Inflation Protected

This week we present our Portfolio Allocation Summary for October 2022.

Executive Summary Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues In this report, we discuss our move last week to shift to a below-benchmark overall global duration stance in more detail. Our strongest conviction view on developed market government bonds is underweighting US Treasuries. The outcome of last week’s FOMC meeting, where the Fed committed to a rapid shift to restrictive US monetary policy, supports that position. Our strongest conviction overweight is on Japan, with the Bank of Japan both willing and able to maintain its cap on longer-term JGB yields. We are also overweight countries where it will be difficult for central banks to lift rates as much as markets expect – core Europe, Australia and Canada. The explosion in UK bond yields, and collapse of the British pound, seen after last week’s UK “mini-budget” shows that investors have not lost the power to punish fiscal and monetary policies that are non-credible - like a massive debt-financed tax cut at a time of high inflation. As a result, the Bank of England will now be forced to raise rates much more than we had been expecting, and Gilts will remain extremely volatile in the near-term. Bottom Line: Maintain a below-benchmark overall duration stance in global bond portfolios. Stay underweight US Treasuries. Upgrade exposure to government bonds in Japan and Canada to overweight, but tactically downgrade UK Gilts to underweight until a more market-friendly policy mix leads to greater stability of the British pound. Feature We shifted our recommended stance on overall global portfolio duration to below-benchmark in a Special Alert published last week. In this report, we go into the rationale for that move in more detail, and present specific details of that shift in terms of allocations by country across the various yield curves. Related Report  Global Fixed Income StrategyReduce Global Portfolio Duration To Below-Benchmark The global inflation and monetary policy backdrops remain toxic for bond markets. Last week saw interest rate increases from multiple developed economy central banks, including the Fed and Bank of England (BoE). The magnitudes of the rate hikes unnerved bond investors, with even the likes of perennial low yielders like the Swiss National Bank and Riksbank lifting rates by 75bps and 100bps, respectively. The Fed followed up its own 75bp hike by digging in its heels on the need for additional policy tightening after the 300bps of hikes already delivered this year (Chart 1). Fed Chair Jerome Powell strongly hinted that a policy-induced US recession is likely the only way to return overshooting US inflation back to the Fed’s 2% target. This triggered a breakout of the benchmark US 10-year Treasury yield above 3.5%. But the real fireworks in global bond markets occurred after the UK government announced its “mini-budget” last Friday that included massive tax cuts to be funded by debt issuance, triggering a sharp decline in the British Pound and spike in UK Gilt yields – a move that spilled over into other bond markets, pushing government bond yields to cyclical highs in the US and euro area. Chart 1Central Banks Keep Trying To “Out-Hawk” Each Other The Global Bond Bear Market Continues The Global Bond Bear Market Continues Chart 2Yields Are Now Driven By Rate Hike Expectations, Not Inflation Yields Are Now Driven By Rate Hike Expectations, Not Inflation Yields Are Now Driven By Rate Hike Expectations, Not Inflation We had been anticipating another move upward in global bond yields for this cycle, and we shifted to a below-benchmark overall global duration stance in advance of the Fed and BoE meetings last week. We see this next move higher in yields as being driven not by rising inflation expectations but by an upward repricing of interest rate expectations, leading to additional increases in real bond yields (Chart 2). Trying to pick a top in bond yields has now become a game of forecasting the level to which policy rates must rise in the current global monetary tightening cycle. On that front, there is still scope for rate expectations, and bond yields, to move higher in most developed market countries, justifying our downgrade of our recommended overall duration exposure to below-benchmark. Shifting rate expectations also lead to the changes in country bond allocations we announced last week. Rate Expectations And Country Bond Allocations Our proxy for medium-term nominal terminal rate expectations in developed market countries, the 5-year/5-year forward overnight index swap (OIS) rate, has been tracking 10-year bond yields very closely in the US and UK and, to a lesser extent, Europe (Chart 3). In those regions, the OIS curves are pricing in an increasing medium-term level of policy rates, leading to markets repricing government bond yields higher. In the US, the OIS curve is pricing in a 2023 peak for the fed funds rate of 4.67%, but with only a modest path of rate cuts in 2024 and 2025, leading to a 5-year/5-year OIS projection of 3.36% as of Monday’s market close. After the Gilt market rout, the UK OIS curve is now pricing in a 2023 peak Bank Rate over 6%, with our medium-term nominal rate proxy settling at 3.69%. In the euro area, the OIS curve is discounting a 2023 peak in the ECB policy rate of 3.22%, with a 5-year/5-year forward OIS rate of 2.7%. For all three of those regions, the market is now pricing in the highest peak in rates for the current tightening cycle. That is not the case in Canada or Australia, where rate expectations and longer-term bond yields are still below cyclical peaks (Chart 4). Japan remains the outlier, with the Bank of Japan’s yield curve control keeping 10-year JGB yields capped at 0.25%, even with the Japan OIS curve pricing in a medium-term terminal rate of 0.75%. Chart 3Rising Yields Reflect Higher Terminal Rate Expectations Rising Yields Reflect Higher Terminal Rate Expectations Rising Yields Reflect Higher Terminal Rate Expectations Chart 4Our High-Conviction Government Bond Overweights Our High-Conviction Government Bond Overweights Our High-Conviction Government Bond Overweights After looking at all the repricing of interest rate expectations and bond yields, we can determine our preferred government bond allocations within our strategic model bond portfolio framework. The US Remains Our Favorite Government Bond Underweight The new set of interest rate forecasts (“the dots”) presented at last week’s Fed meeting showed that the median FOMC member was forecasting the fed funds rate to rise to 4.4% by the end of 2022 and 4.6% by the end of 2023, before falling to 3.9% and 2.9% and the end of 2024 and 2025, respectively. Those are all significant increases from the June dots, where the expectations called for the funds rate to hit 3.4% by end-2022 and 3.8% by end-2023. The median Fed forecasts are now broadly in line with the pricing in the US OIS curve for 2022-2024, although the market expects higher rates than the FOMC in 2025 (Chart 5). Chart 5USTs Still Vulnerable To Additional Fed Hawkish Surprises The Global Bond Bear Market Continues The Global Bond Bear Market Continues There has been a lot of back and forth between the Fed and the markets this year, but the market has generally lagged the Fed interest rate projections for 2023 and 2024 before last week. Market pricing is now in line with the Fed dots, as investors have adjusted to the increasingly hawkish message from Fed officials that are focused solely on slowing growth, and tightening financial conditions, in an effort to bring US inflation down. We see the US Treasury curve as still vulnerable to additional hawkish messaging from the Fed, and a potentially higher-than-anticipated peak in the funds rate versus the FOMC dots. The US consumer is facing a lot of headwinds from higher interest rates and rising food and gasoline prices. However, the latter has fallen 26% from the June 13/2022 peak and is acting as a “tax cut” that also helps reduce US inflation expectations (Chart 6). Consumer confidence measures like the University of Michigan expectations survey have already shown improvement alongside the fall in gas prices, which has boosted real income expectations according to the New York Fed’s Consumer Survey (bottom panel). Even a subtle improvement in consumer confidence due to some easing of inflation expectations can help support a somewhat faster pace of consumer spending at a time of robust labor demand and accelerating wage growth. The Atlanta Fed Wage Tracker is now growing at a year-over-year pace of 5.7%, while the ratio of US job openings to unemployed workers remains near a record high (Chart 7). Fed Chair Powell has noted that the Fed must see significant weakening of the US jobs market for the Fed to consider pausing on its current rate hike path. So far, there is little evidence pointing to a loosening of US labor market conditions that would ease domestically-generated inflation pressures. Chart 6Lower Gas Prices Can Provide A Lift To US Consumer Spending Lower Gas Prices Can Provide A Lift To US Consumer Spending Lower Gas Prices Can Provide A Lift To US Consumer Spending Chart 7A Tight US Labor Market Will Keep The Fed Hawkish A Tight US Labor Market Will Keep The Fed Hawkish A Tight US Labor Market Will Keep The Fed Hawkish Chart 8Stay Underweight US Treasuries Stay Underweight US Treasuries Stay Underweight US Treasuries We expect overall US inflation to decelerate next year on the back of additional slowing of goods inflation, but will likely settle in the 3-4% range in 2023 given stubbornly sticky services inflation and wage growth. The Fed should follow through on its current interest rate projections, with a good chance that rates will need to be pushed up even higher in response to resilient labor market conditions in the first half of 2023. The risk/reward still favors higher US Treasury yields over at least the next 3-6 months, particularly with an improving flow of US data surprises and with bond investor duration positioning now much closer to neutral according to the JPMorgan client survey (Chart 8). Bottom Line: The US remains our highest conviction strategic government bond underweight in the developed markets. Recommended Allocations In Other Countries The path for monetary policy rates outside the US shows a similar profile as in the US, with a “front loading” of rate hikes to mid-2023 followed by modest rate cuts over the subsequent two years (Chart 9). The OIS-implied path for the level of rates is nearly identical in the US, Australia and Canada. On the other hand, markets are discounting much lower of levels of policy rates in Europe and Japan compared to the US, and a considerably higher path for rates in the UK (more on that in the next section). Chart 9Markets Priced For Global 'Front-Loaded' Rate Hikes Markets Priced For Global 'Front-Loaded' Rate Hikes Markets Priced For Global 'Front-Loaded' Rate Hikes We would lean against the US-like pricing of interest rates in Australia and Canada. Based on work we published in a recent Special Report along with our colleagues at BCA Research European Investment Strategy, the neutral real interest rate (“r-star”) is estimated to be deeply negative in Australia and Canada after adjusting for the high level of non-financial debt in those countries (Table 1). That financial fragility makes it much less likely that the Bank of Canada and Reserve Bank of Australia can raise rates as much as the Fed. Table 1Some Big Swings In Our R* Estimates When Including Debt The Global Bond Bear Market Continues The Global Bond Bear Market Continues US-like interest rates would almost certainly trigger a major downturn in house prices and household wealth given the inflated housing values in those two countries – the growth of which is already slowing rapidly in response to rate hikes delivered in 2022. We are maintaining our overweight recommendation on Australian government bonds, while we upgraded Canada to overweight from neutral after last week’s duration downgrade. Chart 10Move To Overweight Japan Move To Overweight Japan Move To Overweight Japan We are also staying overweight on German and French government bonds, as the ECB is unlikely to deliver the full extent of rate increases discounted in the European OIS curve. Our estimated debt-adjusted r-star is also quite negative in the euro area, suggesting that financial fragility issues (due to high government debt in Italy and high corporate debt in France) will likely limit the ECB’s ability to continue with recent chunky rate increases for much longer. In Japan, we continue to view JGBs as an “anti-duration” instrument, given the Bank of Japan’s persistence in maintaining negative interest rates and yield curve control. That makes JGBs a good overweight when global bond yields are rising and a good underweight when global bond yields are falling (Chart 10). Given our decision to reduce our recommended duration exposure to below-benchmark, the logical follow through decision is to upgrade JGBs to overweight. The only remaining country to consider is our view on UK Gilts, which has now become more complicated. Anarchy In The UK The selloff in the UK Gilt market has been stunning in its ferocity. Dating back to last Thursday’s 50bp rate hike by the BoE, the 10-year UK Gilt yield has jumped 120bps and now sits at 4.52%. The increase in yields was identical at the front-end of the Gilt curve, with the 2-year yield jumping 120bps to 4.68%.  The surge in longer-term Gilt yields stands out to the rise in bond yields seen outside the UK, as it also incorporates an increase in our estimate of the UK term premium – a move that was not matched in other countries (Chart 11). The rise in Gilt yields was also much more concentrated in real yields compared to inflation expectations (Chart 12), as markets aggressively repriced the path for UK policy rates after the UK government’s announced debt-financed fiscal package, including £45bn of tax cuts. Chart 11Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Chart 12The Gilt Market Becomes Unhinged The Gilt Market Becomes Unhinged The Gilt Market Becomes Unhinged The UK’s National Institute for Economic And Social Research (NIESR) estimates that the combined impact of the tax cuts and additional spending measures would increase the UK government deficit by a whopping £150bn, or 5% of GDP. The NIESR also estimated that the fiscal measures, including the previously-announced plan for the UK government to cap energy price increases, would result in positive UK GDP growth in the 4th quarter and also lift annual real GDP growth to 2% over 2023-24. The UK government now faces a major credibility issue with markets on its announced fiscal plans. The sheer size of the package, coming at a time when the US economy was already operating at full employment with high inflation, invites a greater than expected monetary policy tightening response from the BoE. The UK OIS curve now forecasts a peak in rates of 6.3% in October 2023, up from the current 2.25%. That would be a massive move in rates in just one year from a central bank that has been relatively gun shy in lifting rates since the 2008 financial crisis, even during the current inflation overshoot. New UK Prime Minister Liz Truss, and her new Chancellor of the Exchequer Kwasi Kwarteng, have both noted they would prefer a mix of looser fiscal policy (aimed at boosting the supply side of the economy to lift potential growth) with tighter monetary policy that would prevent asset bubbles and inflation overshoots. While there is certainly merit in any plan designed to boost medium-term growth by lifting anemic UK productivity through supply-side reforms, the timing of the announcement could not have been worse. Just one day earlier, the BoE announced a plan to go forward with the sale of Gilts from its balance sheet accumulated during quantitative easing. The Truss government needs to find buyers for all the Gilts that must be issued to pay for the tax cuts and stimulus, but the BoE will not be one of them. In the end, however, the BoE’s expected path for interest rates matters more than the increase in Gilt supply in determining the level of Gilt yields and the slope of the Gilt curve. The NIESR estimates that the UK public debt/GDP ratio will rise to 92% by 2024-25, versus its pre-budget forecast of 88%. While that is a meaningful increase, the correlation between the debt/GDP ratio and the slope of the Gilt curve has been negative for the past few years (Chart 13, top panel). The stronger relationship is between the slope of the curve and the level of the BoE base rate (bottom panel), which is pointing to an inversion of the 2-year/30-year curve if the BoE follows market pricing and lifts rates to 6%. Our view dating back to the early summer was that a low neutral interest rate would prevent the BoE from lifting rates as much as markets were discounting without causing a deep recession, lower inflation and, eventually, a quick reversal of rate hikes. The huge UK fiscal stimulus package changes that calculus, as the nominal neutral rate that will be needed to bring UK inflation back to target is likely now much higher. We have always believed that when a thesis underlying an investment recommendation is challenged by new information, it is best to adjust the recommendation to reflect the new facts. Thus, this week, we are tactically downgrading UK Gilts to underweight in our model bond portfolio framework. We still see a significant medium-term opportunity to go overweight Gilts, as UK policy rates pushing into the 4-6% range are not sustainable. However, the BoE will likely have no choice to begin lifting rates at a much more aggressive pace to restore UK policy credibility, especially with the British pound under immense selling pressure (Chart 14). Despite rumors of an inter-meeting rate hike by the BoE this week to try and support the pound, that is likely too risky a step for the BoE to take as it would invite a battle with investors and currency speculators. Such a battle would be difficult to win without a more credible and market-friendly medium-term fiscal policy from the Truss government. Chart 13The BoE Matters More Than Debt Levels For Gilts The BoE Matters More Than Debt Levels For Gilts The BoE Matters More Than Debt Levels For Gilts Chart 14Tactically Move To Underweight UK Gilts Tactically Move To Underweight UK Gilts Tactically Move To Underweight UK Gilts   Bottom Line: We will review our UK Gilt stance once there are more clear signals of stability in the pound, but for now, we will step aside and limit our recommended exposure to Gilts – even after the huge selloff seen to date, which likely has more to go. Summarizing All The Changes In Our Model Bond Portfolio All the changes to our recommended duration exposure and country allocations after the past week, including the new weightings in our model bond portfolio, are shown in the tables on pages 14-16. To summarize: We moved the overall recommended global duration exposure to below-benchmark, and shifted the model bond portfolio duration to 0.9 years below that of the custom benchmark index. We increased the size of the US Treasury underweight, and moved Canada and Japan to overweight. We moved the UK to underweight, on top of the reduction in UK duration exposure that was part of last week’s move to reduce overall portfolio duration. We are also cutting exposure to UK investment grade corporates to underweight, as part of an overall move to reduce UK risk in the portfolio. We slightly increased the overweight in Germany. In next week’s report, we will present the quarterly performance review of our model bond portfolio and, more importantly, we will present out scenario-based return expectations after all the changes made this week. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com     GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The Global Bond Bear Market Continues The Global Bond Bear Market Continues The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) The Global Bond Bear Market Continues The Global Bond Bear Market Continues

Executive Summary There’s Value In TIPS There's Value In TIPS There's Value In TIPS A survey of economic and financial market indicators suggests that we are not yet close to the end of the Fed’s tightening cycle. This argues for a continued flattening of the yield curve and one more push higher in bond yields before the end of the cyclical bond bear market. While headline inflation has rolled over, there is so far little indication of a slowdown in core price appreciation. We see core CPI reaching 3.6% during the next 12 months, driven by decelerating goods prices but sticky wage growth and services inflation. The TIPS market is discounting an overly sanguine view of headline inflation for the next 12 months, and there is value in owning TIPS versus nominal Treasuries. Bottom Line: Investors should reduce portfolio duration to ‘below-benchmark’ and hold a position in 5-year/30-year Treasury curve flatteners. Investors should also overweight TIPS versus nominal Treasuries and own 2-year/10-year TIPS breakeven inflation curve flatteners. Feature US bond yields continued their ascent last week, spurred on by August’s surprisingly high core CPI print and the perception that the Fed will have to tighten policy even more quickly to bring inflation back down. Currently, the market is discounting that the Fed will lift the funds rate to 4.61% by April of next year and then bring it back down to 4.26% by the end of 2023 (Chart 1). Chart 1Rate Expectations Rate Expectations Rate Expectations This market-implied interest rate path would involve 225 bps of tightening at the next 5 FOMC meetings, or an average rate increase of +45 bps per meeting. With a 75 basis point rate increase looking like a lock for this week, market pricing is consistent with additional 50 basis point increases at the final two meetings of this year (November and December) and then two more 25 basis point rate hikes in Q1 2023. After that, the market anticipates that the tightening cycle will be over. Our view continues to be that the peak in the fed funds rate will occur later than April 2023 and that, while a pause in the Fed’s tightening cycle is likely at some point next year, inflation will be strong enough to preclude outright rate cuts. In terms of investment strategy, last week’s report presented empirical evidence showing that, on average, Treasury yields peak 1-2 months before the last rate hike of the cycle.1 In fact, in the seven Fed tightening cycles that we analyzed, the 10-year Treasury yield always peaked within a window spanning four months before the last rate hike and four months after (Table 1). This analysis suggests that even if the fed funds rate peaks in April, as is implied by the market, bond yields likely have one more leg higher before the end of the cyclical bear market. Table 1Timing Fed Tightening Cycles One Last Hurrah For Bond Bears One Last Hurrah For Bond Bears While we have been consistently highlighting that the market is not pricing-in a sufficiently high average fed funds rate for 2023, we have been recommending an ‘at benchmark’ portfolio duration stance on the view that falling inflation could briefly send bond yields lower in the near term. The 10-year Treasury yield did fall back to 2.60% on August 1, but it then rebounded quickly and has continued to head higher since. With Treasury yields unlikely to re-test those depths anytime soon, we recommend shifting to a ‘below-benchmark’ portfolio duration stance to play the final leg higher in bond yields before a US recession ends the cyclical bond bear market. The next section of this report surveys nine cyclical economic indicators and argues that the balance of evidence suggests that the fed funds rate’s peak will occur later than April 2023. Then, the final section of this report discusses our recommended TIPS investment strategy in light of last week’s CPI report and our outlook for inflation. Tracking The Tightening Cycle One of the most useful tools in our arsenal for assessing the state of the interest rate cycle is our Fed Monitor. The Fed Monitor is a composite of 47 economic and financial market variables that has been designed to output a positive value when the data recommend interest rate hikes and a negative value when rate cuts are required. Historically, the Monitor does a good job of lining up with the actual path of the fed funds rate (Chart 2). Chart 2Fed Monitor Says More Tightening Required Fed Monitor Says More Tightening Required Fed Monitor Says More Tightening Required The Fed Monitor is currently down off its highs, but at 1.03 it is well above the zero line. Looking at past tightening cycles, we find that the Monitor has averaged 0.41 on the day of the last rate hike of a cycle, with a range of outcomes spanning -0.49 to +0.93. Notably, the +0.93 upper-end of that range occurred in 1995, a time when the Fed only delivered a modest amount of policy easing before pivoting back to tightening in 1999. The variables in our Fed Monitor can be grouped into three categories: (i) economic growth variables, (ii) inflation variables and (iii) financial market variables. Interestingly, we observe that the Economic Growth component of our Monitor has dipped into negative territory while the Inflation and Financial Conditions components continue to argue for tighter policy (Chart 2, bottom 3 panels). A negative Economic Growth component suggests that we are getting closer to the end of the tightening cycle, but the Fed will likely stay hawkish and tolerate an even deeper negative reading from Economic Growth as long as inflation remains high. In addition to our Fed Monitor, we have identified nine economic indicators (some included in the Fed Monitor and some not) that are particularly relevant for the Fed’s policy stance. In this week’s report, we look at the message these indicators were sending on the day of the last rate hike of seven past tightening cycles. The indicators are: The Sahm Rule: Economist Claudia Sahm has noted that a recession always occurs when the 3-month moving average of the unemployment rate rises by more than 0.5% off its trailing 12-month low.2 We include the unemployment rate’s deviation from its 12-month low as a measure of labor market utilization. Employment Momentum: We look at the 6-month growth rate in nonfarm payrolls as a measure of momentum in the labor market. Inflation: We use 12-month core PCE as a measure of inflation that is most closely related to the Fed’s target. Inflation Momentum: To measure momentum in inflation we look at the difference between 3-month core PCE and 12-month core PCE. Labor Market Tightness: Using responses from the Conference Board’s Consumer Confidence Survey, we look at the number of people who describe jobs as “plentiful” minus the number who describe jobs as “hard to get”. Economic Growth: We use the ISM Manufacturing PMI as a simple measure of the trend in aggregate demand in the US economy. Housing: To assess trends in the housing market we look at the 12-month moving average in housing starts minus the 24-month moving average. Financial Conditions: We use the Goldman Sachs Financial Conditions Index to assess whether financial conditions are accommodative or restrictive. The Yield Curve: We look at the 2-year/10-year Treasury slope to ascertain whether the bond market perceives the monetary policy stance as accommodative or restrictive. Table 2A lists the nine indicators described above and shows their values on the day of the last rate hike of seven past tightening cycles. We also include the current reading from each indicator. Finally, we shade in red every cell that we deem consistent with the Fed stopping its tightening cycle. To make this determination we compare the value on the day of the last rate hike to the median value witnessed on the day of the last hike across all seven tightening cycles. We don’t use median values for the Goldman Sachs Financial Conditions Index or the Treasury slope. Rather, we say that an inverted yield curve and a Financial Conditions reading above 100 are both consistent with the end of rate hikes. Table 2AEconomic Indicators At The End Of Fed Tightening Cycles One Last Hurrah For Bond Bears One Last Hurrah For Bond Bears The last column of Table 2A simply adds up the number of red cells in each row. As of today, we see that only 2 out of nine indicators are consistent with the end of the tightening cycle. The end of a tightening cycle has never occurred with less than four indicators flashing red. Table 2B takes a slightly more sophisticated approach to the same exercise. Rather than simply comparing above or below the median, we rank each indicator as a percentile relative to its value on the day of the last rate hike across seven different tightening cycles. We then combine those percentile ranks with an equal weighting to get an “End of Tightening Score”. Larger values are consistent with a greater likelihood that the tightening cycle will end and lower values are consistent with a lower likelihood. Currently, the End of Tightening Score stands at 28%, lower than on the day of the last rate hike in all of the cycles we analyzed. Table 2BEconomic Indicators At The End Of Fed Tightening Cycles: Percentile Ranks One Last Hurrah For Bond Bears One Last Hurrah For Bond Bears As is the case with our Fed Monitor, the closest End of Tightening Score to today’s occurred in 1995. One key difference between 1995 and today is that core inflation was running much closer to target in 1995. This gave the Fed scope to fine tune its policy stance without risking its inflation fighting credibility. That flexibility is not available to the Fed in today’s high inflation environment. Bottom Line: A survey of economic and financial market indicators suggests that we are not yet close to the end of the Fed’s tightening cycle. This argues for a continued flattening of the yield curve and one more push higher in bond yields before the end of the cyclical bond bear market. Investors should set portfolio duration to ‘below benchmark’ and maintain a position in 5-year/30-year Treasury curve flatteners.3 The TIPS Market Is Too Complacent August’s month-over-month core CPI print came in well above expectations at +0.57%, sending bond yields higher and risk assets lower last week. Zooming out, while falling gasoline prices appear to have shifted the trend in headline inflation, there is so far little evidence of a meaningful move down in core or trimmed mean measures of CPI (Chart 3). Chart 3No Slowdown In Core CPI No Slowdown In Core CPI No Slowdown In Core CPI Chart 4Core CPI Forecast Core CPI Forecast Core CPI Forecast In a recent Special Report, we went through the five major components of CPI (energy, food, shelter, goods and services) and came up with 12-month forecasts for both core and headline inflation.4  For core inflation, we forecast that it will fall to 3.6% during the next 12 months (Chart 4). The main driver of the drop will be a return of goods inflation to pre-pandemic levels (Chart 4, panel 3). We anticipate only a minor pullback in shelter inflation (Chart 4, panel 2) and that services inflation will remain elevated, driven by strong wage growth (Chart 4, bottom panel). Recently, we have seen some evidence that home prices and rents on new leases are decelerating, no doubt a response to high and rising mortgage rates. That said, we don’t anticipate much pass through from those trends into shelter inflation during the next 12 months. First, home price appreciation leads shelter CPI by 18 months (Chart 5A). This means that we shouldn’t expect falling home prices to meaningfully impact shelter inflation until the end of 2023. Second, rental growth on new leases as measured by Zillow and Apartment List has clearly decelerated, but it is still running much hotter than shelter CPI (Chart 5B). Given the limited historical track record, it’s very difficult to say how much (if any) of the recent deceleration in rental growth will ultimately pass through to the CPI. Chart 5AHome Prices & Shelter CPI Home Prices & Shelter CPI Home Prices & Shelter CPI Chart 5BDecelerating Rents Decelerating Rents Decelerating Rents In our research, we have found that measures of labor market utilization are the most important variables to include in any model of shelter inflation. For ease of forecasting, the model shown in Chart 4 and in the top panel of Chart 6 uses the unemployment rate as its measure of labor market tightness. This model works well, but it arguably understates shelter inflation because it doesn’t include a variable capturing wage growth. If we replace the unemployment rate in our model with the more comprehensive aggregate weekly payrolls measure, then we get a much tighter fit and a model that does a better job explaining the recent surge in shelter CPI (Chart 6, bottom panel).5 All in all, we conclude that our expectation that shelter inflation will fall from 6.3% to 4.7% during the next 12 months may wind up being a tad optimistic. When we combine our forecast for 3.6% core inflation with two scenarios for the oil price – a benign one based on what is priced into the futures curve and another based on the forecasts of our commodity strategists – we get an expected range of 2.1% to 4.7% for headline CPI during the next 12 months (Chart 7). According to our Golden Rule of TIPS Investing, if 12-month headline CPI comes in above the current 1-year CPI swap rate then TIPS will outperform nominal Treasuries during the 12-month investment horizon.6 Chart 6Modeling Shelter Inflation Modeling Shelter Inflation Modeling Shelter Inflation Chart 7There's Value In TIPS There's Value In TIPS There's Value In TIPS At present, the 1-year CPI swap rate is 2.76%, near the bottom of our expected range of outcomes for 12-month headline CPI. It seems to us that a lot of things will have to go right for inflation to come in below market expectations during the next year. For this reason, we think it makes sense for investors to overweight TIPS versus nominal Treasuries in US bond portfolios. Chart 8Own Inflation Curve Flatteners Own Inflation Curve Flatteners Own Inflation Curve Flatteners Additionally, we see a lot of value in owning TIPS breakeven curve flatteners (Chart 8). The 2-year and 10-year TIPS breakeven inflation rates are both currently 2.38%, meaning that the 2-year/10-year TIPS breakeven slope is at zero. Higher-than-expected inflation during the next 12 months will put more pressure on the front-end of the breakeven curve than the long end, flattening the curve. Further, logic dictates that an inverted inflation curve is more consistent with an environment where the Fed is fighting above-target inflation than a positively sloped one. There will come a time when it makes sense for the inflation curve to move back into positive territory, but that won’t be until the Fed has brought inflation down much closer to its target. Bottom Line: The inflation outlook priced into markets for the next 12 months is too benign. Investors should overweight TIPS versus nominal Treasuries and own TIPS breakeven inflation curve flatteners.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “A Brief History Of Fed Tightening Cycles”, dated September 13, 2022. 2  https://www.brookings.edu/wp-content/uploads/2019/05/ES_THP_Sahm_web_20190506.pdf 3  For more details on this curve trade please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. 4  Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022. 5  Aggregate weekly payrolls = nonfarm employment x average weekly hours x average hourly earnings 6   Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Chart 1A Hot Labor Market A Hot Labor Market A Hot Labor Market The balance of data that’s come out during the past month points to a labor market that is not cooling very quickly. In fact, it is cooling much more slowly than we anticipated. First, nonfarm payroll growth of +315k in August is well above the +79k that is needed to maintain the unemployment and participation rates at current levels (Chart 1). Second, what had initially looked like a significant drop in job openings was revised away with the July JOLTS report. While the ratio of job openings to unemployed has leveled-off just below 2.0, it is no longer showing any signs of falling (bottom panel). Finally, the employment component of August’s ISM Manufacturing PMI jumped back above 50 and even initial unemployment claims have reversed their nascent uptrend. The conclusion we draw from this spate of strong employment data is that the Fed’s tightening cycle is not close to over. This means that the average fed funds rate that is priced into markets for 2023 is almost certainly too low. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Still Too Hot Still Too Hot Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* Still Too Hot Still Too Hot Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to -267 bps. The average index option-adjusted spread tightened 4 bps on the month, and it currently sits at 145 bps. Our quality-adjusted 12-month breakeven spread ticked up to its 56th percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve suggests that the credit cycle is in its late stages. Corporate bond performance tends to be weak during periods when the yield curve is very flat or inverted. Despite our underweight 6-12 month investment stance, we wouldn’t be surprised to see some modest spread narrowing during the next couple of months as inflation heads lower. That said, spread compression will be limited by the inverted yield curve and the persistent removal of monetary accommodation. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 28 basis points in August, dragging year-to-date excess returns down to -519 bps. The average index option-adjusted spread tightened 15 bps on the month and it currently sits at 494 bps, 125 bps above the 2017-19 average and 43 bps below the 2018 peak. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – increased modestly in August. It currently sits at 6.6% (Chart 3). As is the case with investment grade, high-yield spreads could stage a relief rally during the next few months as inflation falls and recession fears abate. However, the inverted yield curve will likely prevent spreads from moving much below the average level seen during the last tightening cycle (2017-19). All that said, even a move back to average 2017-19 levels would equate to a roughly 7% excess return for the junk index if it is realized over a six month period. This return potential is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we will downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to our 4% estimate of its underlying trend.3 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 100 basis points in August, dragging year-to-date excess returns down to -144 bps. We discussed the outlook for Agency MBS in a recent report.4 We noted that MBS’ poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is over. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have an incentive to refinance at current mortgage rates. With the duration extension trade over, the only thing preventing us from increasing exposure to the Agency MBS space is that spreads still aren’t sufficiently attractive. The average index spread versus duration-matched Treasuries is roughly midway between its post-2014 minimum and post-2014 mean (panel 4). Meanwhile, the option-adjusted spread has moved above its post-2014 mean (bottom panel), but at just 42 bps, it still offers less compensation than a Aa-rated corporate bond or a Aaa-rated consumer ABS. At the coupon level, we moved to a neutral allocation across the coupon stack last month, but this month we initiate a recommendation to favor high-coupon (3%-4.5%) securities over low coupon (1.5%-2.5%) ones. Given the lower duration of high coupon MBS, this position will profit from rising bond yields on a 6-12 month investment horizon. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds outperformed the duration-equivalent Treasury index by 156 basis points in August, bringing year-to-date excess returns up to -563 bps. EM Sovereigns outperformed the Treasury benchmark by 117 bps on the month, bringing year-to-date excess returns up to -677 bps. The EM Corporate & Quasi-Sovereign Index outperformed by 180 bps, bringing year-to-date excess returns up to -491 bps. The EM Sovereign index outperformed the duration-equivalent US corporate bond index by 111 bps in August. Meanwhile, the yield differential between EM sovereigns and US corporates moved deeper into negative territory (Chart 5). As such, we continue to recommend a maximum underweight (1 out of 5) allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 168 bps in August. The index continues to offer a significant yield advantage versus duration-matched US corporates (panel 4). As such, we continue to recommend a neutral (3 out of 5) allocation to the sector. China is the most important trading partner for most EM countries and thus represents a major source of economic growth. Consequently, Chinese import volumes are a useful gauge for the outlook of EM economies. The persistent contraction of Chinese import volumes (bottom panel) therefore sends a negative signal for EM bond performance. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 126 basis points in August, bringing year-to-date excess returns up to -44 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong, but governments have been slow to hire (Chart 6).5 The result is that net state & local government savings are incredibly high (bottom panel) and it will take some time to deplete those coffers. On the valuation front, munis have cheapened up relative to both Treasuries and corporates since last year. The 10-year Aaa Muni / Treasury yield ratio is currently 82%, up from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation municipal bonds and duration-matched US corporates is 80%. The same measure for Revenue bonds is 94%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5/30 Barbell Versus 10-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in August as investors significantly marked up their 12-month rate expectations. Our 12-month Fed Funds Discounter – the market’s expected 12-month change in the funds rate – rose from 78 bps to 175 bps during the month and this caused the 2-year/10-year Treasury slope to flatten by 8 bps and the 5-year/30-year Treasury slope to flatten by 33 bps (Chart 7). We initiated a position in 5/30 flatteners (short 10-year bullet versus duration-matched 5/30 barbell) in our August 9th report.6 The main reason for this recommendation is our view that the Fed tightening cycle is not close to over. Therefore, it is too soon to position for a steepening of the 5-year/30-year Treasury slope. An analysis of past Fed tightening cycles shows that the 5-year/30-year Treasury slope tends to trough earlier than other segments of the yield curve. However, that trough has always occurred within a window spanning five months before the last Fed rate hike and three months after.7 On average, the 5-year/30-year slope troughs 1-2 months before the last Fed rate hike. Given our view that the Fed tightening cycle still has a lot of room to run, we think it makes sense to bet on a further flattening of the 5-year/30-year slope. This trade looks particularly attractive when you consider that a position short the 10-year bullet and long a duration-matched 5/30 barbell provides a yield pick-up of 12 bps (bottom panel). TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 8 basis points in August, bringing year-to-date excess returns up to +264 bps. The 10-year TIPS breakeven inflation rate fell 5 bps on the month, moving back into the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Meanwhile, our TIPS Breakeven Valuation Indicator shows that 10-year TIPS are close to fairly valued versus nominals. In a recent report we unveiled our Golden Rule of TIPS Investing.8 In that report we showed that TIPS of all maturities tend to outperform equivalent-maturity nominal bonds whenever headline CPI inflation exceeds the 1-year CPI swap rate during a 12-month period. The 1-year CPI swap rate is currently 2.77%, and we think this will turn out to be too low based on our modeling of headline CPI. While we see value in TIPS relative to nominals, especially at the front-end of the curve, we also suspect that more value will be created during the next few months as CPI prints come in soft. Therefore, we are reluctant to immediately upgrade TIPS to overweight. Instead, we recommend that investors initiate a 2-year/10-year TIPS breakeven inflation curve flattener. The 2/10 TIPS breakeven inflation curve has recently jumped into positive territory (bottom panel), but an inverted inflation curve is much more consistent with the current macro environment where the Fed is battling above-target inflation. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to -25 bps. Aaa-rated ABS outperformed by 19 bps on the month, bringing year-to-date excess returns up to -24 bps. Non-Aaa ABS outperformed by 76 bps on the month, bringing year-to-date excess returns up to -28 bps. Substantial federal government support caused US households to build up an extremely large buffer of excess savings during the past two years. This year, consumers are starting to draw down that savings and are even starting to take on more debt. The amount of outstanding credit card debt is still low relative to household income, but it is rising quickly in absolute terms (Chart 9). Elsewhere, consumers are still paying down their credit card balances at high rates (panel 4), but banks are no longer easing lending standards on auto loans or credit cards (panel 3). To us, the prevailing evidence suggests that it will be a long time before delinquencies are a serious problem for consumer ABS. This justifies our overweight recommendation. That said, given that the trend toward consumer re-leveraging is in full swing, it makes sense to turn more cautious at the margin. We therefore close our prior recommendation to favor non-Aaa over Aaa-rated consumer ABS and move to a neutral allocation across the consumer ABS credit curve. Non-Agency CMBS: Overweight Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 26 basis points in August, bringing year-to-date excess returns up to -150 bps. Aaa Non-Agency CMBS outperformed Treasuries by 20 bps on the month, bringing year-to-date excess returns up to -103 bps. Non-Aaa Non-Agency CMBS outperformed by 41 bps on the month, bringing year-to-date excess returns up to -280 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently close to their historic averages. However, the most recent Senior Loan Officer Survey showed tightening lending standards and weaker demand for commercial real estate (CRE) loans (Chart 10). This suggests a more negative back-drop for CRE prices and CMBS spreads and causes us to reduce our recommended allocation from overweight (4 out of 5) to neutral (3 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 29 basis points in August, dragging year-to-date excess returns down to -44 bps. The average index option-adjusted spread held flat on the month, close to its long-term average (bottom panel). At 55 bps, the average Agency CMBS spread continues to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 175 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Still Too Hot Still Too Hot Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 1, 2022) Still Too Hot Still Too Hot 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 September 1, 2022) Still Too Hot Still Too Hot 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 -7 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 7 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) Still Too Hot Still Too Hot Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of September 1, 2022) Still Too Hot Still Too Hot   Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1     Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2     Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3    For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4    Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5    Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 6    Please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. 7     In our analysis we examined seven Fed tightening cycles. The five most recent cycles and the two cycles that occurred during the inflation spike of the early 1980s. 8    Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Inflation breakevens have stabilized in the US, where gasoline prices have fallen, but have reaccelerated in the UK and euro area, where natural gas prices have exploded. Inflation breakevens have declined in Canada, potentially due to markets starting to discount a rapid decline in Canadian house price inflation. Our suite of global breakeven models shows that US and Canadian 10-year breakevens are too low, while euro area and UK breakevens are too high. When adjusted for market expectations for the future stance of monetary policies, expressed as the slope of nominal bond yield curves, only the UK stands out with a “conflicted” combination of too-high breakevens and an inverted nominal Gilt curve. Bottom Line: Upgrade inflation-linked bonds to overweight in the euro area (Germany, France, Italy), while downgrading Canadian linkers to underweight. Stay underweight UK linkers, with the Bank of England on course to tip the UK into a deep recession. Maintain a neutral stance on US TIPS, but look to upgrade if the Fed signals a less hawkish path for US monetary policy. Feature Chart 1Intensifying Inflation Worries In Europe Intensifying Inflation Worries In Europe Intensifying Inflation Worries In Europe Inflation-linked bonds (ILBs) have played a useful role for fixed income investors looking to protect their portfolios from the pernicious effects of the current era of high inflation. The rising inflation tide had been lifting all global ILB boats. Given the global nature of the brief deflationary shock from the global COVID lockdowns in 2020, and the persistent inflationary shock of the policy-induced recovery from the pandemic, ILB yields – and breakeven spreads versus nominal bonds – have tended to be positively correlated between countries. Now, some interesting divergences have started to appear between market-based inflation expectations (ILB breakevens or CPI swaps) at the country level. Most notably, inflation expectations have been climbing in the euro area and UK, while staying more stable – below the 2022 peak - in the US (Chart 1). In smaller ILB markets like Canada and Australia, breakevens have rolled over and remain at levels consistent with central bank inflation targets even in the fact of high realized inflation. Amid signs of easing inflation pressures from the commodity and traded goods spaces, and with global central banks now in full-blown tightening cycles to try and rein in overshooting inflation, ILB markets are likely to continue being less correlated. Being selective with ILB allocations at the country level, both on the long and short side of the market, will provide better relative return opportunities for bond investors over the next 6-12 months. To assess where those ILB opportunities lie within the developed market universe, we must first go over what is happening with various measures of inflation expectations in each country. A Country-By-Country Tour Of The Recent Dynamics Of Inflation Expectations US Chart 2Lower Gas Prices, Lower US Inflation Expectations Lower Gas Prices, Lower US Inflation Expectations Lower Gas Prices, Lower US Inflation Expectations In the US, the correlation with inflation expectations and gasoline prices remains quite strong (Chart 2). That has been the case when gas prices were soaring, but the correlation works in both directions. The US national gasoline price has fallen by 22% since the peak on June 13, according to the American Automobile Association. Lower gas prices have helped ease consumer inflation expectations. The July reading of the New York Fed’s Survey of Consumer Expectations showed a dip in the 1-year-ahead inflation expectation to 6.2% from 6.8% in June. The 5-year-ahead inflation expectation, which was introduced to the New York Fed survey back in January, fell sharply in July to 2.3% from 2.8% in June (and from a peak of 3% back in March). The fall in US survey-based inflation is also mirrored in lower TIPS breakevens. The 10-year TIPS breakeven fell from 2.76% at the peak of the national gasoline price in mid-June to a low of 2.29% on July 7. The 10-year breakeven has since recovered to 2.58%, but is still below the levels at the time of the peak in gas prices – and considerably lower than the cyclical peak of 3.02% reached in April. The 2-year TIPS breakeven has fallen even more, down from 4.93% to 2.87% since the April peak. UK Chart 3A Historic Energy Price Shock In The UK A Historic Energy Price Shock In The UK A Historic Energy Price Shock In The UK The UK inflation story has been heavily focused on the historic surge in energy prices. UK headline CPI inflation reached double-digit territory in July, climbing to 10.1% on a year-over-year basis, with the energy component of the CPI rising by a staggering 58%. Within that energy component, natural gas prices have been a huge driver, with the gas component of the CPI index up 96% year-over-year in July (Chart 3). Yet despite the relentless climb in energy prices, and the well-publicized “cost of living crisis” with high inflation rates in many non-energy sectors of the UK economy, survey-based measures of UK inflation expectations have stopped rising. The medium-term (5-10 years ahead) inflation expectation from the Citigroup/YouGov survey of UK consumers fell to 3.8% in July, down from the 4.4% peak reached back in March. Even shorter-term inflation expectations have stabilized in the face of rising energy costs (bottom panel). The dip in survey-based inflation expectations as of the July surveys may only be that – a dip – with the 10-year breakeven rate on index-linked Gilts having climbed from 3.8% to 4.2% so far in August. It’s also possible that the household inflation surveys are picking up the impact from the recent slowing of global goods price inflation (and easing global supply chain disruptions). More likely, in our view, UK households are starting to factor in the impact of BoE monetary tightening and an imminent UK recession – one that the BoE is now forecasting – on future inflation. Euro Area Chart 4European Inflation Expectations On The Rise European Inflation Expectations On The Rise European Inflation Expectations On The Rise In the euro area, inflation expectations are finally responding to the steady climb in realized inflation evident across the region. Headline CPI inflation in the region climbed to 8.9% in July, the highest reading since the inception of the euro in 1999. The inflation has been concentrated in a few sectors, with four percentage points of that 8.9% coming from energy prices and another two percentage points coming from food, tobacco and alcohol. Core inflation (excluding food and energy) was 4.0% in July, less alarming than the headline number but still double the ECB’s inflation target of 2%. The ECB now produces its own survey of consumer inflation expectations, which it has been conducting without publishing the results since April 2020. The ECB started publishing the survey this month, as part of a broader Consumer Expectations Survey that also asks questions on topics like future economic growth and the health of labor markets. The most recent survey in June showed that 1-year-ahead inflation expectations were 5%, and 3-year-ahead were 2.8% (Chart 4). Both measures have risen sharply since February – the month before the Russian invasion of Ukraine that triggered the spike in oil and European natural gas prices – when the 1-year-ahead and 3-year-ahead measures were 3.2% and 2.1%, respectively. Euro area market-based inflation expectations are a little more subdued than those from the ECB’s consumer survey. The 5-year breakeven inflation rate on German ILBs is now at 3.4%, while the 10-year breakeven is at 2.5%. A similar message comes from European inflation swaps, with the 5-year measure at 3.4% and the 10-year measure at 2.8%. Canada Chart 5A Housing-Driven Peak In Canadian Inflation Expectations? A Housing-Driven Peak In Canadian Inflation Expectations? A Housing-Driven Peak In Canadian Inflation Expectations? In Canada, realized inflation is still elevated, but may be peaking. Headline CPI inflation was 7.6% in July, down from 8.1% in June, although this came almost entirely from lower energy inflation. Measures of underlying inflation produced by the Bank of Canada (BoC) also stabilized in July, with the trimmed CPI inflation measure ticking down from 5.4% from 5.5% in June (Chart 5). The latest read on survey-based inflation expectations from the BoC’s quarterly Consumer Expectations Survey for Q2/2022 showed a pickup in the 1-year-ahead measure (from 5.1% in Q1 to 6.8%), 2-year-ahead measure (from 4.6% in Q1 to 5%) and 5-year-ahead measure (from 3.2% to 4%). All of those measures are well above the latest readings on market-based inflation expectations from Canadian ILBs, a.k.a. Real Return Bonds, with the 5-year breakeven at 2.2% and 10-year breakeven at 2.1%. Market liquidity is always a factor in the relatively small Canadian Real Return Bond market, yet it is somewhat surprising that breakevens are so low compared with realized and survey-based inflation. The aggressive tightening so far by the BoC, including a whopping 100bp rate hike last month and more expected over the next year, may be playing a role in dampening inflation breakevens – especially with the BoC’s tightening already having an impact on the Canadian housing market. National house price inflation, which tends to lead overall headline CPI inflation by around one year, was 14.2% in July, down from the 2022 peak of 18.8% (top panel). Australia Chart 6Inflation Expectations Remain Moderate In Australia & Japan Inflation Expectations Remain Moderate In Australia & Japan Inflation Expectations Remain Moderate In Australia & Japan In Australia, headline CPI inflation reached 6.1% in Q2/2022, up from 5.1% in Q1/2022, while the median inflation rate was 4.2%. While energy costs were a big contributor to the rise in overall inflation, the pickup was fairly broad-based with notable increases in the inflation rates related to housing (both house prices and furniture prices). Survey-based measures of inflation expectations in Australia focus on more shorter time horizons, thus they are highly correlated to current realized inflation. On that note, the Melbourne University measure of 1-year-ahead consumer inflation expectations soared from 4.9% in Q1/2022 to 6.2% in Q2/2022, while the early read on Q3/2022 2-year-ahead inflation expectations from the Union Officials survey rose to 4.1% from 3.5% in the previous quarter (Chart 6). Market-based inflation expectations are relatively subdued given the high readings of realized inflation and shorter-term survey-based inflation expectations. The 10-year Australian ILB breakeven is now at 1.9%, while the 5-year/5-year forward CPI swap rate is at 2.4%. The aggressive RBA tightening in 2022, with the Cash Rate having increased 175bps over the last four policy meetings, may be playing a role in holding down ILB breakevens. The relatively moderate pace of wage gains in Australia, with the Wage Price Index climbing 2.6% year-over-year in Q2, may also be weighing on ILB breakevens (middle panel). Japan There is not much exciting to say on the inflation front in Japan. The core (excluding fresh food) CPI inflation rate targeted by the Bank of Japan (BoJ) did hit a 7-year of 2.4% in July, but the core CPI measure more in line with international standards (excluding fresh food and energy) was only 1.2% in July (bottom panel). That was the strongest reading since 2015 but still well below the BoJ’s 2% inflation target. Survey-based consumer inflation expectations from the BoJ’s Opinion Survey showed a noticeable increase in Q2/2022, with the 5-year-ahead measure rising to 5% from 3% in Q1. This is obviously well above realized Japanese inflation, although the same survey showed that Japanese consumers believed that the current inflation rate was also 5%. Market-based Japanese inflation expectations are well below the BoJ survey-based measure, but in line with realized core inflation with the 2-year and 10-year CPI swap rates at 1.22% and 0.9%, respectively. The Message From Our Inflation Breakeven Valuation Models Chart 7A Diminished Case For Overweighting Inflation-Linked Bonds A Diminished Case For Overweighting Inflation-Linked Bonds A Diminished Case For Overweighting Inflation-Linked Bonds From an overall global perspective, the case for favoring ILBs versus nominal government bonds across all countries is less intriguing today than was the case in 2021 and early 2022 (Chart 7). Commodity price inflation is slowing rapidly alongside decelerating global growth. This is true both for oil and especially for non-oil commodities, with the CRB Raw Industrials index now falling on a year-over-year basis (middle panel). Supply chain disruptions on goods prices are easing, which is evident in lower rates of goods inflation in the US and other countries. Given the divergences evident between realized inflation, expected inflation and monetary policy outlook outlined in our tour of global inflation expectations, there may be better opportunities to selectively allocate to ILBs on a country-by-country basis. One tool to help us identify such opportunities is our suite of inflation breakeven fair value models. The models are all constructed in a similar fashion, determining the fair value of 10-year ILB breakevens as a function of the same two factors for each country: The underlying trend in realized inflation, defined as the five-year moving average of headline CPI inflation. This forms the medium-term “anchor” for breakevens. The year-over-year percentage change in the Brent oil price, denominated in local currency terms for each country. This attempts to capture cyclical trends around that medium-term anchor based on movements in oil and currencies. We have breakeven fair value models for eight developed market countries, which are shown in the next four pages of this report. The list of countries includes the US (Chart 8), the UK (Chart 9), France (Chart 10), Germany (Chart 11), Italy (Chart 12), Canada (Chart 13), Australia (Chart 14) and Japan (Chart 15). Chart 8Our US 10-Year Inflation Breakeven Model Our US 10-Year Inflation Breakeven Model Our US 10-Year Inflation Breakeven Model ​​​​​​ Chart 9Our UK 10-Year Inflation Breakeven Model Our UK 10-Year Inflation Breakeven Model Our UK 10-Year Inflation Breakeven Model ​​​​​​ Chart 10Our France 10-Year Inflation Breakeven Model Our France 10-Year Inflation Breakeven Model Our France 10-Year Inflation Breakeven Model ​​​​​​ Chart 11Our Germany 10-Year Inflation Breakeven Model Our Germany 10-Year Inflation Breakeven Model Our Germany 10-Year Inflation Breakeven Model ​​​​​​ Chart 12Our Italy 10-Year Inflation Breakeven Model Our Italy 10-Year Inflation Breakeven Model Our Italy 10-Year Inflation Breakeven Model ​​​​​​ Chart 13Our Canada 10-Year Inflation Breakeven Model Our Canada 10-Year Inflation Breakeven Model Our Canada 10-Year Inflation Breakeven Model ​​​​​ Chart 14Our Australia 10-Year Inflation Breakeven Model Our Australia 10-Year Inflation Breakeven Model Our Australia 10-Year Inflation Breakeven Model ​​​​​ Chart 15Our Japan 10-Year Inflation Breakeven Model Our Japan 10-Year Inflation Breakeven Model Our Japan 10-Year Inflation Breakeven Model ​​​​​ Full disclosure: we decided last year to de-emphasize our breakeven fair value models after the 2020 COVID recession and, more importantly, the sharp global economic recovery in 2021 from the pandemic shock. The rapid acceleration of oil prices – up 2-3 times in all countries - triggered by that recovery created some wild swings in the estimated breakeven fair value. Today, with oil inflation at more “normal” levels below 100%, we have greater confidence in using the models once again in our strategic thinking on ILBs. The broad conclusions from the models are the following: 10-year inflation breakevens are too low in the US, Canada and Germany 10-year inflation breakevens are too high in the UK and Italy 10-year inflation breakevens are fairly valued in France, Japan and Australia. Taken at face value, our models would suggest overweighting ILBs in the US, Canada and Germany and underweighting ILBs in the UK (and staying neutral on France, Japan and Australia) as part of a new regional ILB diversification strategy. However, there is an additional element to consider when assessing the attractiveness of inflation breakevens at the macro level – the expected stance of monetary policy. ILB inflation breakevens often represent a market-based “report card” on the appropriateness of a central bank’s monetary policy. If monetary settings are deemed to be overly stimulative, the markets will price in higher expected inflation and wider breakevens. The opposite holds true if policy is deemed to be too restrictive, leading to reduced expected inflation and narrower breakevens. Thus, any regional ILB allocation strategy should not only use fair value assessments, but also a monetary policy “filter”. In Chart 16, we show a scatter graph plotting the latest deviations from fair value of 10-year breakevens from our eight country fair value models on the x-axis, and the cumulative amount of expected interest rate increases discounted in overnight index swap (OIS) curves for each country on the y-axis. For the latter, we define this as the peak in rates discounted in 2023 (which is the case for all the countries) minus the trough in policy rates at the start of the current monetary tightening cycle (which is near 0% for all the countries). Chart 16No Clear Link Between Rate Hikes & Breakeven Valuations A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds The idea behind the chart is that inflation breakeven valuations should be inversely correlated to the amount of monetary tightening expected by markets. Too many rate hikes would result in markets discounting lower breakevens, and vice versa. However, there is no reliable relationship evident in the chart. For example, the OIS curves are discounting roughly similar levels of cumulative tightening in the US, UK, Canada and Australia, yet ILB breakeven valuations are very different between those countries. In Chart 17, we show a slightly different version of that scatter graph, this time plotting the ILB breakeven fair values versus the slope of the 2-year/10-year nominal government bond yield curve for all eight countries. The logic here is that the slope of the yield curve represents the bond market’s assessment of the appropriateness of future monetary policy. When policy is deemed to be too tight – with an expected peak in rates above what the market believes to be the neutral rate – the yield curve will be flat or even inverted, as markets discount slowing growth in the future and, eventually, lower inflation. Chart 17A Stronger Link Between Yield Curves & Breakeven Valuations A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds There is a clear positive relationship between yield curve slope and inflation expectations evident in the new chart. This provides some evidence justifying adding a monetary policy filter to a regional ILB allocation strategy. Related Report  Global Fixed Income StrategyDovish Central Bank Pivots Will Come Later Than You Think Under this framework, US and Canadian breakevens trading below fair value is consistent with the inverted yield curves in both countries, with markets now discounting a restrictive level of future interest rates that would dampen inflation expectations. The fair value of Australian and Japanese breakevens also appears in line with the slope of the yield curves in those countries. In terms of divergences, the overvaluation of UK breakevens is inconsistent with the inverted nominal Gilt curve, while the three euro area countries should have somewhat higher breakevens (trading more richly to fair value) given the relatively steeper slope of their yield curves. Investment Conclusions Chart 18Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight After surveying our ILB breakeven fair value models, and cross-checking them versus trends in survey-based inflation expectations and our own assessment of future monetary policies, we arrive at the following country allocations within our new regional ILB strategy: Neutral on US TIPS, despite the attractive valuations. However, look to upgrade if the Fed signals a less hawkish path for US monetary policy (not our base case) or if breakevens fall even further below fair value without more deeper US Treasury curve inversion. Underweight UK ILBs. Breakevens are overshooting due to the near-term inflation risk from soaring energy prices – an outcome that will force the BoE to deliver an even tighter monetary policy, with a more deeply inverted yield curve, that will drive the UK into a disinflationary recession. Underweight Canadian ILBs, despite the attractive valuations. Canadian inflation has likely peaked, and the BoC is engineering a disinflationary downturn in the Canadian housing market with aggressive rate hikes that will maintain an inverted yield curve. Overweight German, French and Italian ILBs. The ECB is likely to deliver fewer rate hikes than markets are discounting, keeping the euro area yield curves relatively steep versus the curves of other developed countries. This also provides a better way to play the near-term inflationary upside from overshooting natural gas prices in Europe than overweighting UK ILBs, with the BoE expected to be much more hawkish than the ECB (Chart 18). Neutral Australia and Japan. Underlying inflation momentum is slower than in the other regions, while breakeven valuations are neutral and not out of line with the expected stance of monetary policy. We are incorporating this new regional ILB strategy into our Model Bond Portfolio, which can be seen on pages 18-20. The changes from current allocations involve upgrades to Germany, France and Italy to overweight, and a downgrade of Canada to underweight.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds

Please note that there will no US Bond Strategy publication next week. Our regular publishing schedule will resume on September 6th with our Portfolio Allocation Summary for September. Executive Summary This report describes a framework for implementing long/short positions in the TIPS market relative to duration-matched nominal Treasuries. The framework is modeled after the Golden Rule of Bond Investing that we use to implement portfolio duration trades. The TIPS Golden Rule states that investors should buy TIPS versus nominal Treasuries when their 12-month headline inflation expectations are above those priced into the market, and vice-versa. We demonstrate a method for forecasting headline CPI inflation and conclude that it will fall into a range of 2.4% to 4.8% during the next 12 months, with risks to the upside. This suggests a high likelihood that headline inflation will exceed current market expectations. The TIPS Golden Rule’s Track Record The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record Bottom Line: We see value in TIPS on a 12-month investment horizon but anticipate that an even better entry point to get long TIPS versus nominal Treasuries will emerge during the next couple of months as headline CPI weakens. We recommend a neutral allocation to TIPS for now, though we are looking for a good opportunity to increase exposure. Feature Regular readers will no doubt be familiar with our Golden Rule Of Bond Investing, the framework we use to think about our portfolio duration recommendations. In brief, the Golden Rule states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. Our research shows that this investment strategy has a strong historical track record.1 The thing we like most about the Golden Rule framework is that it provides us with a good method for filtering incoming information. Does this new piece of news or economic data change our 12-month rate expectations? If not, then we probably don’t want to assign much weight to it when setting our portfolio duration. In this Special Report we demonstrate that the same Golden Rule logic that we apply to duration trading can also be applied to the TIPS market. Specifically, it can be applied to long/short positions in TIPS versus duration-matched nominal Treasuries. Developing The TIPS Golden Rule Before diving into the TIPS Golden Rule, it’s worth running through the logic that underpins this investment strategy. The logic starts with the Fisher Equation – the well-known formula that relates nominal bond yields to real bond yields. Simply, the Fisher Equation can be stated as follows:     Nominal Yield = Real Yield + The Cost Of Inflation Protection In financial market terms, we can re-write the equation as:     Nominal Treasury Yield = TIPS Yield + TIPS Breakeven Inflation Rate Two of the three variables in this equation have what we call valuation anchors. The nominal Treasury yield’s valuation is anchored by expectations about the future path for the federal funds rate. Put differently, if you buy a 5-year Treasury note and hold it until maturity, your excess returns versus a position in cash are purely determined by the path of the federal funds rate over that 5-year investment horizon. Similarly, the TIPS breakeven inflation rate’s valuation is anchored by expectations about CPI inflation. If held to maturity, the profits from an inflation protection position (long TIPS/short nominals or short TIPS/long nominals) are purely determined by the path of CPI inflation during the investment horizon. It’s worth noting that, unlike the nominal Treasury yield and the TIPS breakeven inflation rate, the TIPS yield has no independent valuation anchor. Within our framework, the best way to forecast the TIPS yield is to follow a 3-step process: Forecast the nominal yield based on a view about the fed funds rate. Forecast the TIPS breakeven inflation rate based on a view about inflation. Use the Fisher Equation to combine the results from steps 1 and 2 into a forecast for the TIPS yield. As an aside, while our framework relies on viewing the nominal Treasury yield and the TIPS breakeven inflation rate as reflective of expectations for the fed funds rate and CPI inflation respectively, we do not argue that those bond yields can be used to accurately forecast the fed funds rate or CPI inflation. In fact, history tells us that bond markets are usually poor predictors of future outcomes for the fed funds rate and for CPI inflation. Chart 1 shows that there is only a loose correlation (R2 = 22%) between 12-month bond-market implied expectations for the change in the fed funds rate and the actual change in the fed funds rate. Similarly, Chart 2 shows that there is hardly any correlation (R2 = 3%) between market-implied inflation expectations and the 12-month rate of change in headline CPI. Chart 1Market Prices Are A Poor Predictor Of The Fed Funds Rate The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart 2Market Prices Are A Poor Predictor Of Inflation The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing In other words, it’s more advisable to view the expectations priced into bond markets as a breakeven threshold for trading, not as a tool for forecasting. Stating The TIPS Golden Rule To apply the TIPS Golden Rule, investors should follow these three steps: Calculate market-implied expectations for what headline CPI inflation will be over the next 12 months. This can be done by looking at the 1-year CPI swap rate or the 1-year TIPS breakeven inflation rate.2 Develop an independent forecast for 12-month headline CPI inflation. We demonstrate one method for doing this later in the report.3 Compare your own headline CPI forecast with the forecast that is priced in the market. If your own forecast is higher, then you should go long TIPS/short nominal Treasuries. If your own forecast is lower, then you should go short TIPS/long nominal Treasuries. Testing The TIPS Golden Rule Chart 3 shows the historical track record of the TIPS Golden Rule going back to 2005.4 The top panel shows 12-month excess returns from the Bloomberg Barclays TIPS index relative to a duration-matched position in nominal Treasuries. The bottom panel shows whether inflation surprised market expectations to the upside or to the downside during the investment horizon. We can see that, visually, it looks as though TIPS tend to outperform nominal Treasuries when there is an inflationary surprise and underperform when there is a deflationary surprise. Chart 3The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record Chart 4 shows the same relationship in a little more detail. The 12-month inflation surprise is placed on the x-axis and 12-month TIPS excess returns are on the y-axis. For the TIPS Golden Rule to be useful, we would need to see most of the datapoints in the top-right and bottom-left quadrants of the chart, and indeed this is the case. Chart 412-Month TIPS Excess Returns Vs. Inflation Surprises The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Finally, Table 1 shows the relationship in even more detail. It shows that inflationary surprises coincide with positive TIPS excess returns 73% of the time for an average excess return of 2.6%. It also shows that deflationary surprises coincide with negative TIPS excess returns 80% of the time, for an average excess return of -3.2%. Table 112-Month TIPS Excess Returns* And Inflation Surprises (2005 – Present) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Please note that all the above return calculations are performed on the overall Bloomberg Barclays TIPS Index relative to a duration-matched position in nominal Treasuries. However, the TIPS Golden Rule also performs well when applied to TIPS of any maturity. The Appendix of this report replicates the above analysis for every point along the TIPS curve and shows that the results are consistently excellent. Applying The TIPS Golden Rule Now that we have stated the TIPS Golden Rule and demonstrated its effectiveness as an investment strategy, it is time to apply it to the current market. To do that, we first determine 1-year market-implied inflation expectations by looking at the 1-year CPI swap rate. As of last Friday’s close, the 1-year CPI swap rate is 3.16%. This means that if we think headline CPI inflation will be above 3.16% during the next 12 months, then we should go long TIPS versus duration-matched nominal Treasuries. If we think headline CPI inflation will come in below 3.16% during the next 12 months, then we should go short TIPS versus duration-matched nominal Treasuries. Next, we must build up our own forecast of headline CPI inflation for the next 12 months. To do this, we follow a bottom-up approach where we split the CPI basket into five components (energy, food, shelter, core goods, and core services ex. shelter) and model each one individually. Energy Inflation (9% Of Headline CPI) Chart 5Modeling Energy Inflation Modeling Energy Inflation Modeling Energy Inflation Energy accounts for roughly 9% of headline CPI, though its often violent price swings mean that this component usually accounts for a much larger percentage of the volatility in headline CPI. In practice, we can accurately model Energy CPI using the prices of retail gasoline, natural gas, and heating oil (Chart 5). To get a 12-month forecast for Energy CPI we therefore need forecasts for the prices of retail gasoline, natural gas, and heating oil. In this analysis, we will consider two possible scenarios for energy prices. First, a benign ‘low oil price’ scenario where we assume that the prices of retail gasoline, natural gas and heating oil follow the paths discounted in their respective futures curves. Second, we consider a ‘high oil price’ scenario that incorporates the view of our Commodity & Energy Strategy service that a drop in Russian oil supply, among other factors, will cause the Brent crude oil price to reach $119 per barrel by the end of this year and average $117 per barrel in 2023.5 To incorporate this outlook into our model, we regress the prices of retail gasoline, natural gas and heating oil on the Brent crude oil price and extrapolate forward using our commodity strategists’ forecasts. The ‘low oil price’ scenario has Energy CPI inflation falling from its current 32.9% level all the way down to -9.9% during the next 12 months. In contrast, our ‘high oil price’ scenario has it falling to just 15.8%. Food Inflation (13% Of Headline CPI) Chart 6Modeling Food Inflation Modeling Food Inflation Modeling Food Inflation Our Food CPI model is based on the cost of fertilizer, agricultural commodity prices and diesel prices. This model has done a reasonably good job explaining trends in Food CPI inflation over time, but the last few months have seen food inflation jump well above the levels suggested by our model (Chart 6). Given that the inputs to our Food CPI model are highly correlated with the oil price, we also apply the ‘low oil price’ and ‘high oil price’ scenarios discussed above to our Food CPI forecast. Using this method, the ‘low oil price’ scenario has Food CPI inflation falling to 3.8% during the next 12 months and the ‘high oil price’ scenario has it coming down to 4.2%. One key risk to these forecasts is that they both assume that the current gap between food inflation and our model’s fair value will close. It’s possible that other factors not included in our model could prevent the gap from closing. We therefore consider our Food CPI forecast to be quite optimistic. Core Goods Inflation (21% Of Headline CPI) Chart 7Modeling Goods Inflation Modeling Goods Inflation Modeling Goods Inflation Core goods inflation, currently running at 6.9%, appears to have already peaked following its post-pandemic surge. We model Core Goods CPI using the New York Fed’s Global Supply Chain Pressure Index, as it is the supply chain constraints that arose during the pandemic that explain the bulk of the movement in core goods prices since that time (Chart 7).6 To forecast Core Goods CPI, we assume that global supply chain constraints continue to ease and that the New York Fed’s index reverts to its pre-pandemic level during the next 12 months. This gives us a forecast for 12-month Core Goods CPI inflation of 0%. Shelter Inflation (32% Of Headline CPI) Chart 8Modeling Shelter Inflation Modeling Shelter Inflation Modeling Shelter Inflation We model shelter inflation, currently running at 5.6%, using the unemployment rate, rental vacancy rate and home prices (Chart 8). Except for the unemployment rate, all our model’s independent variables enter with a lag of at least 12 months. In other words, we wouldn’t expect any near-term change in home prices to impact Shelter CPI for at least a year. To forecast Shelter CPI, we assume that the unemployment rate rises to 4% during the next 12 months. This results in a shelter inflation forecast of 4.7% for the next 12 months. Much like with food inflation, we tend to view this forecast as relatively optimistic as it assumes a large reversion from the current rate of shelter inflation back to our model’s fair value. It’s conceivable that other factors not included in our model, such as rapid wage growth, could prevent this reversion from occurring. Services ex. Shelter Inflation (24% Of Headline CPI) Chart 9Modeling Services Inflation Modeling Services Inflation Modeling Services Inflation This final component of CPI is a bit of a hodgepodge of different service industries that may not have much in common. However, we find that wage growth does a good job of tracking its trends (Chart 9). We therefore model Services ex. Shelter CPI using the Employment Cost Index, which enters our model with a 10 month lag. To forecast Services ex. Shelter CPI, we assume that the Employment Cost Index holds steady at its current growth rate. This gives us a Services ex. Shelter CPI inflation forecast of 5.5% for the next 12 months. Combining Our Bottom-Up Inflation Forecasts & Investment Conclusions Combining our bottom-up forecasts, we calculate a 12-month headline CPI inflation rate of 2.4% for the ‘low oil price’ scenario and a rate of 4.8% for the ‘high oil price’ scenario. For core CPI inflation, we calculate a 12-month forecast of 3.6%. Given the optimistic assumptions that we incorporated into our forecasts, particularly the large reversions of food and shelter inflation back to our estimated fair value levels, we view the risks to our forecasts as heavily tilted to the upside. We also acknowledge that the re-normalization of global supply chains may not proceed as smoothly as the scenario that is baked into our forecasts. Any hiccup in that process would cause our goods inflation forecast to be too low. Chart 10Inflation Forecasts Inflation Forecasts Inflation Forecasts Chart 10 shows our 12-month headline and core CPI forecasts alongside the market-implied forecast from the CPI swap curve, currently 3.16%. Notice that the market-implied inflation forecast is much closer to the bottom-end of our range of headline CPI estimates, and we have already acknowledged that a lot of things will have to go right for our estimates to pan out. In other words, we see a high likelihood that 12-month headline CPI will be above 3.16% for the next 12 months which, according to our TIPS Golden Rule, tells us that we should go long TIPS versus duration-matched nominal Treasuries. While we acknowledge that there is likely some value in going long TIPS versus nominal Treasuries today, we are inclined to maintain our recommended neutral allocation to TIPS versus nominals for now. Given the recent drop in oil prices, we anticipate further weakness in headline inflation during the next couple of months. This could push TIPS breakeven inflation rates even lower in the near term, creating even more value. The bottom line is that we see attractive value in TIPS versus nominal Treasuries on a 12-month investment horizon. While we maintain a neutral allocation to TIPS for now, we anticipate turning more bullish in the near future, hopefully from a better entry point after one or two more weak CPI prints. Appendix Chart A112-Month TIPS Excess Returns Vs. Inflation Surprises (1-3 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A112-Month TIPS Excess Returns* And Inflation Surprises (1-3 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A212-Month TIPS Excess Returns Vs. Inflation Surprises (3-5 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A212-Month TIPS Excess Returns* And Inflation Surprises (3-5 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A312-Month TIPS Excess Returns Vs. Inflation Surprises (5-7 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A312-Month TIPS Excess Returns* And Inflation Surprises (5-7 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A412-Month TIPS Excess Returns Vs. Inflation Surprises (7-10 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A412-Month TIPS Excess Returns* And Inflation Surprises (7-10 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A512-Month TIPS Excess Returns Vs. Inflation Surprises (10-15 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A512-Month TIPS Excess Returns* And Inflation Surprises (10-15 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A612-Month TIPS Excess Returns Vs. Inflation Surprises (15+ Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A612-Month TIPS Excess Returns* And Inflation Surprises (15+ Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. 2 In this report we use the 1-year CPI swap rate because it is easier to access. 3 To make the TIPS Golden Rule easy to implement, we use seasonally adjusted headline CPI for all our calculations even though TIPS are technically linked to the non-seasonally adjusted index. We also ignore the fact that TIPS coupons adjust to CPI releases with a lag. Our analysis shows that the rule works very well even without incorporating these complications. 4 CPI swap rates are only available from 2004 onwards, so this is the largest historical sample we can use. 5 Please see Commodity & Energy Strategy Weekly Report, “EU Russian Oil Embargoes, Higher Prices”, dated August 18, 2022. 6 For more details on the Global Supply Chain Pressure Index: https://www.newyorkfed.org/research/policy/gscpi#/overview Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

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

Listen to a short summary of this report.     Executive Summary Significant Savings Provide A Moat Around Consumers Significant Savings Provide A Moat Around Consumers Significant Savings Provide A Moat Around Consumers Three mega moats will protect the US economy over the next 12 months: 1) A high number of job openings; 2) Significant pent-up demand; and 3) Strong Fed credibility, which has kept bond yields from rising more than they otherwise would have in response to higher inflation. Ironically, a recession will only occur when investors start believing that a recession will not occur. Without more economic optimism, real yields will not rise into restrictive territory. The double-dip 1980/82 recessions, the 1990-91 recession, the 2001 recession, and the 2007-09 Great Recession were all preceded by an almost identical 21-to-23-month period of a flat unemployment rate. The unemployment rate has been fairly stable since March when it hit 3.6%. Given the three moats, we suspect that it will move sideways well into next year. At that point, the trajectory of inflation will determine the path for the unemployment rate and the broader economy. Inflation will fall significantly over the coming months thanks to lower food and energy prices and easing supply-chain pressures. However, falling inflation could sow the seeds of its own demise. As prices at the pump and the grocery store decline, real wage growth will turn positive. This will bolster consumer confidence, leading to more spending, and ultimately, a reacceleration in core inflation.​​​​ Bottom Line: Stocks will rise over the next six months as recession risks abate, but then decline over the subsequent six months as it becomes clear that the Fed has no intention of cutting rates in 2023 and may even need to raise them further. On balance, we recommend a neutral exposure to global equities over a 12-month horizon.   Don’t Bet on a US Recession Just Yet Many investors continue to expect the US economy to slip into recession this year. The OIS curve is discounting over 100 basis points in rate cuts starting in 2023, something that would probably only happen in a recessionary environment (Chart 1). In contrast to the consensus view, we think that the US will avoid a recession. This is good news for stocks in the near term because it means that earnings estimates, which have already fallen meaningfully this year, are unlikely to be cut any further (Chart 2). It is bad news for stocks down the road because it means that rather than cutting rates in 2023, the Fed could very well have to raise them. Chart 1Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 Image These two conflicting considerations lead us to expect stocks to rise over the next six months but then to fall over the subsequent six months. As such, we recommend an above-benchmark exposure to global equities over a short-term tactical horizon but a neutral exposure over a 12-month horizon. Three mega moats will protect the US economy over the next 12 months: 1) A high number of job openings; 2) Significant pent-up demand; and 3) Strong Fed credibility, which has kept bond yields from rising more than they otherwise would have in response to higher inflation. Let’s explore each in turn.   Moat #1: A High Number of Job Openings While job openings have fallen over the past few months, they are still very high by historic standards (Chart 3). In June, there were 1.8 job openings for every unemployed worker, up from 1.2 in February 2020. At the peak of the dotcom bubble, there were 1.1 job openings per unemployed worker. A high job openings rate means that many workers who lose their jobs will have little difficulty finding new ones. This should keep the unemployment rate from rising significantly as labor demand cools on the back of higher interest rates. Some investors have argued that the ease with which companies can advertise for workers these days has artificially boosted reported job openings. We are skeptical of this claim. For one thing, it does not explain why the number of job openings has risen dramatically over the past two years since, presumably, the cost of job advertising has not changed that much. Moreover, the Bureau of Labor Statistics bases its estimates of job openings not on a tabulation of online job postings but on a formal survey of firms. For a job opening to be counted, a firm must have a specific position that it is seeking to fill within the next 30 days. This rules out general job postings for positions that may not exist. We are also skeptical of claims that increased layoffs could significantly push up “frictional” unemployment, a form of unemployment stemming from the time it takes workers to move from one job to another. There is a great deal of churn in the US labor market (Chart 4). In a typical month, net flows in and out of employment represent less than 10% of gross flows. In June, for example, US firms hired 6.4 million workers. On the flipside “separations” totaled 5.9 million in June, 71% of which represented workers quitting their jobs. Chart 3A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market Chart 4Labor Market Churn Tends To Increase As Unemployment Falls Labor Market Churn Tends To Increase As Unemployment Falls Labor Market Churn Tends To Increase As Unemployment Falls   In fact, total separations (and hence frictional unemployment) tend to rise when the labor market strengthens since that is when workers feel the most emboldened to quit. The reason that the unemployment rate increases during recessions is not because laid-off workers need time to find a new job but because there are simply not enough new jobs available. Fortunately, that is not much of a problem today.   Moat #2: Significant Pent-Up Demand US households have accumulated $2.2 trillion (9% of GDP) of excess savings since the start of the pandemic, most of which reside in highly liquid bank deposits (Chart 5). Admittedly, most of these savings are skewed towards middle- and upper-income households who tend to spend less out of every dollar of income than the poor (Chart 6). Nevertheless, even the top 10% of income earners spend about 80% of their income (Chart 7). This suggests that most of these excess savings will be deployed, supporting consumption in the process. Chart 5Significant Savings Provide A Moat Around Consumers Significant Savings Provide A Moat Around Consumers Significant Savings Provide A Moat Around Consumers Chart 6Unlike The Poor, Middle-To-Upper Income Households Still Hold Much Of Their Pandemic Savings Unlike The Poor, Middle-To-Upper Income Households Still Hold Much Of Their Pandemic Savings Unlike The Poor, Middle-To-Upper Income Households Still Hold Much Of Their Pandemic Savings Some commentators have argued that high inventories will restrain production, even if consumer spending remains buoyant. We doubt that will happen. While retail inventories have risen of late, the retail inventory-to-sales ratio is still near all-time lows (Chart 8). Moreover, real retail sales have returned to their pre-pandemic trend (Chart 9A). Overall goods spending is still above trend, but has retraced two-thirds of its pandemic surge with little ill-effect on the labor market (Chart 9B). Chart 7Even The Wealthy Spend Most Of Their Income Three Mega Moats Around The US Economy Three Mega Moats Around The US Economy Chart 8Retail Inventory-To-Sales Ratios Have Rebounded, But Remain Low Retail Inventory-To-Sales Ratios Have Rebounded, But Remain Low Retail Inventory-To-Sales Ratios Have Rebounded, But Remain Low Chart 9ASpending On Goods Has Been Normalizing (I) Spending On Goods Has Been Normalizing (I) Spending On Goods Has Been Normalizing (I) Chart 9BSpending On Goods Has Been Normalizing (II) Spending On Goods Has Been Normalizing (II) Spending On Goods Has Been Normalizing (II) The latest capex intention surveys point to a deceleration in business investment (Chart 10). Nevertheless, we doubt that capex will decline by very much. Following the dotcom boom, core capital goods orders moved sideways for two decades (Chart 11). The average age of the nonresidential capital stock rose by over two years during this period (Chart 12). Excluding investment in intellectual property, business capex as a share of GDP is barely higher now than it was during the Great Recession. Not only is there a dire need to replenish the existing capital stock, but there is an urgent need to invest in new energy infrastructure and increased domestic manufacturing capacity. Chart 10Capex Intentions Have Dipped Capex Intentions Have Dipped Capex Intentions Have Dipped Chart 11Capex Has Been Moribund For The Past Two Decades (I) Capex Has Been Moribund For The Past Two Decades (I) Capex Has Been Moribund For The Past Two Decades (I) With regards to residential investment, the homeowner vacancy rate has fallen to a record low. The average age of US homes stands at 31 years, the highest since 1948. Chart 13 shows that housing activity has weakened somewhat less than one would have expected based on the significant increase in mortgage rates in the first six months of 2022. Given the recent stabilization in mortgage rates, the chart suggests that housing activity should rebound by the end of the year. Chart 12Capex Has Been Moribund For The Past Two Decades (II) Capex Has Been Moribund For The Past Two Decades (II) Capex Has Been Moribund For The Past Two Decades (II) Chart 13Housing Activity Should Rebound On The Back Of Low Vacancy Rates, An Aging Housing Stock, And Stabilizing Mortgage Rates Housing Activity Should Rebound On The Back Of Low Vacancy Rates, An Aging Housing Stock, And Stabilizing Mortgage Rates Housing Activity Should Rebound On The Back Of Low Vacancy Rates, An Aging Housing Stock, And Stabilizing Mortgage Rates Moat #3: Strong Fed Credibility Even though headline inflation is running at over 8% and most measures of core inflation are in the vicinity of 5%-to-6%, the 10-year bond yield still stands at 2.87%. Two things help explain why bond yields have failed to keep up with inflation. First, investors regard the Fed’s commitment to bringing down inflation as highly credible. The TIPS market is pricing in a rapid decline in inflation over the next two years (Chart 14). The widely-followed 5-year, 5-year forward TIPS inflation breakeven rate is still near the bottom end of the Fed’s comfort zone. Chart 14AWell-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Three Mega Moats Around The US Economy Three Mega Moats Around The US Economy Chart 14BWell-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Well-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Well-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Households tend to agree with the market’s assessment. While households expect inflation to average over 5% over the next 12 months, they expect it to fall to 2.9% over the long term. As Chart 15 illustrates, expected inflation 5-to-10 years out in the University of Michigan survey is in line with where it was between the mid-1990s and 2015. This is a major difference from the early 1980s, when households expected inflation to remain near 10%. Back then, Paul Volcker had to engineer a deep recession in order to bring long-term inflation expectations back down to acceptable levels. Such pain is unlikely to be necessary today. Chart 15Households Expect Inflation To Come Back Down Households Expect Inflation To Come Back Down Households Expect Inflation To Come Back Down Chart 16Markets Think That The Real Neutral Rate Is Low Markets Think That The Real Neutral Rate Is Low Markets Think That The Real Neutral Rate Is Low The second factor that is suppressing bond yields is the market’s perception that the real neutral rate of interest is quite low. The 5-year, 5-year TIPS yield – a good proxy for the market’s estimate of the real neutral rate – currently stands at 0.40%, well below its pre-GFC average of 2.5% (Chart 16). Ironically, a recession will only occur when investors start believing that a recession will not occur. Without more economic optimism, real yields will not rise into restrictive territory. When Will the Moats Dry Up? The US unemployment rate is a mean-reverting series. When unemployment is very low, it is more likely to rise than to fall. And when the unemployment rate starts rising, it keeps rising. In the post-war era, the US has never avoided a recession when the unemployment rate has risen by more than one-third of a percentage point over a three-month period (Chart 17). Chart 17When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising ​​​​​With the unemployment rate falling to a 53-year low of 3.5% in July, it is safe to say that we are in the late stages of the business-cycle expansion. When will the unemployment rate move decisively higher? While it is impossible to say with certainty, history does offer some clues. Remarkably, the double-dip 1980/82 recessions, the 1990-91 recession, the 2001 recession, and the 2007-09 Great Recession were all preceded by an almost identical 21-to-23-month period of a flat unemployment rate (Chart 18 and Table 1). Coincidentally, the Covid-19 recession was also preceded by 22 months of a stable unemployment rate. To the extent that the economy was not showing much strain going into the pandemic, it is reasonable to assume that the unemployment rate would have continued to move sideways for most of 2020 had the virus never emerged. Chart 18The Bottoming Phase Of The Unemployment Rate Has Only Begun The Bottoming Phase Of The Unemployment Rate Has Only Begun The Bottoming Phase Of The Unemployment Rate Has Only Begun Image Inflation is the Key The unemployment rate has been fairly stable since March when it hit 3.6%. Given the three moats discussed in this report, we suspect that it will move sideways well into next year. At that point, the trajectory of inflation will determine the path of the unemployment rate and the broader economy. As this week’s better-than-expected July CPI report foreshadows, inflation will fall significantly over the coming months, thanks to lower food and energy prices and easing supply-chain pressures. The GSCI Agricultural Index has dropped 24% from its highs and is now below where it was before Russia’s invasion of Ukraine (Chart 19). Retail gasoline prices have fallen 19% since June, with the futures market pointing to a substantial further decline over the next 12 months. In general, there is an extremely strong correlation between the change in gasoline prices and headline inflation (Chart 20). Supplier delivery times have also dropped sharply (Chart 21). Chart 19Agricultural Prices Have Started Falling Agricultural Prices Have Started Falling Agricultural Prices Have Started Falling Chart 20Headline Inflation Tends To Track Gasoline Prices Headline Inflation Tends To Track Gasoline Prices Headline Inflation Tends To Track Gasoline Prices Falling inflation could sow the seeds of its own demise, however. As prices at the pump and the grocery store decline, real wage growth will turn positive. That will bolster consumer confidence, leading to more spending (Chart 22). Core inflation, which is likely to decrease only modestly over the coming months, will start to accelerate in 2023, prompting the Fed to turn hawkish again. Stocks will falter at that point. Chart 21Supplier Delivery Times Have Declined Supplier Delivery Times Have Declined Supplier Delivery Times Have Declined Chart 22Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn and Twitter     Global Investment Strategy View Matrix Three Mega Moats Around The US Economy Three Mega Moats Around The US Economy Special Trade Recommendations Current MacroQuant Model Scores Three Mega Moats Around The US Economy Three Mega Moats Around The US Economy

Listen to a short summary of this report.     Executive Summary Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Following last week’s sharp post-FOMC rally, we shifted our 12-month equity recommendation from overweight to neutral. We expect stock prices to rise further during the remainder of the year as US recession risks abate, but then to give up most of their gains early next year as it becomes clear that the Fed has no intention of cutting rates and may even need to raise rates. We have more conviction that US growth will hold up over the next 12 months than we do that inflation will fall as fast as the Fed expects or the breakevens imply. These varying degrees of conviction stem from the same reason: The neutral rate of interest in the US is higher than widely believed. A high neutral rate implies that it may take significant monetary tightening to slow the economy. That reduces the risk of a recession in the near term, but it raises the risk that inflation will remain elevated. A recession is now our base case for the euro area. However, we expect the European economy to bounce back early next year, as gas supplies increase and fiscal policy turns more stimulative. The euro has significant upside over the long haul. Bottom Line: Stocks will continue to recover over the coming months before facing renewed pressure early next year. We are retaining our tactical (3-month) overweight on global equities but are shifting our 12-month recommendation to neutral. Taking Some Chips Off the Table Following last week’s sharp post-FOMC rally, we shifted our cyclical 12-month equity recommendation from overweight to neutral. This note lays out the key considerations in a Q&A format.   Q: Have any of your underlying views about the economy changed recently or has the market simply moved towards pricing in your benign outlook? A: Mainly the latter. While we continue to see a higher-than-normal risk of a US recession over the next 12 months, our baseline (60% odds) remains no recession.   Q: Many would say that we are in a recession already. A: While two consecutive quarters of negative growth does not officially constitute a recession, it is correct to say that every time real GDP has contracted for two quarters in a row, the NBER has ultimately deemed that episode a recession (Chart 1). Chart 1In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession That said, one should keep two things in mind. First, preliminary GDP estimates are subject to significant revisions. According to our calculations, there is a 35% chance that real GDP growth in Q2 will ultimately be revised into positive territory (Chart 2). Even Q1 may eventually show positive growth. Real Gross Domestic Income (GDI), which conceptually should equal GDP, rose by 1.8% in Q1. Chart 2After Further Revisions, It Is Possible That GDP Growth Ends Up Being Positive In Q2 2022 Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A Second, every single US recession has seen an increase in the unemployment rate (Chart 3). So far, that has not happened, and there is good reason to think it will not happen for some time: There are 1.8 job openings per unemployed worker (Chart 4). For the foreseeable future, most people who lose their jobs will be able to walk across the street to find a new one. Chart 3Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Chart 4A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market   Chart 5Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Q: Aren’t other measures of economic activity such as the ISM, consumer confidence, and homebuilder sentiment all signaling that a major slowdown is in progress? A: They are but we should take them with a grain of salt. The composition of consumer spending is shifting from goods to services. This is weighing on manufacturing output. As Chart 5 shows, goods spending has already retraced two-thirds of its pandemic surge, with no ill effects on the labor market. Consumer confidence tends to closely track real wages (Chart 6). Despite an extraordinarily tight labor market, real wages have been shrinking all year. As supply-chain bottlenecks abate, inflation will fall, allowing real wages to rise. This will bolster consumer confidence and spending. Falling gasoline prices will also boost disposable incomes. Prices at the pump have fallen for seven straight weeks and the futures market is pointing to further declines in the months ahead (Chart 7). Chart 6Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Chart 7The Futures Market Points To Further Declines In Gasoline Prices The Futures Market Points To Further Declines In Gasoline Prices The Futures Market Points To Further Declines In Gasoline Prices It is also critical to remember that the Fed is trying to slow the economy by tightening monetary policy. At the start of the year, investors expected the Fed funds rate to be 0.9% in early 2023. Today, they expect it to be 3.4% (Chart 8). Chart 8Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Chart 9Housing Activity Should Recover Now That Mortgage Rates Have Stabilized Housing Activity Should Recover Now That Mortgage Rates Have Stabilized Housing Activity Should Recover Now That Mortgage Rates Have Stabilized   Rising rate expectations curb aggregate demand. This temporarily leads to lower growth. However, once rate expectations stabilize – and demand resets to a lower level – growth will tend to return to trend. The 6-month mortgage yield impulse has already turned up. This suggests that housing and other interest-rate sensitive parts of the economy will begin to recover by the end of the year (Chart 9). Admittedly, if the unemployment rate rises in response to lower aggregate demand, this could set off a vicious circle where higher unemployment leads to less spending, leading to even higher unemployment. However, as noted above, given that the current starting point is one where labor demand already exceeds labor supply by a wide margin, the odds of a such a labor market doom loop are much lower than during past downturns.   Q: Does the question of whether we officially enter a recession or not really matter that much? A: It is a matter of degree. As Chart 10 shows, macroeconomic factors are by far the most important determinant of equity returns over medium-term horizons of about 12 months. As a rule of thumb, bear markets almost always coincide with recessions (Chart 11). Chart 10Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons (I) Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons (I) Chart 11Equity Bear Markets And Recessions Go Hand-In-Hand Equity Bear Markets And Recessions Go Hand-In-Hand Equity Bear Markets And Recessions Go Hand-In-Hand   Chart 12Soaring Energy Prices Have Boosted Earnings Estimates This Year Soaring Energy Prices Have Boosted Earnings Estimates This Year Soaring Energy Prices Have Boosted Earnings Estimates This Year Q: Are you surprised that earnings estimates have not come down faster this year as economic risks have intensified? A: Most analysts have not baked in a recession in their forecasts, so from that perspective, if our baseline scenario of no recession does not pan out, earnings estimates will almost certainly come down (Chart 12). That said, the bar for major downward earnings revisions is quite high. This is partly because we think that if a recession does occur, it is likely to be a mild one. It is also because earnings are reported in nominal terms. In contrast to real GDP, nominal GDP grew by 6.6% in Q1 and 7.8% in Q2.   Q: Let’s turn to interest rates. Why do you think the Fed will not cut rates next year as markets are discounting? A: It all boils down to the neutral rate of interest. In past reports, we made the case that the neutral rate in the US is higher than widely believed. The fact that job vacancies are so plentiful provides strong evidence in favor of our thesis. If the neutral rate were low, the labor market would not have overheated. But it did, implying that monetary policy must have been exceptionally accommodative. The good news for investors is that a high neutral rate implies that the Fed is unlikely to induce a recession by raising rates in accordance with its dot plot. That reduces the risk of a recession in the near term. The bad news is that a high neutral rate will essentially preclude the Fed from cutting rates next year. The economy will simply be too strong for that. Worse still, if the Fed is too slow in bringing rates to neutral, inflation – which is likely to fall over the coming months as supply-chain pressures ease – could reaccelerate at some point next year. That could force the Fed to start hiking rates again.   Chart 13Real Yields Have Scope To Rise Further Real Yields Have Scope To Rise Further Real Yields Have Scope To Rise Further Q: What is your estimate for the neutral rate in the US? A: In the past, we have written that the neutral rate in the US is around 3.5%-to-4%. However, I must admit, I’m not a big fan of this formulation. Real rates matter more for economic growth than nominal rates, and long-term rates matter more than short-term rates. Thus, a better question is what level of real long-term bond yields is consistent with stable inflation and full employment. Based on research we have published in the past, my best bet is that the neutral long-term real bond yield is between 1.5%-and-2%. That is substantially above the 10-year TIPS yield (0.27%) and the 30-year TIPS yield (0.79%) (Chart 13). Given that the yield curve is inverted, the Fed may have to raise policy rates well above 4% in order to drag up the long end of the curve. It is a bit like how oil traders say you need to lift spot crude prices in order to push up long-term futures prices when the oil curve is backwardated.   Chart 14Investors Expect Inflation To Fall Rapidly Over The Next Few Years Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A Q: So presumably then, you would favor a short duration position in fixed-income portfolios? A: Yes, if the whole yield curve shifts higher, you will lose a lot less money in short-term bonds than in long-term bonds. Relatedly, we would overweight TIPS versus nominal bonds. The TIPS market is pricing in a very rapid decline in inflation over the next few years (Chart 14). The widely followed 5-year, 5-year forward TIPS inflation breakeven rate is trading at 2.28%, toward the bottom end of the Fed’s comfort zone of 2.3%-to-2.5%.1   Q: What about credit? A: US high-yield bonds are pricing in a default rate of 6.1% over the next 12 months. This is up from an expected default rate of 3.8% at the start of the year and is significantly higher than the trailing 12-month default rate of 1.4%. In a typical recession, high-yield default rates rise above 8% (Chart 15). Thus, spreads would probably increase if the US entered a recession. That said, it is important to keep in mind that many corporate borrowers took advantage of very low long-term yields over the past few years to extend the maturity of their debt. Only 7% of US high-yield debt, and less than 1% of investment-grade debt, held in corporate credit ETFs matures in less than two years. This suggests that the default cycle, if it were to occur, would be less intense and more elongated than previous ones. Chart 15High-Yield Bonds Are Pricing In Higher Default Rates High-Yield Bonds Are Pricing In Higher Default Rates High-Yield Bonds Are Pricing In Higher Default Rates On balance, we recommend a modest overweight to high-yield bonds within fixed-income portfolios.   Chart 16High Energy Prices Are Weighing On The European Economy High Energy Prices Are Weighing On The European Economy High Energy Prices Are Weighing On The European Economy Q: Let’s turn to non-US markets. The dollar has strengthened a lot against the euro this year as the economic climate in Europe has soured. Can Europe avoid a recession? A: Probably not. European natural gas prices are back near record highs and business surveys increasingly point to recession (Chart 16). That said, the nature of Europe’s recession could turn out to be quite different from what many expect. There are a few useful parallels between the predicament Europe finds itself in now and what the global economy experienced early on during the pandemic. Just like the Novel coronavirus, as it was called back then, represented an external shock to the global economy, the partial cut-off in Russian energy flows represents an external shock to the European economy. Policymakers in advanced economies responded to the pandemic by showering their economies with various income-support measures. European governments will react similarly to the energy crunch. In fact, the political incentive to respond generously is even greater this time around because the last thing European leaders want is for Putin to succeed in his efforts to destabilize the region. For its part, the ECB will set an extremely low bar for buying Italian bonds and the debt of other vulnerable economies. Just like the world eventually deployed vaccines, Europe is taking steps to inoculate itself from its dangerous addiction to Russian energy. The official REPowerEU plan seeks to displace two-thirds of Russian natural gas imports by the end of the year. While some aspects of the plan are probably too optimistic, others may not be optimistic enough. For example, the plan does not envision increased energy production from coal-fired plants, which is something that even the German Green Party has now signed on to. The euro is trading near parity to the dollar because investors expect growth in the common-currency bloc to remain depressed for an extended period of time. If investors start to price in a more forceful recovery, the euro will rally.   Q: China’s economy remains in the doldrums. Could that undermine your sanguine view on the global economy? A: China’s PMI data disappointed in July, as anxiety over the zero-Covid policy and a sagging property market continued to weigh on activity (Chart 17). We do not expect any change to the zero-Covid policy until the conclusion of the Twentieth Party Congress later this year. After that, the government is likely to ease restrictions, which will help to reignite growth. Chart 17The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity Chart 18China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing The property market has probably entered a secular downturn (Chart 18). If a weakening property market were to cause a banking crisis, similar to what happened in the US and parts of Europe in 2008, this would destabilize the global economy. However, we doubt that this will happen given the control the government has over the banking system. In contrast, a soft landing for the Chinese real estate market might turn out to be a welcome development for the global economy, as less Chinese property investment would keep a lid on commodity prices, thus helping to ease inflationary pressures. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn & Twitter   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. View Matrix Image Special Trade Recommendations Current MacroQuant Model Scores Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A

Highlights Chart 1Are Expectations Too Dovish? Are Expectations Too Dovish? Are Expectations Too Dovish? ​​​ The bond market is now priced for the fed funds rate to peak at 3.44% in January and then head back down to 2.79% by the end of 2023 (Chart 1). We strongly push back against the idea that the Fed will be cutting rates in 2023. While inflation will fall during the next few months, strong wage growth suggests that it will be sticky above the Fed’s 2% target for some time. What’s more, comments from yesterday’s ISM PMI release show that “companies continue to hire at strong rates”. Our sense is that it will be difficult to push the unemployment rate up significantly even as economic activity slows. Given that inflation is likely to fall during the next few months, we recommend keeping portfolio duration ‘at benchmark’ for the time being. However, we are now actively looking for an opportunity to reduce portfolio duration and we could change our recommended allocation in the near term. Stay tuned. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview ​​​​​ Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 109 basis points in July, bringing year-to-date excess returns up to -274 bps. The average index option-adjusted spread tightened 11 bps on the month and it currently sits at 144 bps. Similarly, our quality-adjusted 12-month breakeven spread moved down to its 54th percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve suggests that the credit cycle is in its late stages. Corporate bond performance tends to be weak during periods when the yield curve is very flat or inverted. Despite our underweight 6-12 month investment stance, we wouldn’t be surprised to see spreads narrow further during the next couple of months as inflation finally shows signs of rolling over. That said, the persistent removal of monetary accommodation and inverted yield curve will limit how much spreads can compress. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 434 basis points in July, bringing year-to-date excess returns up to -493 bps. The average index option-adjusted spread tightened 100 bps on the month to reach 469 bps, 100 bps above the 2017-19 average and 62 bps below the 2018 peak. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – moved lower in July. It currently sits at 6.2% (Chart 3). As is the case with investment grade, there’s a good chance that high-yield spreads can continue their relief rally during the next couple of months as inflation falls. Due to the flatness of the yield curve, we think it will be difficult for spreads to move below the average seen during the last tightening cycle (2017-19). However, even a move back to average 2017-19 levels would equate to roughly 5% of excess return for the junk index if it is realized over a six month period. This potential return is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we will be inclined to downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to 4%.3 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 129 basis points in July, bringing year-to-date excess returns up to -44 bps. We discussed the outlook for Agency MBS in a recent report.4  We noted that MBS’s poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates. The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (panel 4). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. We had been recommending that investors favor low-coupon (1.5%-2.5%) MBS over high-coupon (3%-4.5%) MBS to take advantage of falling bond yields (bottom panel). Now that bond yields have fallen, we think it is wise to take profits on this position and shift to a neutral allocation across the coupon stack. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds outperformed the duration-equivalent Treasury index by 31 basis points in July, bringing year-to-date excess returns up to -708 bps. EM Sovereigns outperformed the Treasury benchmark by 155 bps on the month, bringing year-to-date excess returns up to -784 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 45 bps, dragging year-to-date excess returns down to -659 bps. The EM Sovereign Index outperformed the duration-equivalent US corporate bond index by 53 bps in July. The yield differential between EM sovereigns and duration-matched US corporates remains negative (Chart 5). As such, we continue to recommend a maximum underweight allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index underperformed duration-matched US corporates by 116 bps in July. The index continues to offer a significant yield advantage versus duration-matched US corporates (panel 4). As such, we continue to recommend a neutral (3 out of 5) allocation to the sector. EM currencies continue to struggle versus the US dollar (bottom panel), and depreciating exchange rates will continue to act as a headwind for USD-denominated EM bond performance. Our Emerging Market Strategy service expects continued near-term weakness in EM currencies.5 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to -169 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong, but governments have been slow to hire.6 The result is that net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete those coffers, even as economic growth slows and federal fiscal thrust turns to drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni / Treasury yield ratio is currently 85%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched US corporates is 89%. The same measure for 17-year+ Revenue bonds stands at 95%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 2-Year Bullet Versus Cash/5 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened out to the 10-year maturity point in July. The 2-year/10-year Treasury slope flattened 28 bps on the month while the 5-year/30-year slope steepened 17 bps. The 2/10 and 5/30 slopes now stand at -22 bps and +30 bps, respectively. We closed our position long the 5-year bullet versus a duration-matched 2/10 barbell in a recent report.7 The reason for the move is that the 5-year note no longer offers a yield advantage versus the 2/10 barbell. That 2/5/10 butterfly spread has continued to compress during the past three weeks, and it now sits at -10 bps (Chart 7). In that same report we initiated a new recommendation: buy the 2-year bullet versus a duration-matched barbell consisting of cash and the 5-year note. This position offers a much more attractive yield advantage of 51 bps (bottom panel). Our new position will deliver strong returns if the 2-year/5-year Treasury slope steepens, something that is likely to occur if the market prices out the rate cuts that are currently discounted for next year. This would be in line with our base case expectation. However, if our base case is wrong and a deep recession forces the Fed to cut rates during the next 6-12 months, then our position should also benefit from a bull-steepening of the 2/5 slope. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 270 basis points in July, bringing year-to-date excess returns up to +256 bps. The 10-year TIPS breakeven inflation rate rose 20 bps on the month, moving back above the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Meanwhile, our TIPS Breakeven Valuation Indicator now shows that TIPS are modestly cheap versus nominals (panel 2). We upgraded TIPS from underweight to neutral in a recent report.8 In that report we noted that TIPS valuation had improved considerably in recent months as the cost of inflation compensation embedded in the market trended down. For example, the 1-year CPI swap rate currently sits at 3.94%, down from a peak of 5.9% in June. Given our expectation that core inflation will be sticky around 4%, the cost of inflation compensation looks a lot more compelling than it did even a month ago. We also closed our long-standing recommendation to short 2-year TIPS in a report published two weeks ago.9 We made this change after the 2-year TIPS yield moved into positive territory for the first time since 2020, up from a 2021 low of -3.07% (bottom panel). We are not yet ready to upgrade TIPS to overweight, despite much improved valuation, because headline inflation is much more likely to trend lower than higher during the next few months. That said, if current valuations persist, we will likely be looking to upgrade TIPS once more before the end of the year.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in July, dragging year-to-date excess returns down to -52 bps. Aaa-rated ABS underperformed by 10 bps on the month, dragging year-to-date excess returns down to -43 bps. Non-Aaa ABS underperformed by 11 bps on the month, dragging year-to-date excess returns down to -104 bps. During the past two years, substantial federal government support for household incomes caused US households to build up an extremely large buffer of excess savings. Nowhere is this more evident than in the steep drop in the amount of outstanding credit card debt that was witnessed in 2020 and 2021 (Chart 9). In 2022, consumers have started to re-lever. The personal savings rate was just 5.1% in June and the amount of outstanding credit card debt has recovered to its pre-COVID level (bottom panel). But while household balance sheets are starting to deteriorate, they remain exceptionally strong in level terms. In other words, it will be some time before we see enough deterioration to cause a meaningful uptick in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in July, bringing year-to-date excess returns up to -175 bps. Aaa Non-Agency CMBS outperformed Treasuries by 18 bps on the month, bringing year-to-date excess returns up to -123 bps. Non-Aaa Non-Agency CMBS outperformed by 22 bps on the month, bringing year-to-date excess returns up to -319 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently slightly above their historic averages. Further, last week’s Q2 GDP report confirmed that commercial real estate (CRE) investment remains weak (Chart 10). Weak investment will continue to support CRE price appreciation which will benefit CMBS spreads. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 24 bps in July, dragging year-to-date excess returns down to -15 bps. The average index option-adjusted spread widened 9 bps on the month. It currently sits at 54 bps, close to its long-term average (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight.  Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 78 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 29, 2022) Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot 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 July 29, 2022) Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot 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 34 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 34 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) Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of July 29, 2022) Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3 For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 Please see Emerging Markets Strategy Charts That Matter, “Beware Of Another Downleg In Risk Assets”, dated June 30, 2022. 6 Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 7 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 9 Please see US Bond Strategy Weekly Report, “Three Conjectures About The US Economy”, dated July 19, 2022. 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