Inflation/Deflation

Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Chart 6Renewables Dominate Incremental New Generation Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Chart 14     Footnotes 1     Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020.  It is available at ces.bcaresearch.com.   2     Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021.  The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3    Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

In lieu of next week’s strategy report, I will be presenting the first Counterpoint webcast titled ‘Mega-Themes, Coming Shocks, And Top Trades’. I hope you can join. Highlights Standard economic theory assumes that money is perfectly fungible. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. This is known as ‘mental accounting bias.’ Mental accounting bias means that we are more likely to use the massive stockpile of savings accumulated during the pandemic to pay down debt than to spend. Mental accounting bias also means that we are overpaying for high-yielding equities. Long-term investors should avoid banks, and they should avoid ‘value.’ Correctly calculated, the equity risk premium is now almost non-existent. US long-term bond yields have much more scope to move down than to move up. Fractal trade shortlist: equities versus bonds, PKR, and New Zealand equities. Feature Chart of the WeekConsumption Is Explained By Wages... Chart of the Week...Not By Stimulus Checks Many economists predict that, once economies fully reopen, the massive stockpile of household savings accumulated during the pandemic will unleash a tsunami of household spending. But economists are not the right people to make this prediction. The answer to whether households will, or will not, spend their stockpile of accumulated savings does not fall into the realm of Economics. It falls into the realm of Psychology. Whether We Spend Money Depends On Which ‘Mental Account’ It Occupies In A Major Anomaly In The Bond Market we pointed out that the propensity to spend out of income is high, but the propensity to spend out of wealth is low. Meaning that whether unspent income gets spent depends on whether households categorise it as additional income or additional wealth. This raised a follow-up question. How can the decision to spend money depend on whether someone categorises it as income or wealth? The answer comes from Psychology, and a phenomenon known as ‘mental accounting bias.’ Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to draw on these accounts for spending. There is a clear hierarchy in our willingness to spend from our ‘mental accounts’. At the top of the hierarchy comes our monthly wage check, followed by the money in our current (checking) account. These ‘income’ accounts we are willing to spend. Further down the hierarchy comes our savings account and our investment portfolio. These ‘savings’ or ‘wealth’ accounts we are unwilling to spend. Standard economic theory assumes that money is perfectly fungible, so that a pound in a current account is no different to a pound in a savings account. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. When we move money from our wages or our current account into our savings account, our willingness to spend it collapses. This explains why consumption closely tracks the wages that dominate our income mental account, but has no meaningful connection with stimulus checks which largely end up in our savings mental account (Chart of the Week and Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Trends Yet while we are unwilling to spend our savings mental account, we are willing to pay down debt with it. Indeed, realising this emotional connection between our savings and our debt, many lenders offer mortgages which ‘offset’ a savings account against the mortgage debt. Pulling all of this together, the stockpile of household savings accumulated during the pandemic is unlikely to boost consumption trends. More likely, it will be used to reduce household debt. In which case, part of the recent rise in public debt will just end up paying down private debt, as happened in Japan during the 1990s (Chart I-3). Chart I-3In Japan, Public Debt Ended Up Paying Down Private Debt This spells trouble for bank asset growth. ‘Value’ Offers No Value Mental accounting bias also explains the dominant phenomenon in the financial markets of recent years – the so-called ‘search for yield’. At first glance, the search for yield makes sense, but on deeper thought the distinction between yield and capital appreciation is irrational. Just like income and wealth, the money that comes from an investment’s yield and the money that comes from its capital appreciation is perfectly fungible (assuming am equal tax treatment). Yet, in practice, many investors put yield and capital appreciation into separate mental accounts, categorising an investment’s yield as spending money, and its capital as saving money. Hence, those investors – say retirees – who want their assets to generate money for their spending mental account have an irrational bias towards investments that generate yield. Whereas those investors that want their assets to boost their saving mental account have a bias towards investments that generate capital growth. To reiterate, given that money is perfectly fungible, these mental accounts are irrational.  Under normal circumstances, these irrational biases are not a problem because there are enough investments available for both the spending and the saving mental accounts. But in recent years, the assets that would normally generate the safe income for the spending account – cash and government bonds – are no longer doing so. Hence, in the ensuing stampede for yield, income fixated investors have suffered a dangerous tunnel vision. By fixating on an equity’s yield rather than on its prospective total return, yield seeking investors are overpaying for high-yielding equities, and thereby sacrificing their long-term wealth. By fixating on an equity’s yield rather than on its prospective total return, investors are overpaying for high-yielding equities. Case in point. The 8 percent forward earnings yield on global financials appears to offer considerably more value than the 5 percent on healthcare and the 3.5 percent on technology. But what really matters is how that forward earnings yield translates into prospective total return. On this basis, the apparent value in financials turns out to be a mirage. Using the post financial crisis relationship between forward earnings yield and prospective return, high-yielding financials were, until very recently, priced to deliver a lower return than low-yielding technology. And financials are still priced to deliver a lower return than lower-yielding healthcare. To deliver the same long-term return as healthcare, the valuation of financials would have to decline by 20 percent (Chart I-4 - Chart I-6). Chart I-4Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Chart I-5Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Chart I-6Tech Is Expensive Therefore, mental accounting bias is a double whammy for banks. It spells trouble for bank asset growth, and it makes investors overpay for high-yielding equities. This creates the ultimate paradox of investment. The defining feature of ‘value’ is that it offers no value! Long-term investors should avoid banks, and they should avoid value. US Bond Yields Have More Scope To Move Down Than Up The foregoing analysis also carries important implications on the correct approach to value equities, and specifically the equity risk premium – meaning, the prospective excess return on equities versus high-quality bonds. The common incorrect approach is to take the forward earnings yield on equities and subtract the 10-year bond yield. Using a US forward earnings yield of 4.5 percent, this would suggest the equity risk premium is a comfortable 3 percent versus the nominal bond yield of 1.5 percent. Or a very comfortable 5.5 percent versus the real bond yield of -1 percent. The glaring error with this approach is that it is subtracting apples from oranges. The 10-year bond yield is the return you will receive from the bond over the next 10 years. But as you have just seen, the forward earnings yield is not the return you will receive from equities over the next 10 years. To subtract apples from apples we must first translate the forward earnings yield into a prospective 10-year total return. The current translation turns out to be a 2 percent nominal return (Chart I-7 - Chart I-8) or a 0 percent real return (Chart I-9 - Chart I-10). Comparing these with the nominal or real bond yields, we find that the equity risk premium is almost non-existent. Chart I-7Convert The Earnings Yield Into A Prospective Nominal Return... Chart I-8…To Find That The Equity Risk Premium Is Almost Non-Existent Chart I-9Convert The Earnings Yield Into A Prospective Real Return... Chart I-10...To Find That The Equity Risk Premium Is Almost Non-Existent The almost non-existent equity risk premium means that equities are richly valued, and that this rich valuation is contingent on bond yields not rising significantly. Moreover, it is not just equities that are richly valued. As we pointed out in The Road To Inflation Ends At Deflation the valuation of $300 trillion of global real estate is also highly contingent on bond yields not rising significantly. Equities are richly valued, and this rich valuation is contingent on bond yields not rising significantly. We conclude that, from current levels, US long-term bond yields have much more scope to move down than to move up. Candidates For Countertrend Reversal The strong rally in equities versus bonds since the pandemic low has reached a point of fractal fragility like that seen at the end of the 2013 bull run and the end of the early 2020 bear run (Chart I-11). As such, the current rally is due a breather. Chart I-11The Rally In Equities Versus Bonds Is Due A Breather In the Asia Pacific region, we note that the recent strong performance of the Pakistan rupee is susceptible to a countertrend sell-off (Chart I-12). Chart I-12Underweight The PKR Lastly, the ultra-defensive New Zealand stock market has massively underperformed over the past year. But fragility on both its 130-day and 65-day fractal structures suggests that it is ripe for a countertrend outperformance (Chart I-13). Chart I-13Overweight New Zealand Accordingly, this week’s recommendation is to overweight New Zealand versus the world, setting the profit target and symmetrical stop-loss at 4 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights Duration: The pace of rate hikes currently priced into the market is reasonable. However, we see strong odds that market expectations will move higher in the coming months, the result of continued strong economic data and the Fed starting to talk about tapering its asset purchases. Investors should maintain below-benchmark portfolio duration. MBS: MBS remain unattractive compared to other US spread products. But within an underweight allocation to MBS, an up-in-coupon bias makes sense. Inflation: Year-over-year CPI inflation was pushed higher by base effects in March, but the report also showed evidence of mounting inflationary pressures beyond simple base effects. Feature After a sizeable drop last Thursday, Treasury yields are now significantly off their recent highs. The 10-year Treasury yield peaked at 1.74% on March 31st but ended last week at only 1.59%. What makes the drop puzzling is that yields are down despite a string of very strong US economic data (Chart 1). This recent development bears a resemblance to the famous 2004/05 bond conundrum when Fed Chairman Alan Greenspan struggled to understand why long-maturity Treasury yields were falling even as the Fed lifted short rates.1 Today, investors are also struggling to understand why long-maturity Treasury yields are falling, only this time the “conundrum” is that they are falling in the face of strong economic data. From our perch, both conundrums have the same answer: The market has already discounted a lot of the news. On June 29th, 2004 – the day before the first rate hike of that cycle – the overnight index swap (OIS) curve was priced for 243 bps of Fed rate hikes for the following 12 months. The Fed went on to deliver 200 bps of rate hikes during that timeframe, slightly less than the market expected. In that environment it is entirely consistent that bond yields should fall (Chart 2). Chart 1Yields Down On Strong Data Chart 2The 2004/05 Bond Conundrum Today, the OIS curve is priced for the Fed to lift rates off the zero bound in December 2022 and for a total of 86 bps of rate hikes by the end of 2023 (Chart 3). Given the Fed’s new Average Inflation Targeting regime, this sort of rate hike cycle will only be achieved if there is a very strong US economic recovery. The incoming US data are so far confirming that narrative but haven’t been strong enough to move rate expectations even higher. Chart 3Market Priced For December 2022 Liftoff As we wrote in last week’s report, we think that the market’s current rate hike expectations look reasonable.2 However, we see a meaningful risk that they could move higher in the coming months as the rapid US economic recovery continues and the Fed starts to back away from its extremely dovish messaging. Chart 4US Will Hit 75% Vaccination Well Before September For example, Fed Chair Jay Powell has said repeatedly that it is too soon to talk about tapering the Fed’s asset purchases. We worry, however, that this tone might be giving investors a false sense of security. If the economic recovery continues at its current pace, we fully expect the Fed to start talking about tapering this year and to begin the process either by the end of 2021 or in early 2022. Last week, St. Louis Fed President Jim Bullard said he would be comfortable starting discussions about tapering when 75%-80% of the US population has been vaccinated. We estimate that if vaccinations continue at a linear pace, we will hit 75% vaccination by September (Chart 4). Given the exponential trend in vaccinations so far, we are likely to reach 75% well before September. The bottom line is that we see the pace of rate hikes currently priced into the market as reasonable. However, we also see strong odds that market expectations will move higher in the coming months, the result of continued strong economic data and the Fed starting to talk about tapering its asset purchases. Investors should maintain below-benchmark portfolio duration. MBS: Stay Up In Coupon Unsurprisingly, the reflation trade has been beneficial for risk assets. Within US fixed income, spread products have generally outperformed Treasuries since bond yields bottomed last August. However, certain spread sectors have fared better than others. Agency Mortgage-Backed Securities, for example, have not done that well. Conventional 30-year Agency MBS have only outperformed a duration-matched position in Treasury securities by 73 bps since bond yields bottomed on August 4th, 2020 (Chart 5). This compares to 446 bps of outperformance for Aaa-rated corporates, 342 bps of outperformance for Aa-rated corporates (Chart 5, panel 2) and 232 bps of outperformance for Agency CMBS (Chart 5, panel 3). Only notoriously low-risk Aaa-rated consumer ABS have delivered less outperformance than Agency MBS (Chart 5, bottom panel). While Agency MBS have not performed well overall, certain segments of the coupon stack have delivered decent excess returns. Specifically, higher coupon MBS have performed much better than low coupon MBS during the recent back-up in yields. Since last August, 4% coupon MBS have outperformed duration-matched Treasuries by 176 bps and 4.5% coupons have outperformed by 257 bps. Meanwhile, 2.5% coupons have underperformed by 10 bps and 3% coupons have underperformed by 15 bps (Chart 6). Chart 5Spread Product Performance Since Trough In Bond Yields Chart 6Favor Premium Coupons In Rising Rate Environment The divergent performance between high and low coupons is easily explained by the risk characteristics of those bonds. Looking at the difference between the 2.5% and 4% coupons, for example, we see that the 2.5% coupons have significantly higher duration and significantly lower convexity (Chart 6, bottom 2 panels). The higher duration means that rising yields hurt 2.5% coupons more and the lower convexity means that rising yields will cause the gap between 2.5% coupon duration and 4% coupon duration to widen further. In short, a rising yield environment is terrible for low-coupon MBS. Conversely, high duration and low convexity are desirable attributes in a falling yield environment. If bond yields fall meaningfully going forward, then low-coupon MBS will outperform the high coupons. Chart 7A shows how option-adjusted spread (OAS) varies with duration across the conventional 30-year Agency MBS coupon stack. We see that the lowest coupons have the highest durations and the lowest OAS. Premium coupons have low durations and high OAS. Chart 7AAgency MBS 30-Year Conventional Coupon Stack: OAS vs. Duration Chart 7B shows how OAS varies with convexity across the coupon stack. Here we see that the 2%, 2.5% and 3% coupons have the most negative convexities. This makes sense as those coupons are closest to the current mortgage rate of 3.04%. A further increase in the mortgage rate would make those coupons less likely to refinance, causing durations to extend meaningfully. Conversely, a drop in the mortgage rate would lead to greater refinancings for those coupons, causing durations to shorten. Notice that 1.5% coupon MBS have relatively high convexity. This is because refinancing is already unattractive for those bonds, and the duration of the 1.5% index has already extended. Chart 7BAgency MBS 30-Year Conventional Coupon Stack: OAS vs. Convexity Given our view that US Treasury yields will be flat-to-higher for the next 6-12 months, we recommend an up-in-coupon bias within Agency MBS. Specifically, the 2%, 2.5% and 3% coupons have the most scope for duration extension in a rising yield environment and should be avoided. The 4% and 4.5% coupons, on the other hand, are less negatively convex and are better able to weather the storm of rising bond yields. In a flat bond yield environment, the best performing coupons are likely to be those with the widest OAS. This makes the 4% and 4.5% coupons look much more attractive than the 1.5% coupons, even though they have similar convexities. Overall, we recommend owning the 4% and 4.5% coupons within the conventional 30-year Agency MBS coupon stack and avoiding the 2%, 2.5% and 3% coupons. One final point worth making is that we also continue to recommend an underweight allocation to MBS within a US bond portfolio. That is, though higher coupon MBS look better than the low coupons, the entire sector looks unattractive compared to alternatives like consumer ABS, Agency CMBS and even investment grade corporate bonds. Chart 8 shows a version of our Excess Return Bond Map, a visual guide that is useful for quickly assessing the risk/reward trade-off between different US spread products.3 The Map shows OAS as a measure of expected return on the Y-axis, and a proprietary risk measure called the “Risk Of Losing 100 Bps” on the X-axis. A higher number on the X-axis indicates less risk of losing 100 bps and vice-versa. Chart 8Excess Return Bond Map Our Bond Map makes it clear that only 4% and 4.5% coupon MBS come close to offering a risk/reward balance that is comparable to other spread sectors. MBS coupons below 4% offer far too little expected return given the amount of risk. Bottom Line: Remain underweight MBS within a US bond portfolio, but favor 4% and 4.5% coupons over 2%, 2.5% and 3% coupons within the Agency MBS coupon stack. March CPI More Than A Base Effect It was well known heading into last week’s March CPI release that the year-over-year inflation number was going to be very strong. This is due to base effects that will persist through to the end of May. That is, 12-month inflation is bound to rise as the negative monthly inflation prints from March, April and May 2020 fall out of the 12-month rolling sample. Year-over-year inflation numbers did indeed rise sharply in March (Chart 9). 12-month headline CPI jumped from 1.68% to 2.64% and 12-month core CPI increased from 1.28% to 1.65%. Base effects exert less influence over the trimmed mean CPI, and that index rose only from 2.04% to 2.12%. The gap between 12-month core CPI and 12-month trimmed mean CPI remains wide, but it should close by May when the impact from last year’s base effects is exhausted (Chart 9, bottom panel). Chart 9Annual Inflation Chart 10Monthly Inflation But base effects were only part of the story last week. Month-over-month inflation also came in very strong for the headline, core and trimmed mean measures. Headline CPI rose 0.62% in March, core CPI rose 0.34% and the trimmed mean rose 0.24% (Chart 10). To put those numbers in context, if those monthly prints are repeated in April and May, 12-month headline CPI will rise to 4.75% by May and 12-month core CPI will rise to 2.79%. Even if we assume more typical 0.15% inflation rates for April and May, we would still expect 12-month headline CPI to reach 3.77% by May and 12-month core CPI to reach 2.41%. Overall, the message from March’s CPI report is that the economy is showing signs of mounting inflationary pressures beyond simple base effects. We have previously written about the ample evidence of bottlenecks in both the goods and service sectors, and we now appear to be seeing those bottlenecks show up in the price data.4 There’s little doubt that 12-month inflation will fall somewhat between May and the end of the year. However, we anticipate that inflation will still be close to the Fed’s target by the end of 2021. This will certainly be the case if the monthly inflation figures remain consistent with March’s print. The main investment implication from this view is that low inflation will not prevent the Fed from tapering its asset purchases either late this year or early next year, and it also won’t prevent the Fed from lifting rates in 2022. Footnotes 1 Greenspan’s remarks: https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 Please see US Bond Strategy Weekly Report, “Overshoot Territory”, dated April 13, 2021, available at usbs.bcaresearch.com 3 For more details on the Bond Map please see page 16 of US Bond Strategy Portfolio Allocation Summary, “It’s A Boom!”, dated April 6, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart of the WeekThe Bond Bear Mantle Being Passed To Canada? US Treasuries: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remains bond bearish and the Fed is likely to begin preparing the market later this year for a tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk of the Bank of Canada shifting to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying – perhaps even before the Fed does the same (Chart of the Week). Downgrade Canadian government bonds to underweight in global fixed income portfolios. US Treasuries: The Pause That Refreshes Chart 2UST Yield Uptrend Has Paused After leading the global government bond market selloff over the past several months, US Treasury yields have calmed down of late. The 10-year Treasury yield is down 14bps from the most recent peak of 1.74% reached March 31, while the 30-year Treasury yield is down 16bps from the peak of 2.45% reached on March 18. These moves have been concentrated in the real yield component, with inflation breakevens stable, as the 10yr and 30yr TIPS yields are down -15bps and -20bps, respectively, since the dates of those peaks in nominal yields (Chart 2). The drift lower in US yields has occurred in the face of an explosive surge in US economic data. Retail sales rose +9.8% in March compared to February and a staggering +27.7% on a year-over-year basis. The Fed’s regional manufacturing surveys showed very robust results for April, with the New York Empire State index hitting the highest level since October 2017 and the Philadelphia Fed headline index surging to a level last seen in 1973. This follows the very strong payrolls and ISM data for March that came out in early April. Yet the US economic data is not unanimously positive. The latest readings from the University of Michigan consumer confidence and NFIB small business optimism surveys both remained well below pre-pandemic peaks (Chart 3). Annual core CPI inflation only inched up 0.2 percentage points in March to 1.6%, a tepid move compared to the base effect driven surge that took year-over-year headline CPI inflation from 1.7% in February to 2.6%. Chart 3Some Mixed Messages From Recent US Data Chart 4Fewer Positive US Data Surprises The overall flow of US economic data has been disappointing versus elevated expectations, as evidenced by the almost uninterrupted decline in the Citigroup US data surprise index since peaking in July of 2020 (Chart 4). This indicator reliably correlated to the momentum of US Treasury yields prior to the COVID-19 outbreak and now, given the bullish growth combination of vaccine optimism and fiscal stimulus, the bond market’s focus is returning to how US data evolves versus expectations - and what that means for the Fed’s future moves on monetary policy. The most senior leadership at the Fed continues to send a consistent message on policy, with no rate hikes expected before 2024 and no hints at when the tapering of quantitative easing (QE) could begin. Yet some Fed officials have started to be a bit more vocal about their comfort level with the current accommodative policy stance and the associated risks to financial stability and inflation. Last week, Dallas Fed President Robert Kaplan noted that he would like to see the Fed begin to withdraw its support for the economy “at the earliest opportunity”. St. Louis Fed President James Bullard was even more specific, noting that once the share of vaccinated Americans reaches “herd immunity” levels of 75-80%, it will be time for the Fed to debate tapering QE. At the moment, however, there is no need for the Fed to move preemptively. Our Fed Monitor - comprised of economic, inflation and financial market data that would signal pressure for the Fed to ease or tighten policy – is at a neutral level (Chart 5). Our 12-month Fed discounter, which measures the change in interest rates over the next year that is priced into the US overnight index swap (OIS) curve, is at 7bps, consistent with a stand-pat Fed. The latest read this month from the New York Fed’s Survey of Primary Dealers (and Survey of Market Participants) showed no change in the median longer-run expectation for the fed funds rate of 2.25% that has prevailed over the past year (middle panel) – despite a sharp recovery in US growth expectations. Chart 5UST Valuations A Bit Stretched The market pricing of the Fed’s next move is still relatively benign, with liftoff not expected until February 2023. This suggests that a pause in the trend of rising Treasury yields was essentially the market getting a bit ahead of itself in pricing in higher longer-term yields. This can be seen by looking at various valuation measures. For example, the 5-year/5-year forward Treasury yield now sits at 2.4%, which is at the high end of the range of longer-run fed funds rate expectations from the Primary Dealer survey. Also, various measures of the term premium on 10-year Treasury yields have returned to the above-zero levels last seen during the Fed’s 2016-2018 rate hiking cycle – even with the Fed not signaling any need to tighten policy in response to rising inflation expectations. Despite these signs of stretched near-term UST valuation, there is still no sign of major global bond investors being comfortable with increasing exposure to Treasuries. For example, despite yields on 10-year Treasuries (hedged into euros and yen) looking historically attractive compared to the near-zero yields on JGBs and sub-zero yields on German Bunds, the US Treasury’s capital flow data shows that foreign investors remain net sellers of Treasuries (Chart 6). It is possible that those foreign buyers need more evidence of a sustained decrease in US bond volatility before moving money into US Treasuries, where duration losses from higher US yields could wipe out the yield pickup from moving into US bonds. While valuations are a bit stretched for Treasuries, technicals appear very oversold. Both the deviation of the 10-year Treasury yield from its 200-day moving average, and the 6-month rate of change of the Bloomberg Barclays US Treasury total return index, are at levels seen only four previous times since 2010 (Chart 7). The JP Morgan client duration positioning surveys and the Market Vane Treasury sentiment index are also approaching post-2010 bearish extremes. It should be noted that both of those measures reached even more bearish extremes during the latter half of the Fed’s 2026-2018 tightening cycle, so there is potential for Treasury sentiment to become even more bearish once the Fed starts to tighten monetary policy – a scenario looking increasingly likely over the next 6-12 months. Chart 6No Foreign Bid For USTs (Yet) Chart 7USTs Are Technically Oversold We continue to expect a robust US economy and rising inflation to force the Fed to begin preparing the market in the latter half of 2021 for QE tapering in 2022, with the first rate hike of the next tightening cycle coming in late 2022. As that outcome appears largely consistent with current market pricing, amid oversold technicals, it is likely that Treasury yields will continue to move sideways over at least the next few weeks. Yet there is little to suggest that yields have peaked and are about to enter a new downtrend, given the accelerating pace of US vaccinations that is boosting optimism on an eventual end to the US leg of the pandemic. Stay defensive on US Treasury exposure, as the cyclical rise in yields is not over yet. Bottom Line: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remain bond bearish and the Fed is likely to begin preparing the market later this year for tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: Downgrade To Underweight In a Special Report published back in February along with our colleagues at BCA Foreign Exchange Strategy, we outlined the case for placing Canadian government debt on “downgrade watch” in global fixed income portfolios.1 We expected Canadian bond yields to continue rising along with the rise in global bond yields and, hence, we maintained our below-benchmark recommended duration exposure within Canada. Chart 8Canada: A High Beta Bond Market Once Again However, we concluded that it was too soon to shift to a full-blown underweight stance on Canadian government bonds with COVID-19 cases still raging through the country, the vaccination program off to a very slow start, and the Bank of Canada (BoC)’s QE program preventing Canadian bonds from returning to their usual “high-beta” status within developed economy bond markets. It now appears that we were too cautious on that front. Canadian government bonds have been one of the worst performing markets year-to-date within the Bloomberg Barclays Global Government bond index, delivering a local currency return of –4.1% - worse than the -3.5% return earned on US Treasuries so far in 2021.2 It is clear that the Canadian government bonds are once again a market more sensitive to global interest rate moves (Chart 8). In that February Special Report, we laid out three factors that could prompt the BoC to move to a less dovish, and more bond bearish, monetary policy stance faster than we expected. Much of that list has already started to come to fruition. 1) Good News On The Vaccine Rollout Sadly, Canada is suffering a third wave of COVID-19 cases that has resulted in the nation’s most populous province, Ontario, implementing the harshest lockdown yet seen during the pandemic. Yet the pace of vaccinations has also been rising with the share of Canadians receiving at least one jab is now 21% (Chart 9) - higher than that of the overall European Union (EU). Canada is now administering more daily vaccinations than both the UK and EU. The quickening pace of vaccinations is already providing a major lift to Canadian economic confidence. The Bloomberg Nanos consumer confidence index is at an all-time high (Chart 10), while the BoC’s Business Outlook Survey for the spring of 2021 was incredibly solid. Two-thirds of firms in that survey expect sales to exceed pre-pandemic levels, even with the latest upturn in COVID-19 cases. Chart 9Canadian Vaccine Rollout Improving Chart 10Booming Optimism The BoC’s Q1/2021 Consumer Survey showed similar levels of optimism. 74% of Canadians surveyed aged 25-54 are planning to engage in levels of social and economic activities equal to, or greater than, those seen prior to the pandemic once the majority is vaccinated (Chart 11). A net majority (18%) of those surveyed plan to spend more on the types of “high-touch” service spending unavailable during the pandemic, like travel, movies and dining in restaurants, once a majority is vaccinated (Chart 12). Chart 11Canadians Are Ready To Have Fun Once Again All of the Canadian survey data is sending a clear message: a faster vaccine rollout will leader to much faster spending by consumers and businesses. 2) Signs Of Financial Stability Risks Highly-indebted Canadians' love affair with real estate has always concerned the BoC. While a combination of cutting policy interest rates to zero and ramping up QE helped stabilize Canadian financial markets during the 2020 pandemic shock, it has also set off a new surge of housing speculation. According to the Bloomberg Nanos consumer survey, 67% of Canadians now expect house prices to appreciate. The demand for homes has given a lift to the Canadian economy through a surge in new housing starts (residential investment is 8% of Canadian real GDP), while pushing national house price inflation back above 10% (Chart 13). Chart 12A Surge In "High-Touch" Spending Awaits Canadian Herd Immunity As already indebted Canadian households pile on more debt to partake in another national home-buying party, the BoC must now concern itself with the potential financial stability risks from a too-rapid rise in housing values. Chart 13Yet Another Canadian Housing Boom In a recent speech, BoC Deputy Governor Toni Gravelle noted that the BoC had to introduce QE in 2020 to help fight COVID-related dysfunction across a variety of Canadian financial markets, including government bonds where liquidity dried up.3 Gravelle also noted that the BoC would begin to dial back QE once it was clear that financial markets no longer needed the support from QE. With Canadian equities booming and Canadian corporate bond spreads near the lowest levels of the past decade (Chart 14), it seems clear that the BoC can begin dialing back its government bond purchase program if it is no longer necessary and likely fueling another housing bubble. 3) Additional Large Fiscal Stimulus The governing Canadian Liberal government of Prime Minister Justin Trudeau delivered a massive amount of fiscal stimulus to the pandemic-stricken Canadian economy in 2020. In the 2021/22 federal budget announced yesterday, another huge burst of spending was introduced, equal to C$101bn or 4.2% of Canadian GDP over the next three years. The spending was described as another COVID relief package, but included many long-term programs like national child care, raising the minimum wage and boosting green investments. According to the projections from the latest IMF World Fiscal Monitor, the “fiscal thrust” for Canada – the change in the cyclically-adjusted primary budget balance as a share of GDP - was projected to turn from a stimulus of +9% in 2020 to a drag of -2% in 2021 (Chart 15). The spending announced in the latest budget will effectively eliminate that drag for the next three years. This will provide a major lift to an economy already likely to see booming post-pandemic growth. Chart 14BoC QE No Longer Necessary Chart 15No Fiscal Drag Now Expected In 2021 Chart 16Canadian Real Yields Are Too Low Given the combination of expanding vaccinations, surging confidence, a renewed housing boom and soaring financial markets, it will be difficult for the BoC to maintain its current policy settings for much longer. This is a central bank that engaged in QE reluctantly last year and numerous BoC officials have stated – even in the worst days of the global pandemic - that they would begin to remove accommodation once it was no longer needed. Interest rate markets have already moved to price in a full-blown BoC tightening cycle. The Canadian OIS curve now discounts “liftoff” (a full 25bp rate hike) in October 2022, with 163bps of rate hikes priced in to the end of 2024 (Chart 16). The projected path of rates is below the BoC’s inflation forecasts to 2023. Thus, the implied Canadian real policy rate is expected to remain negative over the next two years – even though the BoC estimates that the neutral policy rate range is 1.75% to 2.75%, or -0.25% to +0.75% in real terms after subtracting the midpoint of the BoC’s 1-3% inflation target band. In other words, Canadian interest rate markets are vulnerable to any BoC shift in a less dovish direction, as seems increasingly likely sometime in the next few months. Our BoC Monitor is rapidly moving out of the “easier policy required” zone (Chart 17), and the rapid improvement in the Canadian employment situation suggests the BoC will be under more pressure to begin signaling a path towards withdrawing policy accommodation. This will start with an announced tapering of QE purchases, perhaps even ahead of any signals from the Fed that it is doing the same (Chart 18). This justifies a more cautious stance on Canadian fixed income exposure. Chart 17Downgrade Canadian Government Bonds To Underweight Chart 18Could The BoC Start Tapering Before The Fed? While a BoC tapering announcement before the Fed would likely put upward pressure on the Canadian dollar versus the US dollar, that would be something the BoC could live with if the economy was rapidly gaining strength – especially as our currency strategists believe the “loonie” to be undervalued. Thus, we are formally downgrading our strategic recommended allocation to Canadian government bonds to underweight (2 out of 5, see table on page 16). We are also maintaining our recommended below-benchmark duration exposure within dedicated Canadian bond portfolios. We are also cutting the allocation to Canada to underweight in our model bond portfolio and placing the proceeds in both, the US and core Europe (see pages 14-15). Bottom Line: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk that the Bank of Canada shifts to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying. Downgrade Canadian government bonds to underweight in global fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at fes.bcaresearch.com and gfis.bcaresearch.com. 2 That Canadian return is virtually the same after hedging into US dollars, hence that local currency return can be compared to the US dollar denominated Treasury market return. 3https://www.bankofcanada.ca/2021/03/market-stress-relief-role-bank-canadas-balance-sheet Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights On a timeframe of a few years, a net deflationary shock is a near-certainty even if we do not know its precise nature or its precise timing. Hence, investors must build such a deflationary shock or shocks into their long-term investment strategy. Specifically: The 10-year T-bond yield will ultimately reach zero, and the 30-year T-bond yield will ultimately reach 0.5 percent. For patient investors, this presents a mouth-watering 100 percent return on the long-duration T-bond. The structural bull market in equities will continue until T-bond yields reach their ultimate low. Patient equity investors should steer towards ‘growth’ sectors that will surge on the ultimate low in T-bond yields. Fractal trade shortlist: Taiwan versus China, Netherlands versus China, and Sweden versus Finland. Feature Chart I-1For Long-Term Investors, A Shock Is A Near-Certainty Predicting shocks is easy. The precise nature and timing of shocks is not predictable, but the statistical distribution of shocks is highly predictable. This means that the longer our investment timeframe, the more certain we are of encountering at least one shock – even if we cannot predict its precise nature or timing. Many economists and strategists blame their forecasting errors on shocks, such as the pandemic, which they point out are ‘unforecastable.’ Absent the shocks, they argue, their predictions of the economy and the markets would have turned out right. This is a valid excuse for short-term forecasting errors, but it is not a valid excuse for long-term forecasting errors. On a long-term horizon, encountering a major shock, or several major shocks, is a near-certainty. Hence, economists and strategists who are not incorporating the well-defined statistical distribution of shocks into their long-term investment forecasts and strategies are making a mistake. Individual Shocks Are Not Predictable In the 21 years of this century so far, there have been five shocks whose economic/financial consequences have been felt worldwide: the dot com bust (2000); the global financial crisis (2007/8); the euro debt crisis (2011/12); the emerging markets recession (2014/15); and the global pandemic (2020). To these we can add two wide-reaching political shocks: the Brexit vote (2016); and Donald Trump’s shock victory in the US presidential election (2016). In total, this constitutes seven shocks, four economic/financial, two political, and one natural (Chart I-2). Chart I-2The Seven Global Shocks Of The Century (So Far) Some people argue that economic/financial shocks are predictable, because they arise from vulnerabilities in the economy or financial markets, which should be easy to spot. Unfortunately, though such vulnerabilities are obvious in hindsight, the greatest economic minds cannot see them in real time. The greatest economic minds cannot see economic vulnerabilities. Infamously, on the eve of the global financial crisis, Ben Bernanke was insisting that “there’s not much indication that subprime mortgage issues have spread into the broader mortgage market.” Equally infamously, on the eve of the euro debt crisis, Mario Draghi was asking “what makes you think that the ECB must become lender of last resort to governments to keep the eurozone together?” (Chart I-3 and Chart I-4) Chart I-3Bernanke Couldn't See The GFC Chart I-4Draghi Couldn't See The Euro Debt Crisis Which begs the question, what is the current vulnerability that today’s great economic minds cannot see? As we have documented many times, most recently in The Rational Bubble Is Turning Irrational, the current vulnerability is the exponential relationship between rising bond yields and the risk premiums on equities and other risk-assets (Chart I-5 and Chart I-6). Meaning that $500 trillion of risk-assets are vulnerable to any substantial further rise in bond yields. Chart I-5A 1.5 Percent Decline In The Bond Yield Had A Smaller Impact On The Earnings Yield When The Bond Yield Started At 4 Percent... Chart I-6...Than When The Bond Yield Started ##br##At 3 Percent The second type of shock – political shocks – should be predictable as they mostly arise from well-defined events such as elections and referenda, which an army of political experts analyses ad nauseam. Yet the greatest political minds could not see Brexit or President Trump coming. Indeed, even ‘Team Brexit’ didn’t see Brexit coming, because it had no plan on how to implement Brexit once the vote was won. The third type of shocks – natural shocks – are clearly unpredictable as individual events. Nobody knows when the next major pandemic, earthquake, volcano eruption, tsunami, solar flare, or asteroid strike is going happen. Yet, to repeat, while the precise nature and timing of shocks is not predictable, the statistical distribution of shocks is highly predictable. The Statistical Distribution Of Shocks Is Highly Predictable The good news is that shocks follow well-defined statistical ‘power laws’ which allow us to accurately forecast how many shocks to expect in any long timeframe. The 7 shocks experienced through the past 21 years equates to a shock every three years on average, or 3.33 shocks in any 10-year period. The expected wait to the next shock is three years. The next few paragraphs delve into some necessary mathematics, but don’t worry, you don’t need to understand the maths to appreciate the key takeaways. If the past 21 years is representative, we propose that the number of shocks in any 10-year period follows a so-called Poisson distribution with parameter 3.33. From this distribution, it follows that the probability of going through a 5-year period without a shock is just 19 percent, and the probability of going through a 10-year period without a shock is a negligible 4 percent (Chart of the Week). The result is that if you are a long-term investor, then encountering a shock is a near-certainty and should be built into your investment strategy. How can we test our assumption that the number of shocks follows a Poisson distribution? The maths tells us that if the number of shocks follows a Poisson distribution with parameter 3.33, then the ‘waiting time’ between shocks follows a so-called Exponential distribution also with parameter 3.33. On this basis, 63 percent of the waits between shocks should be up to three years, 23 percent should be four to six years, and 14 percent should be over six years. Now we can compare this expected distribution with the actual distribution of waits between the 7 shocks encountered so far in this century. We find that the theory lines up closely with the practice, validating our assumption of a Poisson distribution (Chart I-7 and Chart I-8). Chart I-7The Theoretical Waiting Time Between Shocks… Chart II-8…Is Close To The Actual Waiting Time Between Shocks To repeat the key takeaways, on a long-term timeframe, encountering at least one shock is a near-certainty, and the expected wait to the next shock is three years. A Shock Is A Near-Certainty, And It Will End Up Deflationary Nevertheless, there remains a pressing question: Will the next shock(s) be deflationary or reflationary? It turns out that all shocks end up with both deflationary and reflationary components: either a deflationary impulse followed by a reflationary backlash or, as we highlighted in The Road To Inflation Ends At Deflation, a reflationary impulse followed by a deflationary backlash. But the crucial point is that the deflationary component will swamp the reflationary component. In the seven shocks of this century so far, six have been deflationary impulses with a weaker reflationary backlash; and one – the reflation trade of 2017-18 – was a reflationary impulse with a stronger deflationary backlash. It is our high conviction view that in the next shock(s), the deflationary component will continue to hold the upper hand (Chart I-9). Chart I-9Each Shock Has A Deflationary And Reflationary Component... But The Deflationary Component Tends To Dominate The simple reason is that as financial asset prices, real estate prices, and debt servicing costs get addicted to ever lower bond yields, the economy and financial markets cannot tolerate bond yields reaching previous tightening highs and, just like all addicts, need a new extreme loosening to feel any stimulus. This means that when the next shock comes – as it surely will – it will require lower lows and lower highs in the bond yield cycle. Let’s sum up. On a timeframe of a few years, a shock is a near-certainty even if we do not know its precise nature – economic/financial, political, or natural – or its precise timing. Furthermore, the shock will be net deflationary. Hence, investors must build such a deflationary shock or shocks into their long-term investment strategy. Specifically: The 10-year T-bond yield will eventually reach zero, and the 30-year T-bond yield will ultimately reach 0.5 percent. For patient investors, this constitutes a mouth-watering 100 percent return on the long-duration T-bond. The 10-year T-bond yield will eventually reach zero. The structural bull market in equities will continue until T-bond yields reach their ultimate low. Patient equity investors should tilt towards ‘growth’ sectors that will surge on the ultimate low in T-bond yields. Candidates For Countertrend Reversals This week we have noticed an unusual decoupling among the tech-heavy markets of Taiwan, Netherlands, and China (Chart I-10). Chart I-10An Unusual Decoupling Between Tech-Heavy Netherlands And China Among these three markets, the strong short-term outperformance of both Taiwan and Netherlands are due to supply bottlenecks in the semiconductor sector that have boosted Taiwan Semiconductor Manufacturing and ASML, but we expect these bottlenecks ultimately to resolve.  On this basis and combined with extremely fragile 130-day fractal structures, Taiwan versus China and Netherlands versus China are vulnerable to reversals (Chart I-11 and Chart I-12). Chart I-11Underweight Taiwan Versus China Chart I-12Underweight Netherlands Versus China Our first recommended trade is to underweight Netherlands versus China, setting a profit target and symmetrical stop-loss at 5 percent. Another outperformance that looks fragile on its 130-day fractal structure is Sweden versus Finland, driven by industrials and financials versus energy and materials (Chart I-13). Chart I-13Underweight Sweden Versus Finland Our second recommended trade is to underweight Sweden versus Finland, setting a profit target and symmetrical stop-loss at 4.7 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Dear Client, Next week I will be hosting a series of Roundtable discussions with BCA’s clients in both Europe and Asia. Our next report published on April 28th will be a recap of my observations from these meetings. Best regards, Jing Sima China Strategist Highlights The sharp uptick in Chinese producer prices should be transitory, unlikely to trigger a policy response. There are two scenarios under which Chinese manufacturers’ profit margins will benefit: either Chinese exporters will raise export prices and pass input costs onto American customers, or the RMB will depreciate versus the US dollar and commodities prices will experience a setback. The second scenario is more likely in the next 3-6 months. After a pandemic-driven boost in 2020, US imports from China will likely moderate in the second half of 2021 and into 2022. President Biden’s grand infrastructure spending plan, even if approved later this year, will not be a game changer for China’s exports or economy. The strength in the USD may intensify in the near term, and Chinese policymakers will be happy to allow the RMB to depreciate mildly. Stay underweight Chinese stocks. Feature Last week’s China’s producer price index (PPI) was more elevated than the market expected. However, it does not warrant a policy response, given that the increase was mostly driven by supply constraints rather than an overheating domestic economy. Chinese manufacturers have had a tough time passing on mounting input prices to customers, which raises the question about how profit margins will be maintained. For exporters, the answer may be a combination of increasing export prices in USD terms and depreciating the RMB.  The rate of growth in US demand for Chinese export goods may moderate in the second half of 2021 and into 2022 after a pandemic-driven boost in 2020. China’s economic growth and interest rate differentials with the US will continue to narrow in the rest of this year. We expect the RMB to face headwinds against the USD, at least in the next quarter or two. Meanwhile, global investors should continue to underweight Chinese stocks. The PBoC Will Not React To Supply-Side Price Pressures Chart 1Marchs Strong PPI Does Not Reflect An Overheating Domestic Economy Despite above-expectation readings in China’s PPI, the domestic economy shows no signs of overheating. The upside pressure on producer prices reflects the impact of both the global rally in commodities and base effects (Chart 1). In March, strength in the PPI was also accentuated by seasonality due to a resumption in construction and real estate activity following the Chinese New Year holiday. While base effects and global supply bottlenecks will continue to buoy PPI prints throughout Q2, these effects are likely transitory and would not justify a policy response. At 0.4% year-over-year in March, core CPI remains significantly below the central bank’s 3% target and does not indicate any demand-side pressure. Instead, the inability for Chinese producers to pass on higher input prices to consumers highlights the relatively subdued state of domestic demand (Chart 1, bottom panel). Chart 2Current Macro Policy Works To Cap The Upsides In Both The Price And Quantity Of Money At this point there are little signs that rising producer prices are spilling over to consumer prices. We expect Chinese authorities to continue its current policy trajectory, which intends to keep a steady interbank rate while keeping money supply growth at or below the rate of nominal GDP expansion (Chart 2). China’s Deteriorating Terms Of Trade Chinese export prices climbed slightly in USD terms, but not by enough to offset the RMB’s relentless appreciation from the second half of last year, as indicated by falling export prices in RMB terms (Chart 3). A deteriorating terms of trade (ToT), defined as export prices relative to import costs, means that Chinese producers must export a greater number of units to purchase the same number of imports (Chart 4).  The declining ToT can be a powerful deflationary force for China’s manufacturing sector. Chart 3Chinese Export Prices Are Rising In USD Terms But Falling In Local Currency Terms Chart 4Terms Of Trade Have Been Falling Chart 5Chinese Output Prices Lead US Consumer Inflation By A Year While there are limited choices for China to improve its ToT, manufacturers could raise export prices in USD terms and “recycle” cost-push inflation back to the US. Chinese PPI normally leads US consumer inflation by 12 to 18 months (Chart 5). Hence, it is possible that the US will see import prices from China picking up more momentum by the middle of next year. The RMB’s performance is a key macro driver for manufacturing-related output prices. A depreciation in the RMB can be a meaningful reflationary force for manufacturers. There has been a clear negative correlation between the trade-weighted RMB and Chinese manufacturers' output prices and industrial profits, as shown in Chart 6. In this scenario, the USD will continue to appreciate against the RMB and possibly emerging market currencies, a headwind to global trade (Chart 7). Chart 6A Falling RMB Can Be Reflationary To Chinese Producers Chart 7A Stronger USD Will Be Headwinds For Global Trade Maintaining a strong RMB can partly mitigate the pain stemming from escalating commodity import prices.  However, in our view it is the least preferred option by policymakers. In previous cycles a rapidly strengthening RMB did not have a major impact on Chinese exporters' competitiveness, mainly because declines in commodities prices effectively offset a rising RMB (Chart 8 and Chart 9). Therefore, Chinese exporters did not need to boost prices in USD terms to maintain their profit margins. Chart 8RMB Appreciations Did Not Hurt Chinas Share In Global Trade Chart 9...Because Declines In Commodities Prices Were Able To Offset A Rising RMB Bottom Line: Chinese exporters can either raise prices and pass the inflation onto American customers, or the PBoC will allow further depreciation in the RMB to maintain Chinese producers’ competitiveness. Appreciating the RMB is the least preferred option. Don’t Count On A US Buying Spree  Market participants in China are pricing in large windfalls from the US$1.9 trillion American Rescue Plan and proposed US$2.4 trillion American Jobs Plan.1 A positive export tailwind in Q1 this year boosted China’s economic activity beyond what measures of domestic money and credit would have predicted, as shown in Chart 10. However, given the strongly positive relationship between the export sector and real investment in China, it is concerning that any deceleration in US demand for Chinese export goods would seriously challenge the sanguine view for China’s economy this year (Chart 11). Chart 10Export Strength Appears To Be Propping Up The LKI Chart 11China's Export Sector Is Highly Investment-Intensive Moreover, US demand for Chinese export goods is subject to several countervailing forces, at least in the second half of 2021: The USD currently benefits from widening real interest differentials and stronger US growth relative to the rest of the world. For the next quarter or two, persistent strength in the USD and US Treasury yields will be headwinds to global trade and may cause a temporary setback for the global manufacturing sector (Chart 7 on Page 4). Residential and business investment in the US may not regain much vigor despite large stimulus checks. Our colleagues at BCA US Investment Strategy expect US residential investment to match the long-run trend growth, but the increase will be largely offset by below-trend growth in non-residential investment. More working-from-home options will continue to drive demand for single-family homes in the suburbs and beyond. On the other hand, demand will suffer for office space in central business districts and dwellings in urban centers. Brick-and-mortar retail construction is also going to crater. Consumption for goods in the US may also see below-trend growth in the second half of 2021 and into 2022, whereas the service sector will benefit most from the coming recovery in US business and social activities. Table 1 shows that goods spending rose in 2020 despite an overall decline in consumption, because households dramatically shifted their consumption into goods from services. As such, 2020’s pandemic-driven dividend for Chinese exporters is likely to become a drag on tradeable goods exports to the US in 2021 and/or 2022. Table 1US Consumer Spending Gap Is Almost Entirely On The Services Side It is also important for investors to put the US$2.4 trillion infrastructure spending budget proposed in the American Jobs Plan into prospective. The US lags far behind China in infrastructure spending. In the past 10 years, US public infrastructure investment (federal and state combined) has declined to an average of about $450 billion.2 This compares with China’s US $1.9 trillion yearly spending on infrastructure (Chart 12). China currently consumes seven to eight times more industrial metals than the US (Chart 13). As such, even if the US infrastructure investment plan will be approved later this year, it is unlikely to be a game changer for global commodity prices or Chinese exports. Chart 12Infrastructure Spending, China Vs. The US Chart 13US Consumption Of Industrial Metals Is Too Small Relative To China The proposed US$1.2 trillion spending on the US nation’s roads, bridges, green spaces, water, electricity, and universal broadband will be spread over the next eight years.  The additional $150 billion per annum to the US public infrastructure investment will only boost the US spending from 24% to about 32% of China’s annual infrastructure investment. Furthermore, the fiscal multiplier effect from the extra public spending on investment from the US private sector and overall economy may not be as positive as the market has priced in, depending on the size of corporate tax hikes in the final bill. Bottom Line: After a pandemic-driven boost in 2020, growth in US imports from China will likely moderate in the second half of 2021 and into 2022. The proposed infrastructure spending plan in the US will benefit Chinese exports, but the magnitude of the windfall may be disappointing. Investment Implications As discussed in a previous report, rising US bond yields will have a muted effect on their Chinese counterparts. Tightened regulations on the real estate industry and a new round of environmental protection laws in China will continue to suppress the domestic credit demand.  As a result, interest rate differentials between China and the US will continue to narrow. The strength in the USD has not run its course and the RMB will face slight depreciation pressures in Q2 and possibly into Q3. A declining RMB will provide reflationary benefits to China’s industrial profits, but with about a six-month time lag. In the meantime, we recommend global investors to continue underweighting Chinese stocks (Chart 14A and 14B). Chart 14AContinue Underweighting Chinese Stocks Chart 14BContinue Underweighting Chinese Stocks   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1According to the OECD, recent US stimulus will boost US GDP growth by almost 3 percentage points in the first full year (from 2021Q2 to 2022Q2). The knock-on effect from the stimulus on other economies is projected to be significant, including a half percentage point addition to China’s GDP during the same period. 2The Congressional Budget Office estimated that combined federal, state and local spending on infrastructure was (in 2019 dollars) $441 billion as of 2017. Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. Employment: The US employment boom is just getting started. Total employment is still 8.4 million below pre-pandemic levels, but 37% of missing jobs are from the Leisure & Hospitality sector where demand is about to surge. Fed: The US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year. Feature Chart 1Price Pressures Building The past two weeks brought us a couple of interesting developments directly related to the Treasury market. First, long-dated Treasury yields declined somewhat, presumably because many investors concluded that the yield curve is already priced for the full extent of future Fed rate hikes. Second, we received further evidence – from March’s +916k employment report, the 12% year-over-year increase in producer prices and continued elevated readings from PMI Prices Paid indexes – that economic activity is recovering more quickly than even the most optimistic forecasters anticipated (Chart 1). These two opposing forces highlight a tension in the current outlook for US Treasury yields. Yields now look fairly valued on several different valuation metrics, a fact that justifies keeping bond portfolio duration close to benchmark. However, cyclical economic indicators are surging, a fact that suggests yields will keep rising in the near-term, causing them to overshoot fair value for a time. This week’s report looks at this tension between valuation indicators and cyclical economic indicators through the lens of our Checklist To Increase Portfolio Duration. While we think there are convincing arguments in favor of both “At Benchmark” and “Below Benchmark” portfolio duration stances on a 6-12 month investment horizon, we are deciding to stick with our recommended “Below Benchmark” stance for now, until the economic data are more in line with market expectations. Checking In With Our Checklist Back in February, following the big jump in bond yields, we unveiled a Checklist of several criteria that would cause us to increase our recommended portfolio duration stance from “Below Benchmark” to “At Benchmark”.1 As is shown in Table 1, the Checklist contains seven items that can be grouped into two categories: Valuation Indicators that compare the level of Treasury yields to some estimate of fair value Cyclical Indicators that look at whether trends in the economic data are consistent with rising or falling bond yields Table 1Checklist For Increasing Duration Valuation Indicators Chart 2Valuation Indicators As mentioned above, valuation indicators show that Treasury yields are roughly consistent with fair value, suggesting that a neutral duration stance is appropriate. First, consider the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate (Chart 2). Last week, survey estimates from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers were updated to March, and while there was some upward movement in the estimated long-run neutral rate ranges, the median estimates in both surveys were unchanged from January. The result is that the 5-year/5-year forward Treasury yield remains near the top-end of its survey-derived fair value band (Chart 2, top 2 panels). Second, the same two surveys also ask respondents to forecast what the average fed funds rate will be over the next 10 years. We can derive an estimate of the 10-year term premium by subtracting those forecasts from the 10-year spot Treasury yield (Chart 2, bottom 2 panels). In this case, respondents did raise their average fed funds rate forecasts and our term premium estimates were revised down as a result. While both term premium estimates are now below their 2018 peaks, they remain elevated compared to recent historical averages. Third, we turn to the front-end of the yield curve to look at what sort of Fed rate hike path is priced into the market (Chart 3). We see that the market is currently priced for Fed liftoff in December 2022 and for a total of four 25 basis point rate hikes by the end of 2023. Only a handful of FOMC participants forecasted a similar path at the March Fed meeting. Chart 3Market Priced For December 2022 Liftoff We discussed the wide divergence between market expectations and the Fed’s “dot plot” in a recent report.2 Essentially, the divergence boils down to the Fed focusing more on actual economic outcomes while the market takes its cues from economic forecasts. We think there’s good reason for optimism about the economy, and therefore expect that the Fed will revise its interest rate forecasts higher in the coming months as the “hard” economic data improve. However, we should point out that respondents to the New York Fed’s Survey of Primary Dealers and Survey of Market Participants also have much more benign interest rate forecasts than the market, and respondents to those surveys do not share the Fed’s bias toward actual economic outcomes. Table 2 shows that the average respondent to the Survey of Market Participants only sees a 35% chance that the Fed will lift rates before the end of 2022 and the Survey of Primary Dealers displays a similar result. Table 2Odds Of A Fed Rate Hike By End Of Year The wide gap between rate hike expectations embedded in the yield curve and forecasts from both the FOMC and the New York Fed’s surveys suggests that Treasury yields are at least fairly valued, and perhaps too high. However, the most important question is whether the market’s rate hike expectations look lofty compared to our own forecast. As is explained in the below section (titled “The Employment Boom Is Just Getting Started”), we think that the jobs market will be strong enough for the Fed to lift rates before the end of 2022 and that the market’s anticipated rate hike path looks reasonable. However, even this view is only consistent with a neutral stance toward portfolio duration. Chart 4Higher Inflation Is Priced In For our final valuation indicator we focus specifically on the outlook for inflation compared to what is already priced into the forward CPI swap curve (Chart 4). The forward CPI swap curve is priced for headline CPI inflation to rise to 2.7% by May 2022 before falling back down only slightly. In reality, year-over-year headline CPI will probably spike to even higher levels during the next two months but will then recede more quickly. We think it’s reasonable to expect headline CPI inflation to be between 2.4% and 2.5% in 2022, a range consistent with the Fed’s 2% PCE target, but the forward CPI swap curve reveals that this outcome is already priced. All in all, the message from the valuation indicators in our Checklist is that a robust economic recovery is already reflected in market prices. Thus, even with our optimistic economic outlook, Treasury yields look fairly valued, consistent with an “At Benchmark” portfolio duration stance.  Cyclical Indicators While valuation indicators perform well over longer time horizons, they are notoriously bad at pinpointing market turning points. It’s for this reason that we augment our Checklist with cyclical economic indicators, specifically high-frequency cyclical economic indicators that correlate tightly with bond yields. First, we look at the ratio between the CRB Raw Industrials commodity price index and gold (Chart 5). The CRB index is a good proxy for global economic growth and gold is inversely correlated with the stance of Federal Reserve policy – gold falls when policy is perceived to be getting more restrictive and rises when policy is perceived to be easing. This ratio has shown little evidence of rolling over and further gains are likely as the economy emerges from the pandemic. We also look at other high-frequency global growth indicators like the relative performance between cyclical and defensive equities and the performance of Emerging Market currencies (Chart 5, panels 2 & 3). The trend of cyclical equity sector outperformance continues while EM currencies have shown some tentative signs of weakness. The US dollar is one particularly important indicator for bond yields. As US yields rise relative to yields in the rest of the world it makes the US bond market a more attractive destination for foreign investors. When US yields are attractive enough, these foreign inflows can stop them from rising. One good indication that US yields are sufficiently high to attract a large amount of foreign interest is when investor sentiment toward the dollar turns bullish. For now, the survey of dollar sentiment we track shows that investors are still bearish on the US dollar (Chart 5, bottom panel). Bearish dollar sentiment supports further increases in bond yields. Chart 5Cyclical Indicators Chart 6Data Surprises Still Positive Finally, we track the US Economic Surprise Index as an excellent summary indicator of the US data flow relative to market expectations. The index also correlates tightly with changes in bond yields (Chart 6). Though the index has fallen significantly from the absurd highs seen late last year, it is still elevated compared to typical historical levels. In general, bond yields tend to rise when the economic data are beating expectations, as indicated by a positive Surprise Index. All in all, we see that the cyclical indicators in our Checklist are sending a very different signal than the valuation indicators. This suggests a high probability that yields could overshoot fair value in the near term. Bottom Line: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. The Employment Boom Is Just Getting Started Chart 7Defining "Maximum Employment" The Fed has conditioned the first rate hike of the cycle on both (i) 12-month PCE inflation being at or above 2% and (ii) the labor market being at “maximum employment”. As we’ve previously written, we see strong odds that the inflation trigger will be met in time for a 2022 rate hike.3 This week, we assess the likelihood that “maximum employment” will be reached in time for the Fed to lift rates next year. Fed communications have made it clear that the FOMC’s definition of “maximum employment” is equivalent to an environment where the unemployment rate is between 3.5% and 4.5% - the range of FOMC participants’ NAIRU estimates – and the labor force participation rate has made a more-or-less complete recovery to pre-pandemic levels (Chart 7). Following March’s blockbuster employment report, we update our calculations of the average monthly nonfarm payroll growth that must occur to hit “maximum employment” by different future dates (Tables 3A-3C). Table 3AAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date Table 3BAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date Table 3CAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date For example, to reach the Fed’s definition of “maximum employment” by December 2022, nonfarm payroll growth must average between +410k and +487k per month between now and then. To reach “maximum employment” by the end of this year, payroll growth must average between +701k and +833k over the remaining nine months of 2021. It’s probably unrealistic to expect a return to “maximum employment” by the end of this year, but we do expect at least a couple more monthly payroll reports that are even stronger than last month’s +916k. Our optimism stems from the industry breakdown of the current jobs shortfall. Table 4 shows the change in overall nonfarm payrolls between February 2020 and March 2021. In total, we see that the US economy is missing 8.4 million jobs compared to pre-pandemic. We also see that 3.1 million (or 37%) of those jobs come from the Leisure & Hospitality sector. That sector is predominantly made up of restaurants and bars, two services where demand is about to ramp up significantly as COVID vaccination spreads across the US. A few months in a row of 1 million or more jobs added is highly likely in the near future. Table 4Employment By Industry Bottom Line: We see the boom in employment as just getting started and we expect that the US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Swiss economy will benefit from the pickup in global growth. The recent weakness in the franc has been a welcome development for the Swiss National Bank, but technicals suggest a coiled spring rally in CHF is likely. However, as a low-beta currency, the Swiss franc will lag the upturn in other pro-cyclical currencies over the longer term. We remain long EUR/CHF as a tactical trade but maintain tight stops at 1.095. Long CHF/NZD and CHF/GBP positions look attractive at current levels. Similar to our short EUR/JPY position, this is an excellent portfolio hedge. Feature Chart I-1The Swiss Economy Is On The Mend The Swiss economy has recovered smartly. As of March, the manufacturing PMI was at 66.3, the highest since 2006. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades (Chart I-1). This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. The Swiss franc has been one of the worst performing currencies this year, but that might be about to change. For one, dollar sentiment has been reset with the rise in the DXY index this year. Second, the global economy is transitioning from disinflationary to a gentle tilt towards inflation. This will lift global prices, including import prices into Switzerland. Rising import prices will ease the need for the SNB to maintain emergency monetary settings. Finally, the weakness in the currency has eased financial conditions for Swiss concerns. The Reopening Trade Most economies are entering into a third wave of the Covid-19 pandemic and the Swiss economy is no exception. However, the Swiss authorities have been able to bring the number of new infections down to levels below the euro area in general and Sweden in particular. Vaccinations are progressing smoothly with almost 20% of the population inoculated as of today. This provides a coiled springboard to lift the Swiss economy into robust growth later this year. Switzerland is one of the most open economies in the G10. Exports of goods and services account for over 65% of Swiss GDP, much higher than the euro area (Chart I-2). The constituent of Swiss exports tends to be defensive (medical goods, gold, watches, jewelry) so the franc does not necessarily outperform in a global growth upswing, but definitely does better than the dollar which anchors a more closed economy. Inflation dynamics in Switzerland will be particularly beholden to improvement in the private sector. As we show in Chart I-1, employment should remain robust in the months ahead, which will support wages. Import prices in Switzerland are also about to catapult upwards, which will help lift the consumer price basket (Chart I-3). For a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation, and the weakness in the franc has been a beneficial cushion for good prices. The rise in global tradeable prices is also acting as a catalyst. For the first time in many years, the pendulum might be swinging towards a worry about inflation in SNB corridors. Chart I-2Switzerland Has A Huge Exposure To Trade Chart I-3Swiss Inflation Will Rise Particularly, a rise in Swiss inflation will lessen the need for the SNB to keep rates at the -0.75 level in place for over half a decade. It will also lessen to need for the SNB to fight against franc strength.  Global Developments In A CHF Context There are some additional tailwinds to a strong CHF in today’s context. Volatility has collapsed, with the VIX index well below 20. If one could predict with absolute certainty what will happen with global growth, equity prices, bond yields, or even Covid-19, then low volatility makes sense. However, in the current context of elevated valuations, high uncertainty and a precarious health landscape, it almost makes perfect sense that volatility should rise. The franc tends to do well in an environment where volatility is rising (Chart I-4). Chart I-4The Swiss Franc Tracks The VIX Chart I-5Long-Term Support On CHF/NZD Has Held In fact, from a broad picture perspective, a rotation from US growth outperformance to other parts of the globe that are also stimulating their domestic economies could be met with higher dollar volatility. This has historically been beneficial for the Swiss franc (Chart I-6). Ergo, being long the franc could constitute a “heads, I win; tails I do not lose too much” proposition. Rising global growth and a lower dollar will help the franc, but so will a rise in volatility. Chart I-6CHF/NZD Tracks Dollar Volatility Our Geopolitical Strategy team has also been recommending long Swiss franc positions since February as they believe the Biden administration faces several imminent and serious foreign policy tests, namely over Russia’s military buildup on the Ukraine border, China’s military pressure tactics against Taiwan, and Middle East tensions ahead of any revived US-Iran nuclear deal. They see a 60% chance of some kind of crisis – if not war – over the Taiwan Strait and any of these other issues could also motivate safe haven demand for the rest of this year.  With regard to CHF/GBP, an upside surprise for the Scottish National Party in the May 6 parliamentary election could also hurt the pound since it would herald a second Scots independence referendum in the not-too-distant future. Trading Dynamics As A Safe Haven Chart I-7CHF And The Copper/Gold Ratio Switzerland ticks off all the characteristics of a safe-haven currency. Its large net international investment position of over 100% of GDP generates huge income inflows. Meanwhile, rising productivity over the years has led to a structural surplus in its trading balance and a rising fair value for the currency. Consequently, the franc has tended to have an upward bias over the years, supercharged during periods of risk aversion. This makes the franc a useful constituent of any currency portfolio. More specifically, the franc has tracked the gold-to-copper ratio in recent years. Copper is a good barometer for global economic health while gold is a good proxy for the demand for safety. If the overarching theme is that complacency reigns across markets, a nudge towards safety will benefit flows into the franc (Chart I-7). The current interest-rate regime could also affect the franc-dollar relationship. Global yields have risen. To the extent that we are due for some reprieve, the franc will benefit, given its “low beta” status. Meanwhile, net portfolio flows into Switzerland suffered from the Trump tax cuts that pushed US affiliates in Switzerland to repatriate investments. President Biden’s tax reform will halt and/or reverse this process. SNB Action And Market Implications The past weakness in the franc has been a welcome development for the SNB. In fact, since the start of this year, Swiss central bankers have not had to ramp up asset purchases. Both the dollar and the euro have been relatively strong (Chart I-8). In other words, global dynamics have eased monetary conditions for the Swiss authorities. The latest Article IV report from the IMF also justifies the SNB’s monetary stance. Currency intervention was cited as a viable tool should the SNB do a policy review, especially given the potential inefficacies from QE due to the small bond market in Switzerland. Herein lies the key takeaway for the franc – while it could appreciate in an environment where the dollar resumes its downtrend, it will likely lag other pro cyclical currencies over the longer term. This is because the SNB will be loath to see the franc unanchor inflation expectations. We are long EUR/CHF on this basis, but are keeping tight stops at 1.095. Three key factors suggest this trade could still work well in the coming 12-18 months. Rising interest rates benefit EUR/CHF (Chart I-9). With interest rates in Switzerland well below other countries, the Swiss franc rapidly becomes a funding currency for carry trades. Carry trades, especially towards peripheral bonds in Europe hurt the franc. Chart I-8A Weaker Franc Is Doing The Heavy Lifting For The SNB Chart I-9EUR/CHF Tracks German ##br## Yields The Swiss trade balance has suffered in the face of a global slowdown. It will also lag the European rebound (Chart I-10). In a downturn, commoditized goods prices are the first to drop and recover, while more specialized goods prices eventually gain ground later. Swiss goods are not easily substitutable which is a benefit, but prices are also slower to adjust. Our models suggest the franc is still about 5% overvalued versus the euro. Over the history of the model, this has been a modest premium, but allows the euro to outperform the Swiss franc (Chart I-11). Chart I-10Structural Appreciation In The Swiss Franc Chart I-11EUR/CHF Is Still Cheap Economically, the SNB has to walk a fine line between a predominantly deflationary backdrop in Switzerland and a rising debt-to-GDP ratio that pins it among the highest in the G10 (Chart I-12). Too little stimulus and the economy runs the risk of entering a debt-deflation spiral, as inflation expectations are revised downwards. Too much stimulus and the result will be a build-up of imbalances, leading to an eventual bust. Chart I-12Lots Of Private Debt In Switzerland Today, the SNB is in a sweet spot. Almost every other G10 country is providing the fiscal and monetary stimulus necessary to lift Switzerland from its deflationary paradigm. Investment Conclusions Chart I-13Structural Appreciation In The Franc Still Possible Our long-term fair value models suggest the Swiss franc is currently cheap versus the dollar (Chart I-13). This makes it attractive from a strategic perspective. Usually, the Swiss franc tends to be more of a dormant currency, gently appreciating towards fair value but periodically interspersed with bouts of intense volatility. Interestingly, we may be entering such a riot point. The VIX is low and countries are reintroducing lockdowns, yet overall sentiment remains unequivocally bullish. Finally, Switzerland ticks off all the characteristics of a safe-haven currency. As such, while the dollar has benefited from its reserve status, the franc remains an appropriate hedge in any currency portfolio. In a nutshell, our recommendations are as follows: USD/CHF will stay under parity. EUR/CHF can hit 1.2. NZD/CHF is a sell in the short-term. So is GBP/CHF. The Scandinavian currencies will outperform the franc on a 12-18 month horizon.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 US economic data has been spectacular this week: Starting with the jobs report, the US added 916K jobs in March versus a consensus of 660K jobs. The unemployment rate fell from 6.2% to 6% and wages increased by 4.2% year-on-year. The boost to domestic demand dented the trade balance. The deficit widened from $68.2bn to $71.1bn in February. The FOMC minutes were a non event for markets. The DXY index is giving back some of the gains it accumulated this year, rising over 1% this week. With the US 10-year yield now facing strong resistance near the 1.7% level, the case for a stronger USD is fading. As consensus forecasts coagulate towards a stronger USD, positioning has also been reset towards USD long positions auguring for some volatility in the months ahead. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area are mending: The Sentix investor index catapulted from 5 to 13.1 in April. The Eurozone remains the unsung hero in this recovery. PPI increased to 1.5% year-on-year in February from 0% last month. The euro rose by 1.2% against the dollar this week. To be clear, there are still stale euro longs among more fundamental holders of the currency. This suggests the flushing out of weak hands has more to go. However, the balance of evidence suggests euro area data could reward long positions later this year.  Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been improving: PMI indices remain under 50, but reflect a possible coiled-spring rebound underway. Consumer confidence rebounded from 33.8 to 36.1 in March. The Eco Watchers survey was also encouraging. Sentiment rebounded from 41.3 to 49 in March. The Japanese yen rose by 1.24% against the US dollar this week, and remains the strongest G10 currency in recent trading days. Falling yields have seen Japanese investors retreat from overseas markets such as the UK, pushing up the yen. Speculative positioning is also net yen bearish, which is constructive from a contrarian standpoint. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been positive: Car registrations are picking up smartly, suggesting durable demand might be returning to the UK. Registrations rose 11.5% year-on-year in March versus -35.5% the year before. The UK construction PMI hit a high of 61.7, the highest since 2014. The pound fell by almost 2% versus the euro this week. The violent correction in EURGBP might be a harbinger of the rotation brewing for both UK and US assets versus their global counterparts. Stay tuned. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: The RBA kept rates unchanged at 0.1%. Both the services and manufacturing PMIs remained at an expansionary 55.5 level. The Aussie rose by 0.4% this week. We like the AUD, and are long AUD/NZD as a trade. However, the outperformance of the US economy is also handsomely rewarding AUD/MXN shorts. Mexico benefits a lot more from a pick-up in the US economy than Australia. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data out of New Zealand have been positive: The ANZ commodity price index ticked up by 6.1% in March. ANZ Business confidence deteriorated in March. The activity outlook fell from 16.6 to 16.4 and confidence fell from -4.1 to -8.4. The New Zealand dollar rose by 60bps against the US dollar this week. New Zealand will start taking the back seat in the coming economic rotation as other economies play catch up. The improvement in kiwi terms of trade has been a boon for the currency, and will limit downside on NZD. However, shorting the NZD at the crosses remains an attractive proposition. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 There was scant data out of Canada this week: The Bloomberg Nanos confidence index continues to suggest that Canadian GDP will surprise to the upside. The index rose from 63.7 to 64.1 last week. Demand for Canadian goods remains robust. The trade surplus came in at C$1.04bn in February. The Ivey purchasing managers’ index catapulted to 72.9 from 60 in March. The Canadian dollar was flat against the US dollar this week. While this might come as a surprise, three reasons explain this performance. First, the loonie is one of the best-performing G10 currencies this year and some specter of rotation was in play this week. Second, the correction in oil prices hurt the loonie. Finally, should US economic optimism become more widespread, other currencies could benefit. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: Sight deposits were relatively flat at CHF700bn last week. The Swiss Franc rose by 2% against the US dollar this week. This week’s piece is dedicated to the possibility that the franc has a coiled-spring rebound in the near term. Safe-haven currencies are now benefitting from the drop in yields, while the franc has underperformed other currencies this year. This is welcome news for the SNB.  We have been long EUR/CHF on this expectation, and recommend investors stick with this trade. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The March DNB manufacturing PMI came in at 56.1 from 57.5. Industrial production rose by 5.9% year-on-year versus expectations of a 1.5% increase. The NOK rose by 0.75% against the dollar this week. Norway has handled the Covid-19 crisis admirably and it is an added boon that oil prices, a key export and income valve for Norway, are rising smartly. This has prompted the Norges bank to rapidly bring forward rate hike expectations. This leaves little scope for the NOK to fall durably. We are long the Norwegian krone as a high-conviction bet against both the dollar and the euro. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data releases were above expectations: The Swedbank manufacturing PMI came in at 63.7 in March versus expectations of 62.5. Industrial orders came in at 8.5% year-on-year versus expectations of 5.3% in February. The Swedish krona rose by 2% this week ranking it as the best performing G10 currency. Sweden needs to do a better job at containing the Covid-19 crisis, which will unlock tremendous value in the krona. As a positive, the global manufacturing cycle continues humming and will buffeting Swedish industrial production. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Q1/2021 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark index by +55bps during the first quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +68bps, led overwhelmingly by our underweight to US Treasuries (+63bps). Spread product allocations underperformed by -11bps, primarily due to an overweight on UK corporates (-8bps). Portfolio Positioning For The Next Six Months: We are sticking with an overall below-benchmark portfolio duration stance, given accelerating global growth momentum, expanding vaccinations and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield given more stretched valuations in other credit sectors. On the margin, we are making the following changes to the portfolio allocations: downgrading both UK Gilts and UK investment grade corporates to neutral, while cutting the overall allocation to EM USD credit to neutral. Feature The first quarter of 2021 saw a sharp sell-off in global bond markets on the back of rising growth expectations, fueled by US fiscal stimulus and vaccine optimism. The US was near the front of the pack, with 10-year Treasuries having their biggest first quarter sell-off since 1994. Accommodative financial conditions, fueled by a highly stimulative mix of monetary and fiscal policies and improving sentiment, have lit a fire under a global economy set to reopen from pandemic lockdowns. Going forward, we expect US growth to continue leading the way, with implications for the dollar, commodity prices, and the expected path of policy rates. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the first quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months 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. Q1/2021 Model Portfolio Performance Breakdown: Steering Clear Of Duration Chart 1Q1/2021 Performance: Bearish UST Bets Pay Off The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -1.83%, dramatically outperforming the custom benchmark index by +55bps (Chart 1).1 This follows modest outperformance in 2020 which was driven largely by overweights on spread product initiated after the pandemic shock to markets. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +68bps of outperformance versus our custom benchmark index while the latter underperformed by -11bps. Our allocations to inflation-linked bonds in the US, Canada and Europe - which were a source of outperformance in 2020 - modestly underperformed this quarter (-2bps) as global real yields finally began to pick up. Our outperformance this quarter was driven overwhelmingly by our decision to go significantly underweight US Treasuries, and to position for a bearish steepening of the Treasury curve, ahead of last November’s US presidential election (Table 2). That resulted in the US Treasury allocation generating a massive +63bps of excess return in Q1/2022 as longer-term US yields surged higher. Table 2GFIS Model Bond Portfolio Q1/2021 Overall Return Attribution The size of the US underweight was unusually large as we maintained only a neutral exposure to the other “high beta” markets that are typically positively correlated to US yield moves, Canada and Australia. Although the returns for those two government bond markets were very similar to that of US Treasuries in Q1, so the choice to stay neutral even with a bearish directional view on US yields did not impact the overall portfolio performance. Overweights to the more defensive “low beta” markets of Germany, France and Japan contributed a combined +4bps. We did see some losses on nominal government bonds in peripheral Europe (Italy: -0.6bps; Spain: -1.9bps), however, with the narrowing in spreads thrown off by a botched vaccine rollout. In spread product, underperformance came from overweights to UK investment grade corporates (-8bps), US CMBS (-4bps), and EM USD-denominated corporates (-2bps). This was despite the fact that spreads for UK corporates remained flat while US CMBS spreads actually narrowed. These losses were slightly offset by the overweight to lower-rated US high-yield (+3bps) and underweight to US agency MBS (+2bps). Our spread product losses, in total return terms, highlight the importance of considering duration risk when making a call on spread product, especially at a time when sovereign yields are rising and spreads offer little “cushion”. Duration also played a big part in nominal government bond outperformance, with a whopping +43bps of our total +55bps outperformance concentrated in just US Treasuries with a maturity greater than 10 years. In other words, overweighting overall global spread product and underweighting government bonds still generated major portfolio outperformance, even if there was a more mixed bag of returns within that credit overweight. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2021 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2021 Spread Product Performance Attribution By Sector Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+43bps), maturity between 7 and 10 years (+11bps), and with a maturity between 5 and 7 years (+7bps) Overweight US high-yield (+3bps) Underweight US agency MBS (+2bps) Overweight Italian inflation-indexed BTPs (+2bps) Biggest Underperformers: Overweight UK investment grade corporates (-8bps) Overweight US agency CMBS (-4bps) Overweight Spanish government bonds (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2021. 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 Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2021 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. On that front, our portfolio allocations performed exceptionally well in Q1. In total return terms, the global bond market sell-off was a disaster for both government bonds and spread product. US high-yield, one of our longer-standing overweights, was the only sector to emerge unscathed, delivering a positive return of +42bps. Within our government bond allocation, the “defensive” markets—Japan (-44bps), Germany, (-261bps) and France (-371bps)—were nevertheless shaken by rising yields. On the other hand, we limited our downside by maintaining a neutral stance on the higher beta markets such as Canada (-406bps), New Zealand (-415bps), and the UK (-1389bps). Gilts sold off especially sharply as the UK outperformed global peers on COVID-19 vaccinations while inflation expectations continued to pick up. Our two underweights, US Treasuries (-426bps) and European high-yield (-426bps), were prescient. The latter market was one we chose to underweight given that spreads didn’t offer nearly enough compensation on a default-adjusted and breakeven basis. Bottom Line: Our model bond portfolio outperformed its benchmark index in the first quarter of the year by +55bps – a positive result driven by our underweight allocation to the US Treasury market and overall below-benchmark global duration stance. Future Drivers Of Portfolio Returns & Scenario Analysis Chart 5More Growth-Driven Upside For Global Yields Ahead Looking ahead, the performance of the model bond portfolio will continue to be driven predominantly by the future moves of global government bond yields, most notably US Treasuries. Our most favored leading indicators for global bond yields continue to signal more upside over at least the next six months (Chart 5). Our Global Duration Indicator, comprised of measures of future economic sentiment and momentum, remains at an elevated level. The ongoing climb in the global manufacturing PMI, which typically leads global real bond yields by around six months, suggests that the recent uptick in real yields can continue into the second half of 2021. We are still maintaining a bias towards bearish yield curve steepening across all the countries in the model bond portfolio. It is still far too soon to see bearish flattening of yield curves given the dovish bias of global central banks, many of which are actively targeting an overshoot of their own inflation targets. The US will be the first central bank to see any bearish flattening pressure, as the market more aggressively pulls forward the liftoff date of the next Fed tightening cycle in response to strong US growth, but that is an outcome we do not expect until well into the second half of 2021. With regards to country allocations within the government bond segment of the model bond portfolio, we continue to focus our maximum underweight on the US, while limiting exposure to the markets that are more sensitive to changes in US interest rates (Chart 6). Those “lower yield beta” markets (Germany, France and Japan) will continue to outperform the higher beta markets (Canada, Australia) over the latter half of 2021. We currently have Canada on “downgrade watch”, as economic momentum is accelerating and the housing bubble looks to be reflating, both of which will make the Bank of Canada turn more hawkish shortly after the Fed does. We are more comfortable keeping Australia at neutral, as Australian inflation is likely to remain too underwhelming for the Reserve Bank of Australia to turn less dovish and risk a surge in the Australian dollar. UK Gilts are a more difficult case, atypically acting like a lower beta market over the past few years. As we discussed in a Special Report published last month, we attribute the declining Gilt yield beta to the rolling shocks the UK has suffered over the past thirteen years – the 2008 global financial crisis, the 2012 euro area debt crisis, Brexit and, now, COVID-19 – that have hamstrung the Bank of England’s ability to try even modest interest rate hikes.2 With the impact of those shocks on UK growth now diminishing, we see the central bank under greater pressure to begin normalizing UK monetary policy over the couple of years. We downgraded our cyclical stance on UK Gilts and UK investment grade corporates to neutral from overweight in that Special Report and, this week, we are making the same reduction in UK weightings in our model bond portfolio (see the portfolio tables on pages 20-21). After that change, the overall duration of the model bond portfolio remains below that of the custom benchmark index, now by -0.75 years (Chart 7). Chart 6Low-Beta Markets Will Continue To Outperform USTs Chart 7Overall Portfolio Duration: Stay Below Benchmark We continue to see the dovish bias of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt (Chart 8). Yes, the “easy money” has been made betting on a recovery of inflation expectations from the bombed-out levels seen after the COVID-19 recession in 2020. However, within the major developed economies with inflation-linked bond markets, 10-year breakevens have already climbed beyond the pre-pandemic levels of early 2020 (Chart 9). The next targets are the previous cyclical highs seen in 2018 (and 2019 for the UK). Chart 8Dovish Central Banks Still Positive For Inflation-Linked Bonds Chart 9Inflation Breakevens Returning To Past Cyclical Peaks Chart 10Still A Supportive Backdrop For Global Corporates The 10-year US TIPS breakeven is already past that 2018 peak of 2.18%, and with the Fed showing no sign of concern about US growth and inflation accelerating, the 10-year US breakeven should end up moving into the high end of our expected 2.3-2.5% target range before the Fed begins to turn less dovish. Thus, we are maintaining a core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy, France and Canada. The same aggressive easing of global monetary policy that has been good for relative inflation-linked bond performance continues to benefit global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England remains an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). With the combined balance sheet now expanding at a 55% pace, corporate bonds are still likely to continue to outperform government debt over the remainder of 2021. Much of that expected return outperformance of corporates will come via carry rather than spread compression, though. Our preferred measure of the attractiveness of credit spreads, the historical percentile ranking of 12-month breakeven spreads, shows that only US high-yield spreads are above the bottom quartile of their history among the credit sectors in our model portfolio (Chart 11). Given the absence of spread cushion in those other markets, we are maintaining an overweight stance on US high-yield in the model bond portfolio – especially versus euro area high-yield where we are underweight - while staying neutral investment grade credit in the US and Europe. Chart 11US High-Yield: The Last Bastion Of Attractive Spreads Within the euro area, we continue to prefer owning Italian government bonds over investment grade corporates, given the European Central Bank’s more explicit support for the former through quantitative easing (Chart 12). We expect Italian yields and spreads to converge down to Spanish levels, likely within the next 6-12 months, while there is limited downside for euro area investment grade spreads given tight valuations. Chart 12Favor Italian BTPs Over Euro Area IG We are not only looking at relative valuation considerations in developed market credit. Emerging market (EM) USD-denominated credit has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices. We have positioned for that in our model portfolio through an overall overweight stance on EM USD credit, but one that favors investment grade corporates over sovereigns. Now, with the Chinese credit impulse likely to slow in the latter half of 2021 as Chinese policymakers look to rein in stimulus, a slower pace of Chinese economic growth represents a risk to EM credit (Chart 13). The same can be said for the US dollar, which is no longer depreciating with US bond yields rising and the markets questioning the Fed’s dovish forward guidance on future rate hikes (Chart 14). A strong US dollar would also be a risk to the commodity price rally that has supported EM financial assets. Chart 13Global Policy Mix Becoming Less Supportive For EM Chart 14A Stronger USD Is A Risk For EM Corporates Vs Sovereigns Chart 15A Moderate Overweight To Spread Product Vs Government Debt In response to these growing risks to the bullish EM backdrop, we are downgrading our overall EM USD credit exposure in the model bond portfolio to neutral from overweight. We are maintaining our relative preference for EM investment grade corporates over sovereigns, however, within that overall neutral allocation. Summing it all up, we are sticking with a moderately overweight stance on global spread product versus government debt in the model portfolio, equal to four percentage points (Chart 15). That overweight comes entirely from the US high-yield allocation. After the changes made to our UK and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 41bps (Chart 16). This is an unsurprising outcome given that the current positioning is focused so heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral. That will change as 2021 progresses but, for now, our highest conviction views are in US fixed income. One final point – the relatively concentrated positioning leaves the portfolio “flat carry”, with a yield roughly equal to that of the benchmark index (Chart 17). Chart 16Limited Use Of Portfolio 'Tracking Error' Chart 17Model Portfolio Yield Close To Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the UK and EM, we now turn to 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 2A). 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 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries Base case: Ongoing global vaccinations lead to more of the global economy reopening over the summer, with excess savings built up during the pandemic – augmented by ongoing fiscal support – starting to be spent. US economic growth will be most robust out of the major economies, given the additional boost from fiscal stimulus, while China implements actions to slow credit growth and the euro area lags on vaccinations. The Fed stands its ground and maintains no rate hikes until at least 2023, and US TIPS breakevens climb to levels consistent with the Fed’s 2% inflation mandate (2.3-2.5%). The US Treasury curve continues to bear-steepen, with the 10-year US yield rising to 2%. The VIX falls to 15, the US dollar is flat, the Brent oil price rises +5%, and the fed funds rate is unchanged at 0%. Optimistic case: A rapid pace of global vaccinations leads to booming growth led by the US but including a reopening euro area. Chinese policymakers tighten credit by less than expected. Markets begin to pull forward the timing and pace of future central bank interest rate hikes, most notably in the US but also in the other countries like Canada and the UK. Real bond yields continue to climb globally, but inflation breakevens stay elevated. The steepening trend of the US Treasury curve ends, and mild bear flattening begins with the 10-year reaching 2.2% and the 2-year yield climbing to 0.4%. The VIX stays unchanged at 18, the US dollar rises +5%, the Brent oil price climbs +2.5% and the fed funds rate stays unchanged. Pessimistic case: Setbacks on the pandemic, either from struggles with vaccine distribution or a surge in variant cases, lead to a slower pace of global growth momentum. Europe cannot reopen, China tightens credit policy faster than expected, and US households hold onto to excess savings amid lingering virus uncertainty. Diminished economic optimism leads to a pullback in global equity values and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.5%. The VIX rises to 25, the US dollar falls -2.5% and the fed funds rate stays at 0%. The inputs into the scenario analysis are shown in Chart 18 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 19. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Chart 18Risk Factor Assumptions For The Scenario Analysis Chart 19US Treasury Yield Assumptions For The Scenario Analysis Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The model bond portfolio is expected to deliver an excess return over the next six months of +46bps in the base case and +54bps in the optimistic scenario, but is only projected to underperform by -27bps in the pessimistic scenario. Bottom Line: We are sticking with an overall below-benchmark portfolio duration stance, given accelerating global growth momentum, expanding vaccinations and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield given more stretched valuations in other credit sectors. On the margin, we are making the following changes to the portfolio allocations: downgrading both UK Gilts and UK investment grade corporates to neutral, while cutting the overall allocation to EM USD credit to neutral.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Shakti Sharma Research Associate ShaktiS@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 Please see BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Why Are UK Interest Rates Still So Low?", dated March 10, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth.  The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31ST, 2021) 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 March 31ST, 2021) 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 43 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 43 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) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of March 31st, 2021) Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance