Economy

Highlights Growth & Yields: The massive bond rally of 2019 is in its dying days - the sharp downward momentum of global bond yields is fading, just as leading economic indicators are starting to move higher. Data Surprises & Yields: The risk of a snapback in yields is growing in countries where there are more positive economic data surprises but where yields remain depressed – like the U.S., Canada, Australia and New Zealand. Duration Strategy: We still recommend investors to stick to a neutral (at benchmark) stance on overall portfolio duration in the near term (0-3 months). Markets will need more than just one or two positive data points to be convinced that global growth is rebounding, and U.S.-China trade tensions remain a lingering concern. On a cyclical horizon (6-12 months), however, once it is clear that we’ve entered into a new global manufacturing up-cycle, global yields will rise more sustainably, justifying reduced duration exposure. Feature Chart of the WeekA Potential Bottoming Of Growth & Yields Is The Great Global Bond Rally of 2019 finally running out of gas? Government bond yields in the major developed economies have stabilized and are now starting to drift a bit higher. Benchmark 10-year yields are all up by healthy amounts from the inter-day lows reached on September 3rd (U.S. +18bps, Germany +17bps, U.K. +24bps, Canada +24bps). Yields remain well below intermediate term trend measures like the 200-day moving average, however, suggesting that these rebounds may only be corrective in nature and not yet the start of a more sustained cyclical move higher. Reliable economic data like our global manufacturing PMI are still falling and remain at levels suggesting weakening global growth. Yet on a rate-of-change basis, the pace of the decline in the PMI is fading, indicating that the worst of the downturn is likely behind us. A bottoming of the downward momentum of the PMI typically coincides with fading downward momentum in bond yields (Chart of the Week), which suggests that, at a minimum, bond yields are unlikely to fall below the recent lows. A similar signal is given by our global leading economic indicator (LEI), which has clearly bottomed and is now starting to drift higher. We shifted to a tactically neutral stance on global duration exposure back in early August, based on our near-term concerns that the ratcheting up of U.S.-China trade tensions through new tariffs would further raise economic uncertainty and heighten the demand for safe assets like government bonds – especially given the decline in global manufacturing activity. Last week’s announcement that U.S.-China trade talks would resume in early October was a positive step towards a potential de-escalation of trade tensions, which did help provide a pro-risk lift to global bond yields (at least for one day). For now, however, we are staying with a near-term neutral view on duration until we see more concrete signs of progress from the October 5 U.S.-China trade meetings in D.C. The heightened political drama in the U.K. is another reason to be cautious, with the October 31 Brexit deadline – and potentially a U.K. election before then – fast approaching (NOTE: we will be publishing a joint Special Report on the U.K. with our colleagues at Foreign Exchange Strategy and Geopolitical Strategy on September 20). More fundamentally, we will look to reduce our recommended duration exposure back to below-benchmark once global manufacturing data (i.e. U.S. ISM, Markit PMIs) and economic sentiment data (i.e. global ZEW, German IFO) stabilize – an outcome that grows increasingly likely given the signs of improvement we are seeing in the global LEI. Finding The Biggest Disagreements Between Economic Data & Bond Yields One time-tested way to identify a potential cyclical market top or bottom, for any asset class and not just bonds, is to look for divergences in prices from fundamentals. For example, when bond yields continue to fall despite signs that economic data are starting to improve (or, at least, when there is less data underperforming expectations). We can see such a divergence today when looking at bond yields versus data surprise indices. The most visible divergences between better data surprises and low bond yields are in the U.S., Australia, Canada and New Zealand. In Charts 2 & 3, we show the 26-week change in the benchmark 10-year government bond yield (in basis points) versus the widely followed Citigroup Economic Data Surprise Indices for the U.S., euro area, Japan, the U.K., Australia, Canada, New Zealand and Sweden The broad relationship is that yields fall faster when data is weaker than expected, and vice versa. The relationship is stronger in some countries like the U.S. and the U.K., and very weak in Japan, but we can still look for divergences between yield changes and data surprises for signs of bond yields deviating from economic growth. Chart 2Data Surprises Diverging From Yields In The U.S. … Chart 3… And In "The Dollar Bloc" The most visible such divergences are in the U.S., Japan, Australia, Canada and New Zealand; in those countries, more data releases have been surprising to the upside versus consensus forecasts of late, yet bond yields have been falling at a very rapid rate. In the euro area, the U.K. and Sweden, data has been disappointing versus expectations, justifying the rapid move down in bond yields in those countries purely from an economic growth perspective. For all countries shown, interest rate markets are now priced for aggressive monetary easing. Our 12-month discounters, based on pricing from Overnight Index Swap (OIS) curves, all show that money markets expect central banks to ease policy over the next year. Our discounters remain highly correlated to the level of government bond yields (Charts 4 & 5), which means that the biggest risk to the Great Global Bond Rally of 2019 is that policymakers do not deliver the full amount of easing discounted by markets. Chart 4Bond Yields Are Vulnerable To A Rebound … Chart 5… Given Overly Dovish Policy Expectations That risk looks greatest in countries where there is both a divergence between improving data surprises and low bond yields AND a significant amount of interest rate cuts priced into the OIS curve – like the U.S. (98bps of cuts discounted), Australia (42bps), Canada (32bps) and New Zealand (33bps). Japan (13bps), the euro area (22bps) and Sweden (4bps) are all cases where central bank policy rates (and bond yields) are negative but where additional rate cuts are still discounted. Data continues to disappoint to the downside in the euro area and Sweden, however, suggesting that bond yields there are less at risk of a corrective snapback. A similar argument applies in the U.K. (25bps), where there is not a divergence between weak data and falling Gilt yields. Given the weak correlation between data surprises and changes in bond yields in Japan – an unsurprising outcome given the Bank of Japan’s outright manipulation of JGB yields – we find it difficult to make any conclusions on the next move in yields based solely on an analysis of Japanese data surprises. That risk of higher bond yields is greatest in countries where data surprises are diverging from bond yields AND a significant amount of interest rate cuts are discounted. Bottom Line: The massive bond rally of 2019 is in its dying days - the sharp downward momentum of global bond yields is fading, just as leading economic indicators are starting to move higher. The risk of a snapback in yields is growing in countries where there are more positive economic data surprises but where yields remain depressed – like the U.S., Canada, Australia and New Zealand. The Increasingly Schizophrenic Nature Of Global Central Banks The dovish turn of global monetary policy in 2019 has been fairly limited in terms of the size of cuts, but broad in terms of the number of countries that have delivered cuts. Our Global Monetary Easing Indicator (GMEI), which measures the percentage of central banks (out of a list of 29) that have cut policy rates from three months earlier, is a simple way to measure the “breadth” of the global monetary policy cycle. In Chart 6, we compare the GMEI (shown on an inverted scale) to our global LEI. Historically, the GMEI has peaked around three months after the global LEI troughs. Afterward, facing prospects of improving growth, central banks gradually took their feet off the gas pedal, with the GMEI moving to zero as the global LEI continued to climb. Chart 6Introducing Our Global Monetary Easing Indicator The ups and downs of central banker actions have become more complicated since 2008. After the financial crisis, policymakers had to keep rates at or near the zero lower bound. For the Fed looking over at its Japanese counterpart, the prospect of keeping rates too low for too long, and thereby eventually losing the ability to stimulate the economy through rate cuts in the next downturn, was a fearful one. At the same time, creating overly easy financial conditions and indirectly causing the next asset bubble was another concern for policymakers in the aftermath of the financial crisis. After 2016, central bank behavior became particularly misguided. This “bi-polar” policy environment clearly caused a change in the reaction function of global central banks. Post-crisis, they have been slower to react to signs of global weakness. In 2016, for example, the GMEI peaked a full six months after the trough in the LEI – a longer reaction time compared to previous cycles. Even when they did react, however, it was at a lower intensity, with smaller easings by fewer banks, compared to previous cycles After 2016, however, central bank behavior became particularly misguided. The subsequent monetary tightening was clearly too abrupt. Investor sentiment and expectations of global growth, captured by our GFIS duration indicator (Chart 7), were on their way down while global central banks were all too eager to stop easing, ignoring the data showing signs of global weakness – especially from China. Chart 7Central Banks Are Zigging When They Should Be Zagging By June 2018, none of the central banks included in the GMEI were easing, despite the global LEI having peaked six months earlier. In September 2018, despite facing persistent global weakness – the global manufacturing PMI had fallen from its peak of 54.4 nine months earlier to 52.1 and the global LEI was already in negative territory indicating more weakness to come – only a meagre 3% of central banks had begun stimulating. The Fed exemplified this complacency with its rate hike in December 2018 and its refusal to clearly pivot in a dovish direction until three months later. When they ultimately delivered a rate cut in late July of this year, it was clear they had waited too long. Chart 8How Will Dovish Policymakers Respond To Improving Growth? Globally, the overall policy response was non-existent all the way until May 2019, when central banks finally got with the program and scrambled to ease. Now, with the Fed having cut rates and facing the possibility of further rate cuts (possibly hastened by the Tweeter-in-Chief), global central bankers will not want to be left behind, lest they suffer unwanted currency strength and forgo export competitiveness. However, they might be once again misreading the data and the global easing cycle might be much closer to its end than its beginning. BCA’s Chief Global Strategist, Peter Berezin, has noted that global manufacturing cycles average three years from peak to peak. As the last growth cycle began in late spring of 2017, this means that we are likely at the bottom of the current cycle and therefore, global growth should start to pick up soon. This message is reinforced by our Global LEI diffusion index (Chart 8), which indicates that the Global LEI has put in a bottom and will continue climbing higher in the coming months. The easing of global financial conditions, and the lagged impact of China’s policy stimulus measures from earlier in 2019, corroborate the message from the global LEI. With bonds as overbought as they are today, we expect yields to rebound once investors realize that the sky is not really falling. A pick up in the global LEI, in turn, suggests that the global PMI will follow and should soon move higher, with a lead time of six months based on past cycles (as we show in the bottom panel of Chart 1). Another reliable leading growth indicator, the level of high-yield corporate bond spreads, is also signaling a rebound in both the U.S. and euro area economies over the next few quarters (Chart 9). Chart 9High-Yield Spreads Are A Leading Economic Indicator Global bond yields, meanwhile, seem stuck between a rock and a hard place. As shown in Chart 10, yields move with expectations of future growth. Bond investors are sensitive to declines in expectations of future growth, captured by the global LEI, as this necessitates central bank intervention in the future to lower short-term rates, thus bringing down the expectations component of long-term yields. At the same time, a slowdown in growth in the present increases the safe-haven demand for bonds which again drives down yields. Chart 10Potential Triggers For Higher Bond Yields   Although the global is ticking back up, global policy uncertainty (Chart 10, middle panel) is near all-time highs due to the U.S.-China trade war. In such an environment, investors will naturally flock to the safety of bonds. In previous reports, we have shown how similar the current backdrop is to the 2015/2016 episode, when nervous bond investors were less likely to be forward-looking and needed to see firm evidence of a pickup in global growth before they started to push up yields on a sustained basis. Given the increasing likelihood that global central banks will not be able to fully deliver the amount of aggressive easing discounted by markets because of a more stable growth backdrop, any lessening of trade tensions – a growing possibility with U.S. President Donald Trump gearing up for the 2020 election – should allow calmer heads to once again prevail as global economic momentum improves and policy uncertainty wanes. With bonds as overbought as they are today, we expect yields to rebound once investors realize that the sky is not really falling. It remains to be seen how policymakers respond to that outcome. Given recent history, however, we fear that central bankers could end up turning more hawkish once again faster than markets expect, which would set the stage for a more sustainable rise in global bond yields in 2020. Bottom Line: We still recommend that investors stick to a neutral benchmark overall portfolio duration stance in the near term (0-3 months). Markets will need more than just one or two positive data points to be convinced that global growth is rebounding. On a cyclical horizon, once it is clear that we’ve entered into a new global manufacturing up-cycle, global yields are likely to rise. As Trump reaches for a deal ahead of the 2020 election, the decline in global policy uncertainty will contribute to a more bond-bearish environment.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma, Research Associate shaktis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Waiting For A Manufacturing Rebound The 2015/16 roadmap is holding. As in that period, the ISM Manufacturing PMI has fallen into recessionary territory, but the Services PMI remains strong (Chart 1). As is typically the case, bond yields have taken their cue from the manufacturing index. The resilient service sector and global shift toward easier monetary policy will support an eventual rebound in manufacturing, and the Fed will continue to play its part this month with another 25 basis point rate cut. As for the Treasury market, much stronger wage growth than in 2016 will prevent the Fed from cutting rates back to zero. This means that the 10-year yield will not re-visit its 2016 trough of 1.37% (Chart 1, bottom panel). Strategically, investors should maintain a benchmark duration stance for now, but stand ready to reduce duration once the global manufacturing data stabilize. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 105 basis points in August, dragging year-to-date excess returns down to +323 bps. In remarks last week, Fed Chairman Powell noted that the Fed has lowered the market’s expected path of interest rates, and that he views this easing of financial conditions as providing important support for the economy.1  The July FOMC minutes echoed this sentiment, sending a strong signal that the Fed will do everything it can to prevent a significant tightening of financial conditions. The accommodative monetary environment is extremely positive for corporate spreads. In terms of valuation, Baa-rated securities offer the most value in the investment grade corporate bond space (Chart 2). Baa spreads remain 13 bps above our cyclical target (panel 2).2 Conversely, Aa and A-rated spreads are 2 bps and 1 bp below target, respectively (panel 3). Aaa spreads are 15 bps below target (not shown). The main risk to spreads comes from the relatively poor state of corporate balance sheets. Our measure of gross leverage – total debt over pre-tax profits – was already high, and was revised even higher after the Bureau of Economic Analysis’ annual GDP revision (panel 4). But for now, likely in large part due to accommodative Fed policy, loan officers aren’t inclined to cut off the flow of credit. C&I lending standards remain in “net easing” territory (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 114 basis points in August, dragging year-to-date excess returns down to +551 bps. The average index option-adjusted spread widened 22 bps on the month. At 385 bps, it is well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 49 bps above our target (Chart 3), B-rated spreads are 151 bps above our target (panel 3) and Caa-rated spreads are 398 bps cheap (not shown).3   Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 3.2% over the next 12 months. This translates into 207 bps of excess spread in the High-Yield index after adjusting for expected default losses (panel 4). That 207 bps of excess spread is comfortably above zero, though it is below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 63 basis points in August, dragging year-to-date excess returns down to -31 bps. The conventional 30-year zero-volatility spread widened 9 bps on the month, driven entirely by the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat at 29 bps. At 51 bps, the OAS for conventional 30-year MBS has widened back close to its average pre-crisis level (Chart 4). However, value is less attractive when we look at the nominal MBS spread, which remains near its all-time lows.4 The nominal spread has also widened less than would have been expected in recent months, considering the jump in refi activity (panel 2). The mixed valuation picture means we are not yet inclined to augment MBS exposure. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. An increase in Treasury yields would cause refi activity to slow, putting downward pressure on MBS spreads. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to +152 bps. Sovereign debt underperformed duration-equivalent Treasuries by 45 bps on the month, dragging year-to-date excess returns down to +442 bps. Local Authorities underperformed the Treasury benchmark by 31 bps, dragging year-to-date excess returns down to +212 bps. Meanwhile, Foreign Agencies underperformed by 11 bps, dragging year-to-date excess returns down to +141 bps. Domestic Agencies outperformed by 13 bps in August, bringing year-to-date excess returns up to +44 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +39 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). Investors should favor Mexican sovereigns within an otherwise underweight allocation to the sector as a whole. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 104 basis points in August, dragging year-to-date excess returns down to -46 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 9% in August, and currently sits at 85% (Chart 6). The ratio is close to one standard deviation below its post-crisis mean, but slightly above the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We shifted our recommended stance on municipal bonds from overweight to neutral near the end of July.5 The reason for the downgrade was that the sector had become extremely expensive. Yield ratios have risen somewhat since then, but not yet by enough for us to re-initiate an overweight recommendation. We also continue to observe that the best value in the municipal bond space is found at the long-end of the Aaa curve. 2-year and 5-year M/T yield ratios remain below average pre-crisis levels, while yield ratios beyond the 10-year maturity point are above. 20-year and 30-year Aaa M/T yield ratios, in particular, are the most attractive (panel 2). Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our recent shift to a more cautious stance was driven purely by valuation and not a concern for municipal bond credit quality. A further cheapening in the coming months would cause us to re-initiate an overweight stance.    Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in August, as the global manufacturing recession continued to pull yields down. At present, the 2/10 Treasury slope is just above the zero line at 2 bps, 11 bps flatter than at the end of July. The 5/30 slope is currently 60 bps, 9 bps flatter than at the end of July. Our 12-month Fed Funds Discounter is currently -98 bps (Chart 7). This means that the market is priced for almost four more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of uncertainty surrounding the timing of the next move higher in yields, four rate cuts on a 12-month horizon seems excessive given the underlying strength of the U.S. economy. For this reason, we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts over the next four FOMC meetings. One of those rate cuts will occur this month, but if the global manufacturing data recover, further cuts may not be needed. A short position in this contract continues to make sense. On the Treasury curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 174 basis points in August, dragging year-to-date excess returns down to -104 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.55% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate also fell 21 bps in August. It currently sits at 1.74%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.6 Eventually, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors also need to see evidence that inflation will be sustained near 2%. On that note, recent trends are encouraging. Through July, trimmed mean PCE is running at 2.22% on a trailing 6-month basis (annualized) and at 1.99% on a trailing 12-month basis (bottom panel). As a result, the 10-year TIPS breakeven inflation rate looks very low relative to the reading from our Adaptive Expectations model, a model based on several different measures of inflation (panel 4).7 Supportive Fed policy and rising inflation should support wider TIPS breakevens in the coming months, remain overweight.  ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in August, bringing year-to-date excess returns up to +74 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month. It currently sits at 28 bps, below its minimum pre-crisis level of 34 bps (Chart 9). ABS also appear unattractive on a risk/reward basis, as both Aaa-rated auto loans and credit cards have moved into the “Avoid” quadrant of our Excess Return Bond Map (see Appendix C). The Map uses each bond sector’s spread, duration and volatility to calculate the likelihood of earning or losing 100 bps of excess return versus Treasuries. At present, the Map shows that ABS offer poor expected return for their level of risk. In addition to poor valuation, the ABS sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate in the future (panel 3). Meanwhile, senior loan officers continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 16 basis points in August, dragging year-to-date excess returns down to +218 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 6 bps on the month. It currently sits at 69 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate is somewhat unfavorable, with lenders tightening loan standards (panel 4) amidst falling demand (bottom panel). Commercial real estate prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in August, dragging year-to-date excess returns down to +88 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 56 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 98 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of September 6, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of September 6, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +49 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 49 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12Excess Return Bond Map (As Of September 6, 2019)     Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 https://www.cnbc.com/2019/09/06/watch-fed-chairman-jerome-powells-qa-in-zurich-live.html 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 The nominal spread is simply the difference between MBS index yield and the duration-matched Treasury yield. No adjustment is made for prepayment risk. 5 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Adaptive Expectations Model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation