Fixed Income

Highlights Corporate Bond Returns & Fed Tightening: Corporate bond performance varied considerably during the past four Fed tightening cycles. Our analysis of these periods suggests that valuations and the slope of the yield curve are the two most important factors to monitor. Investment Grade Strategy: Given tight valuations, our analysis of past Fed tightening cycles suggests that it will make sense to downgrade our allocation to investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) once we are confident that the yield curve has shifted into a flatter regime. High-Yield Strategy: De-risking will also be warranted in the high-yield space as the yield curve flattens, but relative valuations dictate that investors should retain a preference for high-yield over investment grade corporates. Feature It is now apparent that the Federal Reserve intends to kick off the next rate hike cycle at the March FOMC meeting. This move has been strongly hinted at in recent Fed speeches and it will be telegraphed more officially when Jay Powell addresses the media tomorrow. In preparation for upcoming rate increases, last week’s report looked at Treasury returns during prior periods of Fed tightening.1 This week, we extend that analysis to the corporate bond market. Specifically, we consider the excess returns that were earned by both investment grade and high-yield corporates during the four most recent rate hike cycles.2 We conclude that a defensive posture toward credit risk will be warranted as Fed tightening gets underway. While we aren’t quite ready to downgrade our recommended allocation to corporate bonds today, we expect to do so within the next couple of months. Corporate Bond Returns During Rate Hike Cycles Table 1 presents excess returns for both the Bloomberg Barclays Investment Grade Corporate Bond Index and the Bloomberg Barclays High-Yield Corporate Bond Index in each of the past four Fed tightening cycles. As was the case last week, we define each tightening cycle as spanning from the first rate hike until the last rate hike. We also exclude periods such as 1997 when the Fed only lifted rates once before reversing course. Table 1Corporate Bond Returns During Fed Rate Hike Cycles Positioning For Rate Hikes In The Corporate Bond Market Positioning For Rate Hikes In The Corporate Bond Market Our first preliminary conclusion is that (unlike with Treasury returns) there is not much commonality between the different cycles. For example, corporate excess returns were quite strong during the 2015-18 cycle and very weak during the 1999-2000 cycle. In other words, it’s even more important to examine each cycle individually to get a sense of how we should position in the corporate bond market today. The 2015-2018 Cycle The most recent Fed tightening cycle started with a 25 basis point rate hike in December 2015. The Fed then went on hold for 12 months before delivering a string of 8 hikes between December 2016 and December 2018. All in all, the tightening cycle lasted 36 months and the Fed raised the target rate by 225 bps. Investment grade corporate bond returns were quite strong during this period (Chart 1A), and there is one major reason why. The start of the tightening cycle happened to coincide with the peak of a default cycle. As a result, corporate spreads were elevated when hiking began and they tightened rapidly throughout 2016 and 2017 (Chart 1A, panel 3). Spread tightening in 2016 and 2017 was helped along by an accommodative policy environment, as evidenced by the fact that the yield curve remained steep (3/10 slope > 50 bps) during those years (Chart 1A, panel 4). It’s notable that returns turned negative in 2018, only after the average index spread moved below 100 bps and the Treasury slope moved below 50 bps. In other words, corporate bond returns were strong early in the cycle but turned negative once value evaporated and the monetary backdrop became less accommodative. High-Yield returns show a similar pattern to investment grade (Chart 1B). Spreads started out very wide in early-2016 and tightened rapidly until monetary conditions turned more restrictive in 2018. Our Default-Adjusted Spread is an additional valuation tool for high-yield bonds (Chart 1B, panel 4). This is calculated as the average index spread less the actual default losses that were experienced during the subsequent 12 months. Our research has shown that high-yield bonds usually outperform Treasuries during 12 month periods in which the Default-Adjusted Spread is above 100 bps (see the Appendix of this report for more details). In this case, the Default-Adjusted Spread was an extremely high 258 bps at the beginning of the tightening cycle and it didn’t dip below 100 bps until after rate hikes ended. Chart 1A2015-2018 Cycle: Investment Grade 2015-2018 Cycle: Investment Grade 2015-2018 Cycle: Investment Grade Chart 1B2015-2018 Cycle: High-Yield 2015-2018 Cycle: High-Yield 2015-2018 Cycle: High-Yield   The 2004-2006 Cycle During this cycle, which spanned from June 2004 to June 2006, the Fed lifted rates by 400 bps (sixteen 25 basis point rate hikes). The fed funds rate rose from 1% to 5.25% during the two-year span. Excess investment grade corporate bond returns were close to zero during this cycle (Chart 2A). Unlike in 2015, corporate spreads started out at tight levels (below 100 bps), though the accommodative monetary environment – as evidenced by the steep yield curve – allowed them to tighten somewhat during the first year of Fed hiking. However, spreads then reverted closer to 100 bps in 2005 as the yield curve flattened to below 50 bps (Chart 2A, panel 4) and the policy backdrop turned more restrictive. Junk bonds performed extremely well during the 2004-06 cycle (Chart 2B), and once again this is due to very attractive starting valuations. The average High-Yield Index spread was 384 bps on the day of the first hike in 2004, compensation that turned out to be astoundingly high when you consider that monthly default events were in the low single digits throughout the entire period (Chart 2B, bottom panel). As was the case in the 2015-18 cycle, our Default-Adjusted Spread measure never dipped below 100 bps. In fact, it troughed at 145 bps in early 2005 (Chart 2B, panel 4). Chart 2A2004-2006 Cycle: Investment Grade 2004-2006 Cycle: Investment Grade 2004-2006 Cycle: Investment Grade Chart 2B2004-2006 Cycle: High-Yield 2004-2006 Cycle: High-Yield 2004-2006 Cycle: High-Yield The 1999-2000 Cycle In this cycle, the Fed lifted rates by 175 bps between June 1999 and May 2000, driving the fed funds rate from 4.75% to 6.5%. Excess investment grade corporate bond returns were poor during this period (Chart 3A), the combination of relatively low starting spreads and a very flat yield curve that even inverted in early 2000 (Chart 3A, panels 3 & 4). High-yield excess returns were even worse than for investment grade (Chart 3B). While, at the onset of Fed tightening, junk spreads were quite elevated in absolute terms (Chart 3B, panel 3), they turned out to be too low compared to the magnitude of default losses that occurred throughout 1999 and 2000 (Chart 3B, bottom panel). Our Default-Adjusted Spread measure started the cycle below 100 bps and then dipped into negative territory in early 2000 (Chart 3B, panel 4). Chart 3A1999-2000 Cycle: Investment Grade 1999-2000 Cycle: Investment Grade 1999-2000 Cycle: Investment Grade Chart 3B1999-2000 Cycle: High-Yield 1999-2000 Cycle: High-Yield 1999-2000 Cycle: High-Yield The 1994-1995 Cycle The Fed surprised markets by lifting rates extremely quickly during this cycle. The Fed moved rates from 3% to 6% in the span of only 12 months between February 1994 and February 1995. This cycle coincided with modestly positive excess returns for investment grade corporates (Chart 4A). The average index spread began the cycle at the extraordinarily tight level of 67 bps (Chart 4A, panel 3). However, unappealing valuations were counteracted by the accommodative monetary environment, as evidenced by a yield curve slope that didn’t dip below 50 bps until the Fed was almost done hiking (Chart 4A, panel 4).    Junk returns were also modestly positive during this period (Chart 4B). Spreads started the cycle at attractive levels (Chart 4B, panel 3) and the default rate was on the downswing (Chart 4B, bottom panel). Junk spreads, however, were mostly rangebound during the period of Fed tightening. Chart 4A1994-1995 Cycle: Investment Grade 1994-1995 Cycle: Investment Grade 1994-1995 Cycle: Investment Grade Chart 4B1994-1995 Cycle: High-Yield 1994-1995 Cycle: High-Yield 1994-1995 Cycle: High-Yield Investment Implications Investment Grade Our analysis of past cycles reveals that valuation and the slope of the yield curve are the two most important factors to consider when assessing the potential for investment grade corporate bond excess returns during a Fed tightening cycle. The 2015-18 period of strong investment grade returns coincided with elevated spreads and a yield curve slope that stayed above 50 bps for the first two years of tightening. In contrast, the 1999-2000 period of negative corporate returns was driven by expensive starting valuations and a very flat curve. Today, investment grade corporate bond valuations are about as expensive as they’ve ever been. The average index option-adjusted spread (OAS) is currently 100 bps, the index OAS has been tighter than this level 40% of the time since 1995 (Chart 5). This does not appear terrible at first blush, but we must also consider that the risk characteristics of the index have changed during the past few decades. Specifically, the index’s average credit rating is lower, and its average duration is higher. If we adjust the index to maintain a constant credit rating through time, we see that the spread falls from its 40th percentile to its 28th percentile (Chart 5, panel 2). If we then adjust for the changing duration of the index by looking at the 12-month breakeven spread instead of the OAS, we see the spread fall to its 7th percentile since 1995 (Chart 5, bottom panel).3 As for the yield curve, the 3-year/10-year Treasury slope is currently very close to 50 bps – the threshold that roughly represents the transition from an accommodative monetary environment to a more neutral one (Chart 6). Given expensive starting valuations, our inclination is to reduce our investment grade corporate bond exposure once we are confident that the 3/10 slope will remain below 50 bps for the remainder of the cycle. We think we are close to reaching that point, but we aren’t quite there yet. Our estimates based on a range of plausible scenarios for Fed tightening suggest that the 3/10 slope will permanently move below 50 bps in the coming months, by July at the very latest. When that occurs, we will reduce our recommended corporate bond exposure from neutral (3 out of 5) to underweight (2 out of 5). Chart 6Watch The Treasury Slope Watch The Treasury Slope Watch The Treasury Slope Chart 5IG Valuation IG Valuation IG Valuation High-Yield The valuation picture for high-yield is somewhat more pleasant than for investment grade. The OAS differential between the high-yield and investment grade indexes is fairly tight, at its 15th percentile since 1995 (Chart 7). However, this differential rises to the 36th percentile when we adjust for the duration differences of the indexes by using the 12-month breakeven spread. Chart 7HY Valuation HY Valuation HY Valuation Applying our Default-Adjusted Spread methodology to today’s junk market, we estimate that the Default-Adjusted Spread will come in above the crucial 100 bps threshold as long as the default rate is 3.5% or lower during the next 12 months (Chart 7, bottom panel). This seems quite likely given the current strong state of corporate balance sheets.4 All that said, the evidence from past cycles suggests that a more defensive posture toward high-yield corporates will also be warranted once we are confident that the 3/10 slope has permanently moved below 50 bps. However, relative valuation dictates that we should still retain a preference for high-yield over investment grade even as we get more defensive overall. Our next move will likely be to downgrade high-yield from overweight (4 out of 5) to neutral (3 out of 5). Some Thoughts On Credit Investment Strategy The above analysis of corporate bond performance shows that it is generally weaker once the yield curve has flattened into a range of 0 – 50 bps. However, that move alone doesn’t guarantee negative excess corporate bond returns. In fact, it is quite plausible that the slope could remain within a 0 – 50 bps range for a long time even as the Fed tightens, and that corporate bonds could still deliver small positive excess returns versus Treasuries. However, we must acknowledge that the risks of Fed overtightening, curve inversion and economic recession increase as the yield curve flattens. We must also acknowledge that current valuations suggest that future excess returns will be small, even if they are positive. For example, if we assume that the average investment grade OAS can’t tighten very much from current levels, then the best we can expect is 100 bps per year of excess return. Meanwhile, 100 bps of spread widening – much less than you would expect in a default cycle – would lead to losses of roughly 850 bps. In other words, it will be profitable to exit investment grade corporate bond positions today as long as the next bout of 100 bps of spread widening occurs within the next 8.5 years (Table 2). The risk/reward trade-off clearly favors a more defensive credit allocation. Table 2The Risk/Reward Trade-off In Corporate Bonds Positioning For Rate Hikes In The Corporate Bond Market Positioning For Rate Hikes In The Corporate Bond Market Interestingly, Table 2 shows that the risk/reward math is more favorable for junk bonds. Depending on our default loss assumptions, the 8.5 years we calculated for investment grade falls to a range of 1.8 to 3 years for high-yield. Bottom Line: Tight valuations and low expected returns suggest that investors should be more cautious on credit risk this cycle. In our view, it is advisable to reduce credit risk allocation earlier than usual this cycle in order to ensure that you aren’t invested during the next big selloff. Appendix Image Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Positioning For Rate Hikes In The Treasury Market”, dated January 18, 2022. 2 We define excess returns as the excess returns earned by the corporate bond index relative to a duration-matched position in US Treasuries. 3 The 12-month breakeven spread can be thought of as the spread widening required for the index to break even with duration-matched Treasuries on a 12-month investment horizon. It can be approximated as OAS divided by duration. 4 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights The bond market assumes that when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. High inflation is followed by lower than average inflation. This means that the ex-post real yield delivered by 10-year T-bonds will turn out to be much higher than the negative ex-ante real yield that 10-year Treasury Inflation Protected Securities (TIPS) are now offering. Long-term investors should overweight 10-year T-bonds versus 10-year TIPS. Underweight (or outright short) US TIPS. Underweight commodities, and especially underweight those commodities that have not yet corrected. Fractal trading watchlist: the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. Feature Chart of the WeekThe Real Yield Turns Out To Be Higher Than Expected The Real Yield Turns Out To Be Higher Than Expected The Real Yield Turns Out To Be Higher Than Expected Real interest rates are negative. Or are they? Given that real interest rates form the foundation of most asset prices, getting this question right is of paramount importance. Over the short term, yes, real interest rates are negative. Policy interest rates in the major developed economies are unlikely to rise quickly from their current near-zero levels. So, they will remain below the rate of inflation. But what about over the longer term, say ten years – are long-term real interest rates truly negative? The Real Bond Yield Is The Mirror Image Of Backward-Looking Inflation The negative US real 10-year bond yield of -0.7 percent comprises the nominal yield of 1.8 percent minus an expected inflation rate of 2.5 percent. This means that the negativity of the real bond yield hinges on the expectation for inflation over the next ten years. Therein lies the big problem. Many people believe that the bond market’s expected 10-year inflation rate is an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. Specifically, in the pandemic era, the bond market has derived its expected 10-year inflation rate from the historic six month (annualized) inflation rate, which it assumes will gradually converge to a long-term rate of just below 2 percent during the first four years, then stay there for the remaining six years2 (Figure I-1). We recommend that readers replicate this simple calculation for themselves to shatter any illusion that there is anything forward-looking about the bond market’s inflation expectation! (Chart I-2). Chart I- Chart I-2Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like now or in early-2008, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words, the bond market extrapolates the last six months of inflation into the next ten years. This observation leads to an immediate investment conclusion. The US six-month inflation rate has already peaked. As it cools, it will also cool the expected 10-year inflation rate, thereby putting upward pressure on the mirror image Treasury Inflation Protected Securities (TIPS) real yield. It follows that investors should underweight (or outright short) US 10-year TIPS (Chart I-3). Chart I-3As Inflation Cools, TIPS Will Underperform As Inflation Cools, TIPS Will Underperform As Inflation Cools, TIPS Will Underperform The Real Bond Yield Is Based On A False Expectation There is a more fundamental issue at stake. The market assumes that when recent inflation has been low, it will be lower than average for the next ten years. And when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. The price level is lower than the 2012 expectation of where it would stand in 2022! Another way of putting this is that the market assumes that any breakout of the consumer price index (CPI) will be amplified over the following ten years (Chart I-4). Yet the reality is that any breakout of the price level tends to trend-revert over the following ten years. This means that after the CPI’s decline in late 2008, the market massively underestimated where the price level would be ten years later. But earlier in 2008, when the CPI had surged, the market massively overestimated where the price level would be ten years later. Chart I-4The Market Exaggerates Any Deviations In The CPI Into The Distant Future The Market Exaggerates Any Deviations In The CPI Into The Distant Future The Market Exaggerates Any Deviations In The CPI Into The Distant Future Today in 2022, the price level seems to be uncomfortably high. But the remarkable thing is that it is still lower than the 2012 expectation of where it would stand in 2022! (Chart I-5). Chart I-5The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The crucial point is that after surges in the price level, realised 10-year inflation turns out to be at least 1 percent lower than the bond market’s expectation (Chart I-6). This means that the ex-post real yield delivered by 10-year T-bonds turns out to be at least 1 percent higher than the ex-ante real yield that 10-year TIPS offered at the start of the ten year period (Chart of the Week). Chart I-6Actual Inflation Turns Out To Be Lower Than Expected Actual Inflation Turns Out To Be Lower Than Expected Actual Inflation Turns Out To Be Lower Than Expected It follows that after the current surge in the price level, the (actual) real yield that will be delivered by 10-year T-bonds over the next ten years will not be the -0.7 percent indicated by the TIPS 10-year real yield. Instead, if history is any guide, it will be at least +0.3 percent. Therefore, in answer to our original question, the real long-term interest rate is almost certainly not negative. Of course, the obvious comeback is that ‘this time is different’. But we really wouldn’t bet the farm on it. Many people thought this time is different during the price level surge in early 2008 as well as the lows in late 2008 and early 2020. But those times were not different. And our bet is that this time isn’t any different either. This means that the real yield on T-bonds will turn out to be much higher than that on TIPS. Long-term investors should overweight T-bonds versus TIPS. Commodities Are Vulnerable A final important observation relates to commodities. Commodity prices have been tightly tracking the 6-month inflation rate, but which way does the causality run in this tight relationship? At first glance, it might seem that the causality runs from commodity prices to the inflation rate. Yet on further consideration, this cannot be right. It is not the commodity price level that drives the overall inflation rate, it is the commodity inflation rate that drives the overall inflation rate. And in the past year, overall inflation has decoupled (upwards) from commodity inflation (Chart I-7 and Chart I-8). Chart I-7Inflation Is Tracking ##br##Commodity Prices... Inflation Is Tracking Commodity Prices... Inflation Is Tracking Commodity Prices... Chart I-8...But Inflation Should Be Tracking Commodity Inflation ...But Inflation Should Be Tracking Commodity Inflation ...But Inflation Should Be Tracking Commodity Inflation Therefore, the causality in the tight relationship between the 6-month inflation rate and commodity prices must run from backward-looking inflation to commodity prices. And the likely explanation is that investors are bidding up commodity prices as a hedge against the backward-looking inflation which they are incorrectly extrapolating into the future. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. It follows that as 6-month inflation cools, so will commodity prices. The investment conclusion is to underweight commodities, and especially to underweight those commodities that have not yet corrected. Fractal Trading Watchlist This week’s observations relate to the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. The US dollar reached a point of fragility in early December, from which it experienced a classic short-term countertrend sell-off. As such, the countertrend sell-off is mostly done. Alternative energy versus old energy is approaching a major buying point. Biotech versus the market is very close to a major buying point. Nickel versus silver is very close to a major selling point. Semiconductors versus technology was on our sell watchlist last week, and has now hit its point of maximum fragility (Chart I-9). Therefore, the recommended trade is to short semiconductors versus broad technology, setting a profit target and symmetrical stop-loss at 6 percent. Chart 9Semiconductors Are Due A Reversal Semiconductors Are Due A Reversal Semiconductors Are Due A Reversal Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2 Inflation is based on the PCE deflator. Fractal Trading System Fractal Trades Image 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights On US inflation and the Fed: If the Fed adheres to its mandate, it has no choice but to hike rates until core inflation drops toward 2% (from its current level above 4%). Yet, share prices will sell off before inflation converges toward the Fed’s target. On US TIPS yields: Rising TIPS yields will depress share prices in the richly valued equity markets like the US, support the greenback, and curtail portfolio flows into EM for a period of time. On China: Despite stimulus, China’s business cycle will continue disappointing over the near-term. Besides, a bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. On financial market divergences: Major selloffs evolve in phases resembling domino effect-like patterns. In contrast, corrections are abrupt, and the majority of markets drop concurrently. Hence, the nature of current market dynamics is more consistent with a major selloff than a short-term correction. On regional allocation within a global equity portfolio: Overweight the euro area and Japan, underweight the US and EM. Feature Ms. Mea is a long-time BCA client and an avid follower of the Emerging Markets Strategy (EMS) service. Since 2017, I have been meeting with her twice a year to exchange thoughts on the global macro environment, to discuss the nuances of our views and to elaborate on investment strategy. We always publish our conversations for the benefit of all EMS clients. This virtual meeting took place earlier this week. Chart 1A Technical Breakout Is In US Bond Yields A Technical Breakout Is In US Bond Yields A Technical Breakout Is In US Bond Yields Ms. Mea: It has been two years since we last met in person. I did not imagine that world travel would stay so depressed for so long when the pandemic began two years ago. I have also been surprised by the recent behavior of financial markets. There have been divergences that I cannot reconcile, such as the woes in China’s real estate sector and resilient commodity prices, the diverging performance of the S&P 500, US small caps and a significant portion of NASDAQ-listed stocks. I will ask you about these later. But let’s start with your main macro themes. Since early last year, you have been advocating two macro themes: (1) China’s slowdown; and (2) rising and non-transitory US inflation. They were controversial a year ago but have now become widely accepted in the investment community. Financial markets have moved a great deal to reflect these macro themes. Don’t you think financial markets have already fully priced in these macro trends? Answer: You are right that these narratives have become well known and financial markets have been moving to price in these developments. However, our bias is that these themes are not yet fully priced in and these macro forces will continue to impact financial markets over the near term. Let’s first discuss US inflation and interest rate moves. Chart 1 illustrates that US government bond yields have broken above major resistance levels. Such a breakout technically entails higher yields. Odds are that US long-term bond yields will move up by another 50 basis points in the months ahead before they pause or reverse. The fundamental justification for higher US bond yields is as follows: The inflation genie is out of the bottle in the US. If the Fed adheres to its inflation mandate, it has no choice but to hike rates until core inflation drops toward 2%. In December, trimmed-mean CPI and median CPI printed 4.8% and 3.8% respectively, well above the Fed’s preferred range of 2-2.25% for core inflation (Chart 2). Critically, these inflation measures are not impacted by volatile components. These measures strip out outliers like used and new car prices, auto parts, as well as energy and food. The core CPI and PCE inflation measures will drop this year but super core inflation will remain north of 3%, well above the Fed’s preferred range. Importantly, a wage inflation spiral is already underway in the US. Employees have experienced substantial negative wage growth in real terms in the past 12 months. Labor shortages are prevalent, and the employee quit rate is very high. Employees are demanding very high wage growth and employers will have little choice but to meet these demands (Chart 3). Chart 2US Super Core Inflation Suggests Broad-Based Inflationary Pressures US Super Core Inflation Suggests Broad=Based Inflationary Pressures US Super Core Inflation Suggests Broad=Based Inflationary Pressures Chart 3US Wages Will Be Accelerating US Wages Will Be Accelerating US Wages Will Be Accelerating Chart 4Rising TIPS Yields = Equity Multiples Comparison Rising TIPS Yields = Equity Multiples Comparison Rising TIPS Yields = Equity Multiples Comparison As a result, the only way to bring down core inflation toward its preferred target range is for the Fed to slow the economy down and curb employment and wage gains. Yet before core inflation converges to the Fed’s target, risk assets will sell off first. Practically, the Fed will talk hawkish and hike until something breaks. The breaking point will be a major selloff in US share prices. US equities have been priced to perfection on the assumption that US interest rates will remain low for many years. As interest rate expectations rise further, US equity multiples are under pressure (Chart 4). Ms. Mea: The recent rise in US bond yields has been largely driven by the real component (TIPS yields), not inflation breakevens. That would usually imply improving US growth prospects. Yet US stocks have corrected as TIPS yields rose. How do you explain this and what should investors expect going forward? Answer: Indeed, the latest rise in US bonds yields is primarily driven by increasing TIPS yields, not inflation breakevens (Chart 5) TIPS yields have not been driven by economic growth expectations in the past couple of years. TIPS yields are breaking out and more upside is likely for reasons unrelated to US economic growth: The Fed’s rhetoric and guidance. TIPS yields typically move with 5-year/5-year forward yields, i.e., expectations for US interest rates in the long run (Chart 6). One of reasons why forward interest rates and TIPS yields have been low is the Fed’s commitment to keep interest rates extremely depressed for so long. As the Fed’s rhetoric has recently changed, so are interest rate expectations and TIPS yields. Given that core inflation will not drop to the Fed’s target range any time soon, the Fed will likely escalate its hawkish rhetoric. Hence, TIPS yields will keep rising, until something breaks. Chart 5US Tips Yields Have Broken Out After A Base Formation US Tips Yields Have Broken Out After A Base Formation US Tips Yields Have Broken Out After A Base Formation Chart 6US TIPS Yields More With Long-Term Interest Rate Expectations US TIPS Yields More With Long-Term Interest Rate Expectations US TIPS Yields More With Long-Term Interest Rate Expectations TIPS demand/supply and momentum. The TIPS market is relatively small, and it has been rigged by the Fed in the past two years or so. As a part of its QE program, the Fed has been buying a large share of TIPS, and it now owns 22% of this market. As a result, TIPS yields have fallen irrespective of economic growth dynamics. As the QE program ends, the Fed will stop purchasing TIPS. There has also been a rush into TIPS by institutional investors. In a quest for inflation protection when the Fed was complacent about inflation, investors have been opting for TIPS. This has also depressed TIPS yields. As the US central bank sounds more hawkish, investors’ demand for inflation protection will likely diminish. In addition, TIPS prices have recently plunged dramatically. Large losses could prompt further liquidation by investors pushing TIPS yields much higher. All of the above and the fact that TIPS yields remain negative suggest that they will continue rising in the coming months. Chart 7Rising TIPS Yields Warrant A Stronger US Dollar Rising TIPS Yields Warrant A Stronger US Dollar Rising TIPS Yields Warrant A Stronger US Dollar Ms. Mea: Your point that TIPS yields will continue rising in the months ahead irrespective of US inflation and growth dynamics is interesting. So, what are the implications of rising US bond yields, especially TIPS yields, on various financial markets? Answer: Falling/low TIPS yields have benefited long duration plays like US stocks, and especially US growth stocks. Declining TIPS yields were a drag on the US dollar (Chart 7). Finally, they also prompted portfolio capital flows to EM. Consistently, rising TIPS yields will depress share prices in the richly valued equity markets like the US (Chart 4, above) support the greenback, and curtail portfolio flows into EM for a period of time. Ms. Mea: But aren’t US share prices positively correlated with US interest rates? Answer: Not always. Chart 8 illustrates that the correlation between the S&P 500 and US Treasury yields varied over time. Prior to the mid-1960s, it was positive. From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields. Since 1997, US share prices have been positively correlated with US government bond yields (Chart 8, top panel). Chart 8US Stock-Bond Correlation: A Paradigm Shift In 2022? US Stock-Bond Correlation: A Paradigm Shift In 2022? US Stock-Bond Correlation: A Paradigm Shift In 2022? Chart 9Early 2020s = Late 1960s? Early 2020s = Late 1960s? Early 2020s = Late 1960s? We believe US markets are now undergoing a major paradigm shift in the stock prices-bond yields correlation. The latter is about to turn negative like it did in the second half of the 1960s. In the mid-1960s, the reason why the stock-to-bond yields correlation turned negative was because US core inflation surged well above 2% in 1966 (Chart 8, bottom panel). This marked a paradigm shift in the relationship between equity prices and US Treasury yields. The same is happening now. As we wrote a year ago in our Special Report titled A Paradigm Shift In The Stock-Bond Relationship, the proper roadmap for the US stock-to-bond correlation is not the last 10 or 20 years, but the second half of the 1960s. After US core CPI surged substantially above 2%, the S&P 500 became negatively correlated with US Treasury yields (Chart 9). Ms. Mea: Let’s now turn to emerging markets. How will EM financial markets perform amid rising US bonds yields? Also, which US yields matter most for EM financial markets, US Treasury yields or TIPS? Answer: Neither US Treasury yields nor TIPS yields have a stable correlation with EM stock prices. Correlations between US nominal bond yields, EM currencies and EM domestic bond yields vary over time. However, US TIPS yields exhibit a reasonably strong positive correlation with mainstream EM local bond yields and the US dollar's exchange rate versus EM currencies (Chart 10). Mainstream EM includes 16 markets but excludes China, Korea and Taiwan. Hence, as US TIPS yields move up, it is reasonable to expect the US dollar to strengthen against mainstream EM currencies and their local bond yields to rise (Chart 10). Currency depreciation and rising domestic bond yields will prove to be toxic for the share prices of these mainstream emerging markets. To sum up, rising US TIPS yields will jeopardize the performance of EM equities, currencies, local rates and credit markets. Ms. Mea: Aren’t many EMs better prepared for rising US nominal/real yields than they were in 2013? Answer: Yes, they are: many EM countries that were running large current account deficits in 2013 now have current account surpluses or small deficits (Chart 11, top panel). Besides, mainstream EMs ramped up their foreign currency debt in the years preceding 2013 while their foreign debt has changed little in the past 6-7 years (Chart 11, bottom panel). Chart 10Rising TIPS Yields Are A Risk To EM Domestic Bonds Rising TIPS Yields Are A Risk To EM Domestic Bonds Rising TIPS Yields Are A Risk To EM Domestic Bonds Chart 11Mainstream EM: Less Vulnerable To The Fed Now Than in 2013 Mainstream EM: Less Vulnerable To The Fed Now Than in 2013 Mainstream EM: Less Vulnerable To The Fed Now Than in 2013 Table 1Current Account Balances In Individual EM Countries Conversation With Ms. Mea: US Inflation Redux, TIPS And Implications For EM Conversation With Ms. Mea: US Inflation Redux, TIPS And Implications For EM Table 1 illustrates the current account balance in individual developing countries. Further, the share of foreign investor holdings in EM local currency bonds has declined a great deal in the past 2 years (Table 2). Finally, many mainstream EM central banks have hiked rates aggressively and their local bond yields have already risen considerably in the past 12 months. These also provide some protection against fixed-income portfolio capital outflows. All in all, vulnerability from foreign portfolio capital outflows in EM is much lower than it was in 2013. Nevertheless, EM financial markets will not remain unscathed if US rates march higher, the US dollar rallies and US stocks wobble. Based on the parameters displayed in Tables 1 and 2, the most vulnerable countries among mainstream EMs are Peru, Colombia, Chile and Egypt. Table 2Foreign Ownership Of Domestic Bonds: January 2022 Versus October 2019 Conversation With Ms. Mea: US Inflation Redux, TIPS And Implications For EM Conversation With Ms. Mea: US Inflation Redux, TIPS And Implications For EM Chart 12China"s Construction Cycle In Perspective China"s Construction Cycle In Perspective China"s Construction Cycle In Perspective Ms. Mea: Let’s now move to your second theme - China’s slowdown. This is well known and arguably priced in financial markets. Importantly, policymakers have been ratcheting up stimulus. Don’t you think now is the time to upgrade the stance on Chinese stocks and China-related plays? Answer: Despite the new round of stimulus, China’s business cycle will continue disappointing over the near-term. As we wrote in last week’s report titled Chinese Equities: Valuations and Profits, Chinese corporate earnings are set to contract in the next 6 months. This means that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive. Importantly, even though property market woes are well known and housing sales and starts have collapsed, housing construction activity has remained resilient (Chart 12). The bottom panel of Chart 12 demonstrates rising completions, which is one of reasons why raw materials prices have been resilient. However, new funding for property developers has dried up and they will be forced to scale back completions/construction activity. Historically, EM non-TMT share prices lagged the turning points in China’s money/credit impulses by several months (Chart 13). Even though the money/credit cycle is now bottoming, a buying opportunity in stocks will likely transpire in a few months. In brief, a tentative bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. Chart 13China"s Credit Cycle And EM Non-TMT Stocks China"s Credit Cycle And EM Non-TMT Stocks China"s Credit Cycle And EM Non-TMT Stocks Ms. Mea: Another topic I wanted to discuss today is divergences in global financial markets. Some equity markets have already fallen significantly, while the S&P 500 index as well as a couple of individual EM equity bourses (India, Taiwan and Mexico) have been firm. There have been massive divergences within the US equity market in general and the NASDAQ index in particular. Besides, EM high-yield corporate spreads have widened but EM investment grade corporate spreads remain tight. Finally, commodity prices have remained firm despite both China’s slowdown and US dollar strength. How should investors interpret these divergences? Answer: Such divergences in financial markets often occur during major selloffs. Notable financial market downturns evolve in phases resembling domino effect-like patterns, where some markets lead while others lag. In contrast, corrections are abrupt, and the majority of markets drop concurrently. For example, the EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then spread to Korea, Malaysia and Indonesia, and finally to the rest of Asia. By August 1998, Russian financial markets had collapsed, triggering the Long-Term Capital Management (LTCM) debacle. The last leg of the crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Chart 14Domino Effect In 2007-08 Domino Effect In 2007-08 Domino Effect In 2007-08 Similarly, the US financial/credit crisis in 2007-08 commenced with the selloff in sub-prime securities in March 2007. Corporate spreads began widening, and bank share prices rolled over in June 2007. Next, the S&P 500 and EM stocks peaked in October 2007 (Chart 14). Despite these developments, commodity prices and EM currencies continued to rally until the summer of 2008 when they finally collapsed in the second half of that year (Chart 14, bottom panel). There was a domino effect in financial markets in both the 2015 and 2018 turbulences. Initially, the selloffs started in the weakest links while other parts were holding up. Then, the selloff spread to all without exception. For example, in 2018, US share prices and high-yield credit spreads were doing quite well until October 2018. Then, a broad-based selloff transpired in the fourth quarter of 2018.  Just as chains break at their weakest links, financial market selloffs begin in the most susceptible sectors. Overpriced US stocks with little or no profits and currencies with zero or negative interest rates have been most vulnerable to rising US interest rates. That is why these segments have sold off first in response to rising US nominal and real rates. Our hunch is that the selloff in global markets due to rising US interest rates will broaden in the coming months. This does not mean that global stocks on the verge of a major bear market, but a double-digit drop in global share prices is likely. The last asset class standing will be commodity prices. These will likely be the last affected by rising US interest rates because many investors buy commodities as an inflation hedge. Besides, oil prices have also been supported by the geopolitical tensions around Ukraine and Iran. It might take investor concerns about the US economy and a slowdown in global manufacturing to trigger a relapse in commodity prices. Chart 15Rising TIPS Yields = European Equities Outperforming US Ones Rising TIPS Yields = European Equities Outperforming US Ones Rising TIPS Yields = European Equities Outperforming US Ones Ms. Mea: What investment strategy do you recommend in the coming months? Answer: As US interest rates continue rising and China’s recovery fails to transpire immediately, EM financial markets remain at risk. Therefore, we recommend a defensive stance for absolute return investors in EM equity and fixed income. We are also continuing to short a basket of EM currencies versus the US dollar. As for global equity regional allocation, the outlook for EM performance is less certain than it was in the past 12 months. Clearly, rising US/DM interest rates herald US equity underperformance versus other DM markets, like the euro area and Japan (Chart 15). The basis is that non-US equities are not as expensive as US ones and, hence, are less vulnerable to rising interest rates. Chart 16EM Relative Equity Performance Is Correlated With The USD, Not US Bond Yields EM Relative Equity Performance Is Correlated With The USD, Not US Bond Yields EM Relative Equity Performance Is Correlated With The USD, Not US Bond Yields Whether EM outperforms or not is mainly contingent on the US dollar, rather than US bond yields. The top panel of Chart 16 demonstrates that EM relative equity performance against DM has a low correlation with US bond yields. Yet, EM equities will underperform their DM peers if the USD strengthens (the greenback is shown inverted on the bottom panel of Chart 16). However, if the greenback depreciates, EM will certainly outperform the US in both equity and the fixed income space. Putting it all together, asset allocators should overweight the euro area and Japan, and underweight the US and EM in a global equity portfolio. Ms. Mea: What about EM local bonds and EM credit markets? Answer: EM credit spreads will widen, and EM local yields will not drop as US bond yields head higher and EM exchange rates depreciate. We continue to recommend investors underweight EM credit versus US corporate credit, quality adjusted. As for local rates, we largely remain on the sidelines of this asset class. Our current recommendations are as follows: receiving 10-year rates in China and Malaysia, paying Czech 10-year rates and betting on 10/1-year yield curve inversions in Mexico and Russia. For a detailed list of our country recommendations for equities, credit, domestic bonds and currencies, please refer to Open Position Tables below. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Image Image

Highlights US Vs. Europe: Growth and inflation momentum remains stronger in the US versus Europe. The latter is taking the bigger economic hit from more severe Omicron economic restrictions and a greater exposure to slowing Chinese demand. European inflation has accelerated, but remains slower and less broad-based than elevated US inflation. The backdrop remains more negative for US fixed income compared to Europe. UST-Bund Spread: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures). Feature Chart of the WeekUS Bond Yields & Bond Volatility Are Both Rising US Bond Yields & Bond Volatility Are Both Rising US Bond Yields & Bond Volatility Are Both Rising Global fixed income markets are off to a volatile start in 2022, on the back of significant repricing of US interest rate expectations. The 10-year US Treasury yield now sits at 1.85%, up +34bps so far in January and is up +72bps from the August 4/2021 intraday low of 1.13%. The 2-year US yield, which is even more sensitive to changes in Fed expectations, is 1.04%, up +31bps so far this month and up +87bps since early August 2021. Yields are rising in other countries as well, with the 10-year benchmark government bond yield up year-to-date in the UK (+24bps), Canada (+45bps) and even Germany (+18bps) where the Bund yield is threatening to return to positive territory. US Treasuries are selling off as markets have heeded the hawkish shift in the Fed’s interest rate guidance. The US overnight index swap (OIS) curve now discounting 89bps of Fed rate hikes in 2022. Bond volatility further out the Treasury curve has increased as yields have moved higher, with the realized volatility of the Bloomberg 7-10 US Treasury index now at an 19-month high (Chart of the Week). We continue to recommend a defensive strategic posture towards direct US Treasuries with below-benchmark exposure on both duration and country allocations in global bond portfolios. However, we prefer a more efficient way to position for the same theme of rising US yields – betting on a wider 10-year US Treasury-German Bund spread. US Growth & Inflation Fundamentals Support A More Hawkish Fed The rise in global bond yields seen in recent weeks has inflicted damage on risk assets, but not in a consistent fashion. Equity markets have taken the brunt of the hit, with the S&P 500 down around -3% so far in January with the tech-heavy NASDAQ down -6%. Yet the MSCI emerging market equity index is up around +1%, European equities are flat and global high-yield corporate bond spreads are essentially unchanged so far this month. While higher bond yields are reflecting expectations of more global monetary tightening over the next year, medium-term interest rate expectations remain subdued. Our proxy for the market pricing of terminal interest rate expectations – 5-year OIS rates, 5-years forward – remains at or below pre-pandemic levels in the US, the UK, Canada and the euro area (Chart 2). Risk assets are performing relatively well in the face of higher bond yields because markets still do not believe that a major increase in interest rates will be needed in the current global tightening cycle. We see this – the likelihood that interest rates will have to rise much more than markets expect - as the biggest vulnerability for global bond markets over the next couple of years. The US remains the “poster child” for this view. In the US, core CPI inflation accelerated to an 31-year high of 5.5% in December. The pickup in US inflation continues to be broad-based, with the Cleveland Fed median CPI and trimmed mean CPI inflation measures reaching 3.8% and 4.8%, respectively (Chart 3). This massive run-up in US inflation has filtered through to medium-term household inflation expectations; the preliminary University of Michigan consumer survey for January showed that inflation 5-10 years out is expected to be 3.1% - the highest level in 13 years. Chart 2Rising Yields Are Not A Threat To Risk Assets ... Yet Rising Yields Are Not A Threat To Risk Assets ... Yet Rising Yields Are Not A Threat To Risk Assets ... Yet ​​​​​ Chart 3The Fed Cannot Ignore Elevated Inflation Expectations The Fed Cannot Ignore Elevated Inflation Expectations The Fed Cannot Ignore Elevated Inflation Expectations ​​​​​​ Chart 4US Demand Steadily Normalizing From The Pandemic Shock US Demand Steadily Normalizing From The Pandemic Shock US Demand Steadily Normalizing From The Pandemic Shock While much of the run-up in US inflation over the past year has been fueled by supply chain disruption and high energy prices, there is still a robust demand component to the high inflation. Consumer spending on goods remains elevated versus its pre-pandemic trend, while services spending is steadily returning back to the pre-pandemic pace (Chart 4). The overall US unemployment rate is now down to 3.9%, the lowest level since February 2020, with broad-based strength in the US labor market across most industries (bottom panel). The rise in consumer inflation expectations has to be most worrisome to Fed officials. Yes, market-based inflation expectations have already seen a significant run-up since the mid-2020 lows, and have even drifted down a bit of late on the back of the more hawkish rhetoric from the Fed. However, survey-based measures of inflation expectations tend to be less volatile than market-based measures, and typically follow trends in realized inflation, which is not slowing down in the US. In other words, rising household inflation expectations are a more reliable indication that an inflationary mindset is becoming entrenched in consumer behavior. US inflation dynamics are transitioning away from supply-driven goods inflation toward more lasting domestically driven forces like tight labor markets, faster wage growth and rising housing costs (Chart 5). Measures of supply chain disruption like global shipping costs are showing signs of peaking (top panel), while commodity price momentum has clearly rolled over – both should eventually feed into slower goods inflation this year. At the same time, tight labor markets will continue to boost US employment costs, which historically have been strongly correlated to US services inflation (middle panel). Chart 5US Inflation Pressures Remain Intense US Inflation Pressures Remain Intense US Inflation Pressures Remain Intense Meanwhile, shelter costs, which represents 32% of the US CPI index, were up 4.2% on a year-over-year basis in December and are likely to continue accelerating given a dearth of housing supply versus demand that is pushing up both house prices and rents (bottom panel). Tying it all together, there are good reasons why the Fed has ramped up the hawkish rhetoric over the past couple of months. However, with the US OIS curve now discounting between 3-4 rate hikes in 2022, it will be harder to generate a second consecutive year of negative returns in the US Treasury market this year. Dating back to the early 1970s, there have only been five calendar years where the Bloomberg US Treasury index delivered an outright negative total return: 1994, 1999, 2009, 2013 and 2021 (Chart 6). None of the four cases prior to last year saw negative returns in the following year, as Treasury yields fell in 1995, 2000, 2010, 2014. Yet even the episodes that saw consecutive years of US yield increases – 1974-75, 1977-81, 1987-88, 2005-06 and 2015-16 – did not see outright negative returns from the Bloomberg US Treasury index. Chart 6Negative Return Years For US Treasuries Are Rare Negative Return Years For US Treasuries Are Rare Negative Return Years For US Treasuries Are Rare Given the starting point of deeply negative real US bond yields, and interest rate expectations that remain too low beyond 2022, we still see value in staying below-benchmark on US duration exposure on a medium-term basis. However, we see a more efficient way to play for higher Treasury yields this year by positioning US Treasury underweights/shorts versus overweights/longs in government bonds in a region where discounted rate hikes will not happen – Europe. The ECB Is In No Hurry To Hike Rates The same supply driven factors that have pushed up US inflation over the past year have also lifted inflation in the euro area. Headline HICP inflation reached an 30-year high of 5.0% in December, while core HICP inflation hit an all-time high of 2.6%. The European Central Bank (ECB), however, is unlikely to deliver any rate hikes in 2022 even with the high inflation, for several reasons (Chart 7): Growth momentum entering 2022 was soft, thanks to Omicron related economic restrictions at the end of 2021 and also weak demand for European exports from China. It will take time for both of those factors to reverse, thus reducing any growth related pressure to tighten monetary policy. Inflation expectations are not exceeding the ECB 2% inflation target, with the 5-year/5-year forward EUR CPI swap now at 1.9% even with headline inflation of 5.0%. The surge in European energy prices will eventually subside in the first half of 2022, which will reduce inflationary pressure on the ECB to tighten. The ECB is ending its pandemic emergency bond buying program (PEPP) in March, and is only partially replacing that buying activity by upsizing its existing pre-pandemic asset purchase program (APP). The ECB will not want to compound the effect of this “tapering” of bond buying by also hiking interest rates, which would surely tighten financial conditions further through higher Italian government bond yields, rising corporate bond yields and a firmer euro. There is little evidence to date showing any pass-through of higher energy-fueled inflation into more domestically-driven inflation. Euro area wage growth was only 1.3% as of the latest available data in Q3/2021 (which is still well after realized inflation had started to accelerate), highlighting the lack of visible “second round” effects on euro area inflation from high energy prices that would prompt the ECB to consider rate hikes (Chart 8). Chart 7An ECB Rate Hike In 2022 Is Unlikely An ECB Rate Hike In 2022 Is Unlikely An ECB Rate Hike In 2022 Is Unlikely ​​​​​​ Chart 8Limited 'Second Round' Effects From Energy-Driven European Inflation Limited 'Second Round' Effects From Energy-Driven European Inflation Limited 'Second Round' Effects From Energy-Driven European Inflation ​​​​​​ The EUR OIS curve is discounting 7bps of rate hikes by year-end. Even that modest amount will not be delivered, which will limit how much further European government bond yields will rise this year. A Better Mousetrap: Playing UST Bearishness Through UST-Bund Spread Widening Trades Combining our view of an increasingly hawkish Fed and a still-dovish ECB produces our highest conviction investment recommendation for 2022: positioning for a wider 10-year US Treasury/Germany Bund spread. This can be done by underweighting the US versus core Europe in global bond portfolios, or shorting US Treasury futures versus German Bund futures as we are already recommending in our Tactical Trade Overlay (see page 15). A Treasury-Bund spread widening view is a more efficient way to play for a more hawkish Fed and higher US Treasury yields, for several reasons: There are many examples over past 30 years where the Treasury-Bund spread widened in consecutive years (Chart 9). This is in contrast to the fewer occurrences of consecutive years of rising Treasury yields shown earlier in this report. Thus, there are better odds that last year’s Treasury-Bund spread widening can be repeated in 2022. Chart 9Consecutive Years Of A Rising UST-Bund Spread Happen Often Consecutive Years Of A Rising UST-Bund Spread Happen Often Consecutive Years Of A Rising UST-Bund Spread Happen Often The realized volatility of Treasury-Bund spread trades is almost always lower than that of an outright short position in US Treasuries, but the direction of returns of the two trades is similar (Chart 10). This shows that there is directionality in the Treasury-Bund spread (i.e. it is driven far more by the movements of US yields), but that is a welcome feature given our more bearish view on US Treasuries. The Treasury-Bund spread remains well below fair value on our fundamental valuation model, with fair value increasing due to widening US-European inflation differentials (Chart 11). Tighter relative monetary policies this year (more tapering and rate hikes from the Fed compared to the ECB) also favor a wider fair value spread on our model. Chart 10UST-Bund Wideners Have Lower Volatility Than Outright UST Shorts UST-Bund Wideners Have Lower Volatility Than Outright UST Shorts UST-Bund Wideners Have Lower Volatility Than Outright UST Shorts ​​​​​ Chart 11The UST-Bund Spread Looks Very Cheap On Our Model The UST-Bund Spread Looks Very Cheap On Our Model The UST-Bund Spread Looks Very Cheap On Our Model ​​​​​​ The gap between our 24-month discounters, which measure the change in policy interest rates over the next two years discounted in OIS curves, for the US and euro area is a reliable leading indicator of the 10-year Treasury-Bund spread (Chart 12, bottom panel). The “discounter spread” is currently calling for the Treasury-Bund spread to widen by more than the current path discounted in US Treasury and German Bund forward rates. Chart 12Position For More UST-Bund Spread Widening In 2022 Position For More UST-Bund Spread Widening In 2022 Position For More UST-Bund Spread Widening In 2022 ​​​​​​ Chart 13UST-Bund Spread Is Not Technically Stretched UST-Bund Spread Is Not Technically Stretched UST-Bund Spread Is Not Technically Stretched ​​​​​ The Treasury-Bund spread is not stretched from a technical perspective (Chart 13). The spread is sitting right at its 200-day moving average and the 26-week change in the spread (a measure of price momentum) is rising but remains well below previous peak levels that have capped past spread increases. Summing it all up, the case is strong for including US-Germany spread widening positions as core holdings in investor portfolios in 2022. The current spread is 185bps and we have a year-end target of 225bps. Bottom Line: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights We reformatted and added three sections to our existing trade tables: strategic themes, cyclical asset allocations and tactical investment recommendations. An extensive audit of our current trade book shows that our country and sector allocation recommendations have been successful. Of the eight open trades in our book, six have so far generated positive returns. We now recommend closing three out of the eight positions, based on a review of the original basis and subsequent performance of our trades. We have also added one cyclical and two tactical trades. We will look for opportunities to propose new trades to our book in the coming months. Feature In this week's report, we introduce our newly formatted trade tables (on Page 15), which include the following: Strategic themes (structural views beyond 18 months) Cyclical asset allocations within Chinese financial markets (in the next 6 to 18 months) Tactical trades (investment recommendations for the next 0 to 6 months) We revisited the original basis and subsequent performance of our open trades as part of an audit of our trade book. We maintain five of the eight trades and will add one cyclical and two tactical trades. Our new features and the rationale for retaining or closing each trade are presented below. Strategic Themes The new Strategic Themes section now includes the following market relevant structural forces: President Xi Jinping’s “common prosperity” policy initiative, which is intended to narrow the nation’s wealth gap; a demographic shift of a shrinking population by 2025; and secular disputes between the US and China (Table 1). Table 1 Introducing New Trade Tables Introducing New Trade Tables These structural aspects will have a macro impact on China’s policy landscape, economy and financial markets. Investors should consider whether the themes point toward a reflationary policy bias; whether they will have a medium- to long-term effect on corporate earnings; and whether these themes will, on a structural basis, warrant higher/lower risk premiums for owning Chinese stocks. Cyclical Equity Index Allocation Recommendations (Relative To MSCI All Country World) Table 2 is a summary of our cyclical recommendations for Greater China equity indexes. We recommend the following equity index allocations within a global equity portfolio, for the next 6 to 18 months: Table 2 Introducing New Trade Tables Introducing New Trade Tables Underweight MSCI China (Chinese investable stocks). Underweight MSCI China A Onshore (Chinese onshore or A-share stocks). Neutral stance on MSCI Hong Kong Index. Overweight MSCI Taiwan Index. Chart 1Chinese Stocks Substantially Underperformed Global Equities Chinese Stocks Substantially Underperformed Global Equities Chinese Stocks Substantially Underperformed Global Equities Our recommendation to underweight MSCI China Index and MSCI China A Onshore Index were extremely successful in 2021 (Chart 1). We will continue to maintain an underweight stance for the time being, based on our concern that the current policy easing measures will be insufficient to revive China’s slowing economy. We expect policy stimulus to step up in the coming months and economic growth to start improving by mid-2022. However, corporate profits are set to disappoint in the first half of the year. This implies that Chinese share prices will remain volatile with substantial downside risks. Chinese investable stocks are in oversold territory and will likely rebound in the near term in both absolute and relative terms (discussed in the Tactical Recommendations section on Page 14) (Chart 2). Nonetheless, on a cyclical basis, they face challenges both from the impact of a slowing economy on earnings growth and ongoing regulatory and geopolitical risks. Our model suggests high odds (70%) of a considerable earnings contraction in Chinese investable stocks in the next 6 to 12 months. We recommend investors upgrade their allocation to the MSCI Hong Kong Index from underweight to neutral within a global equity portfolio. The MSCI Hong Kong equity index appears to be very cheap compared with global equities (Chart 3). Chart 2Chinese Investable Stocks Are Oversold Chinese Investable Stocks Are Oversold Chinese Investable Stocks Are Oversold Chart 3MSCI HK Equities Are Cheap MSCI HK Equities Are Cheap MSCI HK Equities Are Cheap The MSCI Hong Kong equity index includes Hong Kong-domiciled companies and not mainland issuers listed in Hong Kong. Rising US Treasury yields will be a headwind to Hong Kong-domiciled company stock performance because the HKD is pegged to the USD and therefore Hong Kong bond yields tend to follow the direction of bond yields in the US. Chart 4MSCI HK Index Is Defensive In Nature MSCI HK Index Is Defensive In Nature MSCI HK Index Is Defensive In Nature However, an offsetting factor is that due to composition changes over time, the MSCI Hong Kong equity index has become much more defensive and tends to perform better than the emerging Asian and EM equity benchmarks during turbulent times (Chart 4). The weight of insurance companies and diversified financials account for over 40% of the MSCI Hong Kong Index, compared with property stocks, which take up 20% of the equity market cap. The insurance and diversified financials subsectors are less vulnerable to escalating short-term interest rates compared with property stocks. During risk-off phases, the defensive nature in the MSCI Hong Kong Index will support its performance relative to the some of the more industrial- and tech-heavy EM and global equity indexes. We maintain an overweight stance on the MSCI Taiwan Index relative to global equities. The trade (see discussion in the Cyclical Equity And Sector Trades section) has brought an impressive 40% rate of return since its inception in 2019. Cyclical Recommended Asset Allocation (Within Chinese Onshore Assets) Image We recommend an underweight position in equities in China’s onshore multi-asset portfolios (Table 3). Chinese onshore stocks are not cheap and will likely underperform onshore government bonds as the economy struggles to regain its footing. Chart 5Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Chart 5 shows that in the past decade total returns in Chinese onshore stocks have barely kept up with that in onshore long-duration government bonds. During policy easing cycles Chinese onshore stocks generated positive excess returns over government bonds, however, the outperformance has been extremely volatile and very brief. Given that we do not expect Beijing to allow a significant overshoot in stimulus this year, there is a good chance that the returns in Chinese onshore stocks will underperform onshore government bonds. Cyclical Equity And Sector Trades Our rationale for retaining or closing each trade is described below. Chart 6Chinese Onshore Stocks Outperformance Has Been Passive Chinese Onshore Stocks Outperformance Has Been Passive Chinese Onshore Stocks Outperformance Has Been Passive Long China A-Shares/Short Chinese Investable Stocks (Maintain) We initiated this trade in March 2021. The recommendation has been our most successful trade, generating a 40+% return since then (Chart 6). China’s internet platform giants have a large weight in the MSCI Investable index and they remain vulnerable (Chart 7). Although China’s antitrust regulations may have passed the peak of intensity, they will not be rolled back and multiple compression in these stocks will likely continue in 2022. In contrast, the A-share index is heavily weighted in value stocks. The trade is in line with our view that the global investment backdrop has shifted in favor of global value versus growth stocks due to an above-trend US expansion and climbing US bond yields in the next 6 to 12 months. The relative ratio between China A-shares and investable stocks is overbought and will likely pull back in the near term (Chart 8). However, the cyclical and structural outlook continues to favor onshore stocks versus the investable universe. Chart 7Sizable Underperformance In Investable Consumer Discretionary Stocks Sizable Underperformance In Investable Consumer Discretionary Stocks Sizable Underperformance In Investable Consumer Discretionary Stocks Chart 8A Near-Term Pullback In Relative Ratio Is Likely A Near-Term Pullback In Relative Ratio Is Likely A Near-Term Pullback In Relative Ratio Is Likely Long CSI500/Short Broad A-Share Market (Maintain) The CSI500 index, which comprises 500 SMID-cap companies, has outperformed the broad A-share market by 32% since mid-February (Chart 9). We think the outperformance in SMID stocks has not fully run its course. Historically, SMID-caps tend to outperform large caps in the late phase of an economic recovery and the valuation premia in small cap stocks remains near decade lows (Chart 10). In addition, the government’s increasing efforts to support small- and medium-sized corporates will help to shore up confidence in those companies. Therefore, SMID will probably continue to outperform large cap stocks this year. Chart 9A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps Chart 10SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle Long MSCI Taiwan Index/Short MSCI All Country World (Maintain) The MSCI Taiwan equity index has consistently outperformed global equities since mid-2019, mostly driven by the rally in Taiwanese semiconductor stocks. Global chip supply shortages since the COVID pandemic have further boosted the sector’s outperformance (Chart 11). Furthermore, Chart 12 highlights improvements in the cyclical case for Taiwanese stocks as an aggregate. Panels 1 & 2 show an uptick in the new export orders component of Taiwanese manufacturing PMI. The new export orders component has historically coincided with both Taiwanese exports to China and the relative Taiwanese manufacturing PMI on a cyclical basis. As such, the economic fundamentals also support a continued outperformance in Taiwanese stocks. Chart 11A Great Run In MSCI Taiwan Equity Index And Semis A Great Run In MSCI Taiwan Equity Index And Semis A Great Run In MSCI Taiwan Equity Index And Semis Chart 12Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Long Chinese Onshore Industrial Stocks/Short MSCI China A Index (Maintain) This trade, initiated in September last year, has brought a slightly positive return as of today. Our view was based on improving manufacturing investment and policy support for the sector, even though China’s business cycle had already peaked. Chart 13China Onshore Industrials Closely Track Economic Fundamentals China Onshore Industrials Closely Track Economic Fundamentals China Onshore Industrials Closely Track Economic Fundamentals While we maintain the trade for now, we will monitor credit growth in Q1 to assess whether to close the trade. The sector’s performance is highly correlated with our BCA China Activity Index and the Li Keqiang Leading Indicator (Chart 13). A bottoming in both indicators in mid-2022 would suggest that investors should maintain the trade. The caveat, however, is that the sector’s valuations have already become extreme, indicating that the bar may be higher for the sector to outperform even when economic fundamentals improve in 2H22. We will watch for signs of an overshoot in stimulus in the coming three to six months. Conversely, credit growth in Q1 that is at or below expectations will warrant closing this trade. Long Domestic Semiconductor Sector/Short Global Semiconductor Benchmark (Close) Replace with: Long Domestic Semiconductor Sector/Short MSCI China A Onshore The trade has been our biggest loser since its inception in August 2020. Although Chinese onshore semiconductor stocks outperformed the broad A-share market by a large margin, they have underperformed their global peers (Chart 14). Thus, we are closing the trade and replacing it with long Chinese onshore semis relative to the broad A-share market. We remain bullish on Chinese semi stocks, on both a structural and cyclical basis. Secular pressures from the US and the West to curb the advancement of Chinese technology will encourage China’s authorities to double down on supporting state-led technology programs. Moreover, prices of Chinese onshore semis have plummeted since November last year, bringing their lofty valuations closer to long-term trend and providing a better cyclical risk-reward profiles for these stocks (Chart 15). Chart 14Chinese Onshore Semis Underperformed Global... Chinese Onshore Semis Underperformed Global... Chinese Onshore Semis Underperformed Global... Chart 15...But Outperformed Domestic Broad Market ...But Outperformed Domestic Broad Market ...But Outperformed Domestic Broad Market Long Domestic Consumer Discretionary/Short Broad A-Share Market (Close) Chart 16A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance We placed the trade in May 2020 when China’s economy and household discretionary consumption showed a strong rebound from the deep slump in Q1 2020. As strength waned in the country’s domestic demand for housing, housing-related durable goods and automobiles, the sector’s relative performance also started to dwindle from its peak in the fall of last year (Chart 16). Going forward, even though China’s economy will start to improve on a cyclical basis, domestic consumer discretionary sector will face non-trivial headwinds. The performance of its subsectors, such as hotels, restaurants, and services, will remain subdued due to China’s zero tolerance COVID policy that leads to frequent lockdowns and travel restrictions (Chart 17). Moreover, the internet and direct-marketing retail subsectors are facing tighter regulations, which lowers the sector’s profitability and valuations (Chart 18). Chart 17Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Chart 18Online Retailing Also Faces Regylatory Pressures Online Retailing Also Faces Regylatory Pressures Online Retailing Also Faces Regylatory Pressures Short Hong Kong 10-Year Government Bond/Long US 10-Year Treasury (Maintain) In the past decade, Hong Kong's 10-year government bond yield has been consistently below that of the US, even though Hong Kong has an exchange rate pegged to the US dollar and its monetary policy is directly tied to that of the US. Chart 19The US-HK Yield Gap Should Widen In The Coming Months The US-HK Yield Gap Should Widen In The Coming Months The US-HK Yield Gap Should Widen In The Coming Months The US-Hong Kong 10-year yield spread has substantially narrowed since early 2020 when the US Fed aggressively cut its policy rate. In the coming 6-12 months, however, the spread will likely widen given that the Fed will start to normalize rates (Chart 19, top panel). Chart 19 (bottom panel) highlights that the relative total return profile of the trade (in unhedged terms) trends higher over time due to the carry advantage. Although cyclically the relative total return will likely reverse to its trend line and argues for a short stance on US Treasury, we think it is too early to close the trade. The USD will likely remain strong in the near term, and we have yet to turn positive on Chinese and Hong Kong assets over a 6 to 18-mont time horizon. Therefore, we maintain this trade until the USD starts to weaken, and foreign investment flows into China and Hong Kong shows sustainable momentum. Long USD-CNH (Close) We are closing this trade, which we initiated in May 2020 when tensions between the US and China were rising. The trade has lost more than 10% since its inception because the RMB exchange rate was boosted in 2021 by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China would abate. Chart 20A Weaker USD Will Prevent Sizable RMB Depreciation A Weaker USD Will Prevent Sizable RMB Depreciation A Weaker USD Will Prevent Sizable RMB Depreciation We expect all three favorable conditions supporting the RMB to start reversing in 1H22, suggesting downward pressure on the RMB. However, over a longer period of 6 to 18 months the US dollar also has the potential to trend lower, preventing the RMB from any sizable depreciation (Chart 20). The dollar strength in the past year has been the result of both speculative flows into the US dollar based on rising interest rate expectations and portfolio inflows into the US equity markets.  In the next 6 to 18 months, however, our Foreign Exchange Strategist Chester Ntonifor predicts that the dollar could begin a paradigm shift, whereby any actions by the Fed could eventually lead to a weakening of the US dollar. Higher rates than the market expects will initially boost the US dollar, but will also undermine the US equity market leadership, reversing the substantial portfolio inflows from recent years. On the flip side, fewer rate hikes will severely unwind higher rate expectations in the US relative to other developed markets. Chester further predicts that the DXY could touch 98 in the near term but will break below 90 in the next 12-18 months. Tactical Recommendations (0-6 months) We are initiating two tactical trades to go long on the MSCI China Index and MSCI Hong Kong Index relative to global equities. Relative to global stocks, Chinese investable equities are very oversold and offer value. In addition, while US tech stocks are entering a rollercoaster phase due to higher bond yields in the US, Chinese tech stocks will also fall but by a lesser degree because China’s monetary policy cycle is less affected by the Fed’s policy decisions. In other words, Chinese investable stocks may passively outperform global equities. Nonetheless, as noted in our previous reports, Chinese investable stocks face both cyclical and structural challenges. Hence the overweight stance on these stocks is strictly a tactical play rather than a cyclical one. We favor the MSCI Hong Kong Index versus global equities for similar reasons as Chinese investable stocks. The Hong Kong equity index is also technically oversold. Since the composition of the index has become more defensive, it will likely outperform in risk-off phases. In addition, if the US dollar rallies in the near term, share prices of Hong Kong-domiciled companies will materially outperform.   Jing Sima China Strategist jings@bcaresearch.com Strategic View Cyclical Recommendations Tactical Recommendations

Highlights Duration: A look at past rate hike cycles shows that Treasury returns are generally low, though not always negative. For the current cycle, we continue to recommend a below-benchmark portfolio duration stance as we don’t think the full extent of Fed rate hikes is adequately priced in the yield curve. Interest Rate Policy: The Fed will deliver its first rate hike in March and will lift rates 2 or 3 more times this year. We see the fed funds rate moving above 2% this cycle, higher than what is currently priced in the market. Fed Balance Sheet: The Fed will start the passive runoff of its securities holdings in the first half of this year, after one or two rate hikes have been delivered. Balance sheet reduction will proceed more quickly than it did last cycle, but the Fed will refrain from outright sales. Feature Chart 1Market Expectations Are Too Low Market Expectations Are Too Low Market Expectations Are Too Low Rate hikes are just around the corner. In fact, there is a growing consensus among FOMC participants that it will be appropriate to deliver the first rate hike in March, as soon as net asset purchases reach zero. Just last week, San Francisco Fed President Mary Daly called a March rate hike “quite reasonable” and Fed Vice-Chair Lael Brainard testified that the Fed will be “in a position” to lift rates as soon as purchases end. Brainard also mentioned that the Fed has discussed shrinking its balance sheet.1 We expect the Fed to follow through with a 25 basis point rate hike in March, and with 2 or 3 more hikes over the course of 2022. We also see the Fed shrinking its balance sheet this year, via the passive runoff of maturing securities. With all that in mind, this week’s report draws on the experience of past rate hike cycles to give us a sense of what Treasury returns to expect as the Fed lifts rates. We also discuss how the Fed’s balance sheet will evolve over the next few years.  Treasury Returns During Rate Hike Cycles Table 1 provides a useful summary of Treasury returns during the prior four rate hike cycles. The table shows excess Treasury returns versus cash for the Bloomberg Barclays Treasury Index as well as its Intermediate Maturity and Long Maturity sub-indexes. Table 1Treasury Returns During Fed Rate Hike Cycles Positioning For Rate Hikes In The Treasury Market Positioning For Rate Hikes In The Treasury Market The first conclusion we draw is that Treasury returns are generally poor during Fed tightening cycles. Intermediate maturity Treasuries underperformed cash in all four cycles. Long maturity Treasuries provided only modestly positive returns in two of the four cycles and deeply negative returns in one of them. One important caveat is that our analysis only considers cycles where the Fed lifted rates multiple times in a row. For example, we exclude the 1997-98 period when one rate hike in 1997 was quickly reversed in 1998. We also define the most recent tightening cycle as spanning from 2015 to 2018 even though the Fed kept the policy rate steady from December 2015 to December 2016. Obviously, if the Fed is forced to abandon its tightening cycle after one or two hikes, then Treasury returns will be much stronger than our historical analysis suggests. Next, let’s dig a bit deeper by looking at each rate hike cycle individually. The 2015-2018 Cycle Chart 22015-2018 Cycle 2015-2018 Cycle 2015-2018 Cycle The most recent Fed tightening cycle started with a 25 basis point rate hike in December 2015. The Fed then went on hold for 12 months before delivering a string of 8 hikes between December 2016 and December 2018. All in all, the tightening cycle lasted 36 months and the Fed raised the target fed funds rate by 225 bps, from a range of 0% - 0.25% to a range of 2.25% - 2.5% (Chart 2). If we look at the 36-month discounter on the day before the first hike (Chart 2, panel 3), it shows that the market was priced for 159 bps of tightening over the next three years. The fact that the Fed delivered more tightening (225 bps) explains why excess Treasury returns were negative for short and intermediate maturities. The 5-year/5-year forward Treasury yield is another useful metric because it is a good approximation of the market’s expected terminal fed funds rate, i.e. the fed funds rate at the end of the tightening cycle. The 5-year/5-year forward Treasury yield stood at 2.92% in December 2015, slightly above where the fed funds rate peaked in 2018 (Chart 2, bottom panel). This explains why long-maturity excess Treasury returns were slightly positive during the cycle.         The 2004-2006 Cycle Chart 32004-2006 Cycle 2004-2006 Cycle 2004-2006 Cycle During this cycle, which spanned from June 2004 to June 2006, the Fed lifted rates by 400 bps (sixteen 25 basis point rate hikes). The fed funds rate rose from 1% to 5.25% during the two-year span (Chart 3). The 24-month fed funds discounter stood at 369 bps the day before the first hike (Chart 3, panel 3), indicating that the market discounted 31 bps less tightening than was ultimately delivered. Once again, this explains why excess Treasury returns were negative for short and intermediate maturities. The 5-year/5-year forward Treasury yield was 5.72% just prior to the first hike in June 2004 (Chart 3, bottom panel). But, as was the case in the 2015-2018 cycle, the fed funds rate never reached this level. It peaked at 5.25% in 2006 and long-maturity excess Treasury yields were somewhat positive as a result.                 The 1999-2000 Cycle Chart 41999-2000 Cycle 1999-2000 Cycle 1999-2000 Cycle In this cycle, the Fed lifted rates by 175 bps between June 1999 and May 2000, driving the fed funds rate from 4.75% to 6.5% (Chart 4). The 12-month fed funds discounter stood at 108 bps on the day before the first hike (Chart 4, panel 3). Once again, this was slightly less than the 175 bps of tightening that transpired. Excess returns for short and intermediate maturity Treasuries were negative as a result. The 5-year/5-year forward Treasury yield was 5.99% on the day before the first hike (Chart 4, bottom panel). This time, the market’s assessment proved to be too low compared to the funds rate’s 6.5% peak. This divergence explains why long-maturity Treasury excess returns were worse during this period than they were in the 2015-18 and 2004-06 cycles.                 The 1994-1995 Cycle Chart 51994-1995 Cycle 1994-1995 Cycle 1994-1995 Cycle The Fed surprised markets by lifting rates extremely quickly during this cycle. The Fed moved rates from 3% to 6% in the span of only 12 months between February 1994 and February 1995 (Chart 5). The 12-month discounter was only 130 bps at the beginning of the tightening cycle, well short of the 300 bps rate increase that was delivered (Chart 5, panel 3). This large divergence explains why excess Treasury returns were so poor during this period. Interestingly, the 5-year/5-year forward Treasury yield stood at 6.69% just prior to the first hike (Chart 5, bottom panel), not that far from the ultimate peak in the fed funds rate. In other words, while market expectations for the near-term path of interest rates were too low, expectations for the ultimate peak in interest rates were fairly accurate. However, terminal rate expectations became unmoored when the Fed started to tighten, and the 5-year/5-year forward Treasury yield rose all the way to 8.5%, far above the fed funds rate’s ultimate peak. This dramatic shift in terminal rate expectations explains the deeply negative long-maturity Treasury returns observed during the period. Of course, those losses were quickly reversed in H1 1995 once it became clear that the Fed would not lift rates further. The 5-year/5-year forward Treasury yield plummeted back to 6.5%. Investment Implications Let’s apply the above analysis to today’s situation. At present, the 12-month fed funds discounter stands at 93 bps. The 24-month discounter is 151 bps and the 36-month discounter is 159 bps (Chart 1). In other words, the market is discounting that the Fed will deliver between 3 and 4 rate hikes this year, but only 2 more in 2023 before the funds rate stabilizes at roughly 1.5%. Our expectation is that the fed funds rate will rise to at least 2% during the next three years, and we therefore continue to recommend running below-benchmark portfolio duration. For its part, the 5-year/5-year forward Treasury yield is currently 2.03%. This is at the low-end of survey estimates for the long-run neutral fed funds rate (Chart 1, bottom panel). We expect the 5-year/5-year forward Treasury yield to rise closer to the middle of the range of survey estimates (~2.25%) as it becomes clear that the fed funds rate will rise to at least 2%. It’s also possible that, like in the 1994-95 episode, terminal rate expectations will rise dramatically as the Fed lifts rates more quickly than anticipated. This, however, is not our base case outlook given that expectations for a low terminal fed funds rate are very well entrenched. Bottom Line: A look at past rate hike cycles shows that Treasury returns are generally low, though not always negative. For the current cycle, we continue to recommend a below-benchmark portfolio duration stance as we don’t think the full extent of Fed rate hikes is adequately priced in the yield curve. The Balance Sheet Outlook Chart 6Hike First, Then QT Hike First, Then QT Hike First, Then QT We expect the Fed to start shrinking its securities holdings this year. The process will probably begin in the first half of the year after one or two rate hikes have been delivered. To arrive at this conclusion, we first look at how the Fed proceeded during the last tightening cycle. Back then, the Fed waited until the funds rate was around 1% before it started to shrink its balance sheet in September 2017 (Chart 6). Notably, the Fed didn’t immediately move toward the full passive runoff of its portfolio. Rather, it started slowly by permitting only $6 billion of Treasuries and $4 billion of MBS to mature in October 2017. These amounts were gradually increased in the subsequent months. The Fed will move more quickly toward balance sheet reduction this cycle and the pace of said reduction will be faster. Here are the relevant passages from the minutes of the December FOMC meeting: Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience. […] Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode. Many participants also judged that monthly caps on the runoff of securities could help ensure that the pace of runoff would be measured and predictable…2 From these quotes, we surmise that balance sheet runoff will start earlier than last time – after one or two rate hikes instead of four. Also, while the runoff will proceed more quickly than last time, there is still support for maintaining monthly caps on the pace. The Fed will probably not move immediately to the complete passive runoff of its portfolio, and outright bond sales do not appear to be part of the discussion. One concern that investors might have about the Fed’s balance sheet runoff is the extra supply of Treasuries that will hit the market. As an upper-bound, if we assume complete passive runoff starting in April 2022, the Fed’s Treasury holdings will shrink from $5.7 trillion today to $3.5 trillion by the end of 2024, adding an average of $715 billion extra Treasury supply to the market each year (Chart 7). If we exclude T-bills and TIPS to focus only on coupon-paying nominal Treasury securities, then we calculate that Fed holdings will fall from $4.9 trillion to $3 trillion, adding an extra $639 billion of supply to the market on average for the next three years. However, it’s important to note that Fed policy alone doesn’t dictate the supply of Treasury securities. The Treasury department’s issuance plans also need to be considered. When the Fed allows a maturing bond to passively roll off its portfolio it doesn’t dump that bond directly into the market. Rather, the Treasury Department issues new debt to replace the maturing bond. The Treasury could decide, for example, to increase T-bill issuance instead of coupon issuance. In fact, this sort of decision becomes more likely if Treasury officials are concerned about dumping too much coupon supply on the market. Currently, the Treasury Department targets a range of 15% - 20% for the amount of outstanding T-bills as a proportion of the overall funding mix, a target that it is hitting (Chart 8). However, the minutes from the most recent Quarterly Refunding meeting stressed that the Treasury feels the need to maintain “flexibility” when it comes to this target range and noted that “there is likely more leeway at the top of the recommended range than at the bottom.”3 Chart 7The Pace Of ##br##Runoff The Pace Of Runoff The Pace Of Runoff Chart 8T-bill Issuance Could Rise As The Fed's Portfolio Shrinks T-bill Issuance Could Rise As The Fed's Portfolio Shrinks T-bill Issuance Could Rise As The Fed's Portfolio Shrinks Finally, it is important to consider the extent to which the Fed will be able to shrink its balance sheet. The Fed’s goal will be to achieve a reserve supply that allows it to maintain the funds rate within its target band without putting undue pressure on either its Overnight Reverse Repo Facility (ON RRP) or its new Standing Repo Facility (SRF). Chart 9The Fed's Balance Sheet Was Too Small In September 2019 The Fed's Balance Sheet Was Too Small In September 2019 The Fed's Balance Sheet Was Too Small In September 2019 The ON RRP acts as a floor on interest rates and its usage therefore increases when the Fed’s balance sheet is too large. The third panel of Chart 9 shows that this is currently the case. Conversely, the SRF acts as a ceiling on interest rates and its usage will ramp up if the Fed’s balance sheet becomes too small. This last occurred in September 2019 when the Fed briefly lost control of interest rates and was forced to increase repo holdings and reserve supply (Chart 9).​​​​​​​ Going forward, the Fed will continue to run down its balance sheet until ON RRP usage drops close to zero. However, it will want to stop reducing its holdings before SRF usage picks up. It is highly uncertain when this will occur, but we suspect that the Fed won’t be able to get the balance sheet back to September 2019 levels before seeing SRF usage increase. Bottom Line: The Fed will start the passive runoff of its securities holdings in the first half of this year, after one or two rate hikes have been delivered. Balance sheet reduction will proceed more quickly than it did last cycle, but the Fed will refrain from outright sales. While the size of the Fed’s balance sheet will shrink during the next few years, it will remain larger than it was in September 2019.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see https://www.reuters.com/business/exclusive-feds-daly-march-liftoff-is-quite-reasonable-2022-01-13/ and https://www.nbcnews.com/business/economy/interest-rate-hike-come-soon-march-feds-brainard-signals-rcna12112 2 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20211215.pdf 3 https://home.treasury.gov/news/press-releases/jy0464 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Dear Client, Next week there will be no regular strategy report. Instead, we will hold our quarterly webcast which will discuss the outlook for the European economy and assets in 2022. I look forward to this interaction. Best regards, Mathieu Savary   Highlights European and global yields have considerable upside over the coming year, even if inflation peaks in 2022. The post-World War II experience is instructive: massive war-time fiscal and monetary stimulus allowed for an upward re-estimation of the neutral rate as trend nominal growth improved. A similar development is likely to result in an improvement in nominal growth and the neutral rate compared to the post-GFC decade. China and a financial accident outside the US constitute the greatest risks this year to higher yields. European stocks and value stocks will benefit from this rise in yields. Cyclicals in general and industrials in particular are the European sectors most levered to higher yields. Overweight these assets. Defensives will underperform meaningfully if yields rise further. Long Sweden and the Netherlands / Short Switzerland is an appealing trade to bet on higher yields, especially if inflation peaks in 2022. Feature Last week, US Treasury yields finally reached levels that prevailed before the pandemic started. In Europe, German 10-year yields flirted with the symbolic 0% level, rising to their highest reading since May 2019. With the Fed preparing to increase interest rates in March, and global inflation remaining perky, do yields already reflect all the bearish bond news or will they continue to climb higher on a cyclical basis? Moreover, what would be the implications for equity prices of higher yields? BCA expects yields to rise further, for which German Bunds will not be an exception. This process will continue to generate volatility in stock prices, but ultimately, higher equities will prevail. Increasing yields will help European stocks and are strongly associated with an outperformance of cyclical equities. What’s Moving Yields Up? Not all yield increases are created equal. A breakdown of yields helps us understand what investors are pricing in for the future. In the US, the upside in 10-year yields mostly reflects the increase in 5-year yields. This maturity has moved back to levels that prevailed prior to the pandemic, while the 5-year/5-year forward yield remains below its spring 2021 peak (Chart 1, top panel). Moreover, these shifts mirror higher real interest rates, which are rising across maturities, while inflation expectations have been declining in recent weeks or have been flat since mid-2021 on a 5-year/5-year forward basis (Chart 1, middle and bottom panels). This breakdown confirms investors are driving yields higher because they expect more Fed tightening. However, this upgraded view of the Fed’s policy path is limited to the next few years, and long-term policy expectations approximated by the forward rates are not rising as much. In other words, markets do not expect that the Fed will be able to push up interest rates on a long-term basis. In Germany, the breakdown of the most recent shift in yield paints a different picture (Chart 2). As in the US, real yields, not inflation expectations, drove the latest bond selloff. This points toward pricing in an eventual policy tightening in Europe. However, unlike what is happening in the US, 5-year/5-year forward rates are the main force driving yields higher; investors are therefore expecting the ECB to have to follow the Fed later on. Chart 1Near-Term Tightening Is Driving Treasurys Near-Term Tightening Is Driving Treasurys Near-Term Tightening Is Driving Treasurys Chart 2longer-Term Tightening Is Driving Bunds longer-Term Tightening Is Driving Bunds longer-Term Tightening Is Driving Bunds Can the Yield Upside Continue? While BCA’s target for the 10-year Treasury yield in 2022 stands at 2.25% and the Bund yield at 0.25%, the coming two to three years should witness significantly higher yields. The period after World War II offers an interesting historical equivalent. During the War, government spending as a share of GDP exploded, lifting US gross federal debt from 52% of GDP at the dawn of the conflict to 114% at the end of 1945. However, the Fed kept a lid on interest rates during this period to help finance the war effort. T-Bill rates were pegged at 3/8th of a percent and the Fed also capped T-Bond yields at 2.5%. Chart 3The Post WWII Experience The Post WWII Experience The Post WWII Experience As a consequence of this policy effort, the Fed balance sheet increased significantly and continued to do so after the war (Chart 3). The stimulative fiscal and monetary policy, as well as the capacity constraints associated with shifting production from military goods to consumer and capital goods, contributed to an inflation spike to 20% in March 1947. Moreover, the Korean War boosted government spending between 1950 and 1953, resulting in another inflation spike to 9.5% in 1951. The Fed’s cap on yields ended after the March 1951 Treasury-Fed Accord. It was followed by the beginning of a multi-decade uptrend in bond yields, which culminated in 1981 with T-Bond yields above 15% following the inflationary surge of the 1970s. Nonetheless, the yield increase from 2.5% in 1951 to 4% at the end of the 1950s happened after the inflation peak of the Korean War. This original inflection reflected economic vigor and a normalization of the neutral rate after the trauma of the Great Depression. The current situation is not dissimilar. The neutral rate and the market-based estimates of the terminal rate of interest are still very low in the US and in Europe (Chart 4). However, the vast amount of monetary and fiscal stimulus injected in the economy has jolted a recovery. It has also caused a massive wealth transfer to households and the private sector in general that is likely to increase consumption permanently. As a result, growth in the coming decade will be stronger than it was in the past decade, in both the US and Europe. This process will allow the neutral rate to rise over time, which in turn will lift the terminal rate of interest and yields. In this context, even if inflation were to cool in 2022 because some of the supply constraints that marked 2021 dissipate, yields may continue to rise and do so for the remainder of the decade. This is also true in Europe where the household savings rate still towers near 19% of disposable income and may fall by 6% to reach its pre-pandemic levels, as the US experience presages (Chart 5). Chart 4Terminal Rates Proxies Are Too Low Terminal Rates Proxies Are Too Low Terminal Rates Proxies Are Too Low Chart 5European Savings Rate Has Downside European Savings Rate Has Downside European Savings Rate Has Downside A simple modeling exercise confirms that yields will have greater upside over the coming year. Conceptually, yields are anchored by policy rates and the terminal rate, which is somewhere above the neutral rate of interest. One of the key determinants of the nominal neutral rate is the trend growth rate of nominal GDP. While the market cannot know precisely where that growth rate stands, recent experience influences the perception of market participants. Thus, a long-term moving average of nominal GDP growth constitutes a rough proxy of this measure and will relate to investors’ assessment of the neutral rate and the terminal interest rates. Chart 6Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Using this approach reveals two important bearish forces for bonds. Even after accounting for the slow growth rate of both the US and Eurozone economies over the past ten years, as well as extraordinarily low policy rates, T-Notes and Bunds yields are too low (Chart 6). More importantly, if nominal GDP growth is higher this decade than next, this alone will push up the equilibrium level of yields in Advanced Economies. The upside in yields is not without risks. China is still going through a deflationary shock whereby growth is slowing. As China eases policy, Chinese yields will continue to fall, bucking the global trend (Chart 7). In recent years, Chinese yields have rarely diverged from global yields. If Chinese growth plummets from here, the divergence will not be resolved via higher Chinese yields. However, Chinese authorities do not want growth to collapse. Reports from the State Council suggest an acceleration of the implementation of major spending projects under the 14th Five-year plan and that the credit impulse is trying to bottom. Nonetheless, China remains a risk to monitor closely. The second major risk stems from the intertwined nature of the global financial system. The US economy is able to withstand higher Treasury yields, but is the rest of the world? As Chart 8 highlights, US private debt-servicing costs are low today, as a result of minimal interest rates and the decline in debt loads after the GFC. The same is not true for the G-10 outside the US, let alone EM economies. These differences suggest that the US will be much more resilient to rising yields than the rest of the world. A major financial accident outside the US would prompt a wave of risk aversion that would decrease yields around the world. Chart 7An Unusual Divergence An Unusual Divergence An Unusual Divergence Chart 8Will The Rest Of The World Withstand Higher US Yields? Will The Rest Of The World Withstand Higher US Yields? Will The Rest Of The World Withstand Higher US Yields? Bottom Line: Global yields have much greater upside for the years ahead, even if inflation slows in 2022. While BCA targets 2.25% and 0.25% for, respectively, Treasurys and Bund yields this year, the multi-year upside is much greater as neutral rates are re-adjusted upward. The change will not move in a straight line, but the trend will not be friendly for bondholders. In the near-term, the main culprits preventing higher yields are a further slowdown in China as well as a financial accident outside the US. Investment Implications The most obvious investment implication is that investors should use any pullback in yields to sell duration. As a corollary, investors should maintain an overweight stance on equities relative to bonds. The equity risk premium, especially in Europe, remains elevated, and European dividend yields stand near record highs compared to Bund yields (Chart 9). Moreover, when yields rise because of a higher neutral rate, this also means that the expected long-term growth rate of earnings is firming, which negates some of the adverse impacts on valuations of higher discount rates. Nonetheless, if inflation does not stabilize, the increase in yields could become much more painful for stocks, as the negative correlation between stock prices and bond yields would reassert itself—a possibility we described five weeks ago. A rising neutral rate and terminal rate are also associated with an outperformance of European stocks compared to the US and an outperformance of value stocks over growth stocks in Europe (Chart 10). These relationships reflect the greater procyclicality of European equities and value stocks. Chart 9A Valuation Cushion For Stocks A Valuation Cushion For Stocks A Valuation Cushion For Stocks Chart 10Higher Terminal Rates Favor Europe And Value Higher Terminal Rates Favor Europe And Value Higher Terminal Rates Favor Europe And Value Finally, we looked at the performance of European sectors based on the trend in yields. Table 1 highlights that industrials are the great winner when yields rise, which is a testament to their pro-cyclicality. They beat the market on 3-month, 6-month and 12-month horizons by 1.6%, 2.9% and 5.8%, respectively. The regularity of their benchmark-beating performance is extremely high. When yields rise, financials also see a marked improvement of their relative returns compared to their historical average returns. Surprisingly, so do European tech firms, which reflect the more hardware focus of European tech compared to the US. Table 1Rising Yields & Sector Relative Performance Implications Of Rising Yields Implications Of Rising Yields Table 2 repeats the same exercise, but, this time, we control for the slope of the yield curve, focusing on periods when the yield curve is positively sloped. Again, industrials are the star sector, but other cyclicals such as materials and consumer discretionary also stand out. European tech remains dominated by its cyclical properties, while the outperformance of financials becomes more marked. Table 2Rising Yields & Sector Relative Performance With Postive Yield Curve Slope As A Control Variable Implications Of Rising Yields Implications Of Rising Yields Table 3 looks at the behavior of sectors when yields rise and when the Euro Area PMI Manufacturing improves, which is a scenario we expect for most of 2022 once the winter passes. Industrials win more clearly than materials or consumer discretionary. The European tech sector continues to generate a very strong outperformance, while the excess return of financials firms up as well. This scenario also shows a particularly steep underperformance for all the defensive sectors. Table 3Rising Yields & Sector Relative Performance With Improving Manufacturing PMI As A Control Variable Implications Of Rising Yields Implications Of Rising Yields Table 4 completes the picture, focusing on rising yields when core CPI decelerates, another development we foresee in 2022. Once again, industrials stand out as a result of the extent and regularity of their outperformance. However, under this controlling variable, the performance of materials and consumer discretionary stocks deteriorates significantly. Financials also see a large downgrade to their relative performance. Tech performs best under these circumstances. Here, staples suffer the worst fate, closely followed by utilities and healthcare. Table 4Rising Yields & Sector Relative Performance With Falling Core CPI As A Control Variable Implications Of Rising Yields Implications Of Rising Yields Based on these observations, the highest likelihood scenario is that European cyclicals will outperform defensive equities significantly this year after a period of consolidation since last spring. A more targeted approach would be to overweight industrials and tech at the expense of staples and utilities. Geographically, investors should buy a basket of Swedish (overweight industrials) and Dutch stocks (overweight tech), while selling Swiss stocks (overweight healthcare).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance