Gov Sovereigns/Treasurys

Executive Summary Peak Fed Funds? Peak Fed Funds? Peak Fed Funds? The bond market is priced for a fed funds rate that will peak in February 2023 at 3.44% before trending down. We survey several interest rate cycle indicators and conclude that the market’s expected peak is too low and occurs too early. These indicators include: the unemployment rate, financial conditions, PMIs, the yield curve and housing starts. We also update our default rate forecast and are now looking for the default rate to rise to between 4.7% and 5.9% during the next 12 months. While our default rate forecasts imply a reasonably attractive 12-month junk bond valuation, we hesitate to turn too bullish on high-yield given that the next peak in the default rate is still not in sight. Bottom Line: We recommend keeping portfolio duration close to benchmark for the time being, though we will be looking for opportunities to reduce duration in the second half of this year. Similarly, we recommend a neutral (3 out of 5) allocation to junk bonds but will recommend reducing exposure if spreads rally back to average 2017-19 levels. Feature Last week’s report presented three conjectures about the US economy.1 One of those was that a recession will be required to get inflation back to 2%. But when will that recession occur? The question of timing is a vital one for bond investors. Are we on the cusp of recession right now? If so, then bond investors should extend portfolio duration in anticipation of Fed rate cuts and a return to 2% inflation. Conversely, if the recession is delayed, interest rates probably move higher before the cycle ends and investors should consider reducing portfolio duration. This week’s report addresses the topic of timing the next recession and discusses the implications for bond portfolio construction. Timing The Interest Rate Cycle From a bond market perspective, the question of whether the economy is in recession is less important than whether the Fed is hiking or cutting rates. Therefore, for the purposes of this report we will define a “recession” as an economic slowdown that is significant enough for the Fed to start cutting interest rates. Chart 1Peak Fed Funds? Peak Fed Funds? Peak Fed Funds? Now, let’s start by looking at what sort of interest rate cycle is priced in the market. The overnight index swap curve is currently discounting a peak fed funds rate of 3.44% (Chart 1). It is also priced for that peak to occur in 7 months, or by February 2023 (Chart 1, bottom panel). As bond investors, the question we must ask is whether this pricing seems reasonable. To do so, we will perform a survey of different indicators that have strong track records of sending signals near the peaks of interest rate cycles. Unemployment The first indicator we’ll look at is the unemployment rate. Economist Claudia Sahm has shown that a recession always occurs when the 3-month moving average of the unemployment rate rises to 0.5% above its trailing 12-month minimum.2 Table 1 dispenses with the moving average and simply shows the deviation of the unemployment rate from its trailing 12-month minimum on the dates of first Fed rate cuts since 1990. We see that the Fed has typically started to cut rates once the unemployment rate is 0.3-0.4 percentage points off its low. The exception is 2019 when the unemployment rate was only 0.1% off its low, but when inflation was below the Fed’s 2% target. Table 1Unemployment And Inflation When The Fed Starts Easing Recession Now Or Recession Later? Recession Now Or Recession Later? At 3.6%, the unemployment rate is currently at its cycle low. Based on the numbers shown in Table 1, this means that we should only expect the Fed to cut interest rates if the unemployment rises to at least 3.9% or 4.0%. We say “at least” because it’s also important to note that the inflation picture is a lot different today than it was during the periods shown in Table 1. With inflation so much higher, it is reasonable to think that the Fed will tolerate a greater increase in the unemployment rate before pivoting to rate cuts. Looking ahead, initial unemployment claims appear to have bottomed for the cycle and changes in initial claims are highly correlated with changes in the unemployment rate (Chart 2). That said, the trend in claims is currently consistent with a leveling-off of the unemployment rate, not a large increase. Financial Conditions Second, we turn to financial conditions. Fed officials often assert that monetary policy works through its impact on broad financial conditions. Therefore, it’s not too surprising that rate cuts tend to occur only after the Goldman Sachs Financial Conditions Index has moved into restrictive territory. Currently, despite the Fed’s dramatic hawkish shift, the index still shows financial conditions to be accommodative (Chart 3). Chart 2Jobless Claims Moving Higher Jobless Claims Moving Higher Jobless Claims Moving Higher Chart 3Financial Conditions Financial Conditions Financial Conditions   The same caveat we applied to the unemployment rate applies to financial conditions. As long as inflation is above the Fed’s target, it’s highly likely that the Fed will be comfortable with financial conditions that are somewhat restrictive. Therefore, the Fed may not pivot as soon as the Goldman Sachs index moves above 100, as has been the pattern in the recent past. Yield Curve Third, we note that an inverted Treasury curve almost always precedes the start of a Fed rate cut cycle, and the Treasury curve is certainly inverted today (Chart 4). The logic behind this indicator is somewhat circular in the sense that an inverted Treasury curve simply tells us that the market anticipates Fed rate cuts. If data emerge to suggest that Fed rate cuts will be postponed, then the Treasury curve could re-steepen. It’s for this reason that the Treasury curve often inverts well in advance of an economic recession and Fed rate cuts. We explored the relationship in more detail in a recent Special Report.3 Chart 4Interest Rate Cycle Indicators Interest Rate Cycle Indicators Interest Rate Cycle Indicators Chart 5Manufacturing PMIs Manufacturing PMIs Manufacturing PMIs PMIs Typically, the ISM Manufacturing PMI is below 50 by the time of the first Fed rate cut (Chart 4, panel 3). Currently, the ISM Manufacturing PMI is a healthy 53.0, but it has been falling quickly and trends in regional PMI surveys suggest that it will dip below 50 within the next few months (Chart 5). Interestingly, both the ISM and regional PMI surveys show that manufacturing supplier delivery times have come down a lot (Chart 5, panel 2). This gives some hope that goods inflation will trend lower during the next few months, as is our expectation. Recently, there’s also been an unusual divergence between the employment components of the ISM and regional Fed surveys. The New York and Philadelphia Fed surveys are showing strength in their employment components. Meanwhile, the ISM employment figure is below 50 (Chart 5, bottom panel). This divergence likely boils down to labor shortages that complicate how firms are responding to the employment question in the surveys. For example, despite the sub-50 employment figure, the latest ISM release noted that “an overwhelming majority of panelists […] indicate that their companies are hiring.”4 Housing In a recent report, we developed a rule of thumb that says that Fed rate cuts typically don’t occur until after the 12-month moving average of housing starts falls below the 24-month moving average.5 That indicator is coming down, but it still has a lot of breathing room before it dips into negative territory (Chart 4, bottom panel). That same report also outlined that we see the housing market slowdown proceeding in three stages. First, higher mortgage rates will suppress housing demand. This is already happening at a rapid pace as indicated by trends in mortgage purchase applications and existing home sales (Chart 6A). Second, lower housing demand will push up inventories and send prices lower. This has not yet shown up in the data (Chart 6B). Finally, once lower prices and higher inventories sufficiently disincentivize construction, we will see a marked deterioration in housing starts. Currently we see that housing starts have dipped, and homebuilder confidence has plummeted, but starts still haven’t decisively broken their uptrend (Chart 6C). Chart 6AHousing Demand Housing Demand Housing Demand Chart 6BPrices & Inventories Prices & Inventories Prices & Inventories Chart 6CBuilding Activity Building Activity Building Activity Putting It All Together To make sense of all the different indicators that could signal a Fed pivot toward rate cuts, we turn to our Fed Monitor. The Fed Monitor is a composite indicator that includes many of the individual indicators we have already examined in this report, as well as some others. The Fed Monitor is constructed so that a positive reading suggests that the Fed should be hiking rates and a negative reading suggests the Fed should be cutting rates. As can be seen in Chart 7, the Monitor is currently deep in positive territory. Chart 7Fed Monitor Calls For Tighter Money Fed Monitor Calls For Tighter Money Fed Monitor Calls For Tighter Money The Fed Monitor consists of three main sub-components, an economic growth component, an inflation component and a financial conditions component (Chart 7, bottom 3 panels). We see that the economic growth component of the Monitor is consistent with a neutral Fed policy stance – neither hikes nor cuts - and financial conditions point to a mildly restrictive stance. However, unsurprisingly, the inflation component is the highest it has been since the early-1980s and this is applying a ton of upward pressure to the Monitor. While our Fed Monitor is not a perfect indicator, it does speak to the tradeoff between inflation and economic growth that we have already hinted at in this report. Specifically, the Monitor illustrates that as long as inflation remains elevated it will take a significant deterioration in economic growth and financial conditions before the overall Monitor recommends a dovish Fed pivot. To us, this argues for a higher and later peak in the fed funds rate than is currently priced in the curve. Bottom Line: The peak fed funds rate that is currently priced in the market for 2023 is too low, and the funds rate will also likely peak later than what is priced in the curve. That said, falling inflation and economic growth concerns will probably keep a lid on bond yields during the next few months. We advise investors to keep portfolio duration close to benchmark for the time being, but to look for opportunities to reduce exposure. We will consider reducing our recommended portfolio duration stance to ‘below-benchmark’ if the 10-year Treasury yield falls to 2.5% or if core inflation reverts to our estimate of its 4%-5% underlying trend. Timing The Default Rate Cycle The interest rate cycle is not the only important one for bond investors. The default rate cycle is also crucial for spread product allocations because default trends are responsible for a significant amount of the volatility in corporate bond spreads. In this section we consider the outlook for corporate defaults and high-yield bond performance. We model the trailing 12-month speculative grade default rate using gross leverage (total debt over pre-tax profits) and C&I lending standards (Chart 8). Conservatively, if we assume 5% corporate debt growth for the next 12 months and corporate profit growth of between -10% and -20%, our model projects that the default rate will rise to between 4.7% and 5.9% (Chart 8, top panel). It’s notable that, like us, banks are also preparing for an increase in corporate defaults by raising their loan loss provisions (Chart 8, panel 2). Meanwhile, job cut announcements – another reliable indicator of corporate defaults – still don’t point to a higher default rate (Chart 8, bottom panel). Chart 8The Default Rate Has Troughed The Default Rate Has Troughed The Default Rate Has Troughed Interestingly, our model’s conservative projections suggest that in 12 months the default rate will be lower than its typical recession peak. Given today’s cheap junk valuations, this sort of analysis is encouraging a lot of people to turn bullish on high-yield bonds. Chart 9Default-Adjusted Spread Default-Adjusted Spread Default-Adjusted Spread This line of reasoning is not totally unfounded. Using the same forecasted default rate scenarios from Chart 8 along with an assumed 40% recovery rate on defaulted debt, we calculate that the excess spread available in the junk index after subtracting 12-month default losses is between 136 bps and 208 bps. This is below the historical average (Chart 9), but still above the 100 bps threshold that often delineates between junk bond outperformance and underperformance versus duration-matched Treasuries.6 More specifically, Chart 10 shows the relationship between our default-adjusted spread and high-yield excess returns versus Treasuries for each calendar year going back to 1995. We see that, in general, there is a positive relationship between spread and returns and that excess returns are more often positive than negative whenever the default-adjusted spread is above 100 bps. However, Chart 10 also shows periods when a pure analysis of junk bond performance based on the 12-month default-adjusted spread didn’t pan out. The year 2008 is a prime example. The default-adjusted spread came in at 249 bps for 2008, above the historical average. However, junk spreads widened dramatically in 2008 and excess returns were dismal. Chart 10The Default-Adjusted Spread And High-Yield Returns Recession Now Or Recession Later? Recession Now Or Recession Later? The reason the default-adjusted spread valuation framework failed in 2008 is that while the default rate only moved up to 4.9% in 2008, it wasn’t done increasing for the cycle. In fact, the rise in the default rate accelerated in 2009 until it hit 14.6% in November of that year. So, while default losses were low compared to the starting index spread in 2008, junk index spreads widened sharply in 2008 as the market prepared for worse default losses in 2009. The lesson we draw from the 2008 example is that even if the junk bond market is attractively priced relative to expected default losses on a 12-month horizon, unless we can forecast a peak in the default rate it is unwise to be overly bullish on high-yield bonds. Even if a recession doesn’t occur within the next 6-12 months, it will likely occur within the next 12-24 months. In that environment, investors are unlikely to realize the full potential of today’s attractive 12-month junk bond valuations. Chart 11Junk Spreads Junk Spreads Junk Spreads The bottom line is that we maintain a neutral (3 out of 5) allocation to high-yield within US fixed income portfolios for now. Junk spreads are elevated compared to past rate hike cycles and could tighten during the next few months as inflation converges to its underlying 4%-5% trend. That said, we will not turn outright bullish on junk bonds until we can reasonably forecast a peak in the default rate. In the meantime, a sell on strength strategy is more appropriate. We will reduce our recommended allocation to high-yield bonds if the average index spread tightens to its average 2017-19 level (Chart 11) or once inflation converges with its underlying 4%-5% trend. Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1     Please see US Bond Strategy Weekly Report, “Three Conjectures About The US Economy”, dated July 19, 2022. 2     https://www.hamiltonproject.org/assets/files/Sahm_web_20190506.pdf 3    Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 4    https://www.ismworld.org/supply-management-news-and-reports/reports/ism… 5    Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 6    For a more complete analysis of the link between the default-adjusted spread and excess high-yield returns please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds,” dated April 12, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.     Executive Summary The odds of a recession in the US are lower than widely perceived. The probability of a recession is higher in Europe, although this week’s partial resumption of gas flows through the Nord Stream 1 pipeline, along with increased use of coal-fired power plants, should soften the blow. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus. Fading recession risks will buoy stocks in the near term. However, a brighter economic outlook also means that the Fed, and several other central banks, may see little need to cut policy rates in 2023, as the markets are currently discounting. The end result is that government bond yields will rise from current levels, implying that stock valuations will not return to last year’s levels even if a recession is averted. After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050.   Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake The Downside Of A Soft Landing The Downside Of A Soft Landing Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 7Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored   The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12).   Chart 10AUS Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 12Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The Downside Of A Soft Landing The Downside Of A Soft Landing The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess.  With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 20Real Rates Have Jumped This Year Real Rates Have Jumped This Year Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on         LinkedIn & Twitter Global Investment Strategy View Matrix The Downside Of A Soft Landing The Downside Of A Soft Landing Special Trade Recommendations Current MacroQuant Model Scores The Downside Of A Soft Landing The Downside Of A Soft Landing    

Executive Summary We posit three conjectures about the US economy: Inflation has an easy path back to 4%, but a move to 2% will require a higher unemployment rate. It will be more difficult to raise the unemployment rate than many anticipate. The Fed will tolerate a higher unemployment rate than many anticipate. Taken together, these conjectures point to a higher fed funds rate in 2023 than is currently discounted in the market. This suggests that investors should be bearish bonds on a 12-18 month investment horizon. While we are bearish bonds in the medium-to-long term, we retain an ‘at benchmark’ portfolio duration stance for the time being because numerous indicators point to lower bond yields during the next few months. We also recommend an underweight allocation to spread product versus Treasuries, though we highlight the potential for solid near-term junk bond returns. Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Bottom Line: Maintain an ‘at benchmark’ portfolio duration stance. We will recommend reducing portfolio duration if the 10-year Treasury yield falls to 2.5% or if core inflation converges with our 4%-5% estimate of its underlying trend. Feature Uncertainty in bond markets remains elevated as investors seemingly can’t decide whether the US economy is in the midst of an inflationary boom or hurtling towards recession. This week’s report details our view of the current macroeconomic environment by offering three conjectures about the state of the US economy and monetary policy. We conclude by explaining how these conjectures shape our recommended investment strategy. Conjecture #1: Inflation Has An Easy Path Back To 4%, The Path To 2% Will Be More Difficult At 5.9%, core CPI inflation is running well above the Fed’s 2% target. However, we know that some portion of that 5.9% reflects supply side constraints related to the pandemic and some portion reflects an overheating of the demand side of the US economy. This distinction is important because the pandemic-related inflation will eventually subside on its own, without the need for materially slower economic growth. In contrast, a significant economic slowdown and a higher unemployment rate will be required to tame any inflation driven by strong US demand. Chart 1Estimating Trend Inflation Estimating Trend Inflation Estimating Trend Inflation In a recent report we looked at three different techniques for distinguishing between these two types of inflation.1First, we considered the Atlanta Fed’s decomposition of core inflation into flexible and sticky components. At present, the volatile core flexible CPI is running at an 8.4% annual rate and the core sticky CPI stands at 5.4% (Chart 1). Second, we noted that the New York Fed’s Underlying Inflation Gauge is running at 4.8% (Chart 1, bottom panel). Finally, we used wage growth net of trend productivity growth as an estimate of inflation’s underlying trend and calculated that to be 3.7% (Chart 1, bottom panel). From this analysis, our general conclusion is that core CPI inflation can fall into a range of 4%-5% just from the unwinding of pandemic-induced supply-side effects. After that, the Fed will be forced to engineer an economic slowdown to bring inflation from the stickier 4% level back down to its 2% target. Inflation Progress Report Last week’s June CPI report shows that even progress back to our 4%-5% estimate of inflation’s underlying trend is proving difficult. Core CPI rose 0.71% in June, well above expectations, and monthly trimmed mean CPI was an even stronger 0.80% (Chart 2A). Base effects led to a small drop in the annual core CPI number – from 6.0% to 5.9% - but annual trimmed mean CPI moved up to 6.9% (Chart 2B). The strong CPI print has led to increased speculation that the Fed will raise rates by 100 bps this month (see Box). Chart 2AMonthly Inflation Monthly Inflation Monthly Inflation Chart 2BYearly Inflation Yearly Inflation Yearly Inflation Turning to the three major components of core inflation, we see that shelter, goods, and services ex. shelter contributed roughly equal amounts to the June core CPI reading (Chart 3). The elevated reading from core goods inflation is particularly notable because this is one area where we have been anticipating that easing supply-side constraints will send prices lower. Car prices, specifically, have been one of the principal drivers of high inflation and they remained stubbornly high in June (Chart 4). Chart 3Monthly Core CPI Inflation By Major Component Three Conjectures About The US Economy Three Conjectures About The US Economy Chart 4Contribution To Month-Over-Month Core Goods CPI Three Conjectures About The US Economy Three Conjectures About The US Economy Chart 5Supply-Side Constraints Are Easing Supply-Side Constraints Are Easing Supply-Side Constraints Are Easing While it has taken much longer than expected for core goods and other pandemic-driven components of inflation to turn down, leading indicators still suggest that these prices are more likely to fall than rise during the next few months. The New York Fed’s Global Supply Chain Pressure Index has clearly rolled over and supplier delivery times, as measured by both the ISM manufacturing and non-manufacturing surveys, have shortened (Chart 5). While core goods and autos are representative of the sort of inflation that will ease naturally as supply chain constraints abate, shelter inflation is representative of the sort of inflation that will be stickier. That is, a higher unemployment rate will be required to significantly lower shelter inflation. Chart 6Shelter CPI Model Shelter CPI Model Shelter CPI Model Shelter inflation, currently running at 5.6%, can be modeled using the unemployment rate, rental vacancies and home prices (Chart 6). Given that shelter is such a large component of core inflation, it must fall if the Fed is going to achieve its 2% inflation target. That will certainly require a higher unemployment rate and very likely a recession. Bottom Line: Core inflation will move down in the second half of this year, as easing supply-side constraints lead to lower goods prices. Inflation’s downtrend will subside once it reaches its trend level of 4%-5%, at which point a higher unemployment rate and economic recession will be required to move it even lower, back to the Fed’s 2% target. BOX 75 bps Or 100 bps At The Next FOMC Meeting? Guidance provided by Fed Chair Jay Powell at the last meeting FOMC meeting suggested that the committee will choose between lifting rates by 50 bps or 75 bps when it meets later this month. The implication was that any negative inflation surprise would push the committee towards 75 bps. Certainly, last month’s strong employment report and hot CPI print justify a 75 bps move within Powell’s framework. But is it possible that Powell’s guidance from the June FOMC meeting is already stale? Chart B1July FOMC Expectations July FOMC Expectations July FOMC Expectations Investors are increasingly betting that it is, and the market is now discounting some chance of a 100 bps rate hike this month (Chart B1). The reason for this pricing is that the Fed has already backtracked on its guidance once before. Powell ruled out 75 bps rate hikes at the May FOMC press conference. Then, the committee delivered a 75 bps increase in June after core CPI came in hot. Kansas City Fed President Esther George dissented from the June decision because she objected to the Fed flip-flopping on its guidance so quickly. George explained her dissent in a recent speech by saying that “communicating the path for interest rates is likely far more consequential than the speed with which we get there.”2 Where does this leave us for the July meeting? Our expectation is that the Fed will stick to its guidance and deliver a 75 bps increase this month. However, if the market moves to fully price-in a 100 bps move then the committee may be tempted to deliver on those expectations. In other words, the Fed’s recent track record of abandoning its forward rate guidance means that both a 75 bps rate hike and a 100 bps rate hike are in play for July. Conjecture #2: The Labor Market Will Be More Resilient Than Is Widely Believed Chart 7An Extremely Tight Labor Market An Extremely Tight Labor Market An Extremely Tight Labor Market Our second conjecture is that it will be more difficult to lift the unemployment rate than many people think. This view stems from the fact that the labor market is incredibly tight. As Fed officials have often pointed out, there are currently almost two job openings for every unemployed worker in the country (Chart 7). Further, we noted in last week’s report that while the employment readings from both ISM surveys are in contractionary territory, respondents to those surveys were much more likely to cite concerns about the supply side of the labor market than they were to cite concerns about hiring demand.3 In other words, an economy where there are twice as many job openings as unemployed workers and where firms are complaining about a shortage of labor is not one where we are likely to see an immediate surge in layoffs, even as demand starts to soften. Conjecture #3: The Fed Will Tolerate A Higher Unemployment Rate Than Is Widely Believed Chart 8Optimal Control Monetary Policy Optimal Control Monetary Policy Optimal Control Monetary Policy Our final conjecture is that the Fed will persistently run a much more restrictive monetary policy than many investors anticipate. We detailed our logic in a recent report where we argued that the Fed will adopt an optimal control approach to monetary policy.4 An optimal control strategy is employed when the Fed is unlikely to perfectly hit both its full employment goal and its 2% inflation target. In such environments, Janet Yellen has argued that the Fed should set monetary policy to minimize the joint deviations of inflation from target and of the unemployment rate from estimates of its full employment level.5 Chart 8 presents an example of an optimal control loss function that consists of adding together the squared deviations of inflation from 2% and of the unemployment rate from the Congressional Budget Office’s estimate of NAIRU. Using this framework, the Fed’s goal is to minimize the output of the loss function shown in the top panel. The dashed lines in Chart 8 illustrate a scenario where core PCE inflation falls to 4% but where the output from the loss function is held flat. That scenario implies an increase in the unemployment rate from its current level of 3.6% all the way up to 6.7%! This exercise demonstrates that, under an optimal control framework, the Fed would be willing to tolerate an unemployment rate of 6.7% or lower in order to move core inflation back to 4%. We don’t see the unemployment rate hitting 6.7% any time soon. The main point of this analysis is to illustrate that Fed policy is likely to retain a restrictive bias until inflation returns to 2% or lower. It won’t move toward easing policy at the first sign of a higher unemployment rate, as has been the pattern in recent years when inflation was much more contained. Investment Implications To summarize, our three conjectures about the US economy are that: (i) a higher unemployment rate will be required to move inflation from 4% to the Fed’s 2% target, (ii) a lot of demand destruction will be required before we see a significant rise in the unemployment rate and (iii) in its pursuit of lower inflation, the Fed will tolerate a higher unemployment rate than many people expect. Taken together, these three conjectures imply that the fed funds rate will be higher in 2023 than what is currently priced in the curve. At present, the market is priced for the fed funds to peak at 3.67% in March 2023 and then fall back to 3.13% by the end of the year (Chart 9). If our three conjectures pan out, then we think it’s likely that the fed funds rate will move above 4% next year and that it will be higher than 3.13% by the end of 2023. Chart 9Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Portfolio Duration Chart 10High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators Obviously, this view makes us inclined toward a ‘below-benchmark’ portfolio duration stance on a 12-18 month investment horizon. That said, we recommend keeping portfolio duration close to benchmark for now because many indicators suggest that bond yields could fall during the next few months (Chart 10). More specifically, with core CPI still above our 4%-5% estimate of its underlying trend, we see inflation as more likely to fall than rise during the next six months. At the same time, aggregate demand will be slowing as the Fed tightens policy and the unemployment rate is more likely to rise than fall. These factors will keep bond yields contained between now and the end of the year. While we recommend an ‘at benchmark’ portfolio duration stance on a 6-12 month horizon, we will reduce portfolio duration if the 10-year Treasury yield moves back to 2.5% or once core inflation converges to our 4%-5% estimate of trend. At that point, we think inflation will be stickier and it will make sense to position for higher bond yields. Spread Product Our three conjectures also imply a negative environment for spread product. Monetary policy will become increasingly restrictive, and it will be a long time before the Fed moves toward interest rate cuts – the traditional signal to pile into spread product. We therefore advocate an underweight allocation to spread product versus Treasuries in US bond portfolios. One exception to our underweight spread product allocation is that we retain a neutral allocation to high-yield. Our reasoning is that high-yield spreads are elevated and they have the potential to tighten during the next few months as inflation converges toward our estimate of trend. As inflation falls and fears of immediate recession abate, it’s conceivable that junk spreads could revert to their 2017-19 average, the level that prevailed during the previous tightening cycle (Chart 11), and such a move would lead to roughly 8.4% of excess return.6 If such a move were to occur within the next six months, then we would be inclined to reduce our junk bond exposure to underweight. A Quick Note On 2-Year TIPS Chart 11Junk Spreads Are Elevated Junk Spreads Are Elevated Junk Spreads Are Elevated Chart 122-Year TIPS Yield Is Positive Three Conjectures About The US Economy Three Conjectures About The US Economy In last week’s report we recommended upgrading TIPS from underweight to neutral relative to duration-matched nominal Treasuries. However, given that the 2-year TIPS yield was still negative, we did not close our recommendation to short 2-year TIPS or our recommended 2/10 real yield curve flattener and 2/10 inflation curve steepener positions. The 2-year real yield has continued to rise during the past week and, at +9 bps, it is now in positive territory (Chart 12). We were confident that the 2-year TIPS yield would turn positive because the Fed has implied that it is targeting positive real yields across the entire curve. But now that the yield is positive, we are no longer confident in the trade’s upside. Bottom Line: Investors should close out their short 2-year TIPS positions, as well as their 2/10 real yield curve flatteners and 2/10 inflation curve steepeners. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1     Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 2     https://www.kansascityfed.org/Speeches/documents/8875/2022-George-MidAm… 3    Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 4    Please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 5    https://www.federalreserve.gov/newsevents/speech/yellen20120606a.htm 6    Return estimate assumes default losses of 1.8% and that the spread tightening occurs over a six month period.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.     Executive Summary The TIPS Market Foresees A Sharp Deceleration In Inflation What If The TIPS Are Right? What If The TIPS Are Right? TIPS breakevens are pointing to a rapid decline in US inflation over the next two years. If the TIPS are right, the Fed will not need to raise rates faster than what is already discounted over the next six months. Falling inflation will allow real wages to start rising again. This will bolster consumer confidence, making a recession less likely. The surprising increase in analyst EPS estimates this year partly reflects the contribution of increased energy profits and the fact that earnings are expressed in nominal terms while economic growth is usually expressed in real terms. Nevertheless, even a mild recession would probably knock down operating earnings by 15%-to-20%. While a recession in the US is not our base case, it is for Europe. A European recession is likely to be short-lived with the initial shock from lower Russian gas flows counterbalanced by income-support measures and ramped-up spending on energy infrastructure and defense. We are setting a limit order to buy EUR/USD at 0.981. Bottom Line: Stocks lack an immediate macro driver to move higher, but that driver should come in the form of lower inflation prints starting as early as next month. Investors should maintain a modest overweight to global equities. That said, barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. US CPI Surprises to the Upside… Again        Investors hoping for some relief on the inflation front were disappointed once again this week. The US headline CPI rose 1.32% month-over-month in June, above the consensus of 1.1%. Core inflation increased to 0.71%, surpassing consensus estimates of 0.5%. The key question is how much of June’s report is “water under the bridge” and how much is a harbinger of things to come. Since the CPI data for June was collected, oil prices have dropped to below $100/bbl. Nationwide gasoline prices have fallen for four straight weeks, with the futures market pointing to further declines in the months ahead. Agriculture and metals prices have swooned. Used car prices are heading south. Wage growth has slowed to about 4% from around 6.5% in the second half of last year. The rate of change in the Zillow rent index has rolled over, albeit from high levels (Chart 1). The Zumper National Rent index is sending a similar message as the Zillow data.  All this suggests that inflation may be peaking. The TIPS market certainly agrees. It is discounting a rapid decline in US inflation over the next few years. This week’s inflation report did little to change that fact (Chart 2). Chart 1Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Chart 2Investors Expect Inflation To Fall Rapidly Over The Next Few Years What If The TIPS Are Right? What If The TIPS Are Right? TIPS Still Siding with Team Transitory If the TIPS market is right, this would have two important implications. First, the Fed would not need to raise rates more quickly over the next six months than the OIS curve is currently discounting (although it probably would not need to cut rates in 2023 either, given our higher-than-consensus view of where the US neutral rate lies) (Chart 3). The second implication is that real wages, which have declined over the past year, will start rising again as inflation heads lower. Falling real wages have sapped consumer confidence. As real wage growth turns positive, confidence will improve, helping to bolster consumer spending (Chart 4). To the extent that consumption accounts for nearly 70% of the US economy – and other components of GDP such as investment generally take their cues from consumer spending – this would significantly raise the odds of a soft landing.  Chart 3The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 Chart 4Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Chart 5Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Of course, the TIPS market could be wrong. Bond traders do not set prices and wages. Businesses and workers, interacting with each other, ultimately determine the direction of inflation. Yet, the view of the TIPS market is broadly in sync with the view of most households and businesses. Expected inflation 5-to-10 years out in the University of Michigan survey has risen since the pandemic began, but at about 3%, it is close to where it was for most of the period between 1995 and 2015 (Chart 5). As we pointed out in our recently published Third Quarter Strategy Outlook, and as I discussed in last week’s webcast, the fact that long-term inflation expectations are well anchored implies that the sacrifice ratio – the amount of output that must be forgone to bring down inflation by a given amount — may be quite low. This also raises the odds of a soft landing. Investors Now See Recession as the Base Case Our relatively sanguine view of the US economy leaves us in the minority camp. According to recent polling, more than 70% of US adults expect the economy to be in recession by year-end. Within the investment community, nearly half of retail traders and three-quarters of high-level asset allocators expect a recession within the next 12 months (Chart 6). Chart 6Many Investors Now See Recession As Baked In The Cake What If The TIPS Are Right? What If The TIPS Are Right? Reflecting the downbeat mood among investors, bears exceeded bulls by 20 points in the most recent weekly poll by the American Association of Individual Investors (Chart 7). A record low percentage of respondents in the New York Fed’s Survey of Consumer Expectations believes stocks will rise over the next year (Chart 8). Chart 7Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Chart 8Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Resilient Earnings Estimates Admittedly, while sentiment on the economy and the stock market has soured, analyst earnings estimates have yet to decline significantly. In fact, in both the US and the euro area, EPS estimates for 2022 and 2023 are higher today than they were at the start of the year (Chart 9). What’s going on? Part of the explanation reflects the sectoral composition of earnings. In the US, earnings estimates for 2022 are up 2.4% so far this year. Outside of the energy sector, however, 2022 earnings estimates are down 2.2% year-to-date and down 2.9% from their peak in February (Chart 10). Chart 9US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date Another explanation centers on the fact that earnings estimates are expressed in nominal terms while GDP growth is usually expressed in real terms. When inflation is elevated, the difference between real and nominal variables can be important. For example, while US real GDP contracted by 1.6% in Q1, nominal GDP rose by 6.6%. Gross Domestic Income (GDI), which conceptually should equal GDP but can differ due to measurement issues, rose by 1.8% in real terms and by a whopping 10.2% in nominal terms in Q1. Chart 10Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates How Much Bad News Has Been Discounted? Historically, stocks have peaked at approximately the same time as forward earnings estimates have reached their apex. This time around, stocks have swooned well in advance of any cut to earnings estimates (Chart 11). At the time of writing, the S&P 500 was down 25% in real terms from its peak on January 3. Chart 11Unlike In Past Cycles, Stocks Peaked Well Before Earnings What If The TIPS Are Right? What If The TIPS Are Right? This suggests that investors have already discounted some earnings cuts, even if analysts have yet to pencil them in. Consistent with this observation, two-thirds of investors in a recent Bloomberg poll agreed that analysts were “behind the curve” in responding to the deteriorating macro backdrop (Chart 12). Chart 12Most Investors Expect Analyst Earnings Estimates To Come Down What If The TIPS Are Right? What If The TIPS Are Right? Nevertheless, it is likely that stocks would fall further if the economy were to enter a recession. Even in mild recessions, operating profits have fallen by about 15%-to-20% (Chart 13). That is probably a more severe outcome than the market is currently discounting. Chart 13Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Subjectively, we would expect the S&P 500 to drop to 3,500 over the next 12 months in a mild recession scenario where growth falls into negative territory for a few quarters (30% odds) and to 2,900 in a deep recession scenario where the unemployment rate rises by more than four percentage points from current levels (10% odds). On the flipside, we would expect the S&P 500 to rebound to 4,500 in a scenario where a recession is completely averted (60% odds). A probability-weighted average of these three scenarios produces an expected total return of 8.3% (Table 1). This is enough to warrant a modest overweight to stocks, but just barely. Barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. Table 1A Scenario Analysis For The S&P 500 What If The TIPS Are Right? What If The TIPS Are Right? What’s the Right Framework for Thinking About a European Recession? Whereas we would assign 40% odds to a recession in the US over the next 12 months, we would put the odds of a recession in Europe at around 60%. With a recession in Europe looking increasingly probable, a key question is what the nature of this recession would be. The pandemic may provide a useful framework for answering that question. Just as the pandemic represented an external shock to the global economy, the disruption to energy supplies, stemming from Russia’s invasion of Ukraine, represents an external shock to the European economy. In the initial phase of the pandemic, economic activity in developed economies collapsed as millions of workers were forced to isolate at home. Over the following months, however, the proliferation of work-from-home practices, the easing of lockdown measures, and ample fiscal support permitted growth to recover. Eventually, vaccines became available, which allowed for a further shift to normal life. Just as it took about two years for vaccines to become widely deployed, it will take time for Europe to wean itself off its dependence on Russian natural gas. Earlier this year, the IEA reckoned that the EU could displace more than a third of Russian gas imports within a year. The more ambitious REPowerEU plan foresees two-thirds of Russian gas being displaced by the end of 2022. In the meantime, some Russian gas will be necessary. Canada’s decision over Ukrainian objections to return a repaired turbine to Germany for use in the Nord Stream 1 gas pipeline suggests that a full cutoff of Russian gas flows is unlikely. Chart 14The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP During the pandemic, governments wasted little time in passing legislation to ease the burden on households and businesses. The European energy crunch will elicit a similar response. Back when I worked at the IMF, a common mantra in designing lending programs was that one should “finance temporary shocks but adjust to permanent ones.” The current situation Europe is a textbook example for the merits of providing income support to the private sector, financed by temporarily larger public deficits. The ECB’s soon-to-be-launched “anti-fragmentation” program will allow the central bank to buy the government debt of Italy and other at-risk sovereign borrowers without the need for a formal European Stability Mechanism (ESM) program, provided that the long-term debt profile of the borrowers remains sustainable. Get Ready to Buy the Euro All this suggests that Europe could see a fairly brisk rebound after the energy crunch abates. If the euro area recovers quickly, the euro – which is now about as undervalued against the dollar as anytime in its history (Chart 14) – will soar. With that in mind, we are setting a limit order to buy EUR/USD at 0.981.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn & Twitter   Global Investment Strategy View Matrix What If The TIPS Are Right? What If The TIPS Are Right? Special Trade Recommendations Current MacroQuant Model Scores What If The TIPS Are Right? What If The TIPS Are Right?

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary Bond investors can’t seem to decide whether the US economy is in the midst of an inflationary boom or hurtling toward recession. Our sense is that, while US economic growth is clearly slowing, we don’t see the unemployment rate rising enough for the Fed to abandon its tightening cycle any time soon. The 5-year US Treasury yield has tightened relative to the rest of the curve in recent weeks, and the 2-year maturity now looks like the most attractive spot for investors. TIPS breakeven inflation rates have also declined markedly in recent weeks, and TIPS no longer look expensive on our models. TIPS Are No Longer Expensive TIPS Are No Longer Expensive TIPS Are No Longer Expensive Bottom Line: US bond investors should keep portfolio duration close to benchmark. They should also shift Treasury curve allocations from the 5-year maturity to the 2-year maturity and upgrade TIPS from underweight to neutral. Whipsaw Inflationary boom or recession? US bond investors can’t seem to decide and yields are swinging back and forth depending on the latest economic data. Just in the past month we’ve seen the 10-year US Treasury yield peak at 3.49%, fall to 2.82% and then finally move back above 3% following last week’s strong employment report. Not surprisingly, implied interest rate volatility is the highest it’s been since the Global Financial Crisis (Chart 1). Our sense is that, while US economic growth is clearly slowing, we don’t see the unemployment rate rising enough for the Fed to abandon its tightening cycle any time soon. This is especially true because the Fed will tolerate a significant rise in the unemployment rate as long as inflation stays above target.1 Turning to the evidence, decelerating US economic activity is apparent in the manufacturing and non-manufacturing PMIs, which are both falling rapidly from high levels (Chart 2). Though both indexes remain firmly above the 50 boom/bust line, trends in financial conditions suggest that they could dip below 50 within the next few months. Chart 1A Highly Volatile Rates Market A Highly Volatile Rates Market A Highly Volatile Rates Market Chart 2US Growth Is Slowing US Growth Is Slowing US Growth Is Slowing The employment components of both indexes are already in contractionary territory (Chart 2, bottom panel), but this is due to concerns about labor supply, not demand. For example, last week’s ISM non-manufacturing PMI release included three representative quotes from respondents about labor market conditions.2 All three quotes reference concerns about labor supply: Unable to fill positions with qualified applicants. Extremely hard to find truck drivers. Demand for talent is higher, but availability of candidates to fill open roles continues to keep employment levels from increasing. This doesn’t sound like an economy that is on the cusp of surging unemployment, and this is exactly what the Fed is counting on. The Fed’s hope is that slower demand will bring down the large number of job openings without leading to a significant increase in layoffs or a significant rise in the unemployment rate. In that regard, it is notable that job openings ticked down in May, both in absolute terms and relative to the number of unemployed. Meanwhile, the rates of hiring and layoffs held steady (Chart 3). Chart 3Some Hope For A Soft Landing Some Hope For A Soft Landing Some Hope For A Soft Landing Investment Implications Our investment strategy hinges on two key economic views related to the labor market and inflation. First, while a surge doesn’t seem imminent, slowing economic activity means that the unemployment rate is more likely to edge higher between now and the end of the year than it is to fall. Second, as we’ve written in previous reports, US inflation has a relatively easy path back to its underlying trend of approximately 4%.3 After that, it will be more difficult for policymakers to bring inflation from 4% back down to 2%, and we could see the Fed push rates above 4% next year to accomplish this task. Taken together, these two views suggest that growth will be slowing and inflation falling between now and the end of the year. This combination could easily push bond yields lower, especially if recession worries flare up again. High frequency bond yield indicators such as the CRB Raw Industrials / Gold ratio and the relative performance of cyclical versus defensive equities also suggest that bond yields have room to fall (Chart 4). That said, the market is currently priced for the fed funds rate to peak at 3.74% in May 2023 and to fall back to 3.19% by the end of 2023. We see strong odds that inflation will be sticky enough (and the labor market resilient enough) for the Fed to push rates above those levels next year. This leaves us with an ‘at benchmark’ stance on portfolio duration for the time being, with an inclination to turn more bearish on bonds later this year if our base case forecast pans out. More specifically, we would likely reduce portfolio duration if the 10-year Treasury yield falls back to 2.5% or if inflation reverts to its 4% underlying trend. Conversely, we will turn more bullish on bonds if we see signs in the labor market data that point to a Fed pause (or Fed rate cuts) being necessary. For now, growth in nonfarm employment and aggregate weekly payrolls (wages x hours x employment) suggest we aren’t close to this outcome (Chart 5). Chart 4High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators Chart 5The US Labor Market Is Strong The US Labor Market Is Strong The US Labor Market Is Strong Sliding Down The Yield Curve Since early April we’ve been recommending that investors position long the 5-year Treasury note and short a duration-matched barbell consisting of the 2-year and 10-year notes to take advantage of a US yield curve that was quite steep out to the 5-year maturity point and quite flat beyond that. That trade is now played out. The 5 over 2/10 butterfly spread has tightened back to zero and the 2-year note is now the most attractively priced security on the US Treasury curve. Chart 6 shows that the spread between the 2-year note and a duration-matched barbell consisting of cash and the 5-year note offers an extraordinary yield advantage of 92 bps. What’s more, Table 1 shows that, with the exception of the unloved 20-year bond, the 2-year note offers the most attractive 12-month carry on the curve, largely a result of the 18 bps of rolldown attributable to the still-steep slope between the 1-year and 2-year maturity points. Chart 6Shift Into 2s Shift Into 2s Shift Into 2s Table 112-Month Carry Across The US Treasury Curve A Low Conviction US Bond Market A Low Conviction US Bond Market This large shift in relative pricing compels us to close our prior position (long 5-year bullet versus 2/10 barbell) and open a new position: long the 2-year note and short a duration-matched cash/5 barbell. This new position (long 2yr over cash/5) offers attractive 12-month carry, but given the current volatile interest rate environment, it should mainly be expected to profit in the event of a steepening of the 2/5 Treasury slope. With that in mind, it’s notable that the 2/5 slope recently inverted. Inversions of the 2/5 slope are historically rare. They tend to occur near the end of Fed tightening cycles and, with the exception of the early-1980s, they tend to not last that long (Chart 7). Chart 72/5 Inversions Are Rare And Fleeting 2/5 Inversions Are Rare And Fleeting 2/5 Inversions Are Rare And Fleeting Going forward, we see three plausible scenarios for the 2/5 slope during the next 6-12 months. First, the Fed achieves something close to the soft landing it is aiming for. Inflation starts to fall and the unemployment rate edges higher. However, unemployment never reaches levels that necessitate a complete reversal of Fed tightening. The 2/5 Treasury slope bear-steepens in this scenario as the market discounts that the Fed will have to push rates above 4% to hit its inflation target. Second, a deep recession and complete reversal of Fed tightening occur much more quickly than we anticipate. The 2/5 Treasury slope would bull-steepen in this scenario as the front-end of the curve is pulled down by the Fed’s pivot. Third, inflation shows no signs of reversing course. Long-dated inflation expectations jump and the Fed determines that it has no choice but to follow the example of Paul Volcker and tighten, even if the economy falls into a deep recession. As was the case in the early-1980s, the 2/5 Treasury slope could become deeply inverted in this scenario. Our sense is that the first two scenarios are much more likely than the third. We have written in prior reports about how the current spate of inflation is much different than what was seen in the early 1980s.4  This makes us willing to bet against a prolonged deep inversion of the 2/5 slope. Bottom Line: US Treasury curve investors should exit their positions long the 5-year bullet versus a duration-matched 2/10 barbell. They should initiate a position long the 2-year bullet versus a duration-matched cash/5 barbell. Upgrade US TIPS To Neutral Finally, we note that TIPS breakeven inflation rates have declined markedly during the past month. The 10-year TIPS breakeven inflation rate is currently 2.38%, near the lower-end of the Fed’s 2.3%-2.5% target range, and the 5-year/5-year forward TIPS breakeven inflation rate is a mere 2.12%, well below target (Chart 8). We also note that the 5-year/5-year forward TIPS breakeven inflation rate is back below survey estimates of what inflation will be 5-10 years in the future (Chart 8, bottom panel). Chart 8TIPS Breakevens TIPS Breakevens TIPS Breakevens We have been recommending an underweight position in TIPS versus nominal US Treasuries since early April, but the recent valuation shift means it’s time to add some exposure. Critically, our TIPS Breakeven Valuation Indicator has also increased to +0.6, moving into “TIPS cheap” territory (Chart 9). Historically, the 10-year TIPS breakeven inflation rate has averaged an increase of 28 bps in the 12 months following a reading between +0.5 and +1.0 from our Indicator (Table 2). Chart 9TIPS Are No Longer Expensive TIPS Are No Longer Expensive TIPS Are No Longer Expensive Table 2TIPS Breakeven Valuation Indicator Track Record A Low Conviction US Bond Market A Low Conviction US Bond Market The drop in TIPS breakeven inflation rates has been most prominent at the front-end of the curve. The 2-year TIPS breakeven inflation rate is down to 3.22% from a peak of 4.93%. The high correlation between short-maturity TIPS breakevens and realized CPI inflation means that short-dated breakevens can fall further as inflation continues to trend down, but already we see that 3.22% looks like a much more reasonable estimate of average inflation for the next two years than did the 4.93% peak. While we advise investors to upgrade TIPS from underweight to neutral relative to nominal US Treasuries, we continue to recommend an outright short position in 2-year TIPS. The 2-year TIPS yield has risen sharply since its 2021 low (Chart 10), but recent comments from Fed officials imply that the Fed would like to see positive real yields across the entire curve before it declares monetary policy sufficiently restrictive.5 This means that there is still some room for the 2-year TIPS yield to increase, from its current level of -0.10% back into positive territory. Such a move should also lead to more flattening of the 2/10 TIPS curve, and we continue to recommend holding that position as well (Chart 10, bottom panel). Chart 10Stay Short 2-Year TIPS Stay Short 2-Year TIPS Stay Short 2-Year TIPS Bottom Line: Investors should upgrade TIPS from underweight to neutral relative to nominal US Treasuries but maintain outright short positions in 2-year TIPS. 2/10 TIPS curve flatteners and 2/10 inflation curve steepeners also continue to make sense. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on how to think about the tradeoff between the Fed’s inflation and employment goals please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 2 https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/services/june/ 3 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 4 Please see US Bond Strategy Weekly Report, “No Relief From High Inflation”, dated June 14, 2022. 5 Please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum ​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates ​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) ​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit ​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe ​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure ​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 18Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense

Highlights Chart 1Are Expectations Too Dovish? Are Expectations Too Dovish? Are Expectations Too Dovish? The dominant market narrative has clearly shifted in the last few days. The primary concern among investors used to be that the Fed had fallen behind the curve on inflation. Now, asset prices are telling us that investors are more worried about an overly hawkish Fed and an increased risk of recession. The shift is evident in bond market prices. The yield curve is now priced for only 176 basis points of rate hikes over the next 12 months and only 90 bps of tightening over the next 24 months (Chart 1). What’s more, long-dated market-based inflation expectations have plunged to below the Fed’s target range (bottom panel). We recommend keeping portfolio duration close to benchmark for now, as bond yields could still have some downside during the next few months as both inflation and economic growth slow. That said, we suspect that the market is now pricing-in an overly dovish Fed tightening path for the next couple of years, a change that may soon warrant a shift back to below-benchmark portfolio duration. Stay tuned. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance A Narrative Shift A Narrative Shift Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 168 basis points in June, dragging year-to-date excess returns down to -379 bps. The average index option-adjusted spread widened 28 bps on the month and it currently sits at 158 bps. Similarly, our quality-adjusted 12-month breakeven spread moved up to its 61st percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve is very flat, signaling that we are in the mid-to-late stages of the credit cycle. Corporate bond performance tends to be weak during such periods unless spreads start from very high levels. Despite our underweight 6-12 month investment stance, there’s a good chance that spreads will narrow during the next few months as inflation falls. That said, the persistent removal of monetary accommodation and flatness of the yield curve will limit how much spreads can compress. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* A Narrative Shift A Narrative Shift High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 591 basis points in June, dragging year-to-date excess returns down to -889 bps. The average index option-adjusted spread widened 172 bps on the month to reach 578 bps, 209 bps above the 2017-19 average and 41 bps above the 2018 peak. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – moved higher in June. It currently sits at 8% (Chart 3). As is the case with investment grade, there’s a good chance that high-yield spreads will stage a relief rally in the back half of this year as inflation falls. But due to the flatness of the yield curve, we think it will be difficult for spreads to move below the average seen during the last tightening cycle (2017-19). But even a move back to average 2017-19 levels would equate to roughly 11% of excess return for the junk index if it is realized over a six month period. This potential return is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we would be inclined to downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to 4%.3  MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 63 basis points in June, dragging year-to-date excess returns down to -171 bps. We discussed the outlook for Agency MBS in a recent report.4 We noted that MBS’s poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates (panel 4). The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (bottom panel). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. Given that we see some potential for yields to fall during the next six months, we recommend favoring low-coupon MBS (1.5%-2.5%) within an overall underweight allocation to the sector. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds underperformed the duration-equivalent Treasury index by 182 basis points in June, dragging year-to-date excess returns down to -737 bps. EM Sovereigns underperformed the Treasury benchmark by 280 bps on the month, dragging year-to-date excess returns down to -925 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 122 bps, dragging year-to-date excess returns down to -617 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 99 bps in June. The yield differential between EM sovereigns and duration-matched US corporates remains negative. Further, the relative performance of EM sovereigns versus US corporates has been tracking the performance of EM currencies versus the dollar and our Emerging Markets Strategy service sees further headwinds for EM currencies in the near term (Chart 5).5  The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 1 bp in June. The index continues to offer a significant yield advantage versus duration-matched US corporates (bottom panel), and as such, we continue to recommend a neutral (3 out of 5) allocation to the sector.   Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 89 basis points in June, dragging year-to-date excess returns down to -167 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong and yet governments have also been slow to hire.6  The result is that net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete these coffers even as economic growth slows and federal fiscal thrust turns to drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni / Treasury yield ratio is currently 94%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched US corporates is 92%. The same measure for 17-year+ Revenue bonds stands at 97%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2-year/10-year Treasury slope flattened 26 bps on the month and the 5-year/30-year slope flattened 13 bps. The 2/10 and 5/30 slopes now stand at 4 bps and 23 bps, respectively. In a recent Special Report we noted the unusually large divergence between flat slopes at the long end of the curve and steep slopes at the front end.7 This divergence has narrowed in recent weeks, but it remains wide by historical standards. For example, the 5-year/10-year Treasury slope is currently 0 bps while the 3-month/5-year slope is 122 bps. The divergence is happening because the market moved quickly to price-in a rapid near-term pace of rate hikes, but the Fed has only delivered 150 bps of tightening so far and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. The 5 over 2/10 butterfly spread has narrowed during the past month, but the trade continues to look attractive on our model (Chart 7). We also continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade.  TIPS: Underweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 246 basis points in June, dragging year-to-date excess returns down to -14 bps. The 10-year TIPS breakeven inflation rate fell 31 bps on the month, landing back inside the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Consistently, our TIPS Breakeven Valuation Indicator is drifting toward neutral territory, signaling that TIPS are becoming less expensive (panel 2). At the front-end of the yield curve, the 2-year TIPS breakeven inflation rate fell 57 bps in June – from 3.86% to 3.29% - and the 2-year TIPS yield rose 96 bps – from -1.33% to -0.37% (bottom 2 panels). The large drop in short-maturity breakevens is the result of increasing investor conviction that inflation has indeed peaked. In a recent report we made the case that core CPI inflation can fall to a range of 4%-5% (from its current 6.0% rate) without the Fed needing to cause a recession. We also argued that a recession will be required to push inflation from 4% back down to 2%.8 The upshot for bond investors is that TIPS breakeven inflation rates will drop further as core inflation rolls over. This will be particularly true at the front-end of the yield curve. We also noted in last week’s report that Fed policymakers have increasingly indicated a desire for positive real yields across the entire curve.9 This tells us that investors should continue to short 2-year TIPS, targeting a positive real 2-year yield.   ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 21 basis points in June, bringing year-to-date excess returns up to -42 bps. Aaa-rated ABS outperformed by 25 bps on the month, bringing year-to-date excess returns up to -33 bps. Non-Aaa ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -93 bps. During the past two years, substantial federal government support for household incomes caused US households to build up an extremely large buffer of excess savings. Nowhere is this more evident than in the steep drop in the amount of outstanding credit card debt that was witnessed in 2020 and 2021 (Chart 9). In 2022, consumers have started to re-lever. The personal savings rate was just 5.4% in May and the amount of outstanding credit card debt has recovered to its pre-COVID level (bottom panel). But while household balance sheets are starting to deteriorate, they remain exceptionally strong in level terms. In other words, it will be some time before we see enough deterioration to cause a meaningful uptick in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.  Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in June, dragging year-to-date excess returns down to -194 bps. Aaa Non-Agency CMBS outperformed Treasuries by 12 bps on the month, bringing year-to-date excess returns up to -141 bps. Non-Aaa Non-Agency CMBS underperformed by 52 bps on the month, dragging year-to-date excess returns down to -340 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently slightly above their historic averages (Chart 10). Meanwhile, weak commercial real estate (CRE) investment continues to drive strong CRE price appreciation (panel 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 32 basis points in June, bringing year-to-date excess returns up to 9 bps. The average index option-adjusted spread tightened 3 bps on the month. It currently sits at 47 bps, close to its long-term average (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight.  Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 176 basis points of rate hikes during the next 12 months. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. A Narrative Shift A Narrative Shift Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of June 30, 2022) A Narrative Shift A Narrative Shift Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of June 30, 2022) A Narrative Shift A Narrative Shift Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -9 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 9 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) A Narrative Shift A Narrative Shift Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of June 30, 2022) A Narrative Shift A Narrative Shift Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2  Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3 For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 Please see Emerging Markets Strategy Charts That Matter, “Beware Of Another Downleg In Risk Assets”, dated June 30, 2022. 6 Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 7 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 8 Please see US Bond Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 9 Please see US Bond Strategy Weekly Report, “When Dual Mandates Clash”, dated June 28, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.

Executive Summary Calculating Trend Inflation Calculating Trend Inflation Calculating Trend Inflation Investors should anticipate 50 basis point rate hikes at each FOMC meeting, eventually transitioning to 25 bps per meeting once inflation shows clear and convincing evidence of trending down. This transition should occur later this year. Core inflation has peaked for the year and it can fall to a range of 4-5% even in the absence of an economic recession or meaningful labor market weakness. A recession will eventually be required to push inflation from 4% down to the Fed’s 2% target. Economic growth will slow going forward, but we won’t see enough weakness for the Fed to abandon its tightening cycle within the next 6-12 months.       Bottom Line: US bond investors should keep portfolio duration close to benchmark, underweight TIPS versus nominal Treasuries and maintain a defensive posture on corporate bond spreads (underweight IG and neutral HY). The Fed Goes Big Chart 1Inflation Expectations Inflation Expectations Inflation Expectations The US Federal Reserve continued to prove its inflation-fighting mettle last week with a 75 basis point rate hike, the largest single-meeting increase since 1994. Chair Powell had initially telegraphed 50 basis point rate increases for both the June and July FOMC meetings, but he made it clear during last week’s press conference that the committee was spooked by May’s surprisingly high CPI number and by the recent jump in 5-10 year household inflation expectations (Chart 1). Alongside the 75 basis point rate hike, committee members revised up their fed funds rate forecasts. The median FOMC member now expects the funds rate to reach a range of 3.25% to 3.5% by the end of 2022. That is consistent with three more 50 basis point rate hikes and one more 25 basis point hike at this year’s four remaining FOMC meetings. Looking further out, the median committee member anticipates 25-50 bps additional upside in the fed funds rate in 2023 but is then forecasting a modest reduction in 2024. Critically, the fed funds rate is still expected to be above estimates of long-run neutral by the end of 2024. Chart 2 shows how current market expectations compare to the Fed’s forecasts. We see that, even after the Fed’s upward forecast revisions, the market still anticipates a somewhat faster pace of tightening this year. The market is also priced for rate cuts in 2023, likely due to the increasingly widespread expectation that a recession is coming within the next 12 months. Chart 2Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed The Fed’s Near-Term Plan As for what we can expect going forward, we found two comments from Chair Powell’s press conference particularly enlightening. First, he called last week’s 75 basis point rate increase “unusually large” and said that he “doesn’t expect moves of that size to be common.” Second, Powell said that the Committee will need to see “convincing” and “compelling” evidence of falling inflation before it starts to moderate its tightening pace.1 From these statements we deduce the following near-term plan: 1. The Fed’s baseline expectation is to lift rates by 50 bps at each meeting. 2.  A significant upside surprise in either the monthly core CPI data or long-dated inflation expectations would cause the Fed to lift by 75 bps instead of 50 bps. 3.  The Fed will not reduce the pace of tightening to 25 bps per meeting until there is clear and convincing evidence that inflation is trending down. Bottom Line: Investors should anticipate 50 basis point rate hikes at each FOMC meeting, eventually transitioning to 25 bps per meeting once inflation shows clear and convincing evidence of trending down. This transition from 50 bps per meeting to 25 bps per meeting should occur later this year, meaning that the Fed will tighten no more quickly than what is already priced into the yield curve for the remainder of 2022. Inflation: All Clear To 4%, 2% Will Be More Challenging It’s evident from the above discussion that inflation remains the critical input for both monetary policy and US bond yields. In particular, the key questions are: 1. Will inflation trend down, and if so, how quickly? 2. Is an economic recession required to curtail inflation? Our answer to these questions is that core US inflation should fall naturally to a trend rate of roughly 4-5%, even in the absence of recession. However, an economic recession and its associated labor market weakness are likely required to move inflation from 4% back to the Fed’s 2% target. Chart 3Calculating Trend Inflation Calculating Trend Inflation Calculating Trend Inflation To arrive at these conclusions, we seek out different ways of estimating inflation’s underlying trend (Chart 3). The first method we consider is the Atlanta Fed’s decomposition of core inflation into “flexible” and “sticky” components. As defined by the Atlanta Fed, “flexible” items tend to change price more frequently compared to “sticky” items. Items like hotels and new & used vehicles fall into the flexible index, while rent and medical care fall into the sticky index.2 As of May, 12-month core flexible inflation is running at a rate of 12.3%. Meanwhile, core sticky inflation is running at 5.0% (Chart 3, top panel). Second, we consider the New York Fed’s Underlying Inflation Gauge (UIG). The UIG uses a dynamic factor model to derive a measure of trend inflation from a broad set of data.3 In total, the measure uses 346 data series encompassing price measures and other nominal, real and financial variables. The New York Fed has demonstrated that the UIG provides better forecasts of CPI inflation than other measures of core and trimmed mean inflation. At present, the UIG is running at 4.9% (Chart 3, panel 2). A second “prices only” UIG measure that includes only price data and no other economic or financial variables is running hotter at 6.0%. Finally, we can assess inflation’s underlying trend by looking at wage growth. Specifically, we can look at unit labor costs, a measure of wages relative to productivity. Unit labor costs are volatile, but they tend to track core inflation over long periods of time. Unit labor costs grew at an extremely high rate of 8.2% in the four quarters ending in Q1, but this is partly due to huge post-pandemic swings in productivity growth. If we create a more stable measure of underlying wage pressure by subtracting annualized 5-year productivity growth from the 12-month growth rate in average hourly earnings, we see that this trend inflation measure is running at only 3.8% (Chart 3, bottom panel). Chart 4Auto Inflation Will Slow Auto Inflation Will Slow Auto Inflation Will Slow We conclude from our analysis that 12-month core CPI inflation will fall from its current 6.0% back down to its trend level of roughly 4-5% without the Fed needing to slam the brakes on economic growth. This will occur because we will finally see the normalization of some prices that were pushed dramatically higher during the pandemic. Auto price inflation, for example, shot up above 20% last year because the pandemic and the fiscal response to the pandemic conspired to cause a surge in auto sales at the same time as a slump in production (Chart 4). Now, for reasons that have nothing to do with monetary policy but everything to do with the waning impact of the pandemic, we see auto sales rolling over as production ramps up. This will push prices lower in the second half of this year. All that said, once core inflation reaches its 4-5% trend level, more economic pain will be required to push it lower. Shelter, for example, carries a huge weight in the Atlanta Fed’s core sticky CPI and it is highly correlated with the economic cycle. A rising unemployment rate, and an economic recession, will eventually be required to push shelter inflation down. Bottom Line: Core inflation has peaked for the year and it can fall to a range of 4-5% even in the absence of an economic recession or meaningful labor market weakness. A recession and a rising unemployment rate will eventually be required to push inflation from 4% down to the Fed’s 2% target. The Risk Of Recession Just because US inflation can fall to 4% in the absence of recession doesn’t mean that the Fed won’t get impatient and cause one anyways. In fact, the Fed made it clear last week that it isn’t interested in nuanced inflation forecasts. The Fed will tighten aggressively until it is apparent that inflation is rolling over, even if it causes economic pain. In this section, we run through several economic and financial market indicators that often send signals near the peak of Fed tightening cycles and in advance of recessions. We conclude that economic growth is slowing, but we do not yet see any evidence of an imminent recession or of any growth slowdown that would be large enough for the Fed to pause or reverse its tightening cycle. First, we look at financial conditions (Chart 5). The Goldman Sachs Financial Conditions Index has tightened rapidly during the past few months and that tightening is broad-based across all five of the index’s components. That said, the index has still not quite moved into “restrictive” territory. Typically, Fed tightening cycles only end once financial conditions are already restrictive, and in this cycle, high inflation means that the Fed will likely tolerate even more tightening of financial conditions than usual. Second, we observe that the end of a Fed tightening cycle is often marked by a dip in the ISM Manufacturing PMI to below 50. Presently, the PMI is a solid 56.1 but it is falling, and regional Fed surveys suggest that it may soon dip into contractionary territory (Chart 6). Chart 5Financial Conditions Financial Conditions Financial Conditions Chart 6PMIs Are Slowing PMIs Are Slowing PMIs Are Slowing Third, residential construction activity is a strong predictor of both recession and the end of Fed tightening cycles. Specifically, we have observed that Fed tightening cycles tend to terminate once the 12-month moving average of housing starts falls below the 24-month moving average.4  At present, there is strong evidence that higher mortgage rates are starting to bite the housing market. Housing starts dipped sharply in May and homebuilder confidence is trending down (Chart 7). That said, our housing starts indicator still has a long way to go before it signals the end of the Fed’s tightening cycle (Chart 7, bottom panel). Finally, we turn to the labor market where we do not yet see any evidence of an economic slowdown. Nonfarm payroll growth usually turns negative prior to recession, but right now it is running at a rate of 4.5% during the past 12 months and 3.3% during the past three months (Chart 8). The unemployment rate, for its part, is extremely low, but this only reinforces the idea that the Fed won’t be inclined to abandon its tightening cycle anytime soon. Chart 7US Housing US Housing US Housing Chart 8The US Labor Market The US Labor Market The US Labor Market Consider that the Congressional Budget Office estimates that the natural unemployment rate is 4.4% and the median FOMC member estimates that it is 4.0%. In other words, the Fed would still consider the labor market tight even if the unemployment rate rose from its current 3.6% level to around 4%. Even though such an increase in the unemployment rate might technically be consistent with a recession, the Fed would not be inclined to ease monetary policy into such a labor market if inflation is still above its 2% target. Additionally, we must also consider that the labor force participation rate is trending up and it still has breathing room before it reaches its pre-pandemic level. Further increases in labor force participation – which seem likely – could support employment growth going forward even if the unemployment rate stops falling. Bottom Line: The Fed’s rate hikes, and tighter financial conditions more generally, will slow economic growth going forward. However, we don’t see any evidence that growth will be weak enough for the Fed to abandon its tightening cycle within the next 6-12 months. This is especially true because above-target inflation increases the amount of financial conditions tightening and labor market pain that the Fed will tolerate. Investment Implications Portfolio Duration & US Treasury Curve May’s surprisingly elevated CPI number caused US Treasury yields to move above their 2018 peaks across the entire yield curve (Chart 9). But we wouldn’t be surprised to see that uptrend take a breather during the next few months as inflation descends toward its 4-5% underlying trend. As noted above, falling inflation will likely cause the Fed to tighten by no more than what is already discounted between now and the end of the year, this should keep US Treasury yields rangebound. As a result, we advise investors to keep duration close to benchmark in US bond portfolios, with an eye toward re-evaluating this positioning once core inflation moves closer to its underlying trend. Chart 9US Treasury Yields US Treasury Yields US Treasury Yields On the Treasury curve, the 5-year note continues to trade cheap relative to the 2-year/10-year slope (Chart 9, bottom panel). We recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes. TIPS Chart 10Underweight TIPS Versus Nominals Underweight TIPS Versus Nominals Underweight TIPS Versus Nominals Investors should position for inflation falling back to trend by underweighting TIPS versus duration-matched nominal US Treasuries. Not only will falling inflation weigh on TIPS breakeven inflation rates during the next few months but a resolutely hawkish Fed will also apply downward pressure (Chart 10). We are particularly bearish on short-maturity TIPS, and we advise investors to initiate outright short positions in 2-year TIPS (Chart 10, bottom panel). In last week’s press conference, Chair Powell pointed to negative short-maturity real yields as evidence that financial conditions have room to tighten further. To us, this suggests that the Fed will not quit until real yields move into positive territory across the entire yield curve. In an environment of falling inflation, this is likely to occur because of falling TIPS breakeven inflation rates. However, the Fed has now demonstrated that even if inflation doesn’t fall it will push real yields higher with its policy rate actions and forward guidance. Corporate Credit The combination of slowing economic growth and increasingly restrictive Fed policy compels us toward a defensive positioning on corporate bond spreads. Specifically, we advise investors to carry an underweight (2 out of 5) allocation to investment grade US corporate bonds and a neutral (3 out of 5) allocation to high-yield US corporate bonds. Our slight preference for high-yield comes from the view that spread widening is likely to take a breather this year as inflation turns down and the Fed tightens by no more than what is already discounted in the yield curve. Though the long-run prospects for corporate bond returns remain bleak, if inflation moderates this year as we expect, then spreads could easily re-tighten to the average levels seen during the last tightening cycle (2017-19). That would equate to 31 bps of spread tightening for investment grade US corporate bonds (Chart 11), or roughly 300 bps of excess return versus duration-matched US Treasuries.5 For high-yield, a return to average 2017-19 spread levels would equate to 133 bps of spread tightening (Chart 12), or roughly 875 bps of excess return versus duration-matched US Treasuries.6 Chart 11IG Spreads IG Spreads IG Spreads Chart 12HY Spreads HY Spreads HY Spreads In our view, this warrants a slightly higher allocation to high-yield for the time being, though we will likely turn increasingly bearish should spreads tighten to average 2017-19 levels or once inflation converges with its 4-5% trend.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220615.pdf 2 For more info on the Atlanta Fed’s sticky and flexible CPIs please see: https://www.atlantafed.org/research/inflationproject/stickyprice 3 For more info on the Underlying Inflation Gauge please see https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 4 For more details on this indicator please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 This excess return estimate is roughly 31 bps of spread tightening multiplied by average index duration of 7.5. We then add half of the index OAS as an estimate of the carry earned during the next six months. 6 This excess return estimate is roughly 133 bps of spread tightening multiplied by average index duration of 4.3. We then add half of the index OAS, less estimated default losses of 200 bps, as an estimate of the carry earned during the next six months. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns