of $300 trillion of global real estate is also highly contingent on bond yields not rising significantly. Equities are richly valued, and this rich valuation is contingent on bond yields not rising significantly. We conclude that, from current levels, US long-term bond yields have much more scope to move down than to move up. Candidates For Countertrend Reversal The strong rally in equities versus bonds since the pandemic low has reached a point of fractal fragility like that seen at the end of the 2013 bull run and the end of the early 2020 bear run (Chart I-11). As such, the current rally is due a breather. Chart I-11The Rally In Equities Versus Bonds Is Due A Breather In the Asia Pacific region, we note that the recent strong performance of the Pakistan rupee is susceptible to a countertrend sell-off (Chart I-12). Chart I-12Underweight The PKR Lastly, the ultra-defensive New Zealand stock market has massively underperformed over the past year. But fragility on both its 130-day and 65-day fractal structures suggests that it is ripe for a countertrend outperformance (Chart I-13). Chart I-13Overweight New Zealand Accordingly, this week’s recommendation is to overweight New Zealand versus the world, setting the profit target and symmetrical stop-loss at 4 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   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 II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights Duration: The pace of rate hikes currently priced into the market is reasonable. However, we see strong odds that market expectations will move higher in the coming months, the result of continued strong economic data and the Fed starting to talk about tapering its asset purchases. Investors should maintain below-benchmark portfolio duration. MBS: MBS remain unattractive compared to other US spread products. But within an underweight allocation to MBS, an up-in-coupon bias makes sense. Inflation: Year-over-year CPI inflation was pushed higher by base effects in March, but the report also showed evidence of mounting inflationary pressures beyond simple base effects. Feature After a sizeable drop last Thursday, Treasury yields are now significantly off their recent highs. The 10-year Treasury yield peaked at 1.74% on March 31st but ended last week at only 1.59%. What makes the drop puzzling is that yields are down despite a string of very strong US economic data (Chart 1). This recent development bears a resemblance to the famous 2004/05 bond conundrum when Fed Chairman Alan Greenspan struggled to understand why long-maturity Treasury yields were falling even as the Fed lifted short rates.1 Today, investors are also struggling to understand why long-maturity Treasury yields are falling, only this time the “conundrum” is that they are falling in the face of strong economic data. From our perch, both conundrums have the same answer: The market has already discounted a lot of the news. On June 29th, 2004 – the day before the first rate hike of that cycle – the overnight index swap (OIS) curve was priced for 243 bps of Fed rate hikes for the following 12 months. The Fed went on to deliver 200 bps of rate hikes during that timeframe, slightly less than the market expected. In that environment it is entirely consistent that bond yields should fall (Chart 2). Chart 1Yields Down On Strong Data Chart 2The 2004/05 Bond Conundrum Today, the OIS curve is priced for the Fed to lift rates off the zero bound in December 2022 and for a total of 86 bps of rate hikes by the end of 2023 (Chart 3). Given the Fed’s new Average Inflation Targeting regime, this sort of rate hike cycle will only be achieved if there is a very strong US economic recovery. The incoming US data are so far confirming that narrative but haven’t been strong enough to move rate expectations even higher. Chart 3Market Priced For December 2022 Liftoff As we wrote in last week’s report, we think that the market’s current rate hike expectations look reasonable.2 However, we see a meaningful risk that they could move higher in the coming months as the rapid US economic recovery continues and the Fed starts to back away from its extremely dovish messaging. Chart 4US Will Hit 75% Vaccination Well Before September For example, Fed Chair Jay Powell has said repeatedly that it is too soon to talk about tapering the Fed’s asset purchases. We worry, however, that this tone might be giving investors a false sense of security. If the economic recovery continues at its current pace, we fully expect the Fed to start talking about tapering this year and to begin the process either by the end of 2021 or in early 2022. Last week, St. Louis Fed President Jim Bullard said he would be comfortable starting discussions about tapering when 75%-80% of the US population has been vaccinated. We estimate that if vaccinations continue at a linear pace, we will hit 75% vaccination by September (Chart 4). Given the exponential trend in vaccinations so far, we are likely to reach 75% well before September. The bottom line is that we see the pace of rate hikes currently priced into the market as reasonable. However, we also see strong odds that market expectations will move higher in the coming months, the result of continued strong economic data and the Fed starting to talk about tapering its asset purchases. Investors should maintain below-benchmark portfolio duration. MBS: Stay Up In Coupon Unsurprisingly, the reflation trade has been beneficial for risk assets. Within US fixed income, spread products have generally outperformed Treasuries since bond yields bottomed last August. However, certain spread sectors have fared better than others. Agency Mortgage-Backed Securities, for example, have not done that well. Conventional 30-year Agency MBS have only outperformed a duration-matched position in Treasury securities by 73 bps since bond yields bottomed on August 4th, 2020 (Chart 5). This compares to 446 bps of outperformance for Aaa-rated corporates, 342 bps of outperformance for Aa-rated corporates (Chart 5, panel 2) and 232 bps of outperformance for Agency CMBS (Chart 5, panel 3). Only notoriously low-risk Aaa-rated consumer ABS have delivered less outperformance than Agency MBS (Chart 5, bottom panel). While Agency MBS have not performed well overall, certain segments of the coupon stack have delivered decent excess returns. Specifically, higher coupon MBS have performed much better than low coupon MBS during the recent back-up in yields. Since last August, 4% coupon MBS have outperformed duration-matched Treasuries by 176 bps and 4.5% coupons have outperformed by 257 bps. Meanwhile, 2.5% coupons have underperformed by 10 bps and 3% coupons have underperformed by 15 bps (Chart 6). Chart 5Spread Product Performance Since Trough In Bond Yields Chart 6Favor Premium Coupons In Rising Rate Environment The divergent performance between high and low coupons is easily explained by the risk characteristics of those bonds. Looking at the difference between the 2.5% and 4% coupons, for example, we see that the 2.5% coupons have significantly higher duration and significantly lower convexity (Chart 6, bottom 2 panels). The higher duration means that rising yields hurt 2.5% coupons more and the lower convexity means that rising yields will cause the gap between 2.5% coupon duration and 4% coupon duration to widen further. In short, a rising yield environment is terrible for low-coupon MBS. Conversely, high duration and low convexity are desirable attributes in a falling yield environment. If bond yields fall meaningfully going forward, then low-coupon MBS will outperform the high coupons. Chart 7A shows how option-adjusted spread (OAS) varies with duration across the conventional 30-year Agency MBS coupon stack. We see that the lowest coupons have the highest durations and the lowest OAS. Premium coupons have low durations and high OAS. Chart 7AAgency MBS 30-Year Conventional Coupon Stack: OAS vs. Duration Chart 7B shows how OAS varies with convexity across the coupon stack. Here we see that the 2%, 2.5% and 3% coupons have the most negative convexities. This makes sense as those coupons are closest to the current mortgage rate of 3.04%. A further increase in the mortgage rate would make those coupons less likely to refinance, causing durations to extend meaningfully. Conversely, a drop in the mortgage rate would lead to greater refinancings for those coupons, causing durations to shorten. Notice that 1.5% coupon MBS have relatively high convexity. This is because refinancing is already unattractive for those bonds, and the duration of the 1.5% index has already extended. Chart 7BAgency MBS 30-Year Conventional Coupon Stack: OAS vs. Convexity Given our view that US Treasury yields will be flat-to-higher for the next 6-12 months, we recommend an up-in-coupon bias within Agency MBS. Specifically, the 2%, 2.5% and 3% coupons have the most scope for duration extension in a rising yield environment and should be avoided. The 4% and 4.5% coupons, on the other hand, are less negatively convex and are better able to weather the storm of rising bond yields. In a flat bond yield environment, the best performing coupons are likely to be those with the widest OAS. This makes the 4% and 4.5% coupons look much more attractive than the 1.5% coupons, even though they have similar convexities. Overall, we recommend owning the 4% and 4.5% coupons within the conventional 30-year Agency MBS coupon stack and avoiding the 2%, 2.5% and 3% coupons. One final point worth making is that we also continue to recommend an underweight allocation to MBS within a US bond portfolio. That is, though higher coupon MBS look better than the low coupons, the entire sector looks unattractive compared to alternatives like consumer ABS, Agency CMBS and even investment grade corporate bonds. Chart 8 shows a version of our Excess Return Bond Map, a visual guide that is useful for quickly assessing the risk/reward trade-off between different US spread products.3 The Map shows OAS as a measure of expected return on the Y-axis, and a proprietary risk measure called the “Risk Of Losing 100 Bps” on the X-axis. A higher number on the X-axis indicates less risk of losing 100 bps and vice-versa. Chart 8Excess Return Bond Map Our Bond Map makes it clear that only 4% and 4.5% coupon MBS come close to offering a risk/reward balance that is comparable to other spread sectors. MBS coupons below 4% offer far too little expected return given the amount of risk. Bottom Line: Remain underweight MBS within a US bond portfolio, but favor 4% and 4.5% coupons over 2%, 2.5% and 3% coupons within the Agency MBS coupon stack. March CPI More Than A Base Effect It was well known heading into last week’s March CPI release that the year-over-year inflation number was going to be very strong. This is due to base effects that will persist through to the end of May. That is, 12-month inflation is bound to rise as the negative monthly inflation prints from March, April and May 2020 fall out of the 12-month rolling sample. Year-over-year inflation numbers did indeed rise sharply in March (Chart 9). 12-month headline CPI jumped from 1.68% to 2.64% and 12-month core CPI increased from 1.28% to 1.65%. Base effects exert less influence over the trimmed mean CPI, and that index rose only from 2.04% to 2.12%. The gap between 12-month core CPI and 12-month trimmed mean CPI remains wide, but it should close by May when the impact from last year’s base effects is exhausted (Chart 9, bottom panel). Chart 9Annual Inflation Chart 10Monthly Inflation But base effects were only part of the story last week. Month-over-month inflation also came in very strong for the headline, core and trimmed mean measures. Headline CPI rose 0.62% in March, core CPI rose 0.34% and the trimmed mean rose 0.24% (Chart 10). To put those numbers in context, if those monthly prints are repeated in April and May, 12-month headline CPI will rise to 4.75% by May and 12-month core CPI will rise to 2.79%. Even if we assume more typical 0.15% inflation rates for April and May, we would still expect 12-month headline CPI to reach 3.77% by May and 12-month core CPI to reach 2.41%. Overall, the message from March’s CPI report is that the economy is showing signs of mounting inflationary pressures beyond simple base effects. We have previously written about the ample evidence of bottlenecks in both the goods and service sectors, and we now appear to be seeing those bottlenecks show up in the price data.4 There’s little doubt that 12-month inflation will fall somewhat between May and the end of the year. However, we anticipate that inflation will still be close to the Fed’s target by the end of 2021. This will certainly be the case if the monthly inflation figures remain consistent with March’s print. The main investment implication from this view is that low inflation will not prevent the Fed from tapering its asset purchases either late this year or early next year, and it also won’t prevent the Fed from lifting rates in 2022. Footnotes 1 Greenspan’s remarks: https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 Please see US Bond Strategy Weekly Report, “Overshoot Territory”, dated April 13, 2021, available at usbs.bcaresearch.com 3 For more details on the Bond Map please see page 16 of US Bond Strategy Portfolio Allocation Summary, “It’s A Boom!”, dated April 6, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification