Fixed Income

Executive Summary The Chinese Economy Is Facing Deflationary Pressures The Chinese Economy Is Facing A Risk of Deflation The Chinese Economy Is Facing A Risk of Deflation China’s economy is facing a deflationary threat. Core consumer price inflation is below 1%, and producer (ex-factory) price inflation has decelerated rapidly and will soon deflate. Bank loan growth remains subdued due to the deepening property market slump and lackluster credit demand in the private sector. In view of the reluctance of households and enterprises to spend, invest and hire, the multiplier of stimulus in this cycle will be lower than in previous ones. China’s property market woes continued in August and a turnaround is not likely in the near term. China’s overseas shipments are set to contract in the months ahead. China needs to reduce interest rates and weaken its exchange rate to battle deflationary pressures and reflate the system. Thus, Chinese authorities will not prevent a further depreciation in the yuan versus the US dollar - as long as the decline is orderly and gradual. Bottom Line: The risk-reward profile remains unattractive for Chinese stocks in absolute terms. For global equity portfolios, we recommend a neutral allocation to Chinese onshore stocks and an underweight stance in investable stocks. Escalating deflationary pressures mean that onshore asset allocators should continue to favor government bonds over stocks.     Recovery prospects for China’s economy remain dim. Despite August’s better-than-expected growth in industrial output and retail sales, economic activity in the months ahead will be weighed down by a lingering real estate slump, recurring disruptions linked to Covid and a budding contraction in exports. Related Report  China Investment StrategyThe Party Congress And Beyond As discussed in our previous report, China’s transition from zero Covid tolerance to a managed approach to living with the virus will be a measured but protracted process. The conditions are not yet in place for a pivotal change in the country’s dynamic zero-Covid strategy. Thus, the risk of outbreaks and ensuing lockdowns still constitute a major hurdle for private domestic demand in the near term. China’s exports are set to shrink in the coming months due to a relapse in global demand for consumer goods (ex-autos). Domestic and external headwinds confronted by China underscore that the primary economic risk is deflation. Chinese policymakers need to lower interest rates and allow the currency to depreciate to battle deflationary pressures. Odds are high that the PBoC will cut rates further. However, the efficacy of reflationary efforts is doubtful due to three factors: uncertainty over the dynamic zero-Covid policy and the outlook for Omicron; persistent real estate woes; and the downbeat sentiment among corporates and households. Chart 1Upsides In Chinese Equity Prices Are Capped Without Aggressive Stimulus Upsides In Chinese Equity Prices Are Capped Without Aggressive Stimulus Upsides In Chinese Equity Prices Are Capped Without Aggressive Stimulus Therefore, our outlook for China’s business cycle remains a U-shaped recovery with risks skewed to the downside in the next few months.  Consistently, the risk-reward of Chinese stocks remains poor. Their absolute performance is also at risk from a further selloff in US/global equities as discussed in the latest Emerging Markets Strategy report. We continue to recommend a neutral stance on Chinese onshore stocks and underweight allocation for Chinese offshore stocks within a global equity portfolio (Chart 1). Depressed Credit Demand And Low Stimulus Multiplier Demand for credit from China’s private sector remains depressed, reflected by a very muted credit impulse when local government bond issuance is excluded (Chart 2). Critically, banks have been unable to accelerate the pace of lending even after the PBoC cut rates and urged them to boost lending (Chart 3). Chart 2The Credit Impulse Remains Muted The Credit Impulse Remains Muted The Credit Impulse Remains Muted Chart 3Subdued Loan Growth Despite Lower Interest Rates Subdued Loan Growth Despite Lower Interest Rates Subdued Loan Growth Despite Lower Interest Rates The growth rate of medium-to-long-term consumer loans, which are primarily composed of residential mortgages, continues to plunge (Chart 4, top panel). New household loan origination is contracting (Chart 4, bottom panel). Our proprietary measure of marginal propensity to spend for households dropped to an all-time low, mirroring consumers’ downbeat sentiment (Chart 5).  Chart 4Household Loan Demand Is Depressed... Household Loan Demand Is Depressed... Household Loan Demand Is Depressed... Chart 5...And Sentiment Remains in The Doldrums ...And Sentiment Remains in The Doldrums ...And Sentiment Remains in The Doldrums Corporate credit flow improved slightly with medium-to-long-term corporate loan growth ticked up in August (Chart 6). While it is difficult to quantify, it is likely that the recent modest improvement in corporate loan growth was mainly due to state-owned banks’ lending to local government financing vehicles (LGFV) to purchase land. The latter is de-facto bailing out local governments that heavily depend on land sales. Land transfer revenues made up 23% of local government aggregate expenditure in the past 12 months (Chart 7). Chart 6Corporate Loan Growth Slightly Improved In August Corporate Loan Growth Slightly Improved In August Corporate Loan Growth Slightly Improved In August Chart 7Land Sales Are Critical For Local Government Financing Land Sales Are Critical For Local Government Financing Land Sales Are Critical For Local Government Financing Chart 8Corporates' Investment Sentiment Is Worsening Corporates' Investment Sentiment Is Worsening Corporates' Investment Sentiment Is Worsening Consistent with poor business sentiment, enterprises’ investment expectation deteriorated in August (Chart 8). Given private-sector’s reluctance to borrow, the multiplier of stimulus will be lower than that in previous cycles. Consequently, China’s policymakers have no choice but to bump up fiscal stimulus and cut interest rates even more. Property Market: No Turnaround In Sight Yet China’s property market woes continued in August with a further weakening in housing market indicators (Chart 9). Home sales tumbled by 25% in August from a year ago. Real estate investment shrinkage deepened and home price deflation accelerated. Property market indicators probably will begin to show a rate-of-change improvement in the coming months due to a more favorable base effect. However, their annual growth rates will remain deeply negative, probably posting a double-digit retrenchment from a year ago. In brief, the level of housing sales will continue withering (Chart 10, top panel). Chart 9Housing Market Activity And Prices Housing Market Activity And Prices Housing Market Activity And Prices Chart 10Shrinking Sales = Less Funding Shrinking Sales = Less Funding Shrinking Sales = Less Funding Shrinking home sales mean a scarcity of funding for real estate developers who heavily rely on advance payments from homebuyers to finance their projects (Chart 10, middle and bottom panels). Hence, a contraction in property investment will remain intact for the next three to six months and housing construction activities will stay depressed (Chart 11). Chart 11Less Funding = Reduced Completions And Investments Less Funding = Reduced Completions And Investments Less Funding = Reduced Completions And Investments Chart 12Households Are Reluctant To Buy When House Prices Are Falling Households Are Reluctant To Buy When House Prices Are Falling Households Are Reluctant To Buy When House Prices Are Falling Interestingly, to revive housing sales, Guangzhou (a southern Chinese metropolis) plans to loosen price controls to allow new house prices to drop up to 20%. Other provinces might follow suit. This would eventually make housing more affordable, but homebuyers might be reluctant to buy until house prices bottom (Chart 12). Therefore, an imminent rebound in home sales is unlikely. Overseas  Shipments Are Set To Shrink China’s export growth, in both value and volume terms, slowed noticeably in August. The global demand for goods continues to dwindle, which does not bode well for Chinese overseas shipments. Imports for processing trade,1 which historically led China’s exports growth by three months, sank in August (Chart 13). In addition, Shanghai’s export container freight index has plummeted sharply (Chart 14). Both signal an impending shrinkage in the country’s exports volume. Chart 13Plummeted Processing Imports Herald A Downtrend In Exports Plummeted Processing Imports Herald A Downtrend In Exports Plummeted Processing Imports Herald A Downtrend In Exports Chart 14A Sign Of Exports Relapse A Sign Of Exports Relapse A Sign Of Exports Relapse Notably, the country’s exports to the US began to wither in August and this trend will only accelerate in the months ahead. We elaborated on the reasons for the global trade contraction in a previous report. Consistently, the continued underperformance of global cyclical stocks versus defensives, which historically has been a good leading indicator of global manufacturing cycles, points to a worldwide manufacturing downturn (Chart 15). This will be bad news for China, which is the largest manufacturing hub in the world. Deflationary Pressures Will Intensify The Chinese economy is facing a deflationary threat with core consumer inflation below 1% and producer (ex-factory) price inflation falling sharply (Chart 16). Chart 15Global Manufacturing Is Heading Into A Contraction Global Manufacturing Is Heading Into A Contraction Global Manufacturing Is Heading Into A Contraction Chart 16The Chinese Economy Is Facing A Risk of Deflation The Chinese Economy Is Facing A Risk of Deflation The Chinese Economy Is Facing A Risk of Deflation As weaknesses in domestic demand, real estate price and exports deepen, deflationary pressures in the mainland economy will likely intensify. Producer prices will begin deflating in the coming months. Manufactured goods prices have already deflated modestly, which will dampen investment in the industrial sector (Chart 17). Deflationary pressures are set to proliferate given that manufacturing output accounts for one-third of China’s GDP and manufacturing investment accounts for 32% of the nation’s overall fixed-asset investment. Investment in the real estate sector deteriorated severely in August. The downtrend in manufacturing and property investments will cap China’s overall capital spending growth through the end of this year, despite the ongoing rebound in infrastructure investment (Chart 18). Chart 17Manufacturing Prices Are Deflating Manufacturing Prices Are Deflating Manufacturing Prices Are Deflating Chart 18Weakness In Property And Manufacturing Investments Will Cap Overall Capital Spending Weakness In Property And Manufacturing Investments Will Cap Overall Capital Spending Weakness In Property And Manufacturing Investments Will Cap Overall Capital Spending Chart 19Sluggish Household Consumption Sluggish Household Consumption Sluggish Household Consumption Weak income growth and an unwillingness by consumers to spend have taken a heavy toll on retail sales and the service sector since early this year. The growth in goods sales volume edged up in August but remains lackluster and well below pre-pandemic levels (Chart 19). In addition, online retail sales of services continued to shrink (Chart 19, bottom panel). More Downside In The RMB  China needs to reduce its interest rates and weaken its exchange rate to battle deflationary pressures. Therefore, Chinese authorities will not mind more deterioration in the yuan versus the US dollar as long as it is gradual. The PBoC lowered the banks’ foreign exchange (FX) deposit reserve requirement ratio (RRR) from 8% to 6%, effective September 15. However, this will have little impact on altering the current weakening trend of the RMB. The balance of FX deposits at commercial banks was US$910 billion at the end of August. A 2% decrease in the FX deposit reserve ratio will only free about US$18 billion in FX liquidity, which is not large compared with US$80 billion in China’s net portfolio outflows through bond and stock connects so far this year. Capital outflows from China will likely persist for the next few months due to the disappointing economic recovery and widening interest rate differential relative to the US (Chart 20). Moreover, slumping exports will heighten selling pressures on the yuan and increase the government’s tolerance for a weaker currency. The FX settlement rate by banks on behalf of clients has continued to drop, which reflects the reluctance of exporters to sell their foreign currency receipts to banks on the expectation that the RMB will weaken even more (Chart 21).   Chart 20China-US Rate Differentials Indicate RMB Depreciation China-US Rate Differentials Indicate RMB Depreciation China-US Rate Differentials Indicate RMB Depreciation Chart 21Contracting Exports Will Weigh On The RMB Contracting Exports Will Weigh On The RMB Contracting Exports Will Weigh On The RMB Furthermore, despite a 12% depreciation against the US dollar since this March, the RMB remains strong in trade-weighted terms (Chart 22). Finally, the RMB is modestly cheap, which does not constitute sufficient conditions for the exchange rate reversal, especially when macro fundamentals warrant a weaker currency (Chart 23). In short, we expect that the RMB has another 5% to fall versus the US dollar. Chart 22RMB Is Strong In Trade-Weighted Terms RMB Is Strong In Trade-Weighted Terms RMB Is Strong In Trade-Weighted Terms Chart 23The RMB Is Modestly Cheap But Might Undershoot The RMB Is Modestly Cheap But Might Undershoot The RMB Is Modestly Cheap But Might Undershoot Stay Cautious On Chinese Equities Deflationary pressures confronted by the Chinese economy suggest that onshore asset allocators should continue to favor government bonds over stocks (Chart 24). Chart 24China's Onshore Stock-To-Bond Ratio Will Continue Relapsing China's Onshore Stock-To-Bond Ratio Will Continue Relapsing China's Onshore Stock-To-Bond Ratio Will Continue Relapsing Chart 25A-Shares Have Broken Below Their 6-Year Moving Average A-Shares Have Broken Below Their 6-Year Moving Average A-Shares Have Broken Below Their 6-Year Moving Average The onshore CSI 300 stock index had broken through its 6-year moving average technical support, which will become new resistance for the index (Chart 25). The Hang Seng Tech index, which tracks Chinese offshore tech stocks/platform companies, has failed to break above its 200-day moving average (Chart 26). The above tell-tale signs raise the odds of cyclical new lows in these indexes. Within Chinese equities, we continue to recommend overweighting interest rate sensitive sectors, such as consumer staples, utilities and autos (Chart 27). Chart 26Chinese Tech Stocks Still Appear Brittle Chinese Tech Stocks Still Appear Brittle Chinese Tech Stocks Still Appear Brittle Chart 27Interest Rate Sensitive Sectors Benefit From Loosening Monetary Conditions Interest Rate Sensitive Sectors Benefit From Loosening Monetary Conditions Interest Rate Sensitive Sectors Benefit From Loosening Monetary Conditions Finally, we reiterate our long A-share index / short MSCI Investable stock index recommendation, a position we initiated in March 2021. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Table 1China Macro Data Summary China: Battling Deflationary Pressures China: Battling Deflationary Pressures Table 2China Financial Market Performance Summary China: Battling Deflationary Pressures China: Battling Deflationary Pressures Footnotes 1     Processing trade refers to the business activities of importing raw materials, components and accessories, and then re exporting the finished products after processing or assembly. Strategic Themes Cyclical Recommendations

Executive Summary There’s Value In TIPS There's Value In TIPS There's Value In TIPS A survey of economic and financial market indicators suggests that we are not yet close to the end of the Fed’s tightening cycle. This argues for a continued flattening of the yield curve and one more push higher in bond yields before the end of the cyclical bond bear market. While headline inflation has rolled over, there is so far little indication of a slowdown in core price appreciation. We see core CPI reaching 3.6% during the next 12 months, driven by decelerating goods prices but sticky wage growth and services inflation. The TIPS market is discounting an overly sanguine view of headline inflation for the next 12 months, and there is value in owning TIPS versus nominal Treasuries. Bottom Line: Investors should reduce portfolio duration to ‘below-benchmark’ and hold a position in 5-year/30-year Treasury curve flatteners. Investors should also overweight TIPS versus nominal Treasuries and own 2-year/10-year TIPS breakeven inflation curve flatteners. Feature US bond yields continued their ascent last week, spurred on by August’s surprisingly high core CPI print and the perception that the Fed will have to tighten policy even more quickly to bring inflation back down. Currently, the market is discounting that the Fed will lift the funds rate to 4.61% by April of next year and then bring it back down to 4.26% by the end of 2023 (Chart 1). Chart 1Rate Expectations Rate Expectations Rate Expectations This market-implied interest rate path would involve 225 bps of tightening at the next 5 FOMC meetings, or an average rate increase of +45 bps per meeting. With a 75 basis point rate increase looking like a lock for this week, market pricing is consistent with additional 50 basis point increases at the final two meetings of this year (November and December) and then two more 25 basis point rate hikes in Q1 2023. After that, the market anticipates that the tightening cycle will be over. Our view continues to be that the peak in the fed funds rate will occur later than April 2023 and that, while a pause in the Fed’s tightening cycle is likely at some point next year, inflation will be strong enough to preclude outright rate cuts. In terms of investment strategy, last week’s report presented empirical evidence showing that, on average, Treasury yields peak 1-2 months before the last rate hike of the cycle.1 In fact, in the seven Fed tightening cycles that we analyzed, the 10-year Treasury yield always peaked within a window spanning four months before the last rate hike and four months after (Table 1). This analysis suggests that even if the fed funds rate peaks in April, as is implied by the market, bond yields likely have one more leg higher before the end of the cyclical bear market. Table 1Timing Fed Tightening Cycles One Last Hurrah For Bond Bears One Last Hurrah For Bond Bears While we have been consistently highlighting that the market is not pricing-in a sufficiently high average fed funds rate for 2023, we have been recommending an ‘at benchmark’ portfolio duration stance on the view that falling inflation could briefly send bond yields lower in the near term. The 10-year Treasury yield did fall back to 2.60% on August 1, but it then rebounded quickly and has continued to head higher since. With Treasury yields unlikely to re-test those depths anytime soon, we recommend shifting to a ‘below-benchmark’ portfolio duration stance to play the final leg higher in bond yields before a US recession ends the cyclical bond bear market. The next section of this report surveys nine cyclical economic indicators and argues that the balance of evidence suggests that the fed funds rate’s peak will occur later than April 2023. Then, the final section of this report discusses our recommended TIPS investment strategy in light of last week’s CPI report and our outlook for inflation. Tracking The Tightening Cycle One of the most useful tools in our arsenal for assessing the state of the interest rate cycle is our Fed Monitor. The Fed Monitor is a composite of 47 economic and financial market variables that has been designed to output a positive value when the data recommend interest rate hikes and a negative value when rate cuts are required. Historically, the Monitor does a good job of lining up with the actual path of the fed funds rate (Chart 2). Chart 2Fed Monitor Says More Tightening Required Fed Monitor Says More Tightening Required Fed Monitor Says More Tightening Required The Fed Monitor is currently down off its highs, but at 1.03 it is well above the zero line. Looking at past tightening cycles, we find that the Monitor has averaged 0.41 on the day of the last rate hike of a cycle, with a range of outcomes spanning -0.49 to +0.93. Notably, the +0.93 upper-end of that range occurred in 1995, a time when the Fed only delivered a modest amount of policy easing before pivoting back to tightening in 1999. The variables in our Fed Monitor can be grouped into three categories: (i) economic growth variables, (ii) inflation variables and (iii) financial market variables. Interestingly, we observe that the Economic Growth component of our Monitor has dipped into negative territory while the Inflation and Financial Conditions components continue to argue for tighter policy (Chart 2, bottom 3 panels). A negative Economic Growth component suggests that we are getting closer to the end of the tightening cycle, but the Fed will likely stay hawkish and tolerate an even deeper negative reading from Economic Growth as long as inflation remains high. In addition to our Fed Monitor, we have identified nine economic indicators (some included in the Fed Monitor and some not) that are particularly relevant for the Fed’s policy stance. In this week’s report, we look at the message these indicators were sending on the day of the last rate hike of seven past tightening cycles. The indicators are: The Sahm Rule: Economist Claudia Sahm has noted that a recession always occurs when the 3-month moving average of the unemployment rate rises by more than 0.5% off its trailing 12-month low.2 We include the unemployment rate’s deviation from its 12-month low as a measure of labor market utilization. Employment Momentum: We look at the 6-month growth rate in nonfarm payrolls as a measure of momentum in the labor market. Inflation: We use 12-month core PCE as a measure of inflation that is most closely related to the Fed’s target. Inflation Momentum: To measure momentum in inflation we look at the difference between 3-month core PCE and 12-month core PCE. Labor Market Tightness: Using responses from the Conference Board’s Consumer Confidence Survey, we look at the number of people who describe jobs as “plentiful” minus the number who describe jobs as “hard to get”. Economic Growth: We use the ISM Manufacturing PMI as a simple measure of the trend in aggregate demand in the US economy. Housing: To assess trends in the housing market we look at the 12-month moving average in housing starts minus the 24-month moving average. Financial Conditions: We use the Goldman Sachs Financial Conditions Index to assess whether financial conditions are accommodative or restrictive. The Yield Curve: We look at the 2-year/10-year Treasury slope to ascertain whether the bond market perceives the monetary policy stance as accommodative or restrictive. Table 2A lists the nine indicators described above and shows their values on the day of the last rate hike of seven past tightening cycles. We also include the current reading from each indicator. Finally, we shade in red every cell that we deem consistent with the Fed stopping its tightening cycle. To make this determination we compare the value on the day of the last rate hike to the median value witnessed on the day of the last hike across all seven tightening cycles. We don’t use median values for the Goldman Sachs Financial Conditions Index or the Treasury slope. Rather, we say that an inverted yield curve and a Financial Conditions reading above 100 are both consistent with the end of rate hikes. Table 2AEconomic Indicators At The End Of Fed Tightening Cycles One Last Hurrah For Bond Bears One Last Hurrah For Bond Bears The last column of Table 2A simply adds up the number of red cells in each row. As of today, we see that only 2 out of nine indicators are consistent with the end of the tightening cycle. The end of a tightening cycle has never occurred with less than four indicators flashing red. Table 2B takes a slightly more sophisticated approach to the same exercise. Rather than simply comparing above or below the median, we rank each indicator as a percentile relative to its value on the day of the last rate hike across seven different tightening cycles. We then combine those percentile ranks with an equal weighting to get an “End of Tightening Score”. Larger values are consistent with a greater likelihood that the tightening cycle will end and lower values are consistent with a lower likelihood. Currently, the End of Tightening Score stands at 28%, lower than on the day of the last rate hike in all of the cycles we analyzed. Table 2BEconomic Indicators At The End Of Fed Tightening Cycles: Percentile Ranks One Last Hurrah For Bond Bears One Last Hurrah For Bond Bears As is the case with our Fed Monitor, the closest End of Tightening Score to today’s occurred in 1995. One key difference between 1995 and today is that core inflation was running much closer to target in 1995. This gave the Fed scope to fine tune its policy stance without risking its inflation fighting credibility. That flexibility is not available to the Fed in today’s high inflation environment. Bottom Line: A survey of economic and financial market indicators suggests that we are not yet close to the end of the Fed’s tightening cycle. This argues for a continued flattening of the yield curve and one more push higher in bond yields before the end of the cyclical bond bear market. Investors should set portfolio duration to ‘below benchmark’ and maintain a position in 5-year/30-year Treasury curve flatteners.3 The TIPS Market Is Too Complacent August’s month-over-month core CPI print came in well above expectations at +0.57%, sending bond yields higher and risk assets lower last week. Zooming out, while falling gasoline prices appear to have shifted the trend in headline inflation, there is so far little evidence of a meaningful move down in core or trimmed mean measures of CPI (Chart 3). Chart 3No Slowdown In Core CPI No Slowdown In Core CPI No Slowdown In Core CPI Chart 4Core CPI Forecast Core CPI Forecast Core CPI Forecast In a recent Special Report, we went through the five major components of CPI (energy, food, shelter, goods and services) and came up with 12-month forecasts for both core and headline inflation.4  For core inflation, we forecast that it will fall to 3.6% during the next 12 months (Chart 4). The main driver of the drop will be a return of goods inflation to pre-pandemic levels (Chart 4, panel 3). We anticipate only a minor pullback in shelter inflation (Chart 4, panel 2) and that services inflation will remain elevated, driven by strong wage growth (Chart 4, bottom panel). Recently, we have seen some evidence that home prices and rents on new leases are decelerating, no doubt a response to high and rising mortgage rates. That said, we don’t anticipate much pass through from those trends into shelter inflation during the next 12 months. First, home price appreciation leads shelter CPI by 18 months (Chart 5A). This means that we shouldn’t expect falling home prices to meaningfully impact shelter inflation until the end of 2023. Second, rental growth on new leases as measured by Zillow and Apartment List has clearly decelerated, but it is still running much hotter than shelter CPI (Chart 5B). Given the limited historical track record, it’s very difficult to say how much (if any) of the recent deceleration in rental growth will ultimately pass through to the CPI. Chart 5AHome Prices & Shelter CPI Home Prices & Shelter CPI Home Prices & Shelter CPI Chart 5BDecelerating Rents Decelerating Rents Decelerating Rents In our research, we have found that measures of labor market utilization are the most important variables to include in any model of shelter inflation. For ease of forecasting, the model shown in Chart 4 and in the top panel of Chart 6 uses the unemployment rate as its measure of labor market tightness. This model works well, but it arguably understates shelter inflation because it doesn’t include a variable capturing wage growth. If we replace the unemployment rate in our model with the more comprehensive aggregate weekly payrolls measure, then we get a much tighter fit and a model that does a better job explaining the recent surge in shelter CPI (Chart 6, bottom panel).5 All in all, we conclude that our expectation that shelter inflation will fall from 6.3% to 4.7% during the next 12 months may wind up being a tad optimistic. When we combine our forecast for 3.6% core inflation with two scenarios for the oil price – a benign one based on what is priced into the futures curve and another based on the forecasts of our commodity strategists – we get an expected range of 2.1% to 4.7% for headline CPI during the next 12 months (Chart 7). According to our Golden Rule of TIPS Investing, if 12-month headline CPI comes in above the current 1-year CPI swap rate then TIPS will outperform nominal Treasuries during the 12-month investment horizon.6 Chart 6Modeling Shelter Inflation Modeling Shelter Inflation Modeling Shelter Inflation Chart 7There's Value In TIPS There's Value In TIPS There's Value In TIPS At present, the 1-year CPI swap rate is 2.76%, near the bottom of our expected range of outcomes for 12-month headline CPI. It seems to us that a lot of things will have to go right for inflation to come in below market expectations during the next year. For this reason, we think it makes sense for investors to overweight TIPS versus nominal Treasuries in US bond portfolios. Chart 8Own Inflation Curve Flatteners Own Inflation Curve Flatteners Own Inflation Curve Flatteners Additionally, we see a lot of value in owning TIPS breakeven curve flatteners (Chart 8). The 2-year and 10-year TIPS breakeven inflation rates are both currently 2.38%, meaning that the 2-year/10-year TIPS breakeven slope is at zero. Higher-than-expected inflation during the next 12 months will put more pressure on the front-end of the breakeven curve than the long end, flattening the curve. Further, logic dictates that an inverted inflation curve is more consistent with an environment where the Fed is fighting above-target inflation than a positively sloped one. There will come a time when it makes sense for the inflation curve to move back into positive territory, but that won’t be until the Fed has brought inflation down much closer to its target. Bottom Line: The inflation outlook priced into markets for the next 12 months is too benign. Investors should overweight TIPS versus nominal Treasuries and own TIPS breakeven inflation curve flatteners.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “A Brief History Of Fed Tightening Cycles”, dated September 13, 2022. 2  https://www.brookings.edu/wp-content/uploads/2019/05/ES_THP_Sahm_web_20190506.pdf 3  For more details on this curve trade please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. 4  Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022. 5  Aggregate weekly payrolls = nonfarm employment x average weekly hours x average hourly earnings 6   Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary This report looks back at seven recent Fed tightening cycles and summarizes evidence concerning how the US Treasury curve behaves relative to the length and magnitude of the tightening cycle. We document a few consistent relationships. For example, the 10-year Treasury yield tends to peak 1-2 months before the last rate hike of the tightening cycle. We also notice that the Treasury slope is usually inverted by the time it troughs and that the 5-year/30-year slope tends to trough before the 2-year/5-year slope. Given our view that the peak fed funds rate may not occur until the second half of 2023, we expect another leg higher in bond yields before we reach the cyclical peak. We also anticipate further flattening of the 5-year/30-year Treasury curve.   Timing Fed Tightening Cycles A Brief History Of Fed Tightening Cycles A Brief History Of Fed Tightening Cycles Bottom Line: Investors should keep portfolio duration close to benchmark for the time being and should position in 5-year/30-year curve flatteners by selling the 10-year bullet versus a duration-matched 5/30 barbell. While we maintain neutral portfolio duration for now, our bias is to be short duration on a medium-to-long run horizon and we may re-evaluate our recommended duration positioning after this month’s important CPI release and September FOMC meeting. Feature BCA’s Annual Investment Conference was held last week, and we heard a wide variety of views about the outlook for US bonds. Unsurprisingly, the main difference between those with bond-bullish and bond-bearish views was that the bullish panelists anticipated a much quicker end to the Fed’s tightening cycle prompted by a US recession starting late this year or early next year. This week’s report takes a more formal look at the historical linkages between Fed tightening cycles and trends in US Treasury yields. Our goal is to provide some firm evidence that investors can use to translate their views about the length and magnitude of the Fed tightening cycle into concrete positions across the US Treasury curve. Specifically, we look at seven Fed tightening cycles – the five most recent cycles and the two periods of tightening that occurred during the inflationary surge of the early-1980s. The 1977-80 Cycle Chart 1The 1977-80 Cycle The 1977-80 Cycle The 1977-80 Cycle The Fed raised the funds rate by 11.75% between August 1977 and March 1980 in response to sky-high inflation. Then, despite core CPI inflation still running at 12%, it cut rates by 5.5% in 1980 in response to an unemployment rate that had climbed above 6%. This proved to be only a brief reprieve from monetary tightening. With inflation still a problem, the Fed pivoted back to rate hikes later in 1980 even as the unemployment rate continued its ascent. Turning to markets, we see that the Treasury index lost 22% versus a position in cash during the 1977-80 tightening cycle and that index returns troughed in March 1980, around the same time as the last rate hike. The 10-year Treasury yield peaked one month before the last rate hike at 12.72%, 378 bps below the peak fed funds rate that would be attained one month later (Chart 1). As for the shape of the yield curve, the 2-year/10-year Treasury slope troughed at -201 bps one month before the last rate hike of the cycle (panel 4). The 2-year/5-year Treasury slope troughed at -132 bps in the same month as the peak in the funds rate and the 5-year/30-year slope troughed at -123 bps, one month before the last hike (bottom panel). The 1980-81 Cycle After a brief period of cuts in mid-1980, having still not conquered inflation the Fed changed course and lifted the funds rate to a new high in 1981. It did this even with the unemployment rate above 7%. One interesting aspect of this tightening cycle is that the bond market continued to sell off even after the Fed delivered its last rate increase. While the period of Fed tightening spanned from October 1980 until May 1981, excess Treasury index returns versus cash continued to fall until September 1981, losing 20% in the process (Chart 2). The 10-year Treasury yield also peaked four months after the last rate hike at 15.84%, 316 bps below the peak funds rate that was attained four months earlier. Chart 2The 1980-81 Cycle The 1980-81 Cycle The 1980-81 Cycle Looking at the Treasury curve, the 2-year/10-year slope troughed at -132 bps three months after the last rate hike (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed three months after the last rate hike, at -62 bps and -133 bps, respectively (bottom panel). The 1988-89 Cycle The Fed lifted rates from 6.5% in March 1988 to 9.8% in May 1989. Peak-to-trough, the Treasury index lost 7.7% versus cash during this period but returns did trough two months before the last rate hike. The 10-year Treasury yield peaked three months before the last rate hike at 9.32%, 48 bps below the peak fed funds rate (Chart 3). Chart 3The 1988-89 Cycle The 1988-89 Cycle The 1988-89 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at -43 bps (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed two months before the last rate hike, at -20 bps and -42 bps, respectively (bottom panel). The 1994-95 Cycle The Fed doubled the funds rate from 3% in February 1994 to 6% in February 1995. Peak-to-trough, the Treasury index lost 9.4% versus cash during this period but returns did trough three months before the last rate hike. The 10-year Treasury yield peaked three months before the last rate hike at 7.91%, 191 bps above the peak fed funds rate (Chart 4). Chart 4The 1994-95 Cycle The 1994-95 Cycle The 1994-95 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at +15 bps (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed two months before the last rate hike, at +14 bps and +6 bps, respectively (bottom panel). In contrast to earlier cycles, it’s notable that the yield curve never inverted during the 1994-95 tightening cycle and that the 10-year Treasury yield peaked at a level significantly above the fed funds rate. The most likely reason for this is that the Fed’s pivot from rate hikes to cuts in early 1995 occurred abruptly and came as a surprise to market participants. A quick look at the economic data makes it easy to see why. The core PCE and core CPI inflation rates were elevated at the time, at 2.3% and 3.0% respectively, and the unemployment rate was significantly down from a year earlier. The 1999-2000 Cycle The Fed lifted rates from 4.75% in June 1999 to 6.5% in May 2000. Peak-to-trough, the Treasury index lost 8.2% versus cash during this period but returns did trough four months before the last rate hike. The 10-year Treasury yield also peaked four months before the last rate hike at 6.68%, 18 bps above the peak fed funds rate (Chart 5). Chart 5The 1999-2000 Cycle The 1999-2000 Cycle The 1999-2000 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at -47 bps (panel 4). The 5-year/30-year slope troughed one month before the last rate hike at -59 bps but the 2-year/5-year slope didn’t trough until three months after the last rate hike at -15 bps (bottom panel). The 2004-06 Cycle The Fed lifted rates in steady increments of 25 bps per meeting from 1% in June 2004 to 5.25% in June 2006. Peak-to-trough, the Treasury index lost 5.3% versus cash during this period and returns troughed around the same time as the funds rate reached its peak. The peak in the 10-year Treasury yield also occurred at the same time as the peak in the funds rate, though the peak 10-year was 10 bps below the peak funds rate (Chart 6). Chart 6The 2004-06 Cycle The 2004-06 Cycle The 2004-06 Cycle On the Treasury curve, the 2-year/10-year slope troughed five months after the last rate hike of the cycle at -16 bps (panel 4). The 2-year/5-year slope also troughed five months after the last rate hike at -20 bps, while the 5-year/30-year slope troughed much earlier, four months before the last rate hike at -10 bps (bottom panel). The 2015-18 Cycle Finally, in the most recent tightening cycle before the current one, the Fed lifted rates off the zero-lower-bound in December 2015, went on hold for 12 months and then delivered a string of rate hikes bringing the funds rate up to 2.5% by December 2018. Peak-to-trough, the Treasury index lost 6.7% versus cash during this period and returns troughed two months before the peak in the fed funds rate. The peak in the 10-year Treasury yield also occurred two months before the last rate hike at 3.15%, 65 bps above the peak funds rate (Chart 7). Chart 7The 2015-18 Cycle The 2015-18 Cycle The 2015-18 Cycle On the Treasury curve, the 2-year/10-year slope troughed eight months after the last rate hike of the cycle at 0 bps (panel 4). The 2-year/5-year slope also troughed eight months after the last rate hike at -17 bps, while the 5-year/30-year slope troughed much earlier, five months before the last rate hike at +23 bps (bottom panel). Summarizing The Evidence Tables 1 and 2 summarize the data from the seven tightening cycles that we examined. Four main points jump out. Table 1Timing Fed Tightening Cycles A Brief History Of Fed Tightening Cycles A Brief History Of Fed Tightening Cycles Table 2Fed Tightening Cycles: Peak And Trough Levels A Brief History Of Fed Tightening Cycles A Brief History Of Fed Tightening Cycles First, both the level of the 10-year Treasury yield and the Bloomberg Barclays Treasury Excess Return Index tend to hit inflection points around the time of the last rate hike of the cycle. On average, the 10-year Treasury yield peaks 1.3 months before the last rate hike of the cycle, and it has always hit its peak within a window spanning four months before the last hike and four months after. The timing of the trough in index excess returns versus cash looks similar. Second, the 2-year/10-year Treasury slope also tends to trough near the end of the Fed tightening cycle, but the timing of this inflection point varies a lot more than the timing of the peak in yields. In fact, during the last two cycles the 2-year/10-year slope didn’t trough until well after the last rate hike. Third, the 5-year/30-year Treasury slope always troughs at the same time or earlier than the 2-year/5-year Treasury slope. This is consistent with our intuition that the long end of the yield curve will respond more quickly to changes in the economic outlook than the front end of the curve, which remains more tied to the current policy rate. Fourth, there isn’t much consistency in where the 10-year Treasury yield peaks relative to the peak fed funds rate. On average, the 10-year yield tops out 120 bps below the peak fed funds rate, but there is a wide range of outcomes. The 10-year yield peaked 378 bps below the peak fed funds rate in the 1977-80 tightening cycle and it peaked 65 bps above the peak fed funds rate in the 2015-18 cycle. The same holds true for the slope of the Treasury curve. The trough in the slope exhibits a wide range of outcomes, though it is fair to say that we typically expect the slope to be negative when it bottoms. The 2-year/10-year Treasury slope only failed to invert in two tightening cycles (1994-95 and 2015-18) and in both of those cases the Fed was not expected to deliver a large number of rate cuts. In fact, it could have easily been argued that rate cuts were unnecessary based on the inflation and employment data at the time. Investment Implications In applying the lessons from this analysis to the current environment, the first conclusion we reach is that we should only look to extend portfolio duration to above-benchmark when we think that the last rate hike of the cycle will occur in 1-2 months. Currently, the market is priced for the fed funds rate to peak in June 2023 and we expect that peak could occur even later (Chart 8). For this reason, we anticipate another significant leg higher in Treasury yields before the cyclical peak is reached. Chart 8Rate Expectations Rate Expectations Rate Expectations Our historical analysis of past tightening cycles also supports our recommended short 10-year bullet, long 5-year/30-year barbell positioning along the Treasury curve.1 Given that the 5-year/30-year Treasury slope has always troughed within a window spanning five months before the last rate hike and three months after, it makes sense to position for another leg down. This is a particularly attractive trade on the 5-year/30-year portion of the curve because that slope remains in positive territory.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on this trade please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Chart 1A Hot Labor Market A Hot Labor Market A Hot Labor Market The balance of data that’s come out during the past month points to a labor market that is not cooling very quickly. In fact, it is cooling much more slowly than we anticipated. First, nonfarm payroll growth of +315k in August is well above the +79k that is needed to maintain the unemployment and participation rates at current levels (Chart 1). Second, what had initially looked like a significant drop in job openings was revised away with the July JOLTS report. While the ratio of job openings to unemployed has leveled-off just below 2.0, it is no longer showing any signs of falling (bottom panel). Finally, the employment component of August’s ISM Manufacturing PMI jumped back above 50 and even initial unemployment claims have reversed their nascent uptrend. The conclusion we draw from this spate of strong employment data is that the Fed’s tightening cycle is not close to over. This means that the average fed funds rate that is priced into markets for 2023 is almost certainly too low. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Still Too Hot Still Too Hot Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* Still Too Hot Still Too Hot Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to -267 bps. The average index option-adjusted spread tightened 4 bps on the month, and it currently sits at 145 bps. Our quality-adjusted 12-month breakeven spread ticked up to its 56th percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve suggests that the credit cycle is in its late stages. Corporate bond performance tends to be weak during periods when the yield curve is very flat or inverted. Despite our underweight 6-12 month investment stance, we wouldn’t be surprised to see some modest spread narrowing during the next couple of months as inflation heads lower. That said, spread compression will be limited by the inverted yield curve and the persistent removal of monetary accommodation. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 28 basis points in August, dragging year-to-date excess returns down to -519 bps. The average index option-adjusted spread tightened 15 bps on the month and it currently sits at 494 bps, 125 bps above the 2017-19 average and 43 bps below the 2018 peak. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – increased modestly in August. It currently sits at 6.6% (Chart 3). As is the case with investment grade, high-yield spreads could stage a relief rally during the next few months as inflation falls and recession fears abate. However, the inverted yield curve will likely prevent spreads from moving much below the average level seen during the last tightening cycle (2017-19). All that said, even a move back to average 2017-19 levels would equate to a roughly 7% excess return for the junk index if it is realized over a six month period. This return potential is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we will downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to our 4% estimate of its underlying trend.3 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 100 basis points in August, dragging year-to-date excess returns down to -144 bps. We discussed the outlook for Agency MBS in a recent report.4 We noted that MBS’ poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is over. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have an incentive to refinance at current mortgage rates. With the duration extension trade over, the only thing preventing us from increasing exposure to the Agency MBS space is that spreads still aren’t sufficiently attractive. The average index spread versus duration-matched Treasuries is roughly midway between its post-2014 minimum and post-2014 mean (panel 4). Meanwhile, the option-adjusted spread has moved above its post-2014 mean (bottom panel), but at just 42 bps, it still offers less compensation than a Aa-rated corporate bond or a Aaa-rated consumer ABS. At the coupon level, we moved to a neutral allocation across the coupon stack last month, but this month we initiate a recommendation to favor high-coupon (3%-4.5%) securities over low coupon (1.5%-2.5%) ones. Given the lower duration of high coupon MBS, this position will profit from rising bond yields on a 6-12 month investment horizon. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds outperformed the duration-equivalent Treasury index by 156 basis points in August, bringing year-to-date excess returns up to -563 bps. EM Sovereigns outperformed the Treasury benchmark by 117 bps on the month, bringing year-to-date excess returns up to -677 bps. The EM Corporate & Quasi-Sovereign Index outperformed by 180 bps, bringing year-to-date excess returns up to -491 bps. The EM Sovereign index outperformed the duration-equivalent US corporate bond index by 111 bps in August. Meanwhile, the yield differential between EM sovereigns and US corporates moved deeper into negative territory (Chart 5). As such, we continue to recommend a maximum underweight (1 out of 5) allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 168 bps in August. The index continues to offer a significant yield advantage versus duration-matched US corporates (panel 4). As such, we continue to recommend a neutral (3 out of 5) allocation to the sector. China is the most important trading partner for most EM countries and thus represents a major source of economic growth. Consequently, Chinese import volumes are a useful gauge for the outlook of EM economies. The persistent contraction of Chinese import volumes (bottom panel) therefore sends a negative signal for EM bond performance. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 126 basis points in August, bringing year-to-date excess returns up to -44 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong, but governments have been slow to hire (Chart 6).5 The result is that net state & local government savings are incredibly high (bottom panel) and it will take some time to deplete those coffers. On the valuation front, munis have cheapened up relative to both Treasuries and corporates since last year. The 10-year Aaa Muni / Treasury yield ratio is currently 82%, up from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation municipal bonds and duration-matched US corporates is 80%. The same measure for Revenue bonds is 94%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5/30 Barbell Versus 10-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in August as investors significantly marked up their 12-month rate expectations. Our 12-month Fed Funds Discounter – the market’s expected 12-month change in the funds rate – rose from 78 bps to 175 bps during the month and this caused the 2-year/10-year Treasury slope to flatten by 8 bps and the 5-year/30-year Treasury slope to flatten by 33 bps (Chart 7). We initiated a position in 5/30 flatteners (short 10-year bullet versus duration-matched 5/30 barbell) in our August 9th report.6 The main reason for this recommendation is our view that the Fed tightening cycle is not close to over. Therefore, it is too soon to position for a steepening of the 5-year/30-year Treasury slope. An analysis of past Fed tightening cycles shows that the 5-year/30-year Treasury slope tends to trough earlier than other segments of the yield curve. However, that trough has always occurred within a window spanning five months before the last Fed rate hike and three months after.7 On average, the 5-year/30-year slope troughs 1-2 months before the last Fed rate hike. Given our view that the Fed tightening cycle still has a lot of room to run, we think it makes sense to bet on a further flattening of the 5-year/30-year slope. This trade looks particularly attractive when you consider that a position short the 10-year bullet and long a duration-matched 5/30 barbell provides a yield pick-up of 12 bps (bottom panel). TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 8 basis points in August, bringing year-to-date excess returns up to +264 bps. The 10-year TIPS breakeven inflation rate fell 5 bps on the month, moving back into the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Meanwhile, our TIPS Breakeven Valuation Indicator shows that 10-year TIPS are close to fairly valued versus nominals. In a recent report we unveiled our Golden Rule of TIPS Investing.8 In that report we showed that TIPS of all maturities tend to outperform equivalent-maturity nominal bonds whenever headline CPI inflation exceeds the 1-year CPI swap rate during a 12-month period. The 1-year CPI swap rate is currently 2.77%, and we think this will turn out to be too low based on our modeling of headline CPI. While we see value in TIPS relative to nominals, especially at the front-end of the curve, we also suspect that more value will be created during the next few months as CPI prints come in soft. Therefore, we are reluctant to immediately upgrade TIPS to overweight. Instead, we recommend that investors initiate a 2-year/10-year TIPS breakeven inflation curve flattener. The 2/10 TIPS breakeven inflation curve has recently jumped into positive territory (bottom panel), but an inverted inflation curve is much more consistent with the current macro environment where the Fed is battling above-target inflation. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to -25 bps. Aaa-rated ABS outperformed by 19 bps on the month, bringing year-to-date excess returns up to -24 bps. Non-Aaa ABS outperformed by 76 bps on the month, bringing year-to-date excess returns up to -28 bps. Substantial federal government support caused US households to build up an extremely large buffer of excess savings during the past two years. This year, consumers are starting to draw down that savings and are even starting to take on more debt. The amount of outstanding credit card debt is still low relative to household income, but it is rising quickly in absolute terms (Chart 9). Elsewhere, consumers are still paying down their credit card balances at high rates (panel 4), but banks are no longer easing lending standards on auto loans or credit cards (panel 3). To us, the prevailing evidence suggests that it will be a long time before delinquencies are a serious problem for consumer ABS. This justifies our overweight recommendation. That said, given that the trend toward consumer re-leveraging is in full swing, it makes sense to turn more cautious at the margin. We therefore close our prior recommendation to favor non-Aaa over Aaa-rated consumer ABS and move to a neutral allocation across the consumer ABS credit curve. Non-Agency CMBS: Overweight Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 26 basis points in August, bringing year-to-date excess returns up to -150 bps. Aaa Non-Agency CMBS outperformed Treasuries by 20 bps on the month, bringing year-to-date excess returns up to -103 bps. Non-Aaa Non-Agency CMBS outperformed by 41 bps on the month, bringing year-to-date excess returns up to -280 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently close to their historic averages. However, the most recent Senior Loan Officer Survey showed tightening lending standards and weaker demand for commercial real estate (CRE) loans (Chart 10). This suggests a more negative back-drop for CRE prices and CMBS spreads and causes us to reduce our recommended allocation from overweight (4 out of 5) to neutral (3 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 29 basis points in August, dragging year-to-date excess returns down to -44 bps. The average index option-adjusted spread held flat on the month, close to its long-term average (bottom panel). At 55 bps, the average Agency CMBS spread continues to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 175 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Still Too Hot Still Too Hot Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 1, 2022) Still Too Hot Still Too Hot 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 1, 2022) Still Too Hot Still Too Hot 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 -7 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 7 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) Still Too Hot Still Too Hot Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of September 1, 2022) Still Too Hot Still Too Hot   Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1     Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2     Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3    For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4    Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5    Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 6    Please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. 7     In our analysis we examined seven Fed tightening cycles. The five most recent cycles and the two cycles that occurred during the inflation spike of the early 1980s. 8    Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

A message for Foreign Exchange Strategy clients, There will be no report next week, as we take a summer break. We will be joining our clients and colleagues for our annual investment conference to be held in New York, on September 7 & 8. We will resume our publication the following week, with a Special Report on the Hong Kong dollar, together with our China Investment Strategy colleagues. Looking forward to seeing many of you in person. Kind regards, Chester Ntonifor, Foreign Exchange Strategist Executive Summary No Urgency To Tighten Policy No Urgency To Tighten Policy No Urgency To Tighten Policy The biggest medium-term threat for Japan remains deflation, rather than inflation. This suggests that the BoJ will be loathe to abandon yield curve control anytime soon. That said, inflation is still accelerating globally, and has meaningfully picked up in Japan. Betting on a hawkish BoJ policy shift could therefore be a significant macro trade. We have identified five conditions that need to be met for the BoJ to begin removing accommodation. None are currently indicating an imminent need to alter monetary policy settings, particularly with the Japanese economy softening alongside subdued inflation expectations. The yen will soar on any hawkish BoJ policy shift. Currently, BCA Foreign Exchange Strategy is short EUR/JPY. That said, the historical evidence suggests waiting for an exhaustion in yen selling pressure, before placing fresh bets on selling USD/JPY. Longer-term bond yields in Japan, for maturities beyond the BoJ yield target, are already moving higher, while speculative interest in shorting JGBs has increased.  We recommend fading these trends for now – shorting JGBs outright will remain a “widowmaker trade”. Bottom Line: The yen has undershot and longer-term investors should buy it - our preferred way to express that view in the near-term is to be short EUR/JPY.  Bond investors should be underweight “low-beta” JGBs in fixed-income portfolios on a tactical basis, not as a hawkish BoJ bet, but because global bond yields are more likely to stay in broad trading ranges than break to new highs. Feature Chart 1The BoJ Is A Lonesome Dove When Will The BoJ Abandon Yield Curve Control? When Will The BoJ Abandon Yield Curve Control? Almost every G10 central bank has raised rates over the last 12 months, even the perennially dovish banks like the ECB and Swiss National Bank, in response to soaring inflation.  The one exception has been the Bank of Japan (BoJ). The BoJ has kept policy rates unchanged throughout the year (Chart 1), while also maintaining its Yield Curve Control policy of capping 10-year Japanese government bond (JGB) yields at 0.25%. There has been interest from the macro investor community on Japan in recent months, betting on the BoJ eventually succumbing to the global monetary tightening trend.  If the BoJ were to shift gears and turn less accommodative, then the yen would surely soar, while JGBs will go on a fire sale. In this report, jointly published by BCA Research Foreign Exchange Strategy and Global Fixed Income Strategy, we explore the necessary conditions that need to be in place for the BoJ to meaningfully shift policy, most likely starting with the end of Yield Curve Control before interest rate hikes. We see five such conditions, which will form a “checklist” to be monitored in the months ahead. Condition 1: Overshooting Inflation Expectations The BoJ has a policy mandate on inflation and most measures of underlying Japanese inflation are still well below its 2% target. For example, the weighted median and mode CPI inflation rates are only at 0.5%, even as headline CPI inflation has climbed to 2.6% on the back of two primarily non-domestic factors – rapidly rising prices for energy and goods (Chart 2). With such low baseline inflation, it has been hard to lift market-based Japanese inflation expectations like CPI swap rates above 1%, even as far out as ten years (Chart 3). CPI swaps have tended to provide a more realistic assessment of underlying Japanese inflation, adhering more closely to trends in realized core CPI inflation, and thus deserve the most attention from the BoJ.  This is in stark contrast to the BoJ’s own consumer survey of inflation expectations, that has consistently overestimated inflation over the years, which is currently showing both 1-year-ahead and 5-year-ahead inflation expectations at a startling, yet highly inaccurate, 5%.  Chart 2Low Underlying Inflation In Japan Low Underlying Inflation In Japan Low Underlying Inflation In Japan Chart 3No Unmooring Of Inflation Expectations In Japan No Unmooring Of Inflation Expectations In Japan No Unmooring Of Inflation Expectations In Japan The BoJ is likely to side with the more subdued read on market-based inflation expectations in determining if monetary policy needs to turn less dovish – especially with the BoJ’s own estimate of the output gap now at -1.2%, indicating spare capacity in the economy and a lack of underlying inflation pressures (Chart 4). Chart 4Japan Still Suffers From Excess Capacity Japan Still Suffers From Excess Capacity Japan Still Suffers From Excess Capacity Condition 2: Excessive Yen Weakness Our more comprehensive measure of determining the pressure to change monetary policy is captured in our central bank monitor for Japan, a.k.a. the BoJ Monitor.  The Monitor includes economic, inflation and financial variables. This measure suggests that the BoJ should not be tightening monetary policy today (Chart 5). One of the variables that goes into our BoJ Monitor is the yen. The yen impacts monetary conditions through two ways. First, import prices tend to rise as the yen weakens, feeding into domestic inflation. In short, it eases monetary conditions. That has been the story over the last year with the yen falling -15% on a trade-weighted basis (Chart 6). The second impact is through profit translation effects. Overseas earnings for Japanese exporters are buffeted in yen terms as the currency depreciates. Both impacts would tend to put more pressure to tighten monetary policy, on the margin. Chart 5No Urgency To Tighten Policy No Urgency To Tighten Policy No Urgency To Tighten Policy Chart 6Yen Weakness Only Generates Temporary Inflation Yen Weakness Only Generates Temporary Inflation Yen Weakness Only Generates Temporary Inflation However, the impact of yen weakness in boosting profit translation costs for Japanese concerns has eased over the years. As many Japanese companies have offshored production, lower wages in Japan have been offset by higher costs abroad. As a result, profit margins for multinational Japanese corporations are not rising meaningfully relative to their G10 peers, despite yen weakness (Chart 7). That puts the central bank in a quandary regarding how to interpret yen weakness vis-à-vis future policy moves. On the one hand, soaring global inflation and a weak yen should be allowing the BoJ to declare victory on rising inflation expectations in Japan. On the other hand, domestic wage growth will not reach “escape velocity” (Chart 8), and inflation will fail to overshoot on a sustainable basis, if corporate profit margins are not rising meaningfully. Chart 7No Widespread Signs Of Increased Profitability From Yen Weakness No Widespread Signs Of Increased Profitability From Yen Weakness No Widespread Signs Of Increased Profitability From Yen Weakness Chart 8No Escape Velocity Yet In Japanese ##br##Wages No Escape Velocity Yet In Japanese Wages No Escape Velocity Yet In Japanese Wages Of course, Japanese authorities care about excessive moves in the yen, but they also understand their limited ability to alter the path of the currency. The Ministry of Finance last intervened to support the currency in 1998. That helped the yen temporarily, but global factors dictated its longer-term trend. A BoJ monetary tightening designed solely to stabilize the yen, before inflation expectations stabilize at the BoJ target, is a recipe for failure on both fronts. The bottom line is that yen weakness is giving a lift to inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year just to generate a one percentage point increase in Japanese inflation. As such, the current bout of yen weakness is unlikely to alter the longer-term goals of BoJ policy, unless a wave of selling undermines financial stability. Condition 3: Continually Rising Energy Costs Chart 9Japan Is More Energy Dependent Than Many Other Countries Japan Is More Energy Dependent Than Many Other Countries Japan Is More Energy Dependent Than Many Other Countries Policy makers in the eurozone have told us that even in the face of a recession, a threat to their credibility on price stability – like the energy-fueled overshoot of European inflation - is worth defending through monetary tightening. Thus, a continued external energy shock could also cause the BoJ to shift. Our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium on oil to increase in the near term. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 9). A rise in energy costs that unanchors inflation expectations is a threat worth monitoring for the BoJ, one that could drag it into monetary tightening as has been the case in Europe. That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent is likely to soften, assuaging energy import costs (Chart 10). Japan is also ramping up nuclear power production, which can help provide alternative sources to imported energy (Chart 11). Chart 10An Unprecedented Arbitrage An Unprecedented Arbitrage An Unprecedented Arbitrage Chart 11Nuclear Power Could Help? Nuclear Power Could Help? Nuclear Power Could Help? The BoJ would likely not consider an early exit from accommodative monetary policy based solely on energy-fueled inflation.  After all, the current surge in global energy prices, compounded by yen weakness, has barely pushed headline inflation above the BoJ 2% target – with little follow-through into core inflation or wage growth. Condition 4: An Economic Revival In Japan A burst in Japanese growth that absorbs excess capacity and tightens labor market conditions could convince the BoJ that a policy adjustment is due. This could result in higher Japanese interest rates and bond yields.  The yen also tends to appreciate when the Japanese economy is improving (Chart 12). Unfortunately, Japanese growth momentum is going in the wrong direction for that outcome. Chart 12The Yen And the Japanese Economy The Yen And the Japanese Economy The Yen And the Japanese Economy Domestic demand has been under siege from the lingering effects of the pandemic, including an unprecedented collapse in tourism. As the pandemic effects have faded, however, Japan’s economy faces new threats from slowing global growth, waning export demand, and declining consumer confidence (Chart 13). It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains nearly three percentage points below the level implied by its pre-pandemic trend. While Japan’s unemployment rate is 2.6% and falling, it remains above the low reached just before the start of the pandemic. Chart 13A Broad-Based Slowing Of Japanese Growth A Broad-Based Slowing Of Japanese Growth A Broad-Based Slowing Of Japanese Growth What Japan needs now is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Stronger fiscal spending could lift animal spirits in Japan and cause the BoJ to shift. Yet even on that front, the evidence does not point to a direct link from fiscal stimulus to rising inflation expectations – a necessary catalyst for the BoJ to turn more hawkish. A recent study by the Federal Reserve Bank of San Francisco concluded that there was no boost to depressed Japanese inflation expectations from the massive Japanese government fiscal programs during the worst of the 2020 COVID-19 pandemic shock. Waning Japanese economic momentum is not putting any pressure on the BoJ to begin considering a shift to less accommodative monetary settings. Condition 5: More Hawkish Members At The BoJ There are important transitions occurring within the BoJ’s nine-member board that could change the policy bias in a less dovish direction.  In July, two new board members – Hajime Takata and Naoki Tamura – were appointed to the BoJ board. Both brought up the notion of the need for an “exit strategy” from current easy monetary policies at their introductory press conference, although both were also careful to state that they did not think the conditions were in place yet for that to occur. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? Nonetheless, the two new appointees represent a marginally hawkish shift in the policy bias of the BoJ board, especially Takata who replaced one of the more vocal advocates for maintaining aggressive monetary easing, economist Goushi Kataoka.  Of course, the big change at the top of the BoJ will come next April when Governor Haruhiko Kuroda’s current term ends. This will follow the departures of the two deputy governors, Masayoshi Amamiya and Masazumi Wakatabe in March. That means five of nine board members would be changed in less than one year, including the most senior leadership. That would be a huge change for any central bank, but especially for the BoJ where Governor Kuroda has overseen the introduction of all the current aggressive monetary policies, from negative interest rates to massive quantitative easing to Yield Curve Control. A growing constraint for the future of Yield Curve Control As outlined earlier, underlying inflation and growth trends in Japan are nowhere close to justifying an end to Yield Curve Control or even a mere upward tweak of the current 0.25% yield target on 10-year JGBs. However, there are negative spillover effects from the BoJ’s bond market manipulation that could make the current policies less sustainable over the medium term for the new incoming BoJ leadership. We addressed one of those issues earlier with the extreme yen weakness, which is largely a product of the BoJ keeping a lid on Japanese interest rates while almost the entire rest of the world is in a monetary tightening cycle. But another issue to be addressed is the impaired liquidity of the JGB market. After years of steady, aggressive bond buying, the BoJ has essentially “cornered” the JGB market.  The central bank now owns roughly 50% of all outstanding JGBs, doubling its ownership share since Yield Curve Control started in 2016 (Chart 14).  The numbers are even more extreme when focusing on the specific maturity targeted by the BoJ under Yield Curve Control, with the central bank now owning nearly 80% of all 10-year JGBs (Chart 15). Chart 14The BoJ Has Cornered The JGB Market The BoJ Has Cornered The JGB Market The BoJ Has Cornered The JGB Market Chart 15BoJ Now Owns 80% Of 10yr JGBs When Will The BoJ Abandon Yield Curve Control? When Will The BoJ Abandon Yield Curve Control? By absorbing so much supply of the main risk-free asset in the Japanese financial system, the BoJ has made life more difficult for Japanese commercial banks, insurance companies and pension funds that require JGBs for regulatory and risk management purposes. In the most recent BoJ survey of bond market participants, 68 of 69 firms surveyed described the JGB market as having poor liquidity conditions, with an equal amount stating that JGB trading conditions were as bad or worse than three months earlier. The change in BoJ leadership could also bring about a change in policymakers’ desire to continue manipulating the JGB market via Yield Curve Control.  Although the BoJ would have to be very careful in how it signals and executes any change to Yield Curve Control.  There is currently a very wide gap between a 10-year JGB yield at 0.25% and a 30-year JGB yield at 1.25% (Chart 16). If the BoJ completely ended Yield Curve Control, the 10-year yield would converge rapidly towards that 30-year yield, likely reaching 1%. That would create a major negative total return shock to the Japanese banks and institutional investors that still own nearly 40% of JGBs. Chart 1610yr JGB Yields Will Surge Without Yield Curve Control 10yr JGB Yields Will Surge Without Yield Curve Control 10yr JGB Yields Will Surge Without Yield Curve Control A more likely outcome would be the BoJ raising the yield target on the 10-year to something like 0.50%, or perhaps shifting to a different maturity target where the BoJ owns a smaller share of outstanding JGBs like the 5-year sector. Yet without an actual trigger for such a move coming from faster economic growth or core inflation hitting the 2% BoJ target, it is highly unlikely that the BoJ would dare tinker with its yield curve policy, and risk a JGB market blowup, solely over concerns about bond market liquidity. Investment Conclusions None of the items in our newly constructed “BoJ Checklist” are currently indicating that a shift in Japanese monetary policy is imminent.  We therefore see it as being too early to put on the legendary “widowmaker trade” of shorting JGBs, although a case can be made to go long the yen based on longer-term valuation considerations. Japanese yen The carnage in the yen is in an apocalyptic phase, but the BoJ is unlikely to rescue the yen in the near term. As such, short-term traders should be on the sidelines. For longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 17). Meanwhile, according to our PPP models (and a wide variety of others), the Japanese yen is the cheapest G10 currency, undervalued by around -41% (Chart 18). BCA Foreign Exchange Strategy is currently long the yen versus the euro and the Swiss franc. Chart 17The Yen Is On Sale The Yen Is On Sale The Yen Is On Sale Chart 18The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap JGBs Chart 19Stay Tactically Underweight JGBs Stay Tactically Underweight JGBs Stay Tactically Underweight JGBs In the absence of a bearish domestic monetary policy trigger, JGBs should be treated by global bond investors as a risk management tool as much as anything else. The relative return performance of JGBs versus the Bloomberg Global Treasury Index of government bonds is highly correlated to the momentum of global bond yields (Chart 19). Thus, increasing the exposure to JGBs in a global bond portfolio is akin to reducing the interest rate duration of a bond portfolio – both positions will help a portfolio outperform its benchmark when global bond yields rise. On a tactical basis (3-6 month time horizon), an underweight allocation to JGBs in government bond portfolios seems appropriate, even with JGBs offering relatively attractive yields on a currency-hedged basis, most notably for USD-based investors.  Global bond yields are more likely to stay in broad trading ranges, capped by slowing global growth and decelerating goods inflation but floored by stickier non-goods inflation and hawkish central banks. Thus, the defensive properties of JGBs as a “duration hedge” in global bond portfolios are less necessary in the near-term. Beyond the tactical time horizon, the uncertainty over the potential makeup of new BoJ leadership in 2023, along with some easing of global inflation pressures from the commodity space, could justify lower JGB exposure on a more structural basis - if it appears that a new wave of more hawkish policymakers is set to take over in Tokyo. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023.  If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 The Peak In Core PCE Inflation In February 2022 The Peak In Core PCE Inflation In February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023.  Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent.   Chart 1Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 2Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 13Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Low-Yielding Countries Facing High USD Hedging Costs Low-Yielding Countries Facing High USD Hedging Costs Low-Yielding Countries Facing High USD Hedging Costs The US dollar will remain strong alongside continued Fed rate hikes. Interest rate differentials will remain positive for the greenback, alongside other USD-positive factors like slowing global growth and rising investor risk aversion. Relatively high US interest rates have made hedging away US currency risk very expensive for some of the largest holders of US Treasuries like Japan. US Treasury yields, on an FX-hedged basis, look unattractive relative to local currency denominated bonds across the developed world. Increased foreign demand for US Treasuries evident in the US TIC data appears to reflect a re-establishment of positions unwound by global hedge funds and mutual funds dating back to the 2020 “dash for cash” in global financial markets. UST yields must rise even further versus non-US yields to attract more fundamental buyers like Japanese and European institutional investors, given elevated volatility in both US Treasury prices and the dollar. Bottom Line: Global investors should continue to underweight US Treasuries in global bond portfolios, on both a currency-unhedged and USD-hedged basis. Feature Dear Client, The schedule for the next two Global Fixed Income Strategy reports will be impacted by the upcoming Labor Day holiday and next week’s BCA’s annual conference in New York (I hope to see you there!). This Friday, September 2, we will be publishing a joint report with our colleagues at Foreign Exchange Strategy discussing Japan. On Monday, September 12, we will be publishing another joint report with our colleagues at European Investment Strategy, covering estimates of global neutral interest rates. -Rob Robis The title of our report from four weeks ago was “Dovish Central Bank Pivots Will Come Later Than You Think.” This could have also been the title for Fed Chair Jerome Powell's Jackson Hole speech. He reiterated the Fed’s commitment to tighten policy further and “keep at it” until the US economy slows enough to bring down inflation. Other central bankers who spoke at the conference had a similar tone to Powell, talking up an ongoing inflation fight that will require much slower growth and higher unemployment. Related Report  Global Fixed Income StrategyRecent USD Strength Is Not Bond Bullish By quickly and bluntly dispensing any notion that the Fed could soon pause its rate hiking cycle, Powell poured ice cold water on the risk asset rally that boosted the S&P 500 by nearly 17% between mid-June and mid-August. The S&P 500 plunged 3.4% after Powell’s speech, a tightening of US financial conditions that was likely welcomed by the Fed, as it helps their goal of slowing the US economy. Minneapolis Fed President Neil Kashkari even said he was “happy” to see the negative market reaction to Powell’s speech. Powell, Kashkari and the rest of the FOMC are probably happy over the strength of the US dollar, which is also helping tighten US financial conditions – while also having a major impact on global bond returns and currency hedging decisions for investors. A Collision Of A USD Bull Market & Global Bond Bear Market Chart 1A Big Move In The USD A Big Move In The USD A Big Move In The USD The current strength of the US dollar is becoming increasingly broad-based. The EUR/USD exchange rate has fallen below parity, while USD/JPY continues to flirt with the 140 level (Chart 1). The British pound is trading at a 2-year low versus the US dollar, many important emerging market (EM) currencies are struggling, and the Chinese renminbi is set to retest the 7.0 level. The strength of the US dollar is no recent phenomenon. The current uptrend dates back to the start of 2021, with the DXY dollar index up 21% since then. The dollar bull market has been supported by several factors, most critically rising US interest rates. The 2-year US Treasury yield started 2021 just above 0% and now sits at 3.4%. Higher US interest rates have raised the benefit of hedging currency risk into US dollars for global bond investors. The Bloomberg Global Aggregate Bond Index in USD-hedged terms has outperformed the unhedged version of the index by 6.3% over the past year, one of the largest such increases dating back to 2000 (Chart 2). This means that global bond investors have been paid handsomely to simply swap non-US bond exposures into US dollars – in some cases, making low-yielding assets like Japanese government bonds (JGBs), hedged from yen into dollars, comparable to US Treasury yields. Chart 2Big Gains From Hedging Global Bond Exposure Into USD Big Gains From Hedging Global Bond Exposure Into USD Big Gains From Hedging Global Bond Exposure Into USD This wedge between USD-hedged and unhedged bond returns is unlikely to reverse soon, as the fundamental drivers of the dollar remain biased to more dollar strength. The US dollar is not only supported by more favorable interest rate differentials versus other currencies (both in nominal and inflation-adjusted terms), but is also benefitting from its safe haven status at a time of considerable uncertainty on the future of the global economy (Chart 3). Global growth expectations are depressed and showing no signs of turning around anytime soon, particularly in Europe and the UK where electricity and gas prices are climbing at a record pace. The dollar not only typically appreciates during periods of slowing growth, but also during episodes of investor risk aversion. Investors remain cautious, according to indicators like the US equity put/call ratio which shows greater demand for downside protection via puts – an outcome that also typically coincides with a stronger US dollar. In this current environment of broad-based US dollar strength, the gap between hedged and unhedged bond returns has varied widely depending on the base currency of the investor. For a euro-based investor, the performance gap between the unhedged Global Aggregate index and the EUR-hedged index has been 6% over the past year (Chart 4). Chart 3USD Strength Supported By Key Fundamental Drivers USD Strength Supported By Key Fundamental Drivers USD Strength Supported By Key Fundamental Drivers ​​​​​​ Chart 4FX Hedging Decisions Mean Everything In A Global Bond Bear Market FX Hedging Decisions Mean Everything In A Global Bond Bear Market FX Hedging Decisions Mean Everything In A Global Bond Bear Market ​​​​​ Chart 5Low-Yielding Countries Facing High USD Hedging Costs Low-Yielding Countries Facing High USD Hedging Costs Low-Yielding Countries Facing High USD Hedging Costs The gap has been even larger for yen-based investors, with the unhedged index beating the JPY-hedged index by a whopping 13% over the past twelve months. Although Japanese fixed income investors are not typically known for taking unhedged currency risk on foreign bond holdings, doing so would have turned an awful year of global bond returns into a great year, simply due to yen weakness. When looking at current levels of interest rate differentials versus the US, which are the main determinant of currency hedging costs, the low yielding currencies like the euro, yen and Swiss franc see the greatest gain on returns versus the high-yielding US dollar (Chart 5). Hedging euros into dollars results in an annualized pickup of 252bps, while hedging yen into dollars produces an even bigger gain of 327bps. At the same time, the USD-hedging gains for relatively higher yielders are much lower. Hedging Australian dollars into US dollars only produces an annualized gain of 48bps, while hedging Canadian dollars into US dollars produces an annualized loss of -18bps. These varying hedging costs matter for global bond investors, as they impact the attractiveness of an individual country’s bond yields, depending on the investor’s base currency. We show the unhedged yield levels, and currency-hedged yield levels for six main developed market base currencies (USD, EUR, JPY, GBP, CAD, AUD) in the tables on the next two pages. Table 1 shows 2-year government bond yields, Table 2 shows 5-year government bond yields, Table 3 shows 10-year government bond yields and Table 4 shows 30-year government bond yields. Unsurprisingly, hedging into euros and yen, where short-term interest rates are the lowest, produces the smallest yields. Meanwhile, hedging into higher-rate currencies like US dollars and Canadian dollars generates the highest yields. Table 1Currency-Hedged 2-Year Government Bond Yields Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 2Currency-Hedged 5-Year Government Bond Yields Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 3Currency-Hedged 10-Year Government Bond Yields Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 4Currency-Hedged 30-Year Government Bond Yields Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors We take the analysis a step further in the next set of tables on pages 9-11. Here, we take the hedged yields for each currency and compare them to the yields of the base currency. For example, in Table 5, it can be seen that a 2-year US Treasury yield of 3.4%, hedged into euros, produces a yield of 0.82% that is -17bps below the 2-year German yield (which is obviously denominated in euros). In other words, from the point of view of a euro-based investor who wants to hedge away the currency risk in a global bond portfolio, he gets paid a bit more to own a German bond over a US Treasury. Table 5Currency-Hedged 2-Year Govt. Bond Yield Spreads Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Similar results are shown in the subsequent tables for 5-year yields (Table 6), 10-year yields (Table 7) and 30-year yields (Table 8). From these tables, we can make the following broad conclusions: Table 6Currency-Hedged 5-Year Govt. Bond Yield Spreads Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 7Currency-Hedged 10-Year Govt. Bond Yield Spreads Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 8Currency-Hedged 30-Year Govt. Bond Yield Spreads Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors For USD-based bond investors, all non-US markets except Canada have a yield pickup over US Treasuries on an FX-hedged basis For EUR-based investors, all non-euro area markets except Australia produce yields lower than those of Germany on an FX-hedged basis For GBP-based investors, all non-UK bond markets except the US and Canada have yields greater than those of Gilts for maturities from 5-30 years (the results are more mixed across countries for 2-year yields) For JPY-based investors, euro area and Australian bonds are clearly more attractive than JGBs on an FX-hedged basis, while US Treasuries, UK Gilts and Canadian government bonds offer FX-hedged yields below puny JGB yields. This is true up to the 10-year maturity point, as 30-year JGB yields – which are not targeted by the Bank of Japan in its yield curve control program – are much higher than those on the rest of the JGB curve For CAD-based investors, hedging virtually all non-Canadian bonds into CAD results in yields that are higher than Canadian government bond yields, with the largest hedged yield advantage for euro area and Australian bonds For AUD-based investors, only euro area bonds offer a consistent yield pickup over Australian government bonds on an FX-hedged basis. Broadly speaking, government bonds in the euro area and Australia offer consistently attractive FX-hedged yield pickups over the unhedged bonds for all currencies shown in the tables. On the other hand, Canadian government bonds have consistently less attractive FX-hedged yields across all currencies shown. Perhaps most importantly, US Treasuries look unattractive on an FX-hedged basis to all but CAD-based investors – a result that has meaningful implications for the potential of foreign buying to help stem the rise of US bond yields. Bottom Line: The US dollar bull market is having a huge influence on global bond returns. US Treasury yields, on an FX-hedged basis, look unattractive relative to most local currency denominated bonds across the developed world. Who Are The Foreign Buyers Of US Treasuries? When simply looking at currency-unhedged yield spreads, US Treasury yields offer particularly inviting yields over low-yielding (and low “beta” to US yields) markets like Germany and Japan. The unhedged 10-year US-Germany spread is now 160bps, while the unhedged US-Japan spread is up to 286bps (Chart 6). Meanwhile, among high-beta markets, the US-Canada 10-year spread is flat on an FX-unhedged basis, while an unhedged Australian 10-year bond yields 56bps more than a 10-year US Treasury. Chart 6UST Yields Only Look Attractive In FX-Unhedged Terms UST Yields Only Look Attractive In FX-Unhedged Terms UST Yields Only Look Attractive In FX-Unhedged Terms Yet after factoring in the currency hedging costs shown earlier, US Treasuries look consistently unattractive versus the other major developed economy bond markets. Chart 7UST Yields Look Unattractive After Hedging Out USD Exposure UST Yields Look Unattractive After Hedging Out USD Exposure UST Yields Look Unattractive After Hedging Out USD Exposure ​​​​​ A 10-year US Treasury hedged into euros now yields -77bps less than a 10-year German bund, at the low end of the historical range for this spread dating back to 2000 (Chart 7). A 10-year Treasury hedged into GBP and JPY also offers lower yields versus 10-year UK Gilts (-11bps) and 10-year JGBs (-50bps), respectively. The 10-year hedged US-Australia spread (with the US yield hedged into AUD) is also at a stretched negative extreme at -114bps (Chart 8). Despite these broadly unattractive hedged US yield spreads, the US Treasury market has seen significant foreign inflows this year, according to the US Treasury Department’s capital flow (TIC) data. Total net purchases of US Treasuries by foreign buyers accelerated to $470bn (on a 12-month rolling total basis) as of the latest data for June (Chart 9). When broken down by type of buyer, private buyers bought a net $619bn, while official buyers were net sellers to the tune of -$149bn. Chart 8No Compelling Yield Advantage To Owning FX-Hedged USTs No Compelling Yield Advantage To Owning FX-Hedged USTs No Compelling Yield Advantage To Owning FX-Hedged USTs When looking at the TIC data by country, China was an important net seller of -$18bn of Treasuries. This is consistent with the reduced demand for US dollar assets from China, where policymakers are actively targeting a weaker renminbi. Chart 9TIC Data Shows USTs Seeing Foreign Buying (Ex-China) TIC Data Shows USTs Seeing Foreign Buying (Ex-China) TIC Data Shows USTs Seeing Foreign Buying (Ex-China) ​​​​​ There was also net selling from many EM countries that have seen reduced trade surpluses and, hence, fewer US dollars to recycle into Treasuries. Chart 10Even Higher UST Yields Needed To Entice Japanese & European Buyers Even Higher UST Yields Needed To Entice Japanese & European Buyers Even Higher UST Yields Needed To Entice Japanese & European Buyers The largest net buying (Chart 10) was seen from the UK (+$306bn) and Cayman Islands (+$154bn) – the latter being a large source of Treasury buying through hedge funds and offshore investment funds located there. Those two countries accounted for almost all of the net foreign inflows into Treasuries, despite the fact they only hold a combined 12% of all foreign US Treasury holdings. There was modest net buying from the euro area (+$37bn) and small net selling by the country with the largest stock of US Treasury holdings, Japan. The relatively subdued inflows from Europe, and lack of inflows from Japan, are consistent with the unattractive hedged US-Europe and US-Japan yield spreads shown earlier, particularly at a time of elevated US bond yield volatility. The huge inflows from the UK and Cayman Islands are harder to explain on a fundamental basis, but are likely due to a continued normalization of Treasury market liquidity after the spring 2020 “dash for cash”. In a report published back in January, Fed researchers analyzed foreign demand for US Treasuries around the worst of the COVID pandemic shock in 2020. The report concluded that the huge collapse in private inflows into Treasuries – from a peak of +$238bn at the start of 2020 to a trough of -$373bn at the end of 2020 – was the result of aggressive net selling by hedge funds and global mutual funds. These are exactly the types of investors that would be domiciled in the Cayman Islands and UK (London). Specifically, the Fed report noted that: “In short, two prominent reasons for the large sales are the unwind of the Treasury basis trade by hedge funds (including foreign-domiciled funds) and the sudden, massive investor outflows from mutual funds that caused these funds to sell their most liquid assets, U.S. Treasury securities, to meet these redemptions.” The “basis trade” mentioned likely involved buying cash Treasuries versus selling Treasury futures, attempting to exploit unsustainable price differences between the two. As market liquidity conditions dried up in the spring of 2020 during the first wave of global lockdowns, leveraged bond investors needed to frantically unwind positions. For Treasury basis trades, that would have involved selling cash Treasuries, which was likely what is being picked up in the TIC data from the Cayman Islands which showed a huge plunge in net buying in 2020. The mutual fund outflows were likely a global phenomenon, but given the large fund management presence in London, the huge net selling of Treasuries from the UK in 2020 were almost certainly related to global fund managers, not purely UK investors. As Treasury market liquidity conditions normalized in 2021 and 2022, those large sellers in the UK and Cayman Islands (and other offshore investment locations) have likely turned into big net buyers, as evidenced from the TIC data. However, the modest inflows from Europe, and outflows from Japan, tell a more important story about the fundamental demand for US Treasuries. Treasury yields must rise further, widening both currency-hedged and unhedged spreads versus non-US government bonds to more historically attractive levels, to entice more foreign buying. Bottom Line: UST yields must rise even further versus non-US yields to attract more fundamental buyers like Japanese and European institutional investors, given elevated volatility in both US Treasury prices and the dollar. Global investors should underweight US Treasuries in global bond portfolios, on both a currency-unhedged and USD-hedged basis.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Tactical Overlay Trades

Highlights The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Feature Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession September 2022 September 2022 Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory September 2022 September 2022 Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today September 2022 September 2022 How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.1 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions September 2022 September 2022 Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,2 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1  Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 2  Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com

Highlights The odds of a Goldilocks outcome for the US economy increased somewhat in August, but the risks of a US recession over the coming year remain quite elevated. We continue to recommend that investors stay neutrally positioned towards equities within a global multi-asset portfolio. The disinflationary impulse from the July US CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices. It is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. The OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, but it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023. This suggests that a further upward adjustment in the OIS curve is likely warranted, and that a modestly short duration stance is appropriate. Investors believe that the rate hike path priced into the OIS curve would not be recessionary, because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation. From the perspective of market participants, this would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. We agree that the odds of a recession will decline if headline inflation does fall below 4% over the coming year, but it is not yet clear that this will occur. And if it does, the resulting improvement in real wages would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put heavy pressure on equity multiples. This underscores that stock prices face risks in both a recessionary and non-recessionary environment. There are arguments pointing to a decline in the dollar beyond the near term, even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. Stay neutral for now, but look for opportunities to short the dollar beyond the coming few months. Jumping The Gun On Goldilocks The odds of a Goldilocks outcome for the US economy over the coming six to nine months increased somewhat in August. The July CPI report presented some evidence of supply-side and pandemic-related disinflation (Chart I-1), and we saw more resilient manufacturing production in the US – even after excluding the automotive sector – than many manufacturing indicators have been indicating (Chart I-2). In addition, the regional Fed manufacturing index in the especially manufacturing-sensitive state of Pennsylvania surprised significantly to the upside in July, although this was at least somewhat offset by a collapse in the New York and Dallas Fed’s general business conditions indexes (Chart I-3). Chart I-1There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US Chart I-2US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested Against the backdrop of significant recessionary risks, and a debate about whether negative growth in the first half of the year already constitutes a recession in the US, these developments have been positive. The Atlanta Fed’s GDPNow model is pointing to positive (albeit below-trend) growth of 1.4% in Q3, which is consistent with consensus forecasts. The Atlanta Fed’s model is also forecasting the strongest real consumption growth since Q4 2021 (Chart I-4). Equity investors responded to incrementally lower recession odds and a slower pace of inflation by bidding up the S&P 500 from roughly 3800 at the beginning of July to over 4200 in August. Chart I-3Mixed Messages From The Regional Fed Indicators Mixed Messages From The Regional Fed Indicators Mixed Messages From The Regional Fed Indicators Chart I-4The Atlanta Fed GDPNow Model Is Pointing To Positive Growth And Resilient Consumption In Q3 September 2022 September 2022   However, several other developments over the past month continue to highlight that the risks of a US recession over the coming year are quite elevated, which supports our recommendation that investors stay neutrally positioned towards equities within a global multi-asset portfolio: The August flash PMIs were fairly negative, especially for the services sector. The August flash S&P Global manufacturing PMI rose in Germany, but it fell in the US, France, and the UK. Services PMIs declined significantly in all four countries, especially in the US where survey participants noted that “hikes in interest rates and inflation dampened customer spending as disposable incomes were squeezed.” Survey respondents also noted that “new orders contracted at the steepest pace for over two years, as companies highlighted greater client hesitancy in placing new work.” Chart I-5The Conference Board's LEI Is Very Weak The Conference Board's LEI Is Very Weak The Conference Board's LEI Is Very Weak The Conference Board’s leading economic indicator dropped for a fifth month in a row in July, which has always been associated with a US recession (based on the indicator’s current construction). Chart I-5 highlights that the indicator’s market-based and real economy components are both very weak, and that the Conference Board’s coincident indicator has now fallen below its 12-month moving average. While the Philly Fed manufacturing index picked up in July, the new orders component of the regional Fed manufacturing PMIs broadly sank further into contractionary territory (Chart I-6). Chart I-6The Regional Fed New Orders Components Are Very Weak The Regional Fed New Orders Components Are Very Weak The Regional Fed New Orders Components Are Very Weak The Atlanta Fed model shown in Chart I-4 is pointing to a second quarter of negative growth from real residential investment, a component of GDP that reliably peaks in advance of economic contractions.1 Job openings are now pointing to a potential rise in unemployment. The relationship between job openings and unemployment is currently subject to heavy debate, as discussed in a recent report by my colleague Ryan Swift.2 However, abstracting from a theoretical discussion about movements along or shifts in the Beveridge curve, investors should note that the empirical record is fairly clear – Chart I-7 highlights that falling job vacancies occurred alongside a significant rise in the level of unemployment during the last two recessions. We acknowledge that the relationship has seen some deviations since 2018/2019, so this may highlight that a larger decline in job openings will be required for unemployment to trend higher. A 10% rise in the level of unemployment relative to its 12-month moving average has always been associated with a recession, implying that a sustained decline in job openings to 10M or lower would represent a likely recessionary signal – even if that recession proves to be a mild one (see Section 2 of this month’s report). Chart I-7Declining Job Openings Are Pointing To Potentially Higher Unemployment Declining Job Openings Are Pointing To Potentially Higher Unemployment Declining Job Openings Are Pointing To Potentially Higher Unemployment Table I-1 highlights that the disinflationary impulse from the July CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices (particularly gasoline and fuel oil). Outside of the clear impact that falling fuel prices had on airline fares, there is not yet compelling evidence that core inflation is decelerating due to easing supply-side and pandemic-related effects, or due to slowing demand. As we will discuss below, it is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. Table I-1The Disinflationary Impulse From The July CPI Report Is Less Compelling Than It Seems September 2022 September 2022 Inflation And The Fed As we discuss in Section 2 of our report, recessions occur because monetary policy becomes tight, a significant non-policy shock to aggregate demand or supply occurs, or some combination of both develops. We do not believe that monetary policy is currently restrictive on its own (Chart I-8), and we have not yet concluded that a US recession is inevitable. But when combined with the speed of adjustment in interest rates, the fact that real wages have fallen sharply (Chart I-9), and the fact that the Fed is determined to see inflation quickly return to target levels, it is clear that the odds of a recession over the coming 12-18 months remain elevated. Chart I-8Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Chart I-9But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid Many investors do not appear to fully appreciate the fact that the Fed will continue to tighten policy until it sees clear and unequivocal signs that inflation is easing. Importantly, the minutes of the July FOMC meeting highlighted that this is likely to be true even if unambiguous signs of easing supply-side and pandemic-related inflation present themselves. During the July meeting, FOMC participants noted that “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities, some of the heavy lifting would also have to come by imposing higher borrowing costs on households and businesses”. They also emphasized that “a slowing in aggregate demand would play an important role in reducing inflation pressures”. The upshot is that the Fed was aware before the July CPI report that energy-related inflation might fall, but also understood that they would still have to tighten enough to slow aggregate demand to reduce underlying inflationary pressures. It is true that investors are pricing in additional rate hikes from the Fed, but there are two caveats for investors to consider. The first is that while the OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023 (Chart I-10). This suggests that a further upward adjustment in the OIS curve is likely warranted. Second, and more importantly, investors appear to be making the assumption that the rate hikes already built into the OIS curve will not be recessionary. Investors are making this assumption because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation (Chart I-11), which would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. Chart I-10A Further Upward Adjustment In The OIS Curve Is Likely Warranted A Further Upward Adjustment In The OIS Curve Is Likely Warranted A Further Upward Adjustment In The OIS Curve Is Likely Warranted Chart I-11Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation We agree with investors that the odds of a recession will decline significantly, ceteris paribus, if headline inflation does drop below 4% over the coming year. But we noted above that it is not yet clear that this will occur. In addition, we disagree with investors that this would result in a reduction in short-term interest rates, because this belief is based on the view that monetary policy is currently in restrictive territory even without the negative impact of sharply lower real wages. Absent the negative real wage effect, our view is that monetary policy would still be stimulative at current interest rates, which is why we believe that the 2023 portion of the OIS curve is too dovish in a non-recessionary scenario. The Outlook for Stocks The equity market rally that began in early July has been based on the assumption that significant supply-side and pandemic-related disinflation is now a fait accompli. If it is, then the odds of a recession over the coming year are indeed meaningfully lower, and the risk to corporate profits is less than feared. We noted above that investors may have jumped the gun in pricing in substantial disinflation and sharply lower odds of a US recession. But even in a scenario in which the odds of recession do come in significantly, stocks still face risks from a significant rise in real bond yields. Chart I-12Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Investors have been focused on very elevated inflation as the driver of both rising inflation expectations and rising real bond yields, and have assumed that a meaningful slowdown in inflation (as forecast by short-term measures of inflation expectations) implies that the Fed funds rate will return to the Fed’s estimate of neutral. This belief, along with a lower projected Fed funds rate in 2024 than 2023 in the FOMC’s participant forecasts, is the basis for the 2023 “pivot” currently priced into the OIS curve. Given that the Fed funds rate has already reached the Fed’s neutral rate estimate, there is a meaningful chance that this estimate will be revised upwards by the Fed or challenged by investors if economic activity improves in response to a decline in inflation and a corresponding rise in real wages. Such a scenario would highlight to investors that the Fed’s estimate of neutral is likely too low, which would imply a significant increase in real 10-year TIPS yields (which are currently 160 basis points below their pre-2008 average). Chart I-12 highlights the impact that a rise in real long-maturity bond yields could have on equities, even in a non-recessionary scenario where 12-month forward earnings per share grows 8% over the coming year. A rise in 10-year TIPS yields to 1.5% by the middle of 2023 would cause a 16% contraction in the 12-month forward P/E ratio and a 10% decline in stock prices, assuming an unchanged 12-month forward equity risk premium (ERP). It is possible that the ERP could decline in a rising bond yield scenario. Chart I-13 highlights that the ERP is indeed negatively correlated with real bond yields (in part due to the methods that we use to calculate it). The counterpoint is that there are a number of risks that equity investors should be compensated for today that did not exist in the late 1990s or early 2000s, especially the risks of populist policies in many advanced economies and major geopolitical events (as Russia’s invasion of Ukraine recently highlighted). Chart I-14 illustrates that, since 1960, a long-term version of the equity risk premium, calculated using trailing earnings and our adaptive expectations proxy to deflate long-maturity bond yields, has been fairly well explained by the Misery Index (the sum of the unemployment and headline inflation rates). However, the chart also shows that the ERP has been structurally higher over the past decade than the Misery Index would have predicted. It is unclear if this is due to a riskier environment or the negative ERP/real yield correlation that we noted. Chart I-13The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed Chart I-14A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks The conclusion is that investors do not yet appear to have a basis to bet on a declining ERP in a rising bond yield environment, underscoring that even a non-recessionary scenario poses a risk to stock prices. It is worth noting that this second risk facing stocks has essentially been caused by the Fed because of its maintenance of a very low neutral rate estimate that we feel is no longer economically justified. Bond Market Prospects Chart I-15Investors Should Stay Modestly Short Duration, For Now Investors Should Stay Modestly Short Duration, For Now Investors Should Stay Modestly Short Duration, For Now Over the past few months, the Bank Credit Analyst service has continued to recommend that investors maintain a modestly short duration stance even as we recommended reducing equity exposure. The recent rise in the 10-year Treasury yield back to 3% has validated that view (Chart I-15), and reinforces our view that there is significant upside risk to long-maturity bond yields in a non-recessionary scenario. Our expectation that the Fed will raise interest rates to a higher level over the next year than the OIS curve is currently discounting also argues for a modestly short stance, based on BCA’s “Golden Rule” framework. The “Golden Rule” states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. As we detail in Section 2 of our report, the Fed has always cut interest rates in response to a recession in the post-WWII environment, so we would certainly recommend a long duration stance if a recession emerges. But given our view that a recession is still a risk rather than a likely event, we feel that a modestly short duration stance is currently appropriate. Chart I-16US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle As noted above in our discussion of the risks facing stock prices in a non-recessionary scenario, falling inflation that is not associated with a recession will ironically be a bearish signal for long-maturity bonds, because it means that the Fed will have greater capacity to raise interest rates without ending the recovery. The short end of the yield curve could be flat or move modestly lower in response to a significant easing in inflation, but the long end of the curve would be at serious risk of moving higher. We are thus very likely to recommend a short duration stance in response to solid evidence of true supply-side and pandemic-related disinflation, assuming it emerges outside of the context of a recession. Within the credit space, the rise in US corporate bond spreads since the start of the year has meaningfully improved the value of investment- and speculative-grade corporate bonds (Chart I-16), but not so much that it justifies a positive stance towards these assets relative to government bonds given the risks facing the US economy. We continue to recommend an underweight stance towards investment-grade and a neutral stance towards speculative-grade within a fixed-income portfolio. The Outlook For Energy Prices Chart I-17The EU's Oil Embargo Will Cause Russian Oil Production To Tank The EU's Oil Embargo Will Cause Russian Oil Production To Tank The EU's Oil Embargo Will Cause Russian Oil Production To Tank The likely path of commodity prices, particularly that of oil, is an extremely important determinant of whether the US is likely to experience a recession over the coming year. We are among those who have downplayed the significance of oil price shocks in driving contractions in economic output over the past two decades,3 but the current situation is unique given the role that very elevated inflation has played in driving real wages lower. In a recent Strategy Report from our Commodity & Energy Strategy service, my colleague Robert P. Ryan underscored the impact that the European Union’s embargo of Russian oil will likely have on the energy market. If fully implemented, ~ 2.3mm barrels/day of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. EU, UK and US shipping insurance and reinsurance sanctions are also scheduled to be implemented in December, which means that “surplus” Russian oil production cannot be fully reoriented to other countries. Chart I-17 presents the likely impact on Russia’s crude oil output, namely a ~ 2mm barrels/day decline in oil output by the end of next year – nearly equal to the amount of oil set to be embargoed. Our base case view remains that supply and demand in the oil market will remain relatively balanced going into the winter, but the removal from the market of Russian oil production because of the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will ultimately push crude oil prices higher and inventories lower (Chart I-18). The price impact of this event could happen earlier than the immediate supply/demand balance would suggest, if investors have not fully priced in the extent of the decline in Russian oil production that our commodity team is forecasting. Our commodity team’s forecast serves as an important reminder that the economic consequences of Russia’s invasion of Ukraine may not be fully behind us. It also highlights that the recent disinflation observed in the US, which was mostly driven by lower energy prices in July, may not be sustained. Chart I-19 highlights what could happen to US gasoline prices based on the path for oil shown in Chart I-18, and how that forecast is sharply at odds with the current gasoline futures curve. Chart I-20 highlights that US gasoline stocks are currently below their 5-year average; the last time this occurred was in Q1 2021, which was an environment of rising gasoline prices to levels that were higher than what would usually be implied by crude oil prices. Chart I-18Oil Prices Are More Likely To Rise Than Fall Oil Prices Are More Likely To Rise Than Fall Oil Prices Are More Likely To Rise Than Fall Chart I-19Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Chart I-20Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices The upshot is that our commodity team expects oil prices to move higher over the coming 6-12 months, under the assumption that the EU’s embargo against Russian oil moves forward as announced. This poses a clear threat to imminent supply-side and pandemic-related disinflation, and underscores the risks to a Goldilocks economic outcome over the coming few months. The Dollar: Value, Technical Conditions, And The Cycle Chart I-21The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The US dollar moved higher over the past month, after first retreating from its mid-July high for the year. We tempered our view about the likelihood of a falling dollar over the near term in last month’s report, but from a bigger picture perspective we have been surprised by the degree of dollar strength this year. The US dollar is a reliably countercyclical currency, so clearly some of the dollar’s strength has been the result of weakness in risky asset prices (Chart I-21). But the bottom panel of Chart I-21 highlights that the broad trade-weighted dollar has performed even better over the past year than returns to the S&P 500 would have implied, underscoring that the magnitude of the dollar’s strength has been atypical. The last two times that the US dollar performed substantially better than the trend in risky assets would have implied were in 2012 and 2015, years in which euro area breakup risk was a driving force in markets. Alongside the fact that EURUSD has fallen below parity and USDEUR has outperformed even more than the broad trade-weighted dollar has, “excess” dollar returns point strongly to Europe’s energy woes in the aftermath of Russia’s invasion of Ukraine as the key driver of outsized broad dollar strength. Chart I-22 highlights that European natural gas prices have exceeded the level that we had forecasted would occur in a complete cutoff scenario, meaning that Europe’s energy crunch is likely happening now, rather than in the winter. However, even considering the negative economic outlook facing the euro area, there are arguments pointing to a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. First, Chart I-23 highlights that EURUSD has undershot what the trend in relative real interest rates would suggest, which has historically led changes in the euro. This implies that the euro has declined partly because of the introduction of a sizeable risk premium, which may dissipate after the winter. Chart I-22The Euro Has Been Heavily Impacted By Europe's Energy Crunch The Euro Has Been Heavily Impacted By Europe's Energy Crunch The Euro Has Been Heavily Impacted By Europe's Energy Crunch Chart I-23EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest Second, Chart I-24 highlights that the US dollar is extremely overbought and is technically extended to a point that has historically been associated with reversals in the broad dollar trend. Finally, Chart I-25 highlights that the US dollar is extraordinarily expensive based on our valuation models, underscoring that an eventual decline in the dollar may be quite severe. We agree that valuation is not usually an effective market timing tool, but investors should place a greater weight on valuation measures as they are stretched further. Based either on our models or a more traditional PPP approach, the degree of US dollar overvaluation is extreme – arguing for a bearish bias on a 6-12 month timeline barring an unambiguous move towards recession in the US. Chart I-24US Dollar And Indicator The US Dollar Is Heavily Overbought US Dollar And Indicator The US Dollar Is Heavily Overbought US Dollar And Indicator The US Dollar Is Heavily Overbought Chart I-25The US Dollar Is Extremely Expensive The US Dollar Is Extremely Expensive The US Dollar Is Extremely Expensive         Investment Conclusions Considering the economic developments over the past month and the reaction of financial markets, the takeaway for investors seems clear. Market participants have eagerly shifted towards the Goldilocks economic and financial market outcome, based on (so far) incomplete evidence of supply-side and pandemic-related disinflation that has predominantly been driven by declining energy prices. Given significant potential upside risks to oil and US gasoline prices over the coming few months, investors should wait for more durable signs of significant disinflation before downgrading the odds of a US recession over the coming year. We would certainly recommend cutting global equity exposure to underweight were we to determine that the US is likely to experience an imminent recession, but the avoidance of a recession does not necessarily suggest that an overweight stance is warranted. Sharply lower inflation would reduce the odds of a recession, but it would also raise real wages and would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put meaningful pressure on equity multiples. Barring a decline in the equity risk premium, US stocks could face a loss on the order of 10% over the coming year in such a scenario (even under the assumption of positive earnings growth), reinforcing our view that a neutral stance towards global equities is currently appropriate. In addition to a neutral global asset allocation stance, we recommend that investors maintain a neutral regional equity position and a neutral stance towards cyclicals versus defensives, although we do recommend a modest overweight towards value stocks given our view that a modestly short duration stance is appropriate. Although we recommend a neutral stance towards USD over the next few months, we also see ample scope for a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. We believe that there are upside risks to energy prices, which our Commodity & Energy Strategy service recommends playing via the iShares GSCI Commodity Dynamic Roll Strategy (COMT) ETF. As a final point, we remain cognizant of the fact that financial markets rarely trend sideways over 6-to-12 month periods. We continue to regard a neutral global asset allocation stance as a temporary stepping stone either to a further downgrade of risky assets to underweight, or to an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we see unequivocal signs of a substantial and broad-based slowdown in the US headline inflation rate, and if long-maturity real bond yields are well-behaved in response or if we see clear signs of a declining equity risk premium. Thus, investors should note that additional changes to our recommended cyclical allocation may occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields.   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst August 25, 2022 Next Report: September 29, 2022 II. The Fed Funds Rate, Bond Yields, And The Next US Recession The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession September 2022 September 2022 Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory September 2022 September 2022 Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today September 2022 September 2022 How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.4 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions September 2022 September 2022 Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,5 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts In contrast to the recent rally in equities, BCA’s equity indicators continue to paint a bearish outlook for stock prices. Our Monetary, Technical, and Speculative indicators have stopped falling, but they remain very weak. Meanwhile, the recent rally has pushed our valuation indicator back towards a level indicating stocks are considerably overvalued. While it is still a risk and not yet a likely event, the odds of a US recession over the next 12 months remain elevated. We maintain a neutral stance for stocks versus bonds over the coming year. Forward earnings are no longer being revised up, but bottom-up analysts’ expectations for earnings are likely still too optimistic. Although earnings growth will be positive over the coming year if a US recession is avoided, it will be in the mid-to-low single-digits given ongoing pressure on profit margins. Within a global equity portfolio, we maintain a neutral stance on cyclicals versus defensives, small caps versus large, and a neutral stance on regional equity allocation. We recommend a modest overweight towards value versus growth stocks, given our recommendation of a modestly short duration stance within a global fixed-income portfolio. Commodity prices have stopped falling, and our composite technical indicator now highlights that commodities are oversold. Our base-case view is that oil prices are likely to rise over the coming 12-months, barring a US recession. Global food prices have come down in the wake of deal between Russia and Ukraine to allow the latter to resume its agricultural exports. But the recent surge in European natural gas prices suggests that global food inflation may remain elevated, given that natural gas is used in the production of fertilizer. Ongoing weakness in the Chinese property market argues for a neutral stance towards industrial metals, until compelling signs of a more aggressive policy response emerge. US and global LEIs have now fallen into negative territory, underscoring that the risk of a global recession is elevated. Some indicators are easing back towards positive territory, such as our global LEI Diffusion Index and our US Financial Conditions Index, but it is not yet clear if they are heralding a reacceleration in economic activity or merely a less intense pace of decline. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Footnotes 1     Please see The Bank Credit Analyst "Is The US Housing Market Signaling An Imminent Recession?" dated May 26, 2022, available at bca.bcaresearch.com 2     Please see US Bond Strategy "The Great Soft Landing Debate," dated August 2, 2022, available at usbs.bcaresearch.com 3    Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 4    Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com