Fixed Income

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (February 15 at 10:00 AM EST, 15:00 PM GMT, 16:00 PM CET). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Feature This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook – a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the last quarter of 2021 were mixed, with business credit standards easing in the US, Japan, Canada, and New Zealand while remaining mostly unchanged in the euro area and UK (Chart 1). Supply chain disruptions have had a two-pronged effect on borrowing. While they have hurt business confidence and prospects, they have also created loan demand as firms look to replenish depleted inventory stocks. The overall picture is one of solid economic fundamentals that are nonetheless perturbed by inflation concerns and lingering uncertainty regarding Covid-19 infections. Chart 1Credit Standards Eased In Most Developed Markets In Q4/2021 Credit Standards Eased In Most Developed Markets In Q4/2021 Credit Standards Eased In Most Developed Markets In Q4/2021 An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As they have access to detailed, non-public information on a large number of borrowers, loan officers are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of either current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice-versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q4/2021 (Chart 3). This marks the fourth consecutive quarter of easing standards. However, banks did report a slower pace of easing, which correlates with tighter financial conditions on the margin (top panel). While we are still in a period of easy financial conditions in absolute terms, this could soon start to change as hot inflation prints and booming economic data cause the Fed to turn increasingly hawkish. Despite this, banks expect to ease standards further over 2022, indicating confidence that underlying economic fundamentals and corporate health will be able to weather monetary tightening. US banks also reported stronger C&I loan demand from all firms in Q4, marking three consecutive quarters of improvement (middle panel). The picture was optimistic, with banks attributing increased loan demand to inventory financing, mergers & acquisitions, and fixed investment. Meanwhile, only 4.2% and 12.5% of banks saw a decrease in internal funds and increasing precautionary demand, respectively, as somewhat important. Inventories accounted for all but 2% of the 6.9% annualized GDP growth in Q4. With inventory stocks still depressed in absolute terms, we expect inventory restocking will continue to buoy demand over 2022. Chart 3US Credit Conditions US Credit Conditions US Credit Conditions ​​​​​ Chart 4US Loan Demand Outlook For 2022 Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? On the consumer side, banks reported easier standards across the board, with standards easing for credit card, auto, and other consumer loans (bottom panel). However, the pace of easing, which has historically been good at calling turning points in consumer confidence (on a rate-of-change basis), appears to have peaked. Consumer sentiment has already been battered by rampant inflation and falling real wage expectations; tighter credit standards down the road could prove to be a further headwind. As part of the one-off special questions in this edition of the survey, respondents were asked about the reasoning behind their outlook for loan demand over 2022 (Chart 4). Of those that expected higher demand, 70% cited higher spending and investment demand from borrowers as their income prospects improved. Meanwhile, only 33% thought that precautionary demand for liquidity would be a factor. Lenders thought that both, a worsening or an improvement in supply chain disruptions, could contribute to increased demand. 53% expected that continued disruption would create greater inventory financing needs. Meanwhile, 55% expected that easing supply chain troubles would boost demand as product availability concerns faded. Of those that expected weaker loan demand, interest rates were by-and-large the biggest factor, with an overwhelming 96% believing that rising rates would quell loan demand. This was followed by concerns that supply chain disruptions would keep prices high and product availability scarce (70%). On the whole, the responses capture a US economy that is at a tipping point, with market participants watching to see how it weathers an aggressive rate hiking cycle from the Fed. While underlying economic variables such as growth and employment remain strong, it still remains to be seen how much of a tightening in financial conditions the markets can bear. Euro Area In the euro area, banks on net reported a very slight tightening of standards to enterprises for the second consecutive quarter in Q4/2021 (Chart 5). Effectively, standards were unchanged as 96 of the 100 respondents to the survey reported no change from Q3. Slightly lower risk tolerance from banks contributed to tightening while lower risk perceptions related to the general economic outlook and the value of collateral had an easing effect. As in the US, standards in the euro area do show a correlation to overall financial conditions. Those have already tightened noticeably since the February 3rd meeting of the European Central Bank (ECB) Governing Council where President Lagarde set a more hawkish tone. While banks do expect a slight easing of standards over Q1/2022, that is unlikely given high inflation and geopolitical uncertainties which will negatively impact risk perceptions. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions ​​​​​​ Chart 6Credit Demand In Major Euro Area Economies Credit Demand In Major Euro Area Economies Credit Demand In Major Euro Area Economies ​​​​​​ Loan demand growth from enterprises was remarkably strong in Q4, with 18% of firms reporting increased demand for loans (middle panel). The main driver was increased demand for inventories, followed closely by fixed investment and merger & acquisition needs. Loan demand leads realized growth in inventories, which has been already been picking up. In Q1, banks expect continued growth in loan demand, albeit at a slower pace. On the consumer side, however, loan demand only increased slightly, with the pace of growth slowing from the previous quarter (bottom panel). This was in line with consumer confidence taking a hit from rising inflation and the Omicron variant in the fourth quarter. The generally low level of interest rates had a small positive impact, while durable goods spending had a slight negative impact on consumer credit demand. Lenders expect moderate growth in consumer credit demand in Q1. Moving to the four major euro area economies, demand for loans to enterprises picked up in Germany, France, and Italy, while remaining unchanged in Spain (Chart 6). Fixed investment needs made a positive contribution across the board. This is corroborated by data on total lending, which is still growing on a year-on-year basis, even though the pace of growth is slowing in all the major euro area economies except Spain. UK In the UK, overall corporate credit standards eased slightly in Q4/2021, marking the fourth straight quarter of easing (Chart 7). However, there was dispersion along firm size. Large private non-financials accounted for all the easing and standards for small and medium firms actually tightened slightly. Going forward, lenders expect a further easing in standards in Q1, about on par with the easing seen in Q4. Chart 7UK Credit Conditions UK Credit Conditions UK Credit Conditions ​​​​​ Chart 8UK Lenders Expect A Robust Growth To Ease Credit Availability Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? ​​​​​​ On the demand side, lenders reported slightly weaker corporate demand for lending in Q4. Again, the results were uneven across firm size – loan demand from large firms strengthened moderately, while demand from small and medium firms weakened. On average, lenders expect a slight pickup in corporate demand over Q1. Moving to the UK consumer, demand for unsecured lending continued to rise at a brisk pace, hovering around the highest levels since Q4/2014 (bottom panel). Going forward, lenders expect a continued increase in demand, but at a much slower pace. The strong developments in loan growth are seemingly at odds with the GfK consumer confidence index which has declined a total of 12 points since its July peak. Although the Bank of England does not survey respondents on the factors driving household unsecured lending demand, the divergence between confidence and loan demand suggests that precautionary demand for liquidity is playing a role. This lines up with the GfK survey, where expectations for the general economic situation over the next year are in freefall with consumers bracing for high inflation and further Bank Rate increases. Pivoting back to the drivers of corporate lending, the leading factor behind increased credit availability was an improvement in the overall economic outlook, followed by market share objectives (Chart 8). In contrast to the UK consumer, lenders are bullish on the economic outlook and believe it will continue to drive further easing over Q1/2022. On the demand side, investment in commercial real estate, which has seen steady improvement since Q3/2020, was the leading factor. This was followed by merger & acquisition and inventory financing needs. Capital investment needs, meanwhile, were a drag on demand. Moving forward, real estate investment and inventory restocking needs are expected to drive demand. Japan In Japan, credit standards to firms and households continued to ease in Q4/2021 (Chart 9). However, more than 90% of respondents in each case reported that standards were basically unchanged, and there were no reported instances of tightening among the sample of 50 lenders. Those that did report easier standards cited aggressive competition from other banks and strengthened efforts to grow the business. The vast majority of lenders expect standards to remain unchanged over Q1, but there is a slight easing expected on a net percentage basis. Chart 9Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions Business loan demand on the whole was unchanged in Q4 although small and medium firms did increase demand slightly (middle panel). In contrast to other regions, business loan demand tends to behave counter-cyclically in Japan, with businesses borrowing more on a precautionary basis when they are pessimistic and vice-versa. Those dynamics were at play in Q4, with lenders attributing increased demand to a fall in firms’ internally generated funds. Banks expect a slight net pickup in demand next quarter, in line with business confidence which has fallen from its September peak on the back of concerns about Covid-19 infections, supply chain disruptions, and rising input prices. On the consumer side, loan demand was basically unchanged, with a very small net percentage of banks reporting weaker demand (bottom panel). The key reason for decreased demand was a decrease in household consumption, which is in line with retail sales, where the pace of growth has been falling. Even though core inflation in Japan is low, consumers are still exposed to rising energy prices, which might cause them to tighten other parts of their budgets. Canada Chart 10Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions In Canada, business lending standards continued to ease at a slightly slower pace in Q4/2021 (Chart 10). This marks the fourth consecutive quarter of easing conditions, coming amid booming economic activity, high capacity utilization, and buoyant sentiment. Both, price and non-price lending conditions eased at roughly the same pace. On the consumer side, non-mortgage lending conditions continued to ease, but at a slower pace (middle panel). 1-year ahead consumer spending growth expectations, sourced from the Bank of Canada’s (BoC) Survey Of Consumer Expectations, and non-mortgage lending conditions typically display an inverse correlation, with expected spending growth increasing when standards are getting easier on the margin and vice-versa. The divergence in Q4 is explained in part by excess savings accumulated during the pandemic that have yet to be spent down, and in part by expected price increases over the coming year. In either case, it demonstrates that nominal spending has room to grow even in an environment where consumer credit availability is worsening. We also saw mortgage standards ease at a slightly slower pace in Q4, with both price and non-price lending conditions easing (bottom panel). While the BoC has made a hawkish pivot, underlying conditions are still easy – the conventional 5-year mortgage rate is still flat at 4.79%, the same level as Q3/2020. However, house price growth has peaked, and rate hikes this year will help prices moderate further. New Zealand Chart 11New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions In New Zealand, business credit standards eased in the six month period ended September 2021 (Chart 11). However, the real impact of the Reserve Bank of New Zealand’s (RBNZ) tightening is being felt in the housing market, where actual standards entered tightening territory. More importantly, a net 23.1% of respondents expect mortgage credit availability to erode by the end of March; if realized, this figure would be a series high. Banks reporting less credit availability cited regulatory changes and risk perceptions. On the mortgage loan demand side, banks continued to see increased demand even after the record spike in March 2021 (middle panel). Going forward, demand is expected to moderate and fall from current levels. These dynamics have already made their mark on house prices which have already peaked, indicating that the RBNZ’s push is working as intended. Business loan demand does not appear to have been much affected by higher rates, with demand picking up slightly and expected to increase going forward (bottom panel). However, confidence has been falling since September 2021, with businesses feeling the twin bite of supply chain disruptions and labor shortages.   Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q4 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Footnotes 1      The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

Highlights A feedback loop has emerged in European markets. Tightening financial conditions will preempt the European Central Bank from hiking rates as much as the money market is pricing in. The widening in peripheral and credit spreads is overdone. Investors already long should maintain their positions. Investors without exposure will soon find an attractive entry point. Despite these near-term gyrations, the ECB is still on track to hike interest rates once in Q4 2022 and lift them aggressively in 2023. Feature Last week’s hawkish pivot by the European Central Bank (ECB) continues to affect markets. We take the words of the ECB at their face value; we anticipate the Governing Council (GC) to begin lifting interest rates at the end of 2022 and to continue to do so steadily over 2023 and 2024. However, as the shock filters through financial asset prices, we become more confident that the ECB will not lift rates five times in 2022 as the Euro Short Term Rate (ESTR) curve currently anticipates. Chart 1Growing Tensions In The Periphery... Growing Tensions In The Periphery... Growing Tensions In The Periphery... First, the behavior of Italian and Greek bond markets constitutes a major support to our view. Italian and Greek 10-year spreads have widened by respectively 46 and 65 basis points over the past six trading days (Chart 1). This tension highlights that investors still view these economies as continental trouble spots. Meanwhile, the ECB’s communication continues to highlight the need for flexibility to maintain order in the sovereign debt market. The GC does not want inadvertently to engineer a severe tightening in financial conditions in the already fragile periphery. In this context, it is highly unlikely that the ECB will rush to terminate the Asset Purchase Program (APP), an end on which rate hikes depend. Second, the corporate bond market is also going through a significant period of ruction. Both investment grade and high-yield bond yields have risen rapidly in recent days, and they are now retesting their late-2018 levels (Chart 2, top two panels). Spreads too are widening meaningfully, even though they remain further away from their 2018 highs (Chart 2, bottom two panels) The ECB is unwilling to let a liquidity shock morph into a solvency problem for European firms. For now, the behavior of the European credit market remains consistent with a liquidity shock. Funding markets are experiencing a violent adjustment, which is bleeding into the overall level of spreads. However, investors are not differentiating based on credit risk. Chart 3 shows that CCC credit (the lowest rated HY bonds) is not selling off relative to the overall high-yield index, which we would anticipate if investors were worried about underlying default risk. Chart 3No Distinction On Credit Risk No Distinction On Credit Risk No Distinction On Credit Risk Chart 2...And In European Corporates ...And In European Corporates ...And In European Corporates If the liquidity shock were to deepen further and last long enough, the resilience of the corporate sector would fritter away. However, the GC has tried to resist a deflationary shock for more than ten years now, and a solvency problem would undo all the progress made toward escaping the European liquidity trap, especially because wages have yet to recover. Third, members of the ECB’s GC are already trying to talk down the market. President Christine Lagarde displayed a more dovish tone when she spoke in front of the EU Parliament on February 7, 2022. ECB Chief Economist Philippe Lane remains steadfast that wages are not yet a problem. The Governor of the Bank of France, François Villeroy de Galhau still sees an imminent peak in CPI, and Olli Rehn, Governor of the Bank of Finland, recently lectured about the need for a gradual normalization of policy. Even hawks like the Bundesbank’s Joachim Nagel or the DNB’s Klaas Knot have gestured toward higher rates, but only toward the end of the year. In this context, we expect credit spreads to begin to narrow again; however, it will likely first require an easing in funding pressures. This is unlikely to happen until US yields form an interim peak. However, as Chart 4 highlights, the Treasury market is becoming extremely oversold. Moreover, a JP Morgan survey shows that its clients are massively short duration. The risk of a pullback in Treasury yields is growing, even if rising inflation and fears of a tighter Fed prevail for now. If US yields were to decline Bunds would likely follow the Treasury market because the ECB is becoming louder that it does not want to tighten financial conditions abruptly. Hence, a pullback in global risk-free yields will be the key to a period of calm in credit spreads, since valuations have improved materially, with the breakeven spreads on investment grade and high-yield bonds moving back to their 43rd and 44th percentiles, respectively (Chart 5). A stabilization in global yields and European spreads should also percolate to the peripheral sovereign bond market and limit the upside to Italian and Greek spreads. Chart 4Oversold Treasurys Oversold Treasurys Oversold Treasurys Chart 5Restoring Value In Corporates Restoring Value In Corporates Restoring Value In Corporates Bottom Line: The tightening in financial conditions taking place in Europe indicates that money market curves are pricing in the path for European policy rates too aggressively. The ECB has changed since 2011. It will not let peripheral borrowing costs threaten the recovery in Southern European economies, nor will it allow a liquidity shock in the corporate bond market to become a solvency issue that will damage growth prospects. European peripheral and corporate spreads will narrow once global risk-free rates peak.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com

Executive Summary The End Of The Negative Bond Yield Era Europe Joins The Global Bond Bear Market Europe Joins The Global Bond Bear Market Recent price action in developed market government bond markets confirms a backdrop that has been in place for the past several years - movements in US Treasuries define the trend in global yields, but Europe sets the effective floor. Higher core European bond yields are also pushing up non-European yields, in the context of the current global monetary policy tightening cycle. The hawkish market pricing for the ECB this year has gone a bit too far, as the start of European rate hikes this year is more likely in Q4 than in the summer – and only after ECB asset purchases begin to formally wind down. In the UK, the Bank of England appears to be trying to front load policy tightening, both rate hikes and balance sheet runoff, in response to overshooting UK inflation. A shorter, sharper policy tightening cycle means that the UK Gilt curve will continue to bear-flatten.  Bottom Line: Within the “Big 3” developed market central banks, the Fed and Bank of England are more likely to deliver discounted rate hikes than the ECB over the next 6-12 months. Remain underweight US Treasuries and UK Gilts versus German Bunds in global bond portfolios. Feature Chart 1A Global Repricing Of Interest Rate Expectations A Global Repricing Of Interest Rate Expectations A Global Repricing Of Interest Rate Expectations Persistent elevated inflation readings are forcing policymakers to move up the timetable of expected cyclical interest rate increases, but without signaling any change to longer-term interest rate expectations. The result has been an upward move in bond yields led by a repricing of shorter-term yields, leading to bearish yield curve flattening pressure across the developed markets (Chart 1). As the global bond bear market has intensified and broadened across countries and fixed income sectors, the amount of bonds worldwide with negative yields has been slashed by $9 trillion since December (Chart 2). Some notable examples: the 10-year German Bund yield is now up to +0.26%, the 30-year US real TIPS yield is now at +0.04% and even the 5-year Japanese government bond yield climbed to +0.02% for the first time since 2016. Last week, bond markets had to digest both a 25bp Bank of England (BoE) rate hike - that was almost a 50bp move - and a huge upside surprise in the January US employment report. However, it was the more hawkish-than-expected messaging from the European Central Bank (ECB) that really rattled fixed income markets. At the February monetary policy meeting, ECB President Christine Lagarde opened the door to potential ECB rate hikes this year, a notable change from the previous forward guidance that rates would stay unchanged in 2022. This not only triggered a major decline in European government bond prices, but also notable jumps in bond volatility for both longer-term and, especially, shorter-term yields. Implied volatilities for swaptions on 2-year European swap rates now sit at the highest levels since the depths of the European Debt Crisis in 2011 (Chart 3). Chart 2The End Of The Negative Bond Yield Era The End Of The Negative Bond Yield Era The End Of The Negative Bond Yield Era ​​​​​ Chart 3The Front-Ends Of Yield Curves Awaken The Front-Ends Of Yield Curves Awaken The Front-Ends Of Yield Curves Awaken ​​​​​​ Overnight index swap (OIS) curves are now discounting multiple rate hikes from the Fed (+127bps), BoE (+125bps) and ECB (+46bps) this year. Tighter monetary policy is the inevitable consequence of the current combination of steady above-trend growth, tight labor markets and very high inflation in those countries. This mix will continue to put upward pressure on global bond yields through a blend of steady inflation expectations and higher real yields as pandemic era monetary stimulus is removed – a process that is already underway in the US and Europe (Chart 4). Our Central Bank Monitors – designed to measure the cyclical pressure to change monetary policy – are all indicating the need for tightening in the US, UK and euro area. However, the risk is that tightening perceived to be too aggressive or too rapid will be received poorly by financial markets that have grown accustomed to easy money policies during the pandemic. Given the current starting point of high equity valuations and relatively tight corporate credit spreads in the US, financial conditions are no impediment to additional Fed rate hikes in 2022 (Chart 5). The same cannot be said in the UK, where the steady appreciation of the trade-weighted pound is tightening financial conditions, on the margin. In the euro area, financial conditions remain relatively stimulative, as the euro is undervalued on a trade-weighted basis. Chart 4A Recipe For Even Higher Bond Yields A Recipe For Even Higher Bond Yields A Recipe For Even Higher Bond Yields Given high realized inflation, financial stability concerns are playing a secondary role in the policy deliberations of central banks facing an inflation-fighting credibility crisis. In the absence of a big fall in inflation, it will take much larger selloffs in equity and corporate credit markets than what has occurred so far in 2022 before policymakers would step back from interest rate increases over the next year. Chart 5Financial Conditions Are No Impediment To Rate Hikes Financial Conditions Are No Impediment To Rate Hikes Financial Conditions Are No Impediment To Rate Hikes ​​​​​​ The ECB Will Lag The Fed On Rate Hikes Chart 6Faster Growth & Slower Inflation Expected In 2022 Faster Growth & Slower Inflation Expected In 2022 Faster Growth & Slower Inflation Expected In 2022 One of our highest conviction bond market views to begin 2022 called for US Treasuries to underperform German Bunds. Our view was based on the likelihood that the Fed would lift the fed funds rate multiple times this year and the ECB was likely to hold off on rate hikes until the first half of 2023 at the earliest. Last week’s shift in the ECB’s tone does not change that relative call. The Fed is still under far greater pressure to hike rates than the ECB, even if there is now a greater chance that the ECB could begin to tighten by the end of 2022. From an economic growth perspective, both central banks have good reasons to consider withdrawing monetary accommodation. The economic expectations in both the US and euro area have started to recover, according to the ZEW survey of financial market professionals, with a bigger bounce seen in the latter since the trough of last October (Chart 6). The fading Omicron wave is likely playing a large role in lifting economic expectations, as the variant has proven to be less lethal than previous waves of the virus. The ZEW survey also asks respondents about their views on future inflation and interest rate changes. The ZEW Inflation Expectations index has fallen back to pre-pandemic lows in both the US and euro area, indicating that a majority expect lower inflation in the US and Europe over the next year. Both the Fed and ECB also expect inflation to fall from current elevated levels this year. However, there is still a much stronger case for tightening in the US given the tight labor market that is pushing up wages. Last week’s January US payrolls data was a shocker, with employment rising +476,000 on the month when some forecasters were calling for an outright contraction in jobs due to the impact of the Omicron variant. Wage growth accelerated smartly, with average hourly earnings up 0.7% on the month and 5.7% on a year-over-year basis (Chart 7). This continues the trend of wage acceleration seen in other data series like the Employment Cost Index, confirming that the US labor market is tight enough to elicit a strong policy response from the Fed. In the euro area, the recent economic data has been a bit more mixed. The Markit manufacturing PMI rose to a five-month high of 59.0 in January, beating expectations. However, the services PMI fell to a nine-month low of 51.2 as renewed COVID lockdowns weighed on consumer confidence and spending (Chart 8). With Omicron numbers now slowing, some recovery in consumer spending is likely over the next few months as euro area governments reduce restrictions. However, the manufacturing recovery will struggle to gain significant upside momentum without stronger demand for European exports – an outcome that is not currently heralded by an upturn in reliable indicators like the global leading economic indicator or the China credit impulse (Chart 9). Chart 7Persistent US Labor Market Strength Persistent US Labor Market Strength Persistent US Labor Market Strength ​​​​​​ Chart 8A Mixed Picture On European Growth A Mixed Picture On European Growth A Mixed Picture On European Growth ​​​​​​ Even within the euro area inflation data, there are mixed trends that make it less clear that a major tightening cycle is necessary. Headline euro area HICP inflation hit a 37-year high of 5.1% in January, which was heavily influenced by a 28.6% rise in the energy component of the index (Chart 10). Goods price inflation reached 6.8%, its highest level since 1991, fueled by global supply chain disruptions and greater consumer demand for goods versus services during the pandemic. For the latter, services inflation reached a much more subdued 2.4% in January, in line with core HICP inflation of 2.3%. We expect goods price inflation to slow substantially, on a global basis and not just in Europe, as supply chain disruptions ease over the course of 2022 and consumers shift spending back towards services from durable goods as economies reopen post-Omicron. Chart 9A Gloomy Picture For European Exports A Gloomy Picture For European Exports A Gloomy Picture For European Exports ​​​​​ Chart 10European Inflation Surge Focused On Energy & Goods European Inflation Surge Focused On Energy & Goods European Inflation Surge Focused On Energy & Goods ​​​​​ Surging oil and natural gas prices will keep the energy component elevated over the next few months, particularly if geopolitical tensions over Ukraine result in Russia withholding natural gas supplies to Europe. Yet it is not clear how much of this will pass through to core inflation, which actually decelerated in January from the 2.6% pace seen in December 2021 despite surging energy prices. What does a typical ECB liftoff look like? Should the ECB focus more on the headline or core inflation numbers when deciding if rate hikes are necessary later this year? The answer may lie more in the breadth across countries, rather than depth across sectors, of euro area inflation pressures. In the relatively short history of the ECB, dating back to the inception of the euro in 1998, there have been only three monetary tightening episodes that involved interest rate increases: 1999-00, 2006-08 and 2011. In Chart 11, we show the percentage share of individual euro area countries that have accelerating growth momentum (measured as a leading economic indicator above the level of a year earlier), and with headline/core inflation above the ECB’s 2% target. In all three of those past ECB tightening episodes, essentially all euro area countries had to see strong growth or inflation at or above the ECB target before the ECB would hike rates. Chart 11The Growth & Inflation Conditions For An ECB Rate Hike Are In Place The Growth & Inflation Conditions For An ECB Rate Hike Are In Place The Growth & Inflation Conditions For An ECB Rate Hike Are In Place Chart 12Watch European Wages To Determine The ECB's Next Move(s) Watch European Wages To Determine The ECB's Next Move(s) Watch European Wages To Determine The ECB's Next Move(s) A similar story can be told looking at the state of the euro area labor market. The 1999-00 and 2006-08 tightening cycles occurred when nearly all euro area countries had an unemployment rate below the OECD’s estimate of the full employment NAIRU (Chart 12). Only in 2011, which was widely regarded as a major policy error, did the ECB hike rates without widespread labor market strength across the euro area. Right now, the breadth of the growth and inflation data across the euro area would indicate that the ECB will soon begin to tighten policy, if history is any guide. The one missing piece of the puzzle is faster wage growth. Euro area wage growth is severely lagging compared to other developed economies. For the last known data point in Q3/2021, wages were only growing at a 1.5% year-over-year rate. Wage growth has very likely accelerated since then, with the overall euro area unemployment rate now down to an all-time low of 7.0%, well below the OECD NAIRU estimate of 7.7%. The ECB will need to see confirmation of that faster wage growth in the data, however, before embarking on a path of rate hikes. Since last week’s ECB meeting, numerous ECB officials – including President Lagarde - have stated that asset purchases must stop before rate hikes can begin. While the ECB’s pandemic emergency bond buying program is set to end next month, the existing Asset Purchase Program is set to continue with no expiry date. If the ECB officials are to be taken at their word, it is very difficult to imagine a scenario where asset purchases would be fully wound down (i.e. net purchases of zero, with buying only to replace maturing bonds held by the ECB) before the July liftoff date now priced into the Euro OIS curve. Such a rapid removal of the ECB bid would be very disruptive to the riskier parts of European fixed income markets, like Italian and Greek sovereign debt, that have benefited from heavy ECB buying under the pandemic bond buying program. European bond strategy implications While an ECB rate hike in 2022 is now a more probable scenario, it is not yet a done deal. The European growth picture remains mixed, and inflation readings outside of supply-constrained energy and durable goods – including wages - are far less threatening than headline inflation. At the moment, underlying inflation pressures are far more intense in the US. Durable goods inflation in the US reached 16.8% on a year-over-year basis last month, but climbed to “only” 3.8% in Europe (Chart 13). The Cleveland Fed’s trimmed mean CPI index accelerated to 4.8% in January, compared to 3.0% for the euro area trimmed mean CPI inflation gauge constructed by our colleagues at BCA Research European Investment Strategy. Chart 13Stay Positioned For A Wider UST-Bund Spread Stay Positioned For A Wider UST-Bund Spread Stay Positioned For A Wider UST-Bund Spread The Fed has a lot more work ahead of it in terms of tightening monetary policy to rein in inflation pressures (and inflation expectations) than the ECB. This will lead to a faster pace of rate hikes in the US than in Europe and renewed widening of the US Treasury-German Bund yield spread. Financial conditions in Europe will also play a role in limiting when, and how much, the ECB can eventually tighten monetary policy. Yields and spreads on the riskier parts of the European fixed income markets like Italian government bonds have already widened substantially in response to the more hawkish guidance from the ECB (Chart 14). The euro has also stabilized after the steady depreciation seen since the May 2021 peak. Markets are obviously pricing in an end to ECB asset purchases – the precursor to rate hikes – which would force the private sector to absorb a greater share of Italian bond issuance than has been the case over the past few years. It will likely take higher yields to entice those buyers compared to the price-insensitive ECB that has been buying Italian debt as a monetary policy tool. The speed of the adjustment in Italian bond yields has no doubt alerted the ECB Governing Council to the financial stability risks of moving too fast on tightening monetary conditions. We must acknowledge that most the recent trends in the Treasury-Bund spread (narrower) and Italian bond yields/spreads (higher) go against our current strategic recommendations to overweight European fixed income. Markets have moved to price in a far more aggressive move from the ECB than we had envisioned for 2022. However, as highlighted above, it is not clear that the ECB needs to dial back monetary accommodation as rapidly as markets now expect. Thus, we are sticking with our strategic recommendations to overweight euro area government bonds, both in the core and periphery, in global bond portfolios. At the same time, we continue to recommend a below-benchmark duration stance within dedicated European portfolios, even with the 10-year German Bund yield having already reached our end-2022 yield target of 0.25% (Chart 15). European bond yields will remain under upward pressure until euro area inflation finally peaks and the ECB will be under less pressure to tighten. Chart 14ECB Facing An "Italy-vs-Inflation" Tradeoff ECB Facing An "Italy-vs-Inflation" Tradeoff ECB Facing An "Italy-vs-Inflation" Tradeoff ​​​​​ Chart 15Too Much, Too Soon Priced Into Bund Yields Too Much, Too Soon Priced Into Bund Yields Too Much, Too Soon Priced Into Bund Yields ​​​​​ Bottom Line: Markets are overestimating how quickly the ECB can begin to tighten European monetary policy. An initial rate hike can occur in Q4 of this year, at the earliest, which is later than the current mid-summer liftoff date discounted in interest rate forwards. Ride out the current European rates volatility and stay overweight European government debt versus the US. UK Update: The BoE Wants To Tighten Fast At last week's policy meeting, the BoE Monetary Policy Committee (MPC) voted 5-4 to raise Bank Rate by 25bps to 0.5%. That close vote is less dovish than it appears, though, as the four “dissenting” MPC members wanted to raise rates by 50bps instead! This was a hawkish surprise that resulted in bearish flattening of the UK Gilt yield curve. Chart 16UK Gilts: Volatile, But Underperforming UK Gilts: Volatile, But Underperforming UK Gilts: Volatile, But Underperforming We have maintained a below-benchmark strategic recommendation on Gilts since August of last year. The relative performance of Gilts versus the Bloomberg Global Treasury benchmark index has seen tremendous volatility since then, particular after the BoE delayed the expected initial rate hike last November (Chart 16) Gilts began to underperform again after the BoE hiked in December and have continued to be one of the worst performing G10 bond markets, validating our bearish call. After last week’s BoE hike, we still see value in betting on additional Gilt underperformance, as markets may still be underestimating how high the BoE will have to raise rates in the current tightening cycle. In the new set of economic projections from the BoE’s Monetary Policy Report published last week, the central bank raised its expectation for the April peak in UK inflation to 7.25% (Chart 17). This compares to the latest inflation rate of 5.4%. Higher energy and goods prices account for three-quarters of that expected inflation increase, according to the BoE. UK inflation is projected to fall rapidly from that April peak, in response to an expected deceleration of energy and goods prices and slower UK economic growth. However, the Monetary Policy Report also highlighted that domestic UK cost pressures are intensifying in response to a very tight UK labor market. The BoE’s Agents’ survey of UK businesses reported that UK firms continue to have difficulty filling job openings, while also having success in passing on rising labor costs into selling prices. Thus, the UK labor market is now the critical variable to watch to determine how many more rate hikes the BoE will need to deliver in the current cycle. On that note, the BoE expects UK wage growth to accelerate to just under 5% over the next year, which is well above the central bank’s estimate of “underlying” pre-pandemic wage growth around 3.5%. Inflation expectations in the UK remain elevated. The YouGov/Citigroup survey shows that UK consumers expect inflation to be 4.8% on year from now and 3.8% 5-10 years ahead (Chart 18, top panel). Market-based inflation expectations have been more volatile of late but CPI swaps are pricing in inflation of 5.0% in two years and 4.2% in ten years.1 Thus, by any measure – realized inflation, expected inflation or wage growth – UK inflation is too high, which justifies tighter monetary policy. The UK OIS curve now discounts a peak in Bank Rate of 1.85% in April 2023, but this is immediately followed by rate cuts that take Bank Rate to 1.5% by the end of 2024. That path over the next year is a bit more hawkish than the results from the BoE’s new Market Participants Survey of bond investors, which showed an expected peak in Bank Rate of 1.5% sometime in the latter half of 2023. In both cases, Bank Rate is expected to settle below the BoE’s 2% inflation target, or below current inflation expectations. Suggesting an implied belief that the BoE will not be able to raise real interest rates into positive territory. In terms of forward guidance, several BoE officials have noted that they expect that only a few more hikes will be needed to help bring UK inflation back down to the 2% target. Yet the OIS curve is pricing in a “policy error” scenario where the BoE pushes up rates too rapidly and is then forced to cut rates soon afterward. We see both the BoE guidance and the OIS pricing as far too cautious on the eventual peak in Bank Rate, which leads us to maintain our underweight recommendation on UK Gilt exposure, both in terms of duration and country allocation in global bond portfolios. Chart 17BoE Sees A Short, Sharp Shock From Inflation & Rates BoE Sees A Short, Sharp Shock From Inflation & Rates BoE Sees A Short, Sharp Shock From Inflation & Rates We have also been recommending a Gilt curve steepening trade in our Tactical Overlay portfolio on page 20 since last October. This trade went long a 10-year Gilt bullet versus a barbell combination of a 7-year and 30-year Gilt. Chart 18Stay Underweight UK Gilts Stay Underweight UK Gilts Stay Underweight UK Gilts ​​​​​ Our view at the time of trade inception was that a Gilt steepener would benefit from a scenario where the market would be forced to reassess how high rates would go in the next BoE tightening cycle. However, the BoE now appears to be “front loading” the tightening cycle by moving rates sooner and more aggressively, as evidenced by the near 50bp rate hike last week, while also moving to an accelerated runoff of bonds accumulated during quantitative easing operations. The Gilt yield curve has flattened considerably in response to increasing BoE hawkishness, with the yield spread between the 10-year and 2-yield Gilt now down to a mere +17bps. While we still see the potential for the longer-end of the Gilt curve to rise in response to an eventual repricing of terminal rate expectations that appear too low, the BoE’s acceleration of its hiking timetable will make it difficult for the curve to bearishly steepen in the near term. Thus, we are closing out our tactical Gilt curve steepener at a small gain of +23bps.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      UK CPI swaps, and inflation breakevens on index-linked Gilts, reference the UK Retail Price Index (RPI) which typically runs higher than the UK Consumer Price Index (CPI). This imparts an upward bias to UK inflation expectations when compared to CPI swaps and breakevens in other countries. Currently, RPI inflation is running at 7.5% compared to CPI inflation of 5.4%. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Europe Joins The Global Bond Bear Market Europe Joins The Global Bond Bear Market The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Cyclical Recommendations (6-18 Months) Europe Joins The Global Bond Bear Market Europe Joins The Global Bond Bear Market Tactical Overlay Trades

Highlights Chart 1Most Sectors Have Fully Recovered Most Sectors Have Fully Recovered Most Sectors Have Fully Recovered Last week’s January employment report shocked markets by showing much greater job gains than had been anticipated. More important than the headline number, however, were the revisions to prior months that reveal a much different picture of the post-COVID labor market. In overall terms, the revised data show that employment is still significantly below where it was prior to the pandemic. Specifically, the economy is still missing about 2.9 million jobs. However, the data now reveal that more than 60% of the missing jobs come from the Leisure & Hospitality sector and that the Health Care and State & Local Government sectors account for the rest. In other words, except for the few sectors that have been most impacted by the pandemic, the US labor market has made a full recovery (Chart 1). The new data justify the Fed’s recent push toward tightening. This is because there is no longer any evidence of labor market slack beyond what we see in the select few close-contact service industries that have been most impacted by COVID. Investors should maintain below-benchmark portfolio duration as the Fed moves toward rate hikes. Feature Table 1Recommended Portfolio Specification The COVID Labor Market The COVID Labor Market Table 2Fixed Income Sector Performance The COVID Labor Market The COVID Labor Market Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 115 basis points in January. The index option-adjusted spread widened 14 bps on the month to reach 108 bps, and our quality-adjusted 12-month breakeven spread moved up to its 15th percentile since 1995 (Chart 2). This indicates that, despite the recent selloff, corporate bonds remain expensive. We discussed the intermediate-term outlook for corporate bonds in a recent report.1  Specifically, we analyzed the performance of both investment grade and high-yield corporate bonds during previous Fed tightening cycles. Our conclusion is that it will soon be appropriate to reduce our cyclical exposure to corporate credit. For investment grade corporates, this will mean reducing our recommended allocation from neutral (3 out of 5) to underweight (2 out of 5). Our analysis of past cycles suggests that the slope of the yield curve is a critical indicator of corporate bond performance. Excess corporate bond returns are generally strong when the 3-year/10-year Treasury slope is above 50 bps but take a step down when the slope shifts into a range of 0 – 50 bps. The 3/10 slope has just recently dipped below 50 bps (bottom panel). Though our fair value estimates can’t rule out a near-term bounce back above 50 bps, this will become less and less likely as Fed rate hikes approach. We maintain our current recommended allocation for now but expect to downgrade within the next few weeks. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The COVID Labor Market The COVID Labor Market Table 3BCorporate Sector Risk Vs. Reward* The COVID Labor Market The COVID Labor Market High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 158 basis points in January. The index option-adjusted spread widened 59 bps in January to reach 342 bps. 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 – also moved up to 4% (Chart 3). The odds are good that defaults will come in below 4% during the next 12 months, which should coincide with the outperformance of high-yield bonds versus Treasuries. For context, the high-yield default rate came in at 1.24% in 2021 and we showed in a recent report that corporate balance sheets are in excellent shape.2 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). While high-yield valuations are more favorable than for investment grade, the bonds will still have to contend with a more challenging monetary environment this year as the Fed lifts rates and the yield curve flattens. For this reason, we expect to reduce our recommended allocation to high-yield corporates in the coming weeks – from overweight (4 out of 5) to neutral (3 out of 5) – though we will retain our preference for high-yield over investment grade. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in January. The zero-volatility spread for conventional 30-year agency MBS tightened 7 bps on the month, split between a 17 bps tightening of the option-adjusted spread (OAS) and a 10 bps increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.3 This valuation picture is starting to change. The option cost is now up to 36 bps, its highest level since March 2020, and refi activity is slowing as the Fed moves toward rate hikes. At 23 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS. We continue to recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Emerging Market Bonds (USD): Overweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview This week we officially initiate coverage of USD-denominated Emerging Market (EM) bonds. To start, we will focus on investment grade rated Sovereigns, Corporates and Quasi-Sovereigns. We plan to expand our coverage to include high-yield in the coming months. This EM section replaces the previous Government-Related section in our monthly summary. We will continue to cover Government-Related securities from time to time, but that sub-index will no longer be regularly included in our recommended portfolio allocation. Emerging Market bonds underperformed the duration-equivalent Treasury index by 88 basis points in January. EM Sovereigns underperformed the Treasury benchmark by 134 bps on the month and the EM Corporate & Quasi-Sovereign Index underperformed by 58 bps. After strong relative performance in the back-half of 2021, the EM Sovereign index eked out just 4 bps of outperformance versus the duration-equivalent US corporate bond index in January (Chart 5). Meanwhile, the EM Corporate & Quasi-Sovereign index outperformed the duration-matched US corporate index by 24 bps on the month. Yield differentials for EM sovereigns and corporates remain attractive relative to US corporates (panel 4). Additionally, EM currencies are hanging in there versus the dollar even as the Fed moves toward tightening (bottom panel). We recommend an overweight allocation to USD-denominated EM bonds in US bond portfolios, and we maintain our preference for EM sovereign and corporate bonds relative to US corporates with the same credit rating and duration. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 121 basis points in January (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.4 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 19% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk as bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened dramatically in January, and yields continued their sharp rise through the first week of February – though in a more parallel fashion. All in all, the 2-year/10-year Treasury slope has flattened 17 bps since the end of December, bringing it to 62 bps. The 5-year/30-year slope has flattened 19 bps since the end of December, bringing it to 45 bps. The aggressive flattening of the curve has occurred alongside the Fed’s increased near-term hawkishness. Our 12-month discounter has risen from 77 bps at the end of last year to 149 bps today (Chart 7). In other words, the market has gone from anticipating just over three 25 basis point rate hikes during the next 12 months to nearly six! Last week’s report argued that the most recent move to discount more than four 25 basis point rate hikes in 2022 is overdone.5  We contend that tightening financial conditions and falling inflation expectations will cause the Fed to moderate its pace of rate hikes in the second half of this year. We still see the Fed lifting rates three or four times in 2022, but this is now significantly below what’s priced in the market. Given our view, we recommend a position long the 2-year Treasury note versus a barbell consisting of cash and the 10-year note. This trade will profit as a more moderate expected pace of near-term rate hikes limits the upward pressure on the 2-year yield. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 23 basis points in January. The 10-year TIPS breakeven inflation rate has declined by 16 bps since the end of December while the 2-year TIPS breakeven inflation rate has fallen by 1 bp. The 10-year and 2-year rates currently sit at 2.43% and 3.21%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate is down 22 bps since the end of December. It currently sits at 2.05%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given how the market has reacted to the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in January. Aaa-rated ABS outperformed by 19 bps on the month and non-Aaa ABS outperformed by 20 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in January. Aaa Non-Agency CMBS underperformed Treasuries by 3 bps in January, but non-Aaa Non-Agency CMBS outperformed by 2 bps (Chart 10). Though returns have been strong and spreads remain relatively wide, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in January. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.     Appendix A: 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 January 31, 2022) The COVID Labor Market The COVID Labor Market 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 January 31, 2022) The COVID Labor Market The COVID Labor Market 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 -53 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 53 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) The COVID Labor Market The COVID Labor Market Appendix B: 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 11Excess Return Bond Map (As Of January 31, 2022) The COVID Labor Market The COVID Labor Market Recommended Portfolio Specification The COVID Labor Market The COVID Labor Market Other Recommendations The COVID Labor Market The COVID Labor Market Ryan Swift US Bond Strategist rswift@bcaresearch.com    Footnotes 1 Please see US Bond Strategy Weekly Report, “Positioning For Rate Hikes In The Corporate Bond Market”, dated January 25, 2022. 2 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 5 Please see US Bond Strategy Weekly Report, “The Best Laid Plans”, dated February 1, 2022.

Executive Summary The European Central Bank (ECB) has engaged in a decisive pivot toward higher policy rates. Markets are pricing in a first interest-rate hike in July and three more increases thereafter in 2022. This is too much for one year. Limited domestic inflationary pressures, weakness in long-term inflation expectations, economic slack, and vulnerability in the periphery will limit the ECB to one hike in December. Nonetheless, the ECB will increase interest rates more than the market anticipates beyond 2022. The UK is setting up for a dangerous latter half of 2022. Too Much Now, Not Enough Later Too Much Now, Not Enough Later Too Much Now, Not Enough Later Bottom Line: Bet on a steepening of the euro short-term rate (€STR) curve. Current pricing for 2022 is too aggressive; however, it is too timid beyond the yearend. European financials will be the prime beneficiary of this tilt. Feature On Thursday, February 3, ECB President Christine Lagarde announced a decidedly hawkish pivot at the ECB press conference. The Frankfurt-based institution, worried by higher-than-anticipated inflation, no longer excludes rate hikes for 2022. In a context in which the BoE is resolutely hiking rates and the Fed is ready to initiate a sustained tightening campaign, investors are pricing in a 10bp ECB rate hike as early as July 2022. They also foresee three additional increases by the end of the year. We agree that the ECB will start lifting the deposit rate this year; however, we expect the tightening to begin in December. Nonetheless, we expect the ECB to lift policy rates more aggressively than the €STR prices in subsequent years. European Inflation Is Different Chart 1Surprise! Surprise! Surprise! The knee-jerk reaction of investors to price in a sudden, sustained campaign of ECB rate hikes this year similar to that of the Fed is natural in light of elevated Eurozone inflation and inflation surprises (Chart 1). However, we continue to view European inflation as distinct from US inflation. European inflation remains dominated by dynamics in the energy market. While headline inflation increased from 5% to 5.1% in January, the core Consumer Price Index (CPI) declined modestly to 2.3% from 2.6%. Crucially, the variance of headline CPI is still almost fully explained by the variance of its energy component (Chart 2, top panel). However, it is concerning that there is also evident pass-through from energy prices to core CPI taking place today (Chart 2, bottom panel). Naturally, natural gas prices play a particularly important role in this energy-driven inflation spike (Chart 3). Chart 2Energy Still Drives Inflation Energy Still Drives Inflation Energy Still Drives Inflation Chart 3Natural Gas Remains Key Natural Gas Remains Key Natural Gas Remains Key Imported inflation is another key driver of European inflation. Chart 4 highlights that there is a robust relationship between the level of headline Harmonized Index of Consumer Prices (HICP) across EU nations and their import prices. This confirms that a large proportion of the European inflationary outburst has taken root outside of the continent’s borders. Chart 4Imported Inflation? The ECB Is Not the Fed—Not Yet The ECB Is Not the Fed—Not Yet Despite this energy-driven, imported inflation, domestic pressures are still much more muted than those in the US. VAT increases played an important role in pushing core CPI higher. Without this contribution, CPI excluding food and energy would be 50 bps lower (Chart 5). Meanwhile, rent inflation remains a modest 1.1%, which is significantly lower than that in the US (Chart 6, top panel), whereas used car CPI is not nearly as extreme as across the Atlantic (Chart 6, bottom panel). Chart 5Elevated Contribution From Taxes Elevated Contribution From Taxes Elevated Contribution From Taxes Chart 6Comparatively Muted Domestic Inflation Drivers Comparatively Muted Domestic Inflation Drivers Comparatively Muted Domestic Inflation Drivers Wage dynamics too are not yet as concerning in the Eurozone as they are in the US. Negotiated wages remain near a record low of 1.4%, and unit labor costs at 0.9% are still inconsistent with strong underlying inflationary pressures (Chart 7, top and second panel). The labor market is tightening and the Euro Area unemployment rate fell to a new low at 7%. However, the total hours worked have not yet reached their pre-pandemic levels (Chart 7, third panel), which suggests that it could take a few more months before the dislocation caused by the pandemic has been fully absorbed and wages become a risk. That being said, it is only a matter of time, as job vacancies are skyrocketing (Chart 7, bottom panel). Chart 8Plentiful Slack Plentiful Slack Plentiful Slack Chart 7The Labor Market Will Heat Up... Later The Labor Market Will Heat Up... Later The Labor Market Will Heat Up... Later The European output gap also limits a repetition of the wage-price spiral taking hold in the US. The OECD’s Weekly Tracker of GDP, a proxy for the overall Eurozone comprised of Germany, France, Italy, and Spain, reveals that, as of mid-January, aggregate output was still 4.9% below its pre-pandemic trend (Chart 8, top panel). Looking at the actual GDP of European countries individually, only France stands above its pre-pandemic trend, whereas Germany, Italy, and Spain still linger well below the average economic path that prevailed from 2012 to 2019 (Chart 8, bottom panels). Chart 9The Inflationary Role Of Bottlenecks The Inflationary Role Of Bottlenecks The Inflationary Role Of Bottlenecks Bottlenecks have also played an important role in relation to higher inflation. Goods inflation is much more elevated than services inflation (Chart 9, top panel), and industrial companies rank the ability to procure equipment and materials as their most important production constraint (Chart 9, second panel). However, production bottlenecks are dissipating. A recent Ifo survey highlights that the proportion of retailers with procurement issues declined from 82% in December 2021 to 57% in January 2022. Moreover, the supplier deliveries indexes of the PMIs are improving across the world. In fact, our simple Supply Disruption Index has begun to rollover, which points toward an imminent end to the wave of inflation surprises (Chart 9, bottom panel). European inflation expectations bear the imprint of those more modest domestic inflationary pressures, which explains the comparatively more limited wage-price spiral on the continent. The inflation expectations of Eurozone households are rising, but they are still within the norm of the past 20 years. In the US, they are breaking out. Moreover, our Index of Common Inflation Expectations, designed to mimic the New York Fed’s measure, remains well contained and is tentatively rolling over (Chart 10). Collectively, these forces explain the radically different inflation profiles of the Euro Area and the US. On the western shore of the Atlantic, the two-year annualized rate of change of the core CPI has completely shattered its highs of the past 20 years, indicating that more than simple base-effects are contributing to inflation (Chart 11, top panel). Meanwhile, the two-year annualized rate of change of the European core CPI is higher than the past deflationary eight years, but it is still low compared to the rates that prevailed prior to the European sovereign debt crisis (Chart 11, bottom panel). Chart 10Inflation Expectations: Unlike The US Inflation Expectations: Unlike The US Inflation Expectations: Unlike The US Chart 11Realized Inflation: Unlike The US Realized Inflation: Unlike The US Realized Inflation: Unlike The US Chart 12The Coming CPI Peak? The Coming CPI Peak? The Coming CPI Peak? Going forward, there remains a high likelihood that Eurozone inflation will soon peak. The impact of the German VAT increases will soon dissipate from the data, energy inflation will diminish as the annual rate of change of oil and natural gas prices peaks, and the growth in monetary aggregates has normalized sharply. Most importantly, in the absence of significant domestic inflationary pressures, the sharp decline in the ZEW Inflation Expectations components point toward a deceleration in headline HICP (Chart 12). Nonetheless, we cannot be too sanguine. The European output gap is likely to close this year and wages pressures will emerge before the end of 2022. As a result, inflation will not fall below 2% anytime soon. Moreover, as we wrote last week, any long-lasting crisis in Ukraine will prevent energy inflation from declining, and thus, there remains significant upside risk to our inflation view in the coming months.  Bottom Line: European inflation remains dominated by energy prices and imported price pressures. For now, domestic inflation dynamics are still mild, which explains why Europe’s inflation profile is much shallower than that of the US. Moreover, the near-term picture suggests that the imported inflation will peak, giving a respite to the HICP. Nonetheless, toward the yearend, domestic inflationary forces will pick up as wages gain traction. ECB Pricing: Too Much And Too Little ECB President Christine Lagarde delivered a message that was loud and clear: The ECB is abandoning its ultra-dovish stance. Despite this policy pivot, investors are pricing in too many hikes this year, whereas we only expect one rate increase toward yearend. True, if energy prices spike anew, risks to this forecast will be skewed to the upside. Nonetheless, we are inclined to fade the number of rate hikes priced in for 2022 and bet for more hikes in 2023 and 2024 (Chart 13). Chart 13Too Much Now, Not Enough Later Too Much Now, Not Enough Later Too Much Now, Not Enough Later Why does our base case only include one rate hike in December? First, we are considering the entirety of the inflation picture. As we argued above, inflationary dynamics in Europe are much tamer than those in the US, especially in terms of domestic inflation, which the ECB can influence. Moreover, the ECB is still reeling from its infamous 2011 policy mistake, which accentuated underlying deflationary pressures and caused the ECB to undershoot its mandate for eight years in a row (Chart 14). Inflation expectations also offer some leeway to the ECB. Predictions by professional forecasters continue to track below two percent for the medium term. Importantly, market-based inflation expectations remain consistent with a temporary inflation shock, and do not meet yet the ECB’s criteria of being above the 2% target durably. 10-year CPI swaps hover around 2%, driven by the jump in 2-year CPI swaps to 2.7%. Long-dated expectations approximated by the 5-year/5-year forward CPI swap remain below 2% and the inflation curve is its most inverted on record (Chart 15). Chart 15Inflation Swaps Don't Fit The ECB's Criteria Inflation Swaps Don't Fit The ECB's Criteria Inflation Swaps Don't Fit The ECB's Criteria Chart 14The Legacy Of The 2011 Mistake The Legacy Of The 2011 Mistake The Legacy Of The 2011 Mistake In the end, President Lagarde did mention in the press conference that inflation is finally moving toward its target after years of undershoot. In the context described above, it is likely that the ECB will continue to tolerate some higher inflation in the near term if it represses the deflationary mentality that had engulfed the Eurozone last decade and caused a progressive Japanification of the region. This is a small price to pay to exit at last the lower bound of interest rates on a durable basis. Second comes the sequencing of policy. President Lagarde reiterated the importance of the order of events. First, the ECB will have to bring asset purchases to a net zero before lifting rates. It has yet to curtail purchases. The March meeting will be of paramount importance, since it will feature the tapering schedule of the central bank. We continue to see a progressive pace of declining assets purchases that will likely end in September 2022. Moreover, the ECB will want to see how the European economy and markets will absorb the TLTRO cliff this June, when EUR1.3 trillion of facility expire. Chart 16The Italian Constraint The Italian Constraint The Italian Constraint Third, the ECB remains hamstrung by financial dynamics in the periphery. On Thursday, as Bund yields rose 10 basis points, BTP yields rose 21 basis points, bringing the Italian-German spread to 150bps, its highest level since September 2020 (Chart 16). Simply put, the periphery remains fragile because Italy and Spain sport some of the most negative output gaps in the region. Waiting for a stronger position out of those countries would let the ECB increase rates further down the road, allowing for a cleaner exit from negative policy rates in Europe. While these factors continue to favor a cautious posture by the ECB in 2022 and, therefore, support our base view of only one 10bps hike in December to be flagged when net purchases end in September, they will evolve and allow for many more hikes in 2023 and 2024. We expect the following developments to unfold: The output gaps across the region will close this year, which will put the economy in a position of strength and generate stronger domestic inflationary pressures down the road. Salaries will begin to accelerate meaningfully by the summer. This force will accentuate domestic inflationary pressures in late 2022 and 2023, and will contribute to higher household inflation expectations. The periphery will grow increasingly stronger as the Next Generation EU (NGEU) disbursements accelerate in 2022 and 2023. These disbursements are primarily geared toward infrastructure/capex spending (Chart 17) and will therefore sport elevated fiscal multipliers. The resulting strength will provide more resilience to the periphery and limit the tightening of financial conditions caused by higher interest rates. Chart 17The NGEU Will Matter… A Lot The ECB Is Not the Fed—Not Yet The ECB Is Not the Fed—Not Yet Chart 18Terminal Rates Are Too Low Terminal Rates Are Too Low Terminal Rates Are Too Low In the longer term, we also believe that markets still understate the ability of the ECB to lift rates. The market-derived terminal rate proxy for Europe is in the vicinity of the levels recorded in the wake of the European sovereign debt crisis last decade (Chart 18). Fiscal policy is more generous, however, and thus domestic demand is stronger. As a corollary, the accelerator model implies that capex will be more robust than it was last decade. Finally, the European Union is not as politically divided as it once was, which creates a stronger block. Together, these developments suggest that the r-star or the neutral rate of interest in the Euro Area is higher than last decade. Bottom Line: The €STR curve is pricing in the potential path of the ECB this year too aggressively. The ECB is likely to start raising rates in December, not in July. Domestic inflation and inflation expectations remain too modest, while the periphery remains fragile. Moreover, the ECB will stick to the previously decided sequence that calls for an end to net asset purchases ahead of hikes. Beyond 2022, we expect the ECB to increase rates more than what is priced into the €STR curve. Investment Implications The first implication of our view is that the European yield curve is likely to steepen further in the coming year. This is true in absolute terms but also relative to the US. We remain long European steepeners relative to US ones. Second, we continue to favor European financials. European banks are a direct equity play on higher yields and on a steeper yield curve (Chart 19). Moreover, European financials have upside relative to their US competitors. They are cheap, and they will benefit from the relative steepening in the European yield curve (Chart 20). Additionally, European monetary conditions will remain easier this year than US ones, whereas European growth will continue to catch up to the US. Chart 20Roll Over XLF Roll Over XLF Roll Over XLF Chart 19Banks Will Shine More Banks Will Shine More Banks Will Shine More Chart 21A Bit More Stress A Bit More Stress A Bit More Stress Third, the equity market correction might have a little more to run. In the near term, equities had become very oversold. This week’s bounce makes sense after the S&P 500’s RSI plunged below 30. However, hedge funds are not shorting the market as violently as they did in 2018, yet all the major global central banks (apart from the BoJ) are abandoning their pandemic-driven policy. As a result of the prospect of a global decline in liquidity, a retest of the 2018-lows in net exposure is likely as we approach the March Fed meeting, especially as credit spreads are still too low to cause a meaningful change in tone by the Fed (Chart 21). Thus, European stocks could experience another wave of selling in the coming weeks, especially when the risks surrounding Ukraine have yet to clear. Keep some protections in place. Finally, the euro has surged this week. With looming Ukrainian risk, the potential for a repricing downward of the near-term European policy rates and the risk of a last sell-off in equities, the euro could give up some of its recent gains and remain in a churning pattern, in place since December 2021. The uncertainty is therefore elevated for near-term traders. However, considering last week’s ECB pivot and the likelihood of an upward revision of the €STR curve for 2024 rates, long-term investors should use a pull back in the euro in the coming weeks to gain exposure to long EUR/USD. What About The BoE? Last week, the Bank of England increased rates by 25bps to 0.5%, which was a widely expected move. The BoE is naturally ahead of the ECB because inflation swaps stand at 4.3% and are even higher than those in the US. The BoE is forced to be more aggressive because inflation expectations are becoming unmoored, which raises the risk of a wage-price spiral north of the Channel. This is a legacy of years of higher inflation and of the labor-supply problems created by Brexit. Additionally, the UK is exiting Omicron lockdowns faster than the Euro Area, which accentuates its near-term economic strength. The UK is not, however, out of the woods. A perfect storm is brewing for the remainder of the year. Interest rates are set to rise sharply, energy price caps will disappear in two months, and the budget is anticipating a significant tightening in the coming quarters after taxes rise in April. This will hurt economic activity in the latter half of the year and will cause tensions in the domestic market. The tax hikes are not guaranteed and a reversal is still possible. PM Boris Johnson is currently embroiled in the so-called “Partygate” scandal and Rishi Sunak, Chancellor of the Exchequer, is seen as the most likely candidate within the Conservative Party to replace Johnson if he were to be pushed out of power by the 1922 Committee. As a colleague observed, it remains to be seen whether Sunak’s political ambitions will scuttle his fiscal rectitude. Nonetheless, the threats to UK small-cap stocks are increasing, warranting a cautious stance if the tax increases are not revoked in the coming weeks.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Asian Inflation Has Diverged From US Emerging Asia: Domestic Bond Strategy Emerging Asia: Domestic Bond Strategy Inflation has been largely subdued in emerging Asia and will remain so for now. This argues for the outperformance of emerging Asian local bonds versus their EM peers, as well as DM/US bonds.   The most important macro driver of Asian domestic bond yields is inflation. Rising inflation usually also hurts local currencies – creating a toxic cocktail for bonds’ total returns in US dollar terms. Diverging currency dynamics in emerging Asia is what will determine the relative performances of individual bond markets. Chinese, Indian, and Malaysian currencies have a better outlook than currencies in Indonesia, Thailand and the Philippines. Book profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021. Recommendation   Initiation Date Return to Date Short KRW / Long USD 2021-03-25 5.2% Bottom Line: Regional fixed income managers should overweight China, Korea, India and Malaysia, and underweight Indonesia, Thailand and the Philippines within an emerging Asian bond portfolio. In an overall EM domestic bond portfolio however, Thailand and the Philippines should be accorded a neutral allocation, given their better inflation outlook compared to their peers in EMEA and Latin America. Feature US Treasury yields will likely go up further. If history is any guide, EM Asian bond yields should also rise in tandem (Chart 1). The basis is that business cycles in Asia and the US usually move together. Yet, in this cycle, inflation in emerging Asia has diverged considerably from that of the US. US core consumer price inflation has surged while in Asia, core inflation remains largely contained (Chart 2). How should bond investors position themselves in Asian domestic bond markets? Chart 1Asian Bond Yields Usually Move In Line With US Treasury Yields... Asian Bond Yields Usually Move In Line With US Treasury Yields... Asian Bond Yields Usually Move In Line With US Treasury Yields... Chart 2...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds ...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds ...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds Chart 3Relative Domestic Bond Performances In Asian Markets Relative Domestic Bond Performances In Asian Markets Relative Domestic Bond Performances In Asian Markets In this report, we will discuss some of the common factors that drive Emerging Asian bond markets. We will also highlight each individual market’s idiosyncrasies to explain our recommended allocation across local currency bond markets in emerging Asia for the coming year.     Our recommended allocation is as follows: China, Korea, India and Malaysia merit an overweight stance in an emerging Asia domestic bond portfolio, while Indonesia, Thailand, and the Philippines warrant an underweight allocation (Chart 3). That said, given a much more benign inflation outlook in Asia than elsewhere in EM, we recommend that Thailand and the Philippines be accorded a neutral allocation in an overall EM domestic bond portfolio. The Two Drivers For international investors in local bonds, total returns are predicated on two main drivers: (1) the direction and magnitude of change in bond yields; and (2) currency performance. In all Asian countries, the most potent macro factor that drives local bond yields is the country’s inflation. Rising inflation is usually a harbinger of higher bond yields (and hence, worsening bond performance); and falling inflation is an indicator of lower yields (Charts 4 and 5). Chart 4Inflation Is The Most Important Macro Driver … Inflation Is The Most Important Macro Driver... Inflation Is The Most Important Macro Driver... Chart 5… Of Bond Yields In Emerging Asia ... Of Bond Yields In Emerging Asia ... Of Bond Yields In Emerging Asia What’s more, rising inflation in a country is also often associated with a depreciating currency. Currencies in countries with higher/rising inflation in general do worse than in countries with lower/falling inflation. This aspect is especially important when doing a cross-country comparison. The fact that higher inflation negatively impacts both the drivers of bond performance – it pushes up yields and weakens the currency – can indeed be seen happening in Asian financial markets. Rising inflation leads to poor performance of domestic bonds’ total return in dollar terms; and falling inflation leads to a better performance. The upshot is that the potential inflation trajectory is key to any country’s domestic bond performance in both absolute and relative terms. Inflation In Asia Is Benign Most of the Asian countries have their core and trimmed mean consumer price inflation running at or well below their central banks’ targets (Charts 6 and 7). Their inflation outlook also remains largely benign.1 As such, bond yields in these countries are unlikely to rise materially in the near future. Chart 6Inflation Is Running At Or Below … Inflation Is Running At Or Below... Inflation Is Running At Or Below... Chart 7… Central Banks’ Target in Asia ... Central Banks' Target in Asia ... Central Banks' Target in Asia Notably, even the recent surge in US yields did not spook Asian bond yields. The yield differentials between individual Asian domestic and US yields have remained flattish in the past few months. All this implies that Asian domestic bonds, in general, would likely fare better relative to the rest of the EM and the US – where inflation is high and well above their central banks’ targets. Currency Is A Key Differentiator Given inflation, and therefore the bond yield trajectories among Asian economies are unlikely to deviate significantly from one another, the key differentiator of their bond market performance (on a total return basis) will be their exchange rates. In fact, Asian currencies do vary considerably in their outlooks as their fundamentals differ.  For instance, in China and Korea, higher bond yields are usually associated with an appreciating currency (Chart 8, top and middle panels). The key driver of bond yields in these economies is the business cycle. Accelerating growth often pushes up both the currency as well as interest rates. The opposite is also true: decelerating growth usually leads to a weaker currency and falling bond yields.  The consequence is that in these countries, bond performance is tempered by two opposing forces. For example, the effect of falling yields (which is a positive for total return) is often mitigated by the effect of a falling currency (which is a negative for total return), or the other way around. In contrast to China and Korea, ASEAN countries usually experience rising bond yields accompanied by a depreciating currency (Chart 9). A crucial reason for this is significantly higher foreign ownership of their domestic bonds. In periods of stress, when foreigners exit their bond holdings, this leads to both higher yields and a falling currency. During risk-on periods, foreigners’ purchases do the opposite. Chart 8Higher Bond Yields Coincide With A Stronger Currency In China And Korea Higher Bond Yields Coincide With A Stronger Currency In China And Korea Higher Bond Yields Coincide With A Stronger Currency In China And Korea Chart 9Higher Bond Yields Coincide With A Weaker Currency In ASEAN Higher Bond Yields Coincide With A Weaker Currency In ASEAN Higher Bond Yields Coincide With A Weaker Currency In ASEAN In this context, foreign ownership of domestic bonds in ASEAN countries has fallen in the past few years, but remains non-trivial: 19% in Indonesia, 24.2% in Malaysia, 19.9% in the Philippines, and 11.3% in Thailand. Hence, the currency view on ASEAN countries is crucial to get the outlook right for their domestic bond performance. Incidentally, Thailand, the Philippines and Indonesia have a weak currency outlook, while Malaysia’s is neutral. We discuss the individual currency outlooks in more detail in the respective country sections below. But in summary, this warrants a more positive stance on Malaysian domestic bonds compared to Indonesian, Thai and Filipino bonds. Finally, in case of India, bond yields and the rupee have little correlation (Chart 8, bottom panel). The main reasons for that are near absence of foreign investors in Indian government bond markets, and large captive domestic bond investors (its commercial banks). Yet, unlike China and Korea, India also has higher inflation and a persistent current account deficit. All these make the correlation of bond yields with the exchange rate different in India from both ASEAN as well as China and Korea. In the sections below, we discuss each country’s currency and overall bond outlook in more detail. We also explain the reasons behind our relative bond strategy. China: Overweight Chart 10Chinese Bond Yields Will Likely Fall More Chinese Bond Yields Will Likely Fall More Chinese Bond Yields Will Likely Fall More China’s economy will remain weak in the coming months. The hit to the economy from slowing property construction is material. Besides, COVID-induced rotational lockdowns are hurting consumption, income and investment in the service sector. The latest round of stimulus has so far not been sufficient to produce an immediate recovery. We expect growth to revive only in H2 2022. For now, the PBOC will reduce its policy rate further. This and the fact that the yield curve is positively slopped heralds more downside in Chinese government bond yields (Chart 10). Concerning the exchange rate, the ongoing US dollar rally could eventually cause a short period of yuan weakness. However, the latter will be small and short lived. In brief, Chinese domestic bonds will outperform both their Asian and EM peers in the coming months. Korea: Overweight The following factors argue for overweighting Korean bonds within both emerging Asian and EM domestic bond portfolios: Chart 11Korea Has No Genuine Inflation Korea Has No Genuine Inflation Korea Has No Genuine Inflation The Korean won has already depreciated quite a bit against the US dollar. While further downside is possible in the very near term, the medium-term outlook is positive. Even though headline and core inflation have exceeded the central bank’s target of 2%, trimmed mean consumer price inflation has not yet exceeded 2% (Chart 4, middle panel) and services CPI, excluding housing, seems to have rolled over. Importantly, no wage inflation spiral is evident. Unit labor costs have been falling in both the manufacturing and service sectors (Chart 11). Hence, there is little pressure for companies to hike prices. India: Overweight Indian bonds should continue to outperform other EM domestic bonds (Chart 3, middle panel). The combination of prudent fiscal policy, a benign inflation outlook and a cheap currency makes Indian bonds attractive to foreign investors. Even though yields will go up somewhat given a recovering economy, the rise will be capped as the inflation outlook remains benign. The reason for a soft inflation outlook is wages and expectations thereof are quite low (Chart 12). Global commodity prices will also likely soften in the months ahead. That will ease price pressures in India. The Indian rupee is cheap – it is now trading 12% below its fair value versus the US dollar (Chart 13). The rupee will likely be one of the best performers among EM currencies in the year ahead. Chart 12Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Chart 13Indian Rupee Is Cheap Indian Rupee Is Quite Cheap And Will Likely Outperform Many EM Currencies Indian Rupee Is Quite Cheap And Will Likely Outperform Many EM Currencies   The spread of India’s 10-year bonds over that of GBI-EM Broad index is 190 basis points. The currency performance will likely offset any possible capital loss owing to rising yields, while a positive carry will boost total returns. Stay overweight. Indonesia: Underweight Indonesian relative bond yields versus both EM and the US have already fallen massively and at multi-year lows (Chart 14). The currently low yield differential between Indonesia and the aggregate EM local bonds as well as US Treasury yields is a negative for Indonesia’s relative performance going forward. Chart 15 shows that the rupiah is also vulnerable over the next several months as the Chinese credit and fiscal impulse has fallen to its previous lows while the rupiah has not yet depreciated. We believe raw material prices will correct in the coming months, weighing on the rupiah. Hence, the country’s local bonds’ relative performance is facing a currency headwind too. Chart 14Indonesian Relative Bond Yields Are Quite Low Indonesian Bond Yields Are Quite Low Relative To Their EM And US Counterparts Indonesian Bond Yields Are Quite Low Relative To Their EM And US Counterparts Chart 15Indonesian Rupiah Is Vulnerable Indonesian Rupiah Is Vulnerable Indonesian Rupiah Is Vulnerable   Notably, a weaker currency by itself could cause bond yields to rise – because that may prompt foreign bond holders to exit this market. For now, investors would do well to underweight this domestic bond market in an emerging Asian or global EM portfolio. Malaysia: Overweight Chart 16Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian domestic bonds will likely fare well as the nation’s economy is still working through credit excesses of the previous decade. Domestic demand weakness has been exacerbated by a constrained fiscal policy. All of this has paved the way for a strong disinflationary backdrop.   The job market has not recovered either: the unemployment rate is hovering at a high level. That in turn has put downward pressures on wages. Average manufacturing wages are weak. Dwindling wages have contributed to depressed household incomes, leading to weak consumption and falling house prices (Chart 16). Considering the economic backdrop, Malaysia’s yield curve is far too steep (Chart 16, bottom panel). Odds are that the curve will flatten going forward – yields at the long end of the curve are likely heading lower. At a minimum, they will rise less than most other EM countries. Notably, the ringgit is quite cheap, and is unlikely to depreciate much versus the US dollar. Hence, it will outperform many other Asian/EM currencies. That calls for an overweight position in Malaysian local bonds within an Asian/EM universe.  Thailand: Underweight To Neutral Given the high correlation between Thai bond yields and the baht (rising yields coincide with a weakening currency), the total return of Thai bonds in USD terms is highly dependent on the baht’s performance. (Chart 17). The baht outlook remains weak, as the two main drivers of the currency, exports and tourism revenues, remain sluggish and absent, respectively. As such, absolute return investors in Thai domestic bonds should continue to avoid this market. Asset allocators should underweight Thai domestic bonds in an emerging Asia basket. In an overall EM domestic bond portfolio, however, Thai bonds warrant a neutral allocation. That’s because Thailand has been a defensive bond market due to its traditionally strong current account, very low inflation, and lower holding of bonds by foreigners (now at 11.3% of total). In periods of stress, the baht usually falls less than most other EM currencies; and often Thai bond yields fall more (or rise less) than overall GBI-EM yields (Chart 18, top panel). Chart 18Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Chart 17Thai Domestic Bonds' Absolute Performance Is Highly Contingent On The Baht Thai Domestic Bonds' Absolute Performance Is Highly Contingent On the Baht Thai Domestic Bonds' Absolute Performance Is Highly Contingent On the Baht   The net result is that Thai bonds outperform their overall EM brethren in common currency terms during risk-off periods. This is what happened during the EM slowdown of 2014-15, and again during the pandemic scare in early 2020 (Chart 18, bottom panel). Given we are entering a period of volatility in risk assets, it makes sense to have a neutral positioning on Thai bonds in an EM domestic bond portfolio. The Philippines: Underweight To Neutral The Philippines also merits an underweight allocation in an emerging Asian domestic bond portfolio, but a neutral stance within EM. This is because of this market’s dependence on the appetite of foreign debt investors for Philippine debt securities. This appetite depends on how much extra yield the country offers over US Treasuries. Chart 19 shows that whenever the yield differential between the Philippines’ local bonds and US Treasuries widens to 400 basis points or more, the Philippines typically witnesses net debt portfolio inflows over the following year. On the other end, when the yield differential narrows to around 300 basis points or less, foreign fixed income inflows typically stop, and often turn into outflows during the following year. This is what is happening now. Chart 19Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Chart 20Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Going forward, rising US yields would mean that the Philippines’ bond spreads over US Treasuries will continue to stay less than 300 basis points. Consequently, reduced foreign debt inflows will weigh on the peso. Notably, the Philippines’ current account balance has also slid back to deficit, which makes the peso more vulnerable (Chart 20). On a positive note, contained inflation means little upward pressure on bond yields. Further, there might be a lower need of new bond issuances this year as a substantial amount of proceeds from past bond issuances are lying unspent with the central bank. This would help put a cap on bond yields.  Investment Conclusions Emerging Asian local bonds will outperform their counterparts in Latin America and EMEA in common currency terms for now. In the medium and long run, emerging Asian bonds will outperform US/DM bonds on a total return basis in common currency terms. We will discuss rationale for the latter in our future reports. Considering both the overarching macro backdrop as well as their individual situations, it makes sense to overweight China, Korea, India and Malaysia in an emerging Asian domestic bonds portfolio. Whereas Indonesia, Thailand and the Philippines warrant an underweight allocation. Yet, in an overall EM domestic bond portfolio, we recommend a neutral allocation for Thailand and the Philippines. The reason is they have a much better inflation outlook compared to economies in EMEA and Latin America. Chart 21Book Profit On Our Recommended Short Korean Won Trade Book Profit On Our Recommended Short Korean Won Trade Book Profit On Our Recommended Short Korean Won Trade Notably, among the Asian currencies, we have a positive bias on the Chinese yuan and the Indian rupee. On the contrary, we have been shorting the Korean won, the Thai baht, the Philippine peso and the Indonesian rupiah vis-à-vis the US dollar. That said, this week we recommend taking profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021 (Chart 21). Our view on the won has played out well. While the exchange rate might continue depreciating in the near run, the risk/reward of staying short is not very attractive now. Finally, we recommend continuing to receive 10-year swap rates in China and Malaysia. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     For a detailed discussion on each country’s inflation dynamics, please click on our reports on China, India, Indonesia, Malaysia, Thailand, Philippines.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Cyclical UST Curve Flattening, But With Unusually Low Rate Expectations Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve The US Treasury curve is unusually flat given high US inflation and with the Fed not having begun to raise interest rates. The dichotomy between deeply negative real interest rates and a flattening yield curve is not only evident in the US, but in other major developed countries like Germany and the UK. A low term premium on longer-term US Treasury yields is one factor keeping the curve so flat, but the term premium will likely rise as the Fed begins to hike rates. An overly flat US Treasury curve more likely reflects a belief that the neutral real fed funds rate (r-star) is actually negative. This is consistent with markets pricing in a very low peak in the funds rate for the upcoming tightening cycle, despite the current high inflation and tight labor market. Bottom Line: The Fed will hike by less than the market expects in 2022 and longer-term Treasury yields remain too low versus even a moderate 2-2.5% peak in the fed funds rate. Stay in US curve steepeners, as the Treasury curve is already too flat and will not flatten as much as discounted in forward rates this year. Feature Last week’s FOMC meeting essentially confirmed that the Fed will begin lifting rates in March and deliver multiple rate hikes this year. This was considered a hawkish surprise as the Fed signaled imminently tighter monetary policy even with the elevated financial market volatility seen so far in 2022. Fed Chair Jerome Powell noted that the US economy was in a stronger position compared to the 2016-18 tightening cycle, justifying a faster pace of hikes – and an accelerated pace of QE tapering – this time around. Markets have responded to the increasingly hawkish guidance of the Fed by pushing up rate expectations for 2022, continuing a path dating back to last September’s FOMC meeting when the Fed first signaled that QE tapering was imminent (Chart 1). There are now 163bps of Fed rate hikes by year-end discounted in the US overnight index swap (OIS) curve. Some Wall Street investment banks are calling for the Fed to hike as much as 6 or 7 times in 2022. We see this as much too aggressive. Chart 1Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Our base case scenario calls for the Fed to lift rates “only” 3-4 times this year. The persistently high inflation that is troubling the Fed is likely to peak in the first half of 2022, taking some heat off the FOMC to move as aggressively as discounted in markets this year. Although inflation will remain high enough, and the labor market tight enough, to keep the Fed on a tightening path into 2023. The US Treasury Curve Looks Too Flat What is unique about the upcoming Fed tightening cycle is that it is starting with such a flat US Treasury curve. The spread between the 2-year and 10-year yield now sits at 61bps, the lowest level since October 2020. This dynamic is not unique to the US, as yield curves are quite flat in other major countries where policy rates are near 0% and inflation remains relatively high, like the UK and Germany (Chart 2). In the US, the modest slope of the Treasury curve is notably unusual given a growth and inflation backdrop that would be more consistent with much higher bond yields: The US unemployment rate fell to 3.9% in December, well within the range of full employment estimates from FOMC members (Chart 3, top panel) Chart 2Bond Bearish Yield Curve Flattening In The US & UK Bond Bearish Yield Curve Flattening In The US & UK Bond Bearish Yield Curve Flattening In The US & UK US labor costs are accelerating; the wages and salaries component of the Employment Cost Index for Private Industry Workers rose to a 38-year high of 5.0% on a year-over-year basis in Q4/2021 (middle panel) Chart 3Challenges To The Fed's Inflation Fighting Credibility Challenges To The Fed's Inflation Fighting Credibility Challenges To The Fed's Inflation Fighting Credibility ​​​​​​ Higher inflation is becoming more embedded in medium term consumer inflation expectations measures like the University of Michigan 5-10 year ahead series that climbed to 3.1% last month (bottom panel). Importantly, market-based measures of inflation expectations have pulled back, even with little sign of inflation pressures easing. The 5-year TIPS breakeven, 5-years forward has fallen 35bps from the October 2021 peak of 2.41%. The bulk of that decline occurred in January of this year, alongside a rising trend in real TIPS yields as markets began pricing in a faster pace of Fed rate hikes. TIPS breakevens can often be something of a “vote of confidence” by the markets in the appropriateness of the Fed’s policy stance; rising when policy appears overly stimulative and vice versa. Thus, the decline in the TIPS 5-year/5-year forward breakeven, which climbed steadily higher since the Fed introduced massive monetary easing in March 2020 in response to the pandemic, can be interpreted as a sign that markets agree with the Fed’s recent hawkish turn. However, while the move in TIPS breakevens is sensible, the flatness of the Treasury curve appears unusual. In Chart 4, where we look at the previous times since 1975 that the 2-year/10-year US Treasury spread flattened to 70bps (just above the current level). In past cycles, the Treasury curve would be flattening into such a level after the Fed had already hiked rates a few times, which is obviously not the case today. Also, US unemployment was typically approaching, or falling through, the full employment NAIRU when the 2/10 Treasury curve fell to 70bps, suggesting diminished spare economic capacity and rising inflation pressures – similar to the current backdrop. Chart 4The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now Chart 5UST Curve Too Flat Relative To Inflation Pressures UST Curve Too Flat Relative To Inflation Pressures UST Curve Too Flat Relative To Inflation Pressures In those past cycles, the funds rate was rising at a faster pace than that of core inflation, suggesting that the Fed was pushing up real interest rates. The backdrop looks very different today, with US realized inflation soaring and the real funds rate now deeply negative. In the top panel of Chart 5, we show a “cycle-on-cycle” chart of the 2/10 Treasury curve versus an average of the previous five instances where the curve flattened to 70bps. The green line is the median outcome of all the cycles, while the shaded region represents the range of all the outcomes. In the other panels of the chart, we show US economic variables (the Conference Board leading economic index and the ISM Manufacturing index) and US inflation variables (the wages and salaries component of the Employment Cost Index and the US Congressional Budget Office estimate of the US output gap). The panels are all lined up so that the vertical line in the middle of the chart represents the date that the 2/10 curve falls to 70bps. The conclusion from Chart 5 is that the US economic variables shown are currently at the high end of the range of past curve flattening episodes, but the inflation variables are well above the high end of the historical range. In other words, the current modest slope of the 2/10 Treasury curve is in line with US growth momentum but is too flat relative to US inflation trends. So Why Isn’t The US Treasury Curve Steeper? There are a few possible reasons why the US curve is as flat as it is before the Fed has even begun tightening amid above-trend US growth and very high US inflation: Fears of a deeper financial market selloff The Fed believes strongly in the role of financial conditions in transmitting its monetary policy into the US economy. That often means that, during tightening cycles, the Fed hikes rates “until something breaks” in the financial markets, like a major equity market downturn or a big widening in corporate credit spreads. Such moves act as a brake on US growth through negative wealth effects for investors and by raising the cost of capital for businesses – reducing the need for additional Fed tightening. If bond investors thought that a major market selloff was likely before the Fed could successfully lift rates back to neutral (or even restrictive) levels during a tightening cycle, then they would discount a lower peak level of the funds rate. This would also lower the expected peak level of longer-term Treasury yields, resulting in a flatter Treasury yield curve. Given the current elevated valuations on so many asset classes – like equities, corporate credit and housing – it is likely that the relatively flat Treasury curve incorporates some believe that the Fed will have difficulty delivering a lot of rate hikes in this cycle. However, it should be noted that the US financial conditions remain quite accommodative, even after the recent equity market turbulence (Chart 6), and represent no impediment to US growth that reduces how much tightening the Fed will need to do. Longer-term bond term premia are too low A relatively flat yield curve could reflect a lack of a term premium on longer-maturity bonds. That is certainly the case when looking at the slope of the 2/10 government yield curve in the US, as well as in the UK and Germany (Chart 7).1 Chart 6US Financial Conditions Are No Impediment To US Growth US Financial Conditions Are No Impediment To US Growth US Financial Conditions Are No Impediment To US Growth ​​​​​​ Chart 7Flatter Yield Curves? Or Just Lower Bond Term Premia? Flatter Yield Curves? Or Just Lower Bond Term Premia? Flatter Yield Curves? Or Just Lower Bond Term Premia? ​​​​​ The term premium is the defined as the extra yield that investors require to commit to own a longer-maturity bond instead of the compounded yield from a series of shorter-maturity bonds. The latter can also be expressed as the “expected path of short-term interest rates”, which is often proxied by an average expected path of the monetary policy rate over the life of the longer-maturity bond. So the term premium on a 10-year US Treasury yield is the difference between the actual 10-year Treasury yield and the expected (or average) path of the fed funds rate over the next ten years. The term premium can also be thought of as a risk premium to holding longer-term bonds. On that basis, the term premium should correlate to measures of bond risk, like bond price volatility or inflation volatility. That is definitely true in the US, where the 10-year Treasury term premium shows a strong correlation to the MOVE index of Treasury market option-implied volatility or a longer-term standard deviation of headline CPI inflation (Chart 8). Estimated term premia can also rise during periods of slowing economic growth momentum, but that is typically due to a rapid decline in the expected path of interest rates rather than a rise in bond risk premia (in this case, this is probably more accurately described as a rise in bond uncertainty). Currently, a low term premium on US Treasury yields is justified by the relatively low level of bond volatility and solid US growth momentum. However, the term premium looks far too low compared to the more volatile US inflation seen since the start of the COVID-19 pandemic. With the Fed set to respond to that higher inflation with rate hikes, rising real interest rate expectations could also give a lift to the Treasury term premium. Our favorite proxy for the market expectation of the peak/terminal real short-term interest rate for the major developed market economies is the 5-year/5-year forward OIS rate minus the 5-year/5-year forward CPI swap rate. That “real” 5-year/5-year forward rate measure is typically well correlated to our estimates of the 10-year term premium in the US, Germany and the UK (Chart 9). This correlation likely reflects the level of certainty bond investors have over the likely future path of real interest rates. When there is more uncertainty about how high rates will eventually go to in a tightening cycle, a higher term premium is required. The opposite is true during periods of very low and stable interest rates. Chart 8Drivers Of US Term Premia Pointing Upward Drivers Of US Term Premia Pointing Upward Drivers Of US Term Premia Pointing Upward ​​​​​​ Chart 9Bond Term Premia Positively Correlated To Real Rate Expectations Bond Term Premia Positively Correlated To Real Rate Expectations Bond Term Premia Positively Correlated To Real Rate Expectations ​​​​​​ Chart 10Global Yield Curves Are Too Flat Versus Real Policy Rates Global Yield Curves Are Too Flat Versus Real Policy Rates Global Yield Curves Are Too Flat Versus Real Policy Rates Currently, the estimated 10-year US term premium is increasing alongside a rising market-implied path for the real fed funds rate. We anticipate these trends will continue as the Fed lift rates over the next couple of years, boosting longer-term Treasury yields and potentially putting some steepening pressure on the US Treasury curve (or at least limiting the degree of flattening as the Fed tightens). Markets believe that the neutral real rate (r*) is negative Historically, yield curve slopes for government bonds were well correlated to the level of real interest rates, measured as the central bank policy rate minus headline inflation. That relationship has broken down in the US, with the Treasury curve flattening in the face of soaring US inflation and an unchanged fed funds rate (Chart 10). Similar dynamics can also be seen in the German and UK yield curves. The most plausible reason for such a dramatic shift in the relationship between curve slopes and real policy rates is that bond investors now believe that the neutral real interest rate, a.k.a. “r-star”, is negative … and perhaps deeply so. The New York Fed has produced estimates of the US r-star dating back to the 1960s. The gap between the real fed funds rate and that r-star estimate has typically been fairly well correlated to the slope of the Treasury curve (Chart 11). When the real fed funds rate is below r-star, indicating that the policy is accommodative, the Treasury curve is usually steepening, and vice versa. Under this framework, the recent flattening trend of the Treasury curve would indicate that policy is actually getting tighter, despite the falling, and deeply negative, real fed funds rate of -5.4% (deflated by core inflation). Chart 11UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' The last known estimate of r-star from the New York Fed was 0%, but no update has been provided for almost two years. Blame the pandemic for that. The sharp lockdown-fueled collapse in US GDP growth in 2020, and the rapid recovery in growth as the economy reopened, made it impossible to estimate the the “neutral” level of real interest rates given such massive swings in demand that were not related to monetary policy. One way to try and “back out” the implicit pricing of r-star currently embedded in US Treasury yields is to estimate a model linking the gap between the real fed funds rate and r-star to the slope of the Treasury curve. We did just that, with the results presented in Chart 12. This model estimates the “Real Policy Gap”, or r-star minus the real fed funds rate, as a function of the 2/10 Treasury curve slope. In other words, the model shows the Real Policy Gap that is consistent with the current slope of the curve. Chart 12Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation The model estimates that the current 2/10 curve slope is consistent with a Real Policy Gap of 96bps. With US core CPI inflation currently at 5%, and assuming r-star is still 0% as per the last New York Fed estimate, the fed funds rate would have to rise to 4% to justify the current slope of the 2/10 curve. While that may sound like an implausibly large increase in the funds rate, similar results are produced using straightforward Taylor Rules.2 We can also use our Real Policy Gap model to infer the level of inflation that is consistent with a Gap of 96bps, for various combinations of the funds rate and r-star. Those are shown in Table 1. Assuming the funds rate rises in line with current market expectations to 1.7% and r-star remains close to 0%, the current slope of the 2/10 Treasury curve suggests a fall in US inflation to just around 3% - still above the Fed’s inflation target - from the current 5%. Table 1The UST Curve Slope Has Already Discounted A Big Drop In US Inflation Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve We see this as the most plausible reason for the relatively flat level of the 2/10 US Treasury curve. Markets expect somewhat lower US inflation and a moderate rise in the funds rate over the next couple of years, making the real funds rate less negative but not pushing it above a negative r-star expectation. This would suggest upside risk for US Treasury yields, and potential bearish steepening pressure, as markets come to realize that the neutral real fed funds rate is actually positive, not negative. Fight The Forwards, Stay In US Treasury Curve Steepeners While it may sound counter-intuitive with the Fed set to begin a rate hiking cycle, we continue to see better value in tactically positioning in US Treasury curve steepening trades. Specifically, we are keeping our recommended trade in our Tactical Overlay on page 19, where we are long a 2-year Treasury bullet versus a duration-neutral barbell of cash (a 3-month US Treasury bill) and a 10-year Treasury bond. The trade is currently underwater, but we see good reasons to expect the performance to rebound over the next few months. The front end of the curve now discounts more hikes than we expect will unfold in 2022, which should limit further increases in the 2-year Treasury yield. At the same time, the 10-year yield looks too low relative to the expected cyclical peak for the fed funds rate (Chart 13). One way we can assess this is by comparing 5-year/5-year forward Treasury rates to survey estimates of the longer run, or terminal, fed funds rate. The median FOMC forecast (or “dot”) for the terminal funds rate is 2.5%, the median terminal rate forecast from the New York Fed’s Survey of Primary Dealers is 2.25% and the median terminal rate forecast from the New York Fed’s Survey of Market Participants is 2%. This sets a range of estimates of the longer-run terminal rate of 2-2.5%, in line with the current expectations of the BCA Research bond services. The current 5-year/5-year forward Treasury rate is 2.0%, at the low end of that range. We see those forwards rising to the upper part of that 2-2.5% range by the end of 2022, which will push the 10-year Treasury yield toward our year-end target of 2.25%. Chart 13The 5-Year/5-Year UST Forward Rate Is Too Low The 5-Year/5-Year UST Forward Rate Is Too Low The 5-Year/5-Year UST Forward Rate Is Too Low ​​​​​​ Chart 14Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent ​​​​​​ Some of our colleagues within the BCA family see the longer-term neutral funds rate as considerably higher than survey estimates, perhaps as high as 3-4%. We are sympathetic to that view, but it will take signs of US economic resiliency in the face of rate hikes before bond investors – and more importantly, the Fed – arrive at that conclusion. This would make steepening trades more attractive on a strategic, or medium-term, basis as the market realizes that the Fed is further behind the policy curve (i.e. the funds rate even further below a higher terminal rate) than previously envisioned. For now, we do not see the US Treasury curve flattening at the pace discounted in the Treasury forward curve over the next 3-6 months (Chart 14, top panel). However, this will be more of a carry trade by betting against the forwards over time. A bearish steepening of the Treasury curve with a swift upward move in the 10-year Treasury yield is less likely with bond investor/trader positioning already quite short (bottom two panels).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com       Footnotes 1      The term premium estimates shown here are derived from our own in-house framework. For those familiar with the various term premium estimates on the 10-year US Treasury yield produced by the Fed, our estimates are currently in line with those produced by the ACM model and the Kim & Wright model. 2     A fun US Taylor Rule calculator, which can be used to generate Taylor Rules under a variety of assumptions, is available on the Atlanta Fed’s website here. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades