Fixed Income

Highlights Fed/BoE: Both the Fed and the Bank of England found ways to talk down 2022 rate hike expectations discounted in US and UK bond markets. This is only a temporary reprieve, however, as the near-term uncertainties over the persistence of cost-push inflation will eventually be overwhelmed by medium-term certainties of demand-pull inflation confirmed by tightening labor markets. Stay underweight US Treasuries and UK Gilts in global bond portfolios. US Treasury Curve: Longer-term US Treasury yields are priced too low relative to the likely peak in the fed funds rate in the next cycle. Position for a steeper US Treasury curve until Fed rate hikes are imminent, which will likely not be until Q4/2022. Feature Chart of the WeekShifting Rate Expectations Driving Bond Yields As QE Fades Shifting Rate Expectations Driving Bond Yields As QE Fades Shifting Rate Expectations Driving Bond Yields As QE Fades Bond market uncertainty about future monetary policy moves is on the rise. Bond volatility has picked up, most notably at the front end of yield curves that are most sensitive to rate hike expectations which have been intensifying. Yet last week, the Federal Reserve and Bank of England (BoE) were able to talk bond investors off the ledge – at least, temporarily - by pushing back against expectations of multiple rate hikes in the US and UK in 2022. Central bankers in those countries are stuck in a difficult spot. Inflation is high enough to warrant some tightening of monetary policy. Yet there are lingering concerns over how long the current upturn in global inflation will last. Meanwhile, there are just enough questions on the underlying pace of economic momentum to require policymakers to see more data, especially in labor markets, before feeling comfortable enough to pull the trigger on actual rate hikes. We now see that happening first in the UK early next year, and in the US in late 2022. One thing that is certain is that the ups and downs of interest rate expectations – and the central bank forward guidance that influences them – will increasingly become the more dominant driver of bond yields and yield curve shape as global pandemic bond-buying programs get wound down (Chart of the Week). On that front, we see more potential for bond-bearish steepening in the UK and US over the next several months. The BoE: Another Bad Date With The Unreliable Boyfriend The UK financial press infamously dubbed the BoE “the unreliable boyfriend”, under the leadership of former Governor Mark Carney, for hinting at interest rate increases that never materialized. At last week’s Monetary Policy Committee (MPC) meeting, rates were kept unchanged in a 7-2 vote despite some intense signaling in recent weeks that a rate hike was imminent. Under current BoE Governor Andrew Bailey, this edition of the MPC is more like an indecisive spouse than unreliable boyfriend. On the one hand, there is a clear overshoot of UK inflation (and inflation expectations) that would justify a rate hike as soon as possible (Chart 2). The BoE’s new economic forecasts presented in the November Monetary Policy Report (MPR) called for headline CPI inflation to reach a peak of 5% in April 2022 – significantly higher than the 4% late-2021 forecast from the August MPR. On the other hand, high current inflation is already having a dampening effect on economic sentiment. The GfK index of UK consumer confidence is down -10% from the peak seen in July, despite diminishing concerns over COVID seen in public opinion polls (Chart 3, middle panel). A similar divergence is evident in the BoE’s Decision Maker Panel survey of UK Chief Financial Officers, which showed that uncertainty over future sales was somewhat elevated compared to diminished concerns about COVID and Brexit (bottom panel). Chart 2Fed/BoE Cannot Stay Dovish For Much Longer Fed/BoE Cannot Stay Dovish For Much Longer Fed/BoE Cannot Stay Dovish For Much Longer Chart 3High UK Inflation Raises Growth Uncertainty High UK Inflation Raises Growth Uncertainty High UK Inflation Raises Growth Uncertainty The BoE highlighted these divergences in economic sentiment series in the November MPR as examples of how high inflation, fueled by global supply chain disruptions and soaring energy prices, introduced uncertainty into the central bank’s forecasts. Even more uncertainty exists in the BoE’s ability to assess the amount of spare capacity, and underlying inflationary pressure, in the UK economy. The BoE dedicated a 9-page section of the November MPR to a discussion about estimating the growth of the supply-side of the UK economy, evidence of how difficult that process has become during the COVID era. The BoE concluded that the pandemic would end up reducing the level of UK potential supply by -2% from pre-COVID levels, even though the growth rate would return to a pre-pandemic pace of around 1.5% by 2023-24. This is a combination that makes setting monetary policy tricky. Reduced supply indicates that the UK economy has a smaller output gap with more inflationary pressure that would require higher interest rates. Yet sluggish growth in potential supply implies that the UK equilibrium interest rate is likely still very low, thus the BoE would not have to raise rates much to get policy back to neutral. This uncertainty over the size of the output gap in the UK economy will force to BoE to focus more on the labor market as the best “real-time” measure of spare capacity. On that front, the evidence is also difficult to interpret. The UK unemployment rate fell to 4.5% over the three months to August, the last available data before the UK government’s COVID furlough schemes, which protected worker incomes hit by COVID job losses, ended on September 30. The UK Office of National Statistics estimates that there were between 900,000 and 1.4 million UK workers furloughed in late September, representing a significant source of labor supply to be absorbed when the government income assistance ends. Thus, the BoE would need to see at least a month or two of post-furlough employment reports – not just job growth, but labor force participation - to assess how quickly those workers were being reabsorbed into the UK labor market. By the BoE’s own estimates, the impact of the furlough schemes, combined with the compositional issues arising from pandemic job losses being borne more by lower-wage workers, boosted UK wage growth by 2.2% (Chart 4, bottom panel). “Underlying” wage growth, net of those effects, is 0.6%, above the pre-COVID peak, suggesting a tightening labor market before the return of furloughed workers to the labor force. In the end, we see the BoE’s November non-hike as nothing more than a delay of the inevitable. While a December hike is possible, this would represent a “double tightening” of monetary policy with the current BoE quantitative easing program set to expire at year-end. The more likely date for a rate hike is now February. This would give the MPC a few months of post-furlough labor data to assess the amount of spare capacity in UK labor markets. We expect the data to show enough underlying health in labor demand relative to supply for the BoE to conclude that accelerating wage growth represents a more sustainable form of UK inflation in 2022 than energy prices or supply-chain disruptions were in 2021, justifying a move to begin hiking rates. We continue to recommend positioning for a steeper UK Gilt curve, focused on longer-maturities where yields were too low relative to even a moderate future BoE rate hike cycle (Chart 5). We entered a new tactical butterfly spread trade last week, going long the 10-year Gilt bullet versus a duration-neutral 7-year/30-year barbell – we continue to like that trade as a way to play for eventual BoE rate hikes in the first half of 2022. Chart 4BoE Needs More Employment Data To Confirm Wage Uptrend BoE Needs More Employment Data To Confirm Wage Uptrend BoE Needs More Employment Data To Confirm Wage Uptrend Chart 5Stay In UK Long-End Gilt Curve Steepeners Stay In UK Long-End Gilt Curve Steepeners Stay In UK Long-End Gilt Curve Steepeners Bottom Line: The Bank of England is still on a path to begin rate hikes, either in December or, more likely, February of next year. Stay underweight UK Gilts. Position For A Steeper US Treasury Curve The Fed announced last week that tapering would begin right away in November, in a move that has been hinted at since the summer. The monthly pace of purchases of Treasuries and Agency MBS will decline by $10 billion and $5 billion, respectively in November and also December. The Fed declined to commit to any specific tapering amounts beyond that, although it seems likely that the same monthly pace of reduction will continue in 2022. This would take the buying of Treasuries and MBS, net of maturing debt, to zero by June of next year, clearing the first necessary hurdle before the FOMC could contemplate a hike in the funds rate. A completion of the taper by June has been hinted at in the speeches of several Fed officials in recent weeks. This is a bit faster than the expected pace of tapering seen in the most recent New York Fed Primary Dealer and Market Participant Surveys from September (Chart 6), but should not be categorized as a hawkish surprise. There were also few bond-bearish signals on future policy moves hinted at by Fed Chair Jay Powell in post post-FOMC meeting press conference. Chart 6 Chart 7Upside Risk To UST Yields From A Tightening Labor Market Upside Risk To UST Yields From A Tightening Labor Market Upside Risk To UST Yields From A Tightening Labor Market Powell did note that it was still not clear how long the current supply chain/commodity price driven surge in inflation would persist into next year. The expectation, however, was that these forces would eventually subside and allow US inflation to return back to levels much closer to the Fed’s 2% target. Given the uncertainties in the timing of that peak and decline in US inflation, the Fed has limited ability to calibrate any post-taper rate hikes by focusing solely on inflation - especially with longer-term inflation expectations still at levels consistent with the Fed’s target. The Fed will continue to look at US labor market developments to determine the timing and pace of future rate hikes. The last set of FOMC economic projections compiled for the September meeting have the US unemployment rate falling to 3.8% next year, below the median FOMC estimate of full employment at 4%, with one 25bp rate hike penciled in for 2022. We can use that as a baseline assumption on what the Fed considers to be the level of “maximum employment” that would need to be reached before rate hikes could begin. The US unemployment rate fell to 4.6% in October, thus there is still some more to go before hitting that 3.8% rate hike threshold. Yet among the FOMC members, the estimates of full employment range from 3.5%-4.5%, so the October print did knock on the door of that range (Chart 7, middle panel). With US wage growth already showing signs of breaking out – the Atlanta Fed Wage Tracker hit a 14-year high of 14% in September (bottom panel), while the Employment Cost Index rose by a record quarterly pace of 1.3% in Q3 – the Fed will likely be under a lot of pressure to begin hiking rates soon after the taper is expected to end next June. Chart 8UST Curve Forwards Too Flat Vs. Likely Fed Rate Hikes UST Curve Forwards Too Flat Vs. Likely Fed Rate Hikes UST Curve Forwards Too Flat Vs. Likely Fed Rate Hikes We still see December 2022 as the most likely liftoff date, although a faster decline in unemployment could move that timetable forward. The bigger issue for the US Treasury market, however, is not the timing of liftoff but how fast the pace of hikes will be afterward. On that note, future rate expectations are still far too low. For example, according to the New York Fed’s Primary Dealer Survey, the fed funds rate is expected to average only 1.7% over the next ten years (top panel), a level that has proved to be a ceiling for the 10-year Treasury yield so far in 2021. Our colleagues at BCA Research US Bond Strategy recently made the case for expecting the US Treasury curve to bearishly steepen in the coming months. In their view, longer-maturity Treasury yield forward rates were too low compared to a fair value determined by the likely path for the funds rate that assumes rate hikes start in December of next year and rise by 100bps per year to a terminal rate of 2.08% (Chart 8). Interestingly, 2-year Treasury forward rates were in line with the projections of our US Bond Strategy team’s fair value framework. We fully agree with our US Bond colleagues on the likelihood of future Treasury curve steepening. This fits with our views on many developed market countries, not just the US, where longer-maturity bond yields were pricing in too few future rate hikes relative to what was likely to occur over the next few years. Even when taking a much longer perspective, the US Treasury curve looks too flat right now. Going back to the mid-1980s, the current 2-year/10-year US Treasury curve slope of just over 100bps has never been reached (in a flattening move) in the absence of actual Fed rate hikes (Chart 9). Chart 9UST Curve Has Never Been This Flat Without Some Actual Fed Rate Hikes UST Curve Has Never Been This Flat Without Some Actual Fed Rate Hikes UST Curve Has Never Been This Flat Without Some Actual Fed Rate Hikes This week, we are adding a new trade to our Tactical Overlay table to benefit from this expected move in the US yield curve, a US Treasury 2-year/10-year curve steepener (combined with a position in cash, or US 3-month treasury bills, to make the entire trade duration-neutral). We are also taking profits on our previous Tactical US curve flattening trade, which has returned 0.84% since initiation back in June. The exact securities and weightings for our new trade can be found in the Tactical Overlay Trades table below. Bottom Line: Longer-term US Treasury yields are priced too low relative to the likely peak in the fed funds rate in the next cycle. Position for a steeper US Treasury curve until Fed rate hikes are imminent, which will likely not be until Q4/2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Overlay 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 Fed: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Nominal Treasuries: We project that Treasury securities will still deliver negative total returns, even if Fed liftoff is delayed until December 2022. Investors can protect returns by favoring the 2-year note (long 2yr over cash/10yr barbell) and 20-year bond (long 20yr over 10yr/30yr barbell). TIPS: Investors should short 2-year TIPS outright in anticipation of falling short-dated inflation expectations during the next 12 months. The Taper Is Done, Now Onto Liftoff The Fed announced a tapering of its asset purchases last week and the details of the tapering plan were consistent with what had already been signaled to the public. The Fed will purchase $70 billion of Treasuries this month (compared to $80 billion in October) and $35 billion of agency MBS (down from $40 billion in October). It will then reduce monthly Treasury and MBS purchases by $10 billion and $5 billion each month, respectively, until it reaches net zero asset purchases by June of next year (Chart 2). The Fed didn’t give specific guidance on what will happen with the balance sheet after June, but it’s highly likely that it will follow the pattern of the last tightening cycle and keep the balance sheet flat for a long time, until the fed funds rate is well above the zero bound. The Fed also gave itself the option to increase or decrease the pace of purchases if such changes are warranted by the economic outlook, but it would take a major shock to knock the Fed off its pre-set course. Chart 1The Market's Liftoff Expectations The Market's Liftoff Expectations The Market's Liftoff Expectations Chart 2Net Purchases Will Reach Zero By June Net Purchases Will Reach Zero By June Net Purchases Will Reach Zero By June With the tapering announcement out of the way, the Fed can now turn to the more important question of when to start lifting interest rates. Jay Powell made it clear at last week’s press conference that the committee hasn’t yet formally taken up the issue, but that didn’t stop reporters from pressing the Chairman to provide more details about when the Fed will hike. None of that should be too surprising. There’s intense market interest and a great deal of uncertainty about the timing of Fed liftoff. Two months ago, markets were pricing-in no rate hikes at all in 2022. Now, markets are looking for Fed liftoff at the September 2022 FOMC meeting and are discounting a 90% chance of 2 rate hikes by the end of next year (Chart 1). The Fed’s Thinking On Liftoff So, what did we learn from last week’s FOMC Statement and press conference about how the Fed is thinking about the liftoff date? First, we know from previous comments that the Fed would prefer to reduce net asset purchases to zero before it starts lifting rates. This means that the July 2022 FOMC meeting is the first “live meeting” where a rate hike could possibly occur, and the fed funds futures market is already pricing-in a 74% chance that liftoff will occur at that meeting (Chart 1). We aren’t so sure. In fact, we don’t see the Fed lifting rates until December 2022, and Chair Powell’s comments about inflation at last week’s press conference only increased our confidence in that view. On inflation, Powell echoed comments by Fed Governor Randal Quarles that we flagged in a recent report.1 Both Powell and Quarles put less emphasis on the length of time that inflation remains above the Fed’s target and more emphasis on the causes of that inflation and whether it’s appropriate for the Fed to lean against it. Here’s Powell from last week (emphasis added): Supply constraints have been larger and longer lasting than anticipated. Nonetheless, it remains the case that the drivers of higher inflation have been predominantly connected to dislocations caused by the pandemic, specifically the effects on supply and demand from the shutdown, the uneven reopening, and the ongoing effects of the virus itself. Our tools cannot ease supply constraints. Like most forecasters, we continue to believe that our dynamic economy will adjust to the supply and demand imbalances, and that as it does, inflation will decline to levels much closer to our 2 percent longer-run goal. Of course, it is very difficult to predict the persistence of supply constraints or their effects on inflation. Global supply chains are complex; they will return to normal function, but the timing of that is highly uncertain.2 Essentially, Powell is pointing out that it would be a mistake for the Fed to tighten policy to bring down inflation only to find out that the economy’s natural supply side response was about to do so anyways. The Fed would have dragged down aggregate demand for no reason. So what would cause the Fed to lift rates? We see two potential triggers. The first liftoff trigger would be an assessment by the FOMC that the labor market has reached “maximum employment”. This is the liftoff condition that the Fed has officially set for itself. The second liftoff trigger would be an uncomfortable increase in long-dated inflation expectations. A spike in long-dated inflation expectations would be worrying enough that the Fed would abandon its “maximum employment” goal and tighten earlier. The “Maximum Employment” Trigger Chart 3How Far From "Maximum Employment"? How Far From "Maximum Employment"? How Far From "Maximum Employment"? The concept of “maximum employment” brings a whole host of other issues along with it. How will the Fed know if the labor market is at “maximum employment”? We’ve discussed this topic at length ourselves and have come to a few helpful conclusions.3 First, we can infer from the most recent Summary of Economic Projections that the Fed views an unemployment rate of 3.8% as roughly consistent with “maximum employment”. It is therefore highly unlikely that the Fed will even consider declaring victory on its employment goal until the unemployment rate is in the vicinity of 3.8%, down from its current 4.6% (Chart 3). Second, there are good reasons to believe that the aging of the US population and the recent sharp increase in retirements will prevent the labor force participation rate from re-gaining its pre-pandemic level. However, FOMC participants seem to agree that the prime-age (25-54) labor force participation rate should be close to its February 2020 level for the “maximum employment” condition to be satisfied (Chart 3, bottom panel). Chair Powell even specifically referenced the prime-age participation rate at last week’s press conference. Chart 4 We think a declaration of “maximum employment” will only occur once the unemployment rate is near 3.8% and the prime-age (25-54) labor force participation rate is near its February 2020 level of 82.9%, up from its current 81.7%. It’s unlikely that these conditions will be met in time for a July 2022 rate hike. The Appendix to this report updates our scenarios for the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and participation rates by specific future dates. Our scenarios use the overall participation rate (not the prime-age one), but we think the scenarios derived from the New York Fed’s Surveys of Market Participants and Primary Dealers come close to capturing reasonable conditions for “maximum employment”. Based on those scenarios, we calculate that average monthly nonfarm payroll growth of 602k to 733k is required to reach “maximum employment” by June 2022. Conversely, average monthly payroll growth of only 379k to 455k is required to reach “maximum employment” by December 2022. We see the latter as easily achievable and the former as more of a stretch. On the topic of employment growth, it’s worth noting that both monthly nonfarm payroll growth and the prime-age labor force participation rate were dragged down by the spread of the Delta variant during the past few months (Chart 4). With new COVID cases falling, we should see stronger payroll growth and a higher prime-age part rate in the months ahead. Relatedly, falling COVID cases will also help alleviate some the constraints on labor supply as workers grow less fearful of the virus and more confident about re-entering the labor force. This will not only push prime-age participation higher, but it will also take some of the sting out of wage growth. Wage growth has been extremely high recently as the number of job openings has far outpaced the number of new hires (Chart 5). Fading COVID fears should increase the pace of hiring and slow wage growth. This will give the Fed even more confidence that it should stay the course. Chart 5Peak Wage Growth? Peak Wage Growth? Peak Wage Growth? The Inflation Expectations Trigger Chart 6Inflation Expectations Are Well-Anchored Inflation Expectations Are Well-Anchored Inflation Expectations Are Well-Anchored We noted above that the Fed would abandon its “maximum employment” liftoff condition if long-dated inflation expectations rose to uncomfortably high levels. Specifically, we like to track the 5-year/5-year forward TIPS breakeven inflation rate relative to a target range of 2.3% to 2.5% (Chart 6). As long as the 5-year/5-year breakeven rate stays within that range or below, the Fed will be guided by its “maximum employment” goal. However, if that rate were to break above 2.5% for a significant period of time, the Fed would be sufficiently worried about an expectations-driven inflationary spiral that it would abandon its “maximum employment” trigger and bring forward the liftoff date. We don’t expect to see a breakout above 2.5% in the 5-year/5-year forward TIPS breakeven inflation rate anytime soon. The rate has stayed well contained throughout the past few months even as inflation skyrocketed. It would be strange for it to suddenly spike after inflation has already peaked.4 Bottom Line: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Treasury Market Positioning For A December 2022 Liftoff To determine how we should position within the Treasury market, we translate our above views on the timing of Fed liftoff into fair value estimates for different segments of the Treasury curve. Specifically, we assume a scenario where the Fed starts hiking in December 2022 and then lifts rates at a pace of 100 bps per year until reaching a terminal rate of 2.08%. That 2.08% terminal rate is based on an expected target range of 2%-2.25% that is inferred from responses to the New York Fed’s Surveys of Market Participants and Primary Dealers. We assume that the effective fed funds rate will trade 8 bps above the lower-bound of its target range, as it does currently. Table 1 shows expected 12-month total returns for each Treasury maturity, assuming the market moves to fully price-in our expected funds rate path during the next year. Table 1Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.08% Terminal Rate A Rate Hike Next Summer? Don’t Count On It. A Rate Hike Next Summer? Don’t Count On It. The first observation that jumps out is that, except for the 2-year and 20-year maturities, expected Treasury returns are negative across the board. This justifies sticking with our recommended below-benchmark portfolio duration stance. Second, our expectation that liftoff will be delayed relative to current market expectations gives the 2-year note slightly better expected returns, particularly relative to the 10-year note. As a result, we advise investors to hold 2/10 yield curve steepeners. Specifically, investors should go long the 2-year note versus a duration-matched barbell consisting of the 10-year note and cash. Third, the 20-year bond looks to be priced cheaply on the curve. It offers expected 12-month returns of +79 bps while the 10-year note and 30-year bond are both projected to lose money. We recommend taking advantage of this situation by going long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This proposed trade offers positive carry of 20 bps (Chart 7). Further, the 10/20 slope is stuck in the middle of where it was on the 2015 and 2004 liftoff dates (Chart 7, panel 2). The 20/30 slope, meanwhile, is inverted and well below where it was on the 2015 and 2004 liftoff dates (Chart 7, bottom panel). Our 20 over 10/30 trade will profit as the 20/30 slope re-steepens, even if the 10/20 slope doesn’t move that much. Chart 7Buy 20s Versus 10s30s Buy 20s Versus 10s30s Buy 20s Versus 10s30s It could be argued that our recommend trades are all predicated on a fed funds rate scenario that embeds too low of a terminal rate. In fact, the median projection of FOMC participants would place the terminal rate closer to 2.5% than to 2%. If we alter our scenario by increasing the terminal rate assumption from 2.08% to 2.58%, it only improves the outlook for our recommended positions (Table 2). Table 2Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.58% Terminal Rate A Rate Hike Next Summer? Don’t Count On It. A Rate Hike Next Summer? Don’t Count On It. In the new scenario, expected Treasury returns are more negative – especially at the long-end. However, the 2-year note is still expected to earn a small profit. Our 20 over 10/30 trade performs slightly worse in this second scenario compared to the first one (+1.79% versus +1.95%), but it is still expected to make money.  TIPS Chart 8A Lot Of Upside In Short-Maturity Real Yields A Lot Of Upside In Short-Maturity Real Yields A Lot Of Upside In Short-Maturity Real Yields We have one final government bond recommendation based on our expectation that Fed liftoff will be delayed until December 2022. That trade is to go short 2-year TIPS. Alternatively, investors could enter 2/10 inflation curve steepeners or 2/10 real yield curve flatteners. Our base case economic outlook is that supply side constraints (both in global supply chains and in the labor market) will loosen during the next 12 months. This will push down short-dated inflation expectations while long-dated inflation expectations stay relatively close to the Fed’s target. If we assume that both the 2-year and 10-year TIPS breakeven inflation rates trend towards the middle of the Fed’s 2.3% to 2.5% target range during the next 12 months and that the nominal 2-year and 10-year yields follow the paths predicted by the fair value scenario presented in Table 1, then we see that the 2-year real yield has a lot of upside (Chart 8). This is true both in absolute terms and relative to the 10-year real yield. We advise investors to short 2-year TIPS outright. Alternatively, 2/10 inflation curve steepeners or 2/10 real yield curve flatteners will also perform well during the next 12 months. Bottom Line: We suggest four different ways that bond investors can profit from the Fed delaying liftoff until December 2022. Investors should keep portfolio duration low, enter 2/10 nominal curve steepeners, buy the 20-year T-bond versus a 10/30 barbell and short 2-year TIPS.  Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a significant increase in the labor force participation rate (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 62.7%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +455k in order to hit “maximum employment” by the end of 2022. Image Image Image Image Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth prints +400k per month going forward, we would expect Fed liftoff between December 2022 and June 2023. Chart A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 2 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20211103.pdf 3 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 4 For more details on our inflation outlook please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. Unlike in the late 1990s, when rising wages were counterbalanced by robust productivity gains, most of the recent rebound in US productivity growth will prove to be illusory. US inflation will follow a “two steps up, one step down” trajectory. We are currently at the top of those two steps, but rising unit labor costs will eventually drive inflation higher. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted. Such an inversion does not make sense to us. Hence, we are initiating a trade going long the 20-year bond versus the 30-year bond. Go short the 10-year Gilt on any break below 0.85%. UK real bond yields are amongst the lowest in the world. The Bank of England will eventually have to turn more hawkish, which will support the beleaguered pound. Structurally higher bond yields will benefit value stocks. Banks stand to gain from rising bond yields while tech could suffer. The eventual re-emergence of supply-side pressures will catalyze more investment spending. This will bolster industrial stocks. The Supply Side Matters, Again Savings glut, secular stagnation; call it what you will, but for the better part of two decades, the global economy has faced a chronic shortfall of aggregate demand. Times are changing, however. The predominant problem these days is not a lack of spending; it is a lack of production. Unlike during the Global Financial Crisis – when worries about moral hazard complicated efforts to bail out homeowners and banks – the victims of the pandemic elicited sympathy. As a result, governments in developed economies rolled out a slew of measures to support workers and businesses. Thanks to bountiful fiscal transfers, households in the US have accrued $2.2 trillion in income since the start of the pandemic, about $1.2 trillion more than one would have expected based on the pre-pandemic trend (Chart 1). With many services unavailable, consumers diverted spending towards manufactured goods. At first, sellers were able to dip into their inventories to meet rising demand. By early this year, however, inventories had been depleted (Chart 2). Shortages began to pop up across much of the global supply chain. Chart 1Stimulus-Supported Income Growth Boosted Goods Consumption Stimulus-Supported Income Growth Boosted Goods Consumption Stimulus-Supported Income Growth Boosted Goods Consumption Chart 2The Pandemic Depleted Inventories The Pandemic Depleted Inventories The Pandemic Depleted Inventories While today’s empty warehouses can be largely attributed to surging demand for goods, supply-side disruptions have also played an important role. Four disruptions stand out: 1) semiconductor shortages; 2) transportation bottlenecks; 3) inadequate energy supplies; and 4) reduced labor force participation. Let us examine all four in turn. Semiconductor Shortages Chart 3Car Prices Have Jumped Car Prices Have Jumped Car Prices Have Jumped The global supply chain was not equipped to handle the dislocations caused by the pandemic. The combination of just-in-time inventory systems and far-flung supplier networks ensured that bottlenecks in one part of the global economy quickly filtered down to other parts of the economy. Few industries are as important as semiconductors. The auto sector has felt the brunt of the chip shortage. Both new and used vehicle prices have soared as dealer lots have emptied out (Chart 3). The drop in vehicle spending alone shaved 2.4 percentage points off US real GDP growth in the third quarter. Semiconductor makers have ramped up production to meet growing demand. The US Census Bureau’s Quarterly Survey of Plant Capacity Utilization showed that semiconductor plants operated an average of 73 hours per week in the first half of this year, up from around 45-to-50 hours prior to the pandemic (Chart 4). Chip production in Northeast Asia has rebounded (Chart 5). Southeast Asian production dropped in August due to Covid lockdowns, with semiconductor exports falling by over a third in Malaysia and Vietnam. Fortunately, since then, a decline in Covid cases and rising vaccination rates have spurred a recovery throughout the region. Chart 4Chipmakers Are Working Overtime Chipmakers Are Working Overtime Chipmakers Are Working Overtime Chart 5Semiconductor Production Has Accelerated In Northeast Asia Semiconductor Production Has Accelerated In Northeast Asia Semiconductor Production Has Accelerated In Northeast Asia Chart 6Memory Chip Prices Are Declining Memory Chip Prices Are Declining Memory Chip Prices Are Declining Commentary from semiconductor companies and automakers suggest that the chip shortage will ease over the coming months. In an auspicious sign, US auto sales jumped to 13.1 million in October from 12.3 million in September. Memory chip prices are also falling (Chart 6). Nevertheless, the overall chip market is unlikely to return to balance until 2023. Transportation Bottlenecks Unlike semiconductors and high-end electronics, which usually arrive by air, bulkier items such as furniture, sporting goods, and housing appliances typically arrive by sea. Port congestion, insufficient warehouse capacity, and a lack of truck chassis on which to place containers have all contributed to transportation bottlenecks. Chart 7Transportation Bottlenecks: Past The Worst? Transportation Bottlenecks: Past The Worst? Transportation Bottlenecks: Past The Worst? As with the semiconductor shortage, we are probably past the worst point in the shipping crisis. Drewry’s composite World Container Index has edged down 11% from its highs, although it is still up more than three-fold from mid-2020 levels (Chart 7). The easing in container shipping costs follows a dramatic 47% decline in the Baltic Dry Index since early October. The number of ships waiting to unload cargo off the coast of Los Angeles and Long Beach remains near record highs (Chart 8). Port congestion should ease over the next few months. US port throughput usually falls starting in the late fall and remains weak during the winter months, bottoming shortly after the Chinese New Year. If throughput remains elevated near current levels this year, this should be enough to clear much of the backlog. Looking further out, shipping costs could face additional downward pressure. Chart 9 shows that the number of container ships on order has risen to a 10-year high; these new ships will be delivered over the next two years. Chart 8Port Congestion Should Ease Over The Coming Months Port Congestion Should Ease Over The Coming Months Port Congestion Should Ease Over The Coming Months Chart 9Shipbuilders Are Busy Shipbuilders Are Busy Shipbuilders Are Busy Inadequate Energy Supplies After a torrid rally since the start of the year, energy prices have come off their highs. The price of Brent oil has dipped 6% from its October peak. US natural gas prices have retreated 11%. Natural gas prices in Europe have fallen 37%. Chart 10 The biggest move has been in coal prices, which have dropped 36% over the past two weeks alone. Futures curves are pricing in further declines in key energy prices (Chart 10). BCA’s Commodity and Energy Strategy service expects energy prices to soften over the next 12 months, but not as much as markets are discounting. Their latest forecast calls for the price of Brent crude to average $81/bbl in 2021Q4, $80/bbl in 2022 (versus market expectations of $77/bbl), and $81/bbl in 2023 (versus market expectations of $71/bbl). As we discussed a few weeks ago, years of underinvestment have led to tight supply conditions across the entire energy complex (Chart 11). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Gas reserves followed a similar trajectory, increasing by only 5% between 2010 and 2020 compared to 30% over the prior ten years (Chart 12). Chart 11 Chart 12   With little spare capacity, energy markets have become increasingly vulnerable to shocks. A cold snap across the Northern Hemisphere this spring depleted natural gas supplies, while a lack of wind reduced energy production by European wind farms. Increased gas imports from Russia could have mitigated the problem, but the dispute over the Nord Stream 2 pipeline prevented that from happening. The pipeline is popular with German voters (Chart 13). BCA’s geopolitical team expects it to be approved, a welcome development given that La Niña is highly likely to lead to colder-than-normal temperatures across northern Europe this winter. Chart 13 China has also restarted 170 coal mines and will probably begin re-importing Australian coal. Beijing is also allowing utilities to charge higher prices, which should help stave off bankruptcies across the sector. These measures should help mitigate China’s energy crisis. Chart 14US Rig Count Has Risen From Low Levels US Rig Count Has Risen From Low Levels US Rig Count Has Risen From Low Levels A bit more oil production will also help. The US rig count, while still far below its 2014 highs, has doubled since last year (Chart 14). BCA’s commodity strategists expect output in the Lower 48 states to average 9.5mm b/d in 2022 and 10mm b/d in 2023, versus 2021 production levels of 9.0mm b/d. Nevertheless, shale producers are a lot more disciplined these days. Debt reduction and cash flow generation are now the top priorities. This implies that fairly high oil prices may be necessary to catalyze additional investment in the industry.  Reduced Labor Force Participation Despite the rapid economic recovery, US employment remains 5 million below its pre-pandemic peak. One would not know this from the survey data, however. A record 51% of small businesses expressed difficulty finding qualified workers in the October NFIB survey. The share of households reporting that jobs are plentiful versus hard-to-get has returned to its 2000 highs. Both the quits rate and the job openings rate are well above their pre-pandemic levels (Chart 15). A wave of early retirement accounts for some of the apparent labor market tightness. About 1.3 million more workers have retired since the pandemic began than one would have expected based on demographic trends. Yet, there is more to the story than that. The labor force participation rate for workers aged 25-to-54 has not fully recovered; the employment-to-population ratio for that age cohort is still 2.5 percentage points below pre-pandemic levels (Chart 16). Chart 15 Chart 16Labor Force Participation Has Room To Rise Labor Force Participation Has Room To Rise Labor Force Participation Has Room To Rise   There is considerable uncertainty about how many workers will re-enter the labor force over the coming months. On the one hand, the expiration of enhanced unemployment benefits could prod more workers into the job market. Diminished anxiety about the virus should help. While the number has fallen by half, there are still 2.5 million people not working due to concerns about getting or spreading Covid-19 (Chart 17). According to Boston College’s Center for Retirement Research, the retirement rate rose more for older lower-income workers than higher-income workers (Chart 18). Some of these retirees may decide to re-enter the labor force. Chart 17Less Anxiety About The Coronavirus Should Increase Labor Supply Poorer Older Workers Were More Likely To Retire Last Year Poorer Older Workers Were More Likely To Retire Last Year Chart 18   On the other hand, the imposition of vaccine mandates could reduce labor supply. About 100 million US workers are currently subject to the mandates. According to the Census Household Pulse Survey, about 8 million of them are unvaccinated and attest that “they will definitely not get the vaccine.” Perhaps the biggest question mark is over whether the pandemic will lead to permanent changes in peoples’ perspectives on the optimal work/life balance. High burnout rates (especially in the health care sector), a reluctance to restart the daily commute to the office, and the desire to spend more time with family have all contributed to what some commentators have dubbed The Great Resignation. Ultimately, the deciding factor may be wages. Wage growth accelerated during the late 1990s as the labor market tightened (Chart 19). This drew a lot of people – especially less-skilled workers – into the labor force. Recently, wage growth has exploded at the bottom end of the income distribution, and our guess is that this will entice more people to seek employment (Chart 20). Chart 19Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Chart 20Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly     Will Higher Productivity Growth Mitigate Supply-Side Pressures? The late 1990s saw a resurgence in productivity growth. This helped restrain unit labor costs in the face of rising wages. Chart 21 While US productivity did jump during the pandemic, we are sceptical of claims that this can be attributed to efficiency gains from digitalization and work-from-home practices. A recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. It is telling that productivity outside of the US generally declined during the pandemic (Chart 21). This suggests that last year’s productivity gains stemmed mainly from increased operating leverage, a common feature of post-recession US recoveries (Chart 22). Supporting this view is the fact that productivity growth slowed from 4.3% in Q1 to 2.4% in Q2 on a quarter-over-quarter annualized basis. Productivity declined by 5% in Q3, leading to an 8.3% increase in unit labor costs. Chart 22US Productivity Tends To Jump After Recessions US Productivity Tends To Jump After Recessions US Productivity Tends To Jump After Recessions Chart 23Capital Goods Orders Have Soared Capital Goods Orders Have Soared Capital Goods Orders Have Soared The only saving grace is that core capital goods orders have soared (Chart 23). This should translate into increased business capital spending next year and higher productivity down the road. Investment Implications Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. This is consistent with our “two steps up, one step down” projection for US inflation. We are probably near the top of those two steps at present. This implies that the next move for inflation is to the downside, even if the longer-term trend is still to the upside. The US 10-year Treasury yield should stabilize at around 1.8% in the first half of 2022, before moving higher later in the year. As we discussed last week, markets are understating the true level of the neutral rate of interest. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted (Chart 24). Such an inversion does not make sense to us. Hence, as of this week, we are initiating a trade going long the 20-year bond versus the 30-year bond. We would also go short the 10-year Gilt on any break below 0.85%. The Bank of England’s “surprising hold” knocked the yield down 14 basis points to 0.93%. UK real bond yields are amongst the lowest in the world (Chart 25). Growth is strong and will remain buoyant as Brexit headwinds fade. The BoE will eventually have to turn more hawkish, which will support the beleaguered pound. Chart 24Go Long US 20-Year Bonds Versus 30-Year Bonds Go Long US 20-Year Bonds Versus 30-Year Bonds Go Long US 20-Year Bonds Versus 30-Year Bonds Chart 25UK Real Bond Yields Are Amongst The Lowest In The World UK Real Bond Yields Are Amongst The Lowest In The World UK Real Bond Yields Are Amongst The Lowest In The World   Structurally higher bond yields will benefit value stocks. Chart 26 shows that there has been a close correlation between the US 30-year Treasury yield and the relative performance of global value versus growth stocks. Banks stand to gain from rising bond yields while tech could suffer (Chart 27). Chart 26Higher Bonds Yields Favor Value Stocks Higher Bonds Yields Favor Value Stocks Higher Bonds Yields Favor Value Stocks Chart 27     The re-emergence of supply-side pressures could affect companies in a variety of unexpected ways. For example, Facebook and Google both rely heavily on revenue from advertising. But what is the point of trying to boost demand for your product if you already cannot produce enough of it? Companies such as Hershey and Kimberly-Clark are already cutting ad spending in response to supply-chain bottlenecks. Finally, tight supply conditions will catalyze more investment spending. This will benefit industrial stocks. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Chart 28 Special Trade Recommendations The Supply Side Strikes Back The Supply Side Strikes Back Current MacroQuant Model Scores Chart 29