Inflation Protected

Highlights Equity valuations are extremely stretched versus bonds, so there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. We estimate that bond yields can rise by no more than 30 bps, before the Fed is forced to talk them back down again. Starting from an earnings yield that is extreme versus its history, we should prudently assume that the prospective long-term real return from equities will be far below the current earnings yield of 4.6 percent, and closer to zero, even if not actually negative. In capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. Fractal analysis: Cotton, and Polish equities. Feature Chart of the WeekTech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Tech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Tech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Equity valuations are extremely stretched versus bonds. The upshot is that there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. This is not just an abstract hypothesis – it is an empirical fact, as recent market action is making painfully clear. Since February, the global tech sector has tracked the 30-year T-bond price almost one-for-one. The near perfect fit proves that the tech (and broader growth stock) rally has been entirely premised on the bond market rally. Hence, on the three occasions that bonds have sold off sharply – including in the last couple of weeks – tech stocks have sold off sharply too (Chart of the Week). Put simply, the performance of the tech sector is being driven by the change in its valuation, and the change in its valuation is being driven by the change in the bond yield (Chart I-2). Chart I-2Tech Stock Valuations Are Being Driven By The Bond Yield Tech Stock Valuations Are Being Driven By The Bond Yield Tech Stock Valuations Are Being Driven By The Bond Yield Of course, stock prices are also premised on earnings. So, given enough time, rising earnings can make valuations less stretched, adding more wiggle room for bonds to sell off. The trouble is that a change in earnings happens much more gradually than can a change in valuation – a 10 percent rise in earnings can take a year, whereas a 10 percent fall in valuation can happen in a week. Bond Yields Remain The Dominant Driver Of The Stock Market For the next few months at least, the movement in bond yields will remain the dominant driver of the most stretched parts of the stock market and, by extension, the overall market itself. This is especially true for the growth-heavy S&P 500 which, since March, has been tracking the 30-year T-bond price one-for-one (Chart I-3). Chart I-3The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The key question for investors is, what is the upper limit to bond yields before stock market damage causes the Federal Reserve to talk them down again? To answer this question, our working assumption is that a 15 percent drawdown in growth stocks would damage the growth-heavy S&P 500 enough – and thereby worsen ‘financial conditions’ enough – for the Fed to change its tone. Based on this year’s very tight relationship between tech stocks and the 30-year T-bond yield, a 15 percent drawdown would occur if the 30-year T-bond yield increased to 2.4 percent from 2.1 percent today (Chart I-4). Chart I-4The Fed's 'Pain Point' Is Only 30 Basis Points Away The Fed's 'Pain Point' Is Only 30 Basis Points Away The Fed's 'Pain Point' Is Only 30 Basis Points Away This confirms our view that the resistance level to long-duration bond yields is around 30 bps above current levels, equivalent to around 1.8 percent on the 10-year T-bond yield. More About The ‘Negative Equity Risk Premium’ Our recent report The Equity Risk Premium Turns Negative For The First Time Since 2002 caused quite a stir. So, let’s elaborate and clarify the arguments we made about the equity risk premium (ERP) – the estimated excess return that stocks will deliver over bonds over a long investment horizon, such as 10 years. Many investors estimate the ERP by taking the stock market’s earnings yield – currently 4.6 percent in the US1 – and subtracting the real 10-year bond yield – currently -0.9 percent on US Treasury Inflation Protected Securities (TIPS). At first glance, this presents a very generous ERP of 5.5 percent. So, equities are attractively valued versus bonds, right? Wrong. The glaring error is that the earnings yield estimates the stock market’s prospective return only if the earnings yield starts and ends at the same level. If it does not, then the prospective return could be very different to the earnings yield. For example, imagine that the stock market was trading at a bubble price-to-earnings multiple of 100, meaning an earnings yield of 1 percent. Clearly, from such a bubble valuation, nobody would expect the market to return 1 percent. Instead, as the bubble burst, and valuations normalised, the prospective return would be deeply negative. It follows that when, as now, the earnings yield is extreme versus its history, we must build in some prudent normalisation to estimate the prospective return. The question is, how? One approach is to use history to inform us of the likely normalisation. Chart I-5 does this using the ‘best-fit’ relationship between the earnings yield at each point through 1990-2011 and subsequent 10-year real return from each starting point. Using the best-fit for this specific episode, the current earnings yield of 4.6 percent implies a prospective 10-year real return not of 4.6 percent, but of -1.1 percent. Chart I-5Based On History, The Current Earnings Yield Implies A Prospective 10-Year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 10-year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 10-year Real Return Much Less Than 4.6 Percent Yet this best-fit approach meets a common reproach – that the best-fit for this specific episode is massively distorted by the dot com bubble peak and the global financial crisis (GFC) trough occurring (by coincidence) almost 10 years apart. We can counter this reproach in two ways. First, the best-fit relationship is much better than the raw earnings yield even for undistorted 10-year periods such as 1995-2005 or 2011-2021. Better still, we can change the prospective return from 10 years to 7 years and thereby remove the dot com bubble peak to GFC trough distortion. Chart I-6 shows that this 7-year best-fit relationship also works much better than the raw earnings yield. Chart I-6Based On History, The Current Earnings Yield Implies A Prospective 7-Year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 7-year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 7-year Real Return Much Less Than 4.6 Percent Admittedly, the best-fit comes from just one episode in history, and there is no certainty that the 10-year and 7-year relationships that applied during that one episode should apply through 2021-31 and 2021-28 respectively. Nevertheless, starting from an earnings yield that is extreme versus its history, as is the case now, we should prudently assume that the prospective long-term real return from equities will be far below 4.6 percent, and closer to zero, even if not actually negative. Will The ‘Real’ Real Yield Please Stand Up Measuring the ERP also requires an estimate of the prospective real return on bonds. This part should be easy because the yield on the US 10-year TIPS – currently -0.9 percent – is the guaranteed 10-year real return of buying and holding that investment. It is derived by taking the yield on the 10-year T-bond – currently 1.5 percent – and subtracting the market’s expected rate of inflation over the next 10 years – currently 2.4 percent. But the equivalent real return on the much larger conventional bond market could be quite different. In this case, it will be the 10-year T-bond yield minus the actual rate of inflation over the next 10 years. To the extent that the actual rate of inflation turns out less than the expected rate of 2.4 percent, the real return on the T-bond will turn out higher than that on the TIPS. In fact, this has consistently turned out to be the case. The market has consistently overestimated the inflation rate over the subsequent 10 years, meaning that the real return on T-bonds has been around 1 percent higher than that on TIPS (Chart I-7). Chart I-7Will The 'Real' Real Yield Please Stand Up Will The 'Real' Real Yield Please Stand Up Will The 'Real' Real Yield Please Stand Up Yet given the current surge in inflation, and no end in sight for supply chain disruptions and bottlenecks, is it plausible that the next ten years’ rate of inflation will be lower than 2.4 percent? The answer is yes. Because, as my colleague Peter Berezin points out: in capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. And gluts always cause prices to collapse. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. The Cotton Is Stretched, And So Are Polish Equities Talking of shortages, cotton now adds to the list of commodities in which supply bottlenecks have raised prices to extremes. Cotton prices have reached a 10-year high due to weather conditions in the US (the world’s biggest cotton producer) combined with shipping disruptions. However, with cotton now exhibiting extreme fragility on its combined 130/260-day fractal structure, there is a high likelihood of a price reversal in the coming months when the shortage turns into a glut (Chart I-8). Chart I-8The Cotton Is Stretched The Cotton Is Stretched The Cotton Is Stretched Meanwhile, the bank-heavy Polish equity market has surged on the back of the spectacular outperformance of its banks sector. This strong uptrend has now reached the point of fragility on its 130-day fractal structure that has indicated several previous reversals (Chart I-9). Chart I-9Poland's Outperformance Is Stretched Poland's Outperformance Is Stretched Poland's Outperformance Is Stretched Accordingly, this week’s recommended trade is to underweight the Warsaw General Index versus the Eurostoxx 600, setting a profit target and symmetrical stop-loss at 6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Based on the 12-month forward earnings yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades     Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations      

Highlights Q3/2021 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark index by +8bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +4bps, led by the timely downgrade of UK Gilts to underweight in early August. Spread product allocations outperformed by +4bps, coming entirely from the overweights to high-yield in the US and Europe. Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration exposure, concentrated in the US and UK. We expect global growth will rebound from the Delta variant and supply chain disruptions will keep inflation elevated for longer, both of which will push global bond yields higher as central banks – led by Fed – turn less dovish. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations still look the least stretched compared to corporate debt in other countries. Feature Global bond markets have had a lot of sources of uncertainty to digest over the past few months. Renewed COVID fears due to the spread of the Delta variant, slowing global growth momentum, supply chain disruptions leading to surging realized inflation, the ongoing US fiscal policy debate in D.C., concerns over Chinese corporate debt and the increasingly hawkish monetary policy signals sent by global central banks, most notably the Fed. The net result of these narratives has been some major swings in government bond market performance during the third quarter of 2021. The benchmark 10-year government bond yield in the US started the quarter at 1.48%, fell to an intraday low of 1.12% on August 4, then soared higher to end the quarter back at 1.50%. Even bigger moves were seen in other countries, with the 10-year UK Gilt yield doubling from its Q3 low of 0.48% on August 4 while the 10-year German bund yield is now 30bps above its low for the quarter. Despite this yield volatility, however, spreads for riskier credit market assets like US high-yield have remained generally well behaved. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during Q3/2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. We anticipate that bond investor uncertainty will switch from concerns about global growth to worries that stubbornly elevated inflation will elicit bond-bearish monetary policy responses from central banks. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2021 Model Bond Portfolio Performance: Positive Returns In An Uncertain Environment Chart 1Q3/2021 Performance: Riding The Duration Roller Coaster Q3/2021 Performance: Riding The Duration Roller Coaster Q3/2021 Performance: Riding The Duration Roller Coaster The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was +0.21%, slightly outperforming the custom benchmark index by +8bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +4bps of outperformance versus our custom benchmark index while the latter also outperformed by +4bps. Those small positive excess returns should be considered a victory, given the huge yield swings within the quarter, particularly for government bonds. We maintained a significant underweight position to US Treasuries in the portfolio during Q3, given our view that markets were underestimating the risks that the US economy would weather the summer Delta storm. As Treasury yields declined steadily during July and August, so did the relative performance of our model bond portfolio. The government bond portion of the portfolio was underperforming the benchmark by as much as -30bps before global bond yields bottomed out in early August. In the end, there was only a slight underperformance (-2bps) from the US Treasury portion of the portfolio during the quarter (Table 2). Table 2GFIS Model Bond Portfolio Q3/2021 Overall Return Attribution GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Our biggest government bond overweights have been concentrated in the euro area. There, the sum of active returns during Q3 from our government bond allocations was +3bps, although that came entirely from above-benchmark allocations to inflation-linked bonds in Germany, France and Italy. We did make one major shift in our government bond allocations during the quarter, and it was both timely and successful. We downgraded our recommended UK Gilt exposure to underweight on August 11.2 We observed that the Bank of England (BoE) was starting to prepare the markets for less accommodative monetary policy, with the UK economy holding up well as its Delta variant surge was losing momentum. The BoE rhetoric has proven to be even more hawkish than we anticipated, hinting at a possible rate hike before the end of 2021, leading Gilts to be the worst performing government bond market in our model portfolio universe during the quarter. The result: our UK underweight contributed +4bps to the portfolio performance during the quarter. Turning to the credit side of the portfolio, the most successful positions were our overweight tilts on high-yield in the US (+3bps) and euro area (+1bps). All other exposures contributed little to returns, an unsurprising development given our neutral allocations to investment grade corporates in the US, UK and euro area, as well as for USD-denominated EM corporates. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q3/2021 Government Bond Performance Attribution GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Chart 3GFIS Model Bond Portfolio Q3/2021 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Biggest Outperformers: Overweight UK Gilts with a maturity greater than 10-years (+4bps) Overweight Italian inflation-linked bonds (+2bps) Overweight US high-yield: Ba-rated (+2bps) and B-rated (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10-years (-2bps) Overweight Japanese Government Bonds in longer maturity buckets: 7-10 years (-1bps) and greater than 10-years (-1bps) Overweight UK inflation-linked bonds (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q3 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q3/2021 GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. As can be seen in the chart, the bars look very close to that ideal for Q3/2021. Among the markets that represent our overweights, the most notably positive returns came from all euro area government bonds (a combined +136bps) and euro area corporates (a combined +20bps from investment grade and high-yield). Returns within our recommended underweight positions were even more notable: UK Gilts (-302bps), New Zealand government bonds (-103bps), EM USD-denominated sovereigns (-85bps), and Canadian government bonds (-45bps). Bottom Line: Our model bond portfolio slightly outperformed its benchmark index in the third quarter of the year by +8bps – a moderately positive result coming equally from underweight positions in government bonds and overweight allocations to spread product. Future Drivers Of Portfolio Returns Chart 5Negative Real Yields: The Biggest Mispricing In Global Bond Markets Negative Real Yields: The Biggest Mispricing In Global Bond Markets Negative Real Yields: The Biggest Mispricing In Global Bond Markets Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by our below-benchmark overall duration tilt – focused on our underweight stance on US Treasuries – and our overweight stance on high-yield corporates. Our most favored cyclical indicators for global bond yields are still, in aggregate, signaling more upside potential over at least the next six months, although the nature of the signal is changing (Chart 5). While our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, has peaked, the overall level of 10-year bond yields within the major developed markets remains well below levels implied by the Indicator (top panel). That is most clearly evident when looking at the large gap between deeply negative real bond yields and the still-elevated level of the global manufacturing PMI, which typically leads real yields by around six months (second panel). We continue to view this gap between real yields and growth as the biggest mispricing in global bond markets – one that will eventually be rectified by the incremental reduction in monetary accommodation that is signaled by our Global Central Bank Monitor (bottom panel). The combined message from our Central Bank Monitor, Duration Indicator and the manufacturing PMI is that global bond yields are still too low, suggesting a below-benchmark overall portfolio duration stance remains appropriate. With regards to country allocation within the government bond side of our model portfolio, we continue to overweight countries where central banks are less likely to begin normalizing pandemic-era monetary policy quickly (Germany, France, Italy, Spain, Japan, Australia), while underweighting countries where normalization is expected to begin within the next 6-12 months (the US, UK and Canada). We have the highest conviction on the US and UK underweights, with a curve-flattening bias for both markets relative to the rest of the major developed markets (Chart 6). The bond-friendly (and risk asset-friendly) impact of global quantitative easing programs is fading, on the margin, with the annual growth rate of central bank balance sheets having already slowed sharply (Chart 7). The pace of tapering, and any subsequent rate hikes, will differ by country and support our government bond country allocations in the model portfolio. Chart 6Expect More Relative Curve Flattening In The US & UK Expect More Relative Curve Flattening In The US & UK Expect More Relative Curve Flattening In The US & UK Chart 7The 'Great Global Taper' Has Begun The 'Great Global Taper' Has Begun The 'Great Global Taper' Has Begun   Chart 8Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens We expect the Fed to taper its pace of bond purchases over the first half of 2022, setting up a first Fed rate hike late next year. The Bank of Canada and the BoE will be the other developed market central banks that will both end QE and lift rates before the Fed does the same. On the other hand, the ECB, Bank of Japan and the Reserve Bank of Australia will maintain a more relatively dovish stance in 2022, with very modest tapering (at worst) and no rate hikes. Turning to inflation-linked bonds, we are maintaining an overall neutral allocation given the competing forces of rising global inflation and rich valuations. Our Comprehensive Breakeven Indicators combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. Those indicators suggest that the most attractive markets to position for further upside potential for breakevens are Italy, France, Canada and Japan (Chart 8). On the back of this, we are maintaining our overweight allocations to inflation-linked bonds in the euro area and Japan in our model portfolio, while staying neutral on US TIPS. Chart 9Fading Support For Credit Markets From Global QE In 2022 Fading Support For Credit Markets From Global QE In 2022 Fading Support For Credit Markets From Global QE In 2022 Moving our attention to the credit side of our model portfolio, a moderate overweight stance on overall global corporates (focused on high-yield) versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets is flashing a warning sign for the future performance of global spread product. The annual growth rate of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has been an excellent leading indicator (by about twelve months) of the annual excess returns of both global investment grade and high-yield corporates during the “QE Era” since the 2008 financial crisis (Chart 9). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond outperformance around February 2022, particularly for high-yield versus government bonds and investment grade (top two panels). At the same time, our preferred measure of the attractiveness of credit spreads - the historical percentile ranking of 12-month breakeven spreads – shows that lower-rated high-yield credit tiers in the US and euro area offer spreads that are relatively high versus their own history compared to other credit sectors in our model bond portfolio universe (Chart 10). Using this metric, investment grade corporate spreads look much more fully valued, particularly in the US. Chart 10Lower-Rated High-Yield & EM Sovereigns Offer Relatively Attractive Spreads GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Given sharply reduced default risks in the US and Europe, with strong nominal growth supporting corporate revenues alongside low borrowing rates, the fundamental backdrop for riskier high-yield corporates is still positive. Thus, we are maintaining our overweights to high-yield bonds in both the US and euro area, while sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce that exposure in the model portfolio sometime in early months of 2022, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that means about the future path for global monetary policy and risk asset performance. Within the euro area, we are maintaining overweights to Italian and Spanish government bonds given the likelihood that the monetary policy backdrop will remain supportive (Chart 11). We expect the ECB to be one of the most accommodative central banks within our model portfolio universe in 2022. At worst, the ECB could deliver a modest reduction of total asset purchases, but with no rate hikes. Chart 11A Relatively Dovish ECB Will Be Positive For European Credit A Relatively Dovish ECB Will Be Positive For European Credit A Relatively Dovish ECB Will Be Positive For European Credit Chart 12EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering Finally, we are sticking with a cautious stance on emerging market (EM) spread product in our model bond portfolio. Slowing Chinese economic growth, a firming US dollar, rate hikes across EM in response to high inflation, and the coming turn in the Fed policy cycle are all headwinds to the relative performance of EM USD-denominated corporates and sovereigns (Chart 12). We are sticking with our overall modestly underweight stance on EM USD-denominated credit. However, rebounding global growth and some potential policy stimulus in China could prompt us to consider an upgrade in the coming months.   Summing it all up, our overall allocations and risks in our model portfolio leading into Q4/2021 look like this: An overall below-benchmark stance on global duration, equal to -0.75 years versus the custom index (Chart 13). A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 14). This overweight comes almost entirely from allocations to US and euro area high-yield corporates. The tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is relatively low at 55bps (Chart 15). This fits with our desire to maintain only a moderate level of absolute portfolio risk, while focusing exposures more on relative tilts between countries and credit sectors. Chart 13Overall Portfolio Duration: Stay Below Benchmark GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Chart 14Overall Portfolio Allocation: Small Spread Product Overweight GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry” of 16bps (Chart 16).   Chart 15Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Chart 16Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts We now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare We see global growth momentum, the stickiness of supply-driven inflation pressures and the Fed monetary policy outlook as the three most important factors for fixed income markets over the next six months, thus our scenarios are defined along those lines. Base case Global growth rebounds from the dip seen during July and August as fears over the spread of the Delta variant subside. Unemployment rates across the developed economies continue to decline on the back of ongoing demand/supply imbalances in labor markets. China is a relative growth laggard, but this will trigger fresh macro stimulus measures (credit, monetary, perhaps fiscal) from policymakers concerned about missing growth targets. Global supply chain disruptions will remain stubbornly persistent, keeping upward pressure on realized inflation rates in most countries even as commodity price momentum cools a bit on a rate of change basis. Most developed market central banks will move to dial back pandemic monetary policy stimulus to varying degrees, most notably the Fed and the Bank of England. The Fed will begin tapering its asset purchases around the turn of the year, to be completed during Q4/2021 thus setting the stage for a Fed rate hike in December. In this scenario, we expect the US Treasury curve to see some initial mild bear-steepening alongside moderately wider longer-term TIPS breakevens, before entering a more typical cyclical bear-flattening as the Fed begins tapering and rate hike expectations get pulled forward. The net result over the next six months: the entire US Treasury curve shifts higher in roughly parallel fashion, with the 10-year reaching 1.70% by next March. The VIX drifts a bit lower from the current 21 to 18, the US dollar is flattish (faster global growth offsets more USD-favorable real yield differentials versus other developed markets), the Brent oil price goes up +5% on the back of stronger global demand, and the fed funds target rate is unchanged at 0-0.25%. Upside growth & inflation surprise Global growth accelerates amid sharply diminished COVID risks and rallying stock and credit markets that loosen financial conditions. Consumer & business confidence recover smartly, as do hiring and capex. Global inflation rates accelerate from current elevated levels, but less from supply squeezes and more from fundamental pressures and faster wage growth. China loosens macro policies, but developed market central banks shift in an even more hawkish direction. The Fed signals a rapid 2022 taper and a funds rate liftoff well before year-end. In this scenario, real bond yields drift higher globally, but inflation breakevens stay elevated with the earlier surge in realized inflation proving not to be “transitory”. The US Treasury curve shifts much higher than in our base case, led by the 5-year maturity with bear-flattening beyond that point. The 10-year US Treasury yield climbs to 1.90% by the end of Q1/2022. The VIX moves higher to 25, the US dollar falls -3% (faster global growth offsetting a relatively modest increase in US/non-US real yield differentials), the Brent oil price goes up +10% and the fed funds target range is unchanged at 0-0.25%. Downside growth & inflation surprise Global growth loses additional momentum as consumer and business confidence stay muted. Supply/demand mismatches in labor markets remain unresolved, leading to a slower pace of employment growth. China does not signal adequate stimulus to offset its slowdown, while a weakened Biden administration implements a much smaller-than-expected US fiscal stimulus. Supply chain disruptions persist, keeping inflation elevated even as growth slows (stagflation). Developed market central banks, stuck between slowing growth and elevated inflation, are unable to ease in response to slower growth. The Fed chooses a slower drawn-out taper with liftoff delayed to 2023. Diminished economic optimism leads to a pullback in global equity values, lower government bond yields and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall, with the 10-year yield moving back down to 1.25% alongside lower inflation breakevens. The VIX rises to 30, the safe-haven US dollar rises +5%, the Brent oil price falls -10% and the fed funds target range stays at 0-0.25%. The inputs into the scenario analysis are shown in Chart 17 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 18. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Chart 17Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Chart 18US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis     Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare The model bond portfolio is expected to deliver a positive excess return over the next six months of +60bps in the base case scenario and +57bps in the optimistic growth scenario, but is projected to underperform by -26bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration exposure, concentrated in the US and UK. We expect global growth will rebound from the Delta variant and supply chain disruptions will keep inflation elevated for longer, both of which will push global bond yields higher as central banks – led by Fed – turn less dovish. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations still look the least stretched compared to corporate debt in other countries.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Research Global Fixed Income Strategy/ European Investment Strategy Weekly Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

  Highlights Chart 1Bond Yields Still Track The "Re-Opening" Trade Bond Yields Still Track The "Re-Opening" Trade Bond Yields Still Track The "Re-Opening" Trade Bond yields rose notably in September, with the bulk of the move coming in the days after the Fed teased an upcoming tapering of its asset purchases and revealed slightly hawkish revisions to its interest rate projections. Interestingly, some of the details of the bond market move don’t mesh nicely with the mildly hawkish policy surprise that the Fed delivered. For example, the Treasury curve steepened on the month and long-maturity TIPS breakeven inflation rates rose. Our sense is that September’s market moves were less driven by the Fed and more by a revival of the reflation (or re-opening) trade from earlier this year. The daily new US COVID case count ticked down and, while overall S&P 500 returns were negative on the month, a basket of equities designed to profit from the end of the pandemic soundly beat a basket of “COVID winners” (Chart 1). With the delta COVID wave receding, we remain confident that economic growth will be sufficiently strong for the Fed to launch a new rate hike cycle in December 2022. The Treasury curve will bear-flatten as that outcome gets priced in.   Feature Table 1Recommended Portfolio Specification A Bout Of Reflation A Bout Of Reflation Table 2Fixed Income Sector Performance A Bout Of Reflation A Bout Of Reflation Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to +193 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 99 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report presented the results of a scenario analysis for investment grade corporate bond returns during the next 12 months.1 We concluded that investment grade corporate bond total returns will be close to zero or negative during the next 12 months and that excess returns versus duration-matched Treasuries are capped at 85 bps. With that in mind, we advise investors to seek out higher returns in junk bonds, municipal bonds and USD-denominated Emerging Market sovereign and corporate bonds. We also recommend favoring long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* A Bout Of Reflation A Bout Of Reflation Table 3BCorporate Sector Risk Vs. Reward* A Bout Of Reflation A Bout Of Reflation High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 53 basis points in September, bringing year-to-date excess returns up to 558 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first eight months of the year, well below the estimate generated by our macro model. Another recent report considered different plausible scenarios for junk bond returns during the next 12 months.4 We concluded that junk bond total returns will fall into a range of -0.29% to +1.80% during the next 12 months and that excess returns versus duration-matched Treasuries will be between +0.94% and +1.84%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in September, bringing year-to-date excess returns up to -43 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 19 bps in September. The spread is wide compared to recent history, but it remains tight compared to the recent pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) tightened 6 bps in September to reach 31 bps (panel 3). This is above the 22 bps offered by Aaa-rated consumer ABS but below the 52 bps offered by Aa-rated corporate bonds and the 33 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 15 basis points in September, dragging year-to-date excess returns down to +69 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 95 bps in September, dragging year-to-date excess returns down to -87 bps. Foreign Agencies outperformed the Treasury benchmark by 5 bps on the month, bringing year-to-date excess returns up to +49 bps. Local Authority bonds outperformed by 24 bps in September, bringing year-to-date excess returns up to +406 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to +24 bps. Supranationals underperformed by 4 bps, dragging year-to-date excess returns down to +27 bps. Last week’s report looked at performance and valuation trends for Emerging Market sovereign and corporate bonds relative to US corporates.6 The recent underperformance of EM bonds versus US corporates has led to attractive relative valuations in the sector. We see investment grade EM sovereign and corporate bonds both outperforming investment grade US corporates during the next 12 months. The outperformance will be the result of better starting valuations and an acceleration of EM growth in 2022. The bonds of Colombia, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar look particularly attractive within the USD-denominated EM sovereign space. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in September, bringing year-to-date excess returns up to +292 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 Both General Obligation (GO) and Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporate bonds with the same credit rating and duration (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in September, with yields moving sharply higher – especially in the 5-10 year maturity space. The 2-year/10-year Treasury slope steepened 14 bps to end the month at 124 bps. The 5-year/30-year slope flattened 5 bps to end the month at 110 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 2.08%, the 5-year/5-year forward Treasury yield is already within our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.30% in one year’s time and 1.62% in five years (Chart 7). The latter rate has 131 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 256 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in September, bringing year-to-date excess returns up to +627 bps. The 10-year TIPS breakeven inflation rate rose 3 bps on the month, while the 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps. At 2.41%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to a steepening of the inflation curve (bottom panel). We recommend that investors position for a steeper 2/10 inflation curve, or alternatively for a flatter 2/10 real Treasury curve. We noted in last week’s report that the combination of nominal curve flattening and inflation curve steepening will lead to a large flattening of the 2/10 real curve during the next 6-12 months.9The 2-year TIPS yield, in particular, has a lot of upside.                         ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent nominal Treasury index by 3 basis points in September, bringing year-to-date excess returns up to +43 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +32 bps. Non-Aaa ABS outperformed by 7 bps, bringing year-to-date excess returns up to +99 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in September, bringing year-to-date excess returns up to +195 bps. Aaa Non-Agency CMBS outperformed Treasuries by 4 bps in September, bringing year-to-date excess returns up to +96 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 4 bps on the month, dragging year-to-date excess returns down to +525 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in September, bringing year-to-date excess returns up to +94 bps. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 33 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 30th, 2021) A Bout Of Reflation A Bout Of Reflation 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 30th, 2021) A Bout Of Reflation A Bout Of Reflation 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 -17 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 flattens by less than 17 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) A Bout Of Reflation A Bout Of Reflation Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of September 30th, 2021) A Bout Of Reflation A Bout Of Reflation Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3  Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5  Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 7  Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8  Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 9  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021.

Highlights Monetary Policy: It’s all but certain that tapering will begin next month and conclude by the middle of next year, but the FOMC is currently split right down the middle on whether it will be appropriate to lift rates in H2 2022. We present five factors to track to decide when the Fed will hike rates. Yield Curve: A bear-flattening of the nominal yield curve remains the most likely scenario for the next 6-12 months. Maintain a position short the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Investors should enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. The 2-year real yield, in particular, has a lot of upside during the next 6-12 months. EM Bonds: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling. Feature This past week was quite eventful for US bond investors. First, the Fed presented its September update on Wednesday, offering some hints about the timing and pace of asset purchase tapering alongside its updated economic and interest rate forecasts. Then, bonds sold off sharply on Thursday, Friday and Monday with the 10-year Treasury yield rising all the way to 1.49%. The first section of this week’s report looks at what we learned from last week’s FOMC meeting and opines on some monetary policy questions that remain unanswered. The second section updates our views on portfolio duration, the yield curve and TIPS in light of last week’s large market moves. Finally, we conclude with an update on the outlook for USD-denominated Emerging Market bonds. Powell Answers Some Small Questions, Avoids The Big One The Small Questions The start date for asset purchase tapering is the first small question that the Fed answered last week. A new sentence was added to the post-meeting statement saying that “a moderation in the pace of asset purchases may soon be warranted” and, in his press conference, Chair Powell clarified that the purpose of the new language is “to put notice out there that [tapering] could come as soon as the next meeting”. After this statement from the Fed, we expect asset purchase tapering to be announced at the next FOMC meeting on November 3rd. A delay until December is possible if September’s employment report is a massive disappointment, but the bar for delaying tapering beyond November appears high. Chair Powell also shed some light on a second small question related to the Fed’s balance sheet. Specifically, the pace of asset purchase tapering. In his press conference the Chair said that “participants generally view that, so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate.” The information about the pace of tapering is slightly more interesting than the start date, if only because Fed policymakers have expressed a desire for net purchases to reach zero before the first interest rate increase. The fact that the Fed is planning to reach net zero purchases by the middle of next year suggests that it wants to leave the door open for a possible rate hike in the second half of 2022. This message was confirmed by the Fed’s updated interest rate projections (Chart 1). The projections revealed an even split (9 vs. 9) on the Committee between those that expect at least one 25 basis point rate increase before the end of 2022 and those that do not expect to lift rates next year. It’s also notable that, out of the 9 participants that don’t expect a rate hike in 2022, 8 anticipate lifting rates in 2023. Chart 1Rate Expectations Rate Expectations Rate Expectations Of course, as Chair Powell often points out, the Fed’s interest rate projections are contingent on the future state of the economy and will almost certainly be revised as the outlook evolves. What’s more important from a forecasting perspective is knowing how the Fed will react to different economic conditions. The Big Question With that in mind, we know that the Fed has promised not to lift rates until the labor market reaches “maximum employment”. However, as we noted in a recent report, the Fed hasn’t provided much detail on what “maximum employment” actually means.1 Powell’s comments last week didn’t add much clarity, but we can hunt for clues in the Summary of Economic Projections (SEP). In the SEP, we first notice that 13 FOMC participants expect the unemployment rate to be 3.8% - 3.9% or lower by the end of 2022 (Chart 2A). It is logical to assume that this group includes the 9 participants who expect to lift rates in 2022 and 4 additional ones. We also observe that 17 out of 18 participants anticipate an unemployment rate of 3.8% - 3.9% or lower by the end of 2023 (Chart 2B), exactly matching the number of participants who expect to lift rates by then. We can therefore infer that the Fed views an unemployment rate of roughly 3.8% as consistent with “maximum employment”. That is, FOMC participants tend to have rate hikes penciled into their forecasts once the unemployment rate is below 3.8%. Chart 2AFOMC 2022 Unemployment Rate Projection Distribution Damage Assessment Damage Assessment Chart 2BFOMC 2023 Unemployment Rate Projection Distribution Damage Assessment Damage Assessment The SEP’s inflation forecasts are less illuminating than the unemployment ones. All but 4 participants expect core PCE inflation to be above the Fed’s 2% target at the end of 2022 (Chart 3A) and no FOMC participant is forecasting below-2% core PCE at the end of 2023 (Chart 3B).2 The most we can take away from these forecasts is that 14 FOMC participants expect inflation to be above target in 2022, but five of those participants don’t see the labor market as being tight enough to lift rates by then. Chart 3AFOMC 2022 Core PCE Inflation Rate Projection Distribution Damage Assessment Damage Assessment Chart 3BFOMC 2023 Core PCE Inflation Rate Projection Distribution Damage Assessment Damage Assessment The revelation that FOMC participants view a 3.8% unemployment rate as consistent with “maximum employment” is illuminating, but it doesn’t tell the entire story. We don’t know, for example, what assumptions about labor force participation the different Fed officials are using. Our sense is that the following five criteria will ultimately determine when the Fed starts to lift interest rates: An unemployment rate in the neighborhood of 3.8%. Prime-age (25-54) labor force participation close to its pre-pandemic level (Chart 4, top panel). Accelerating wage growth (Chart 4, bottom 2 panels). Long-dated inflation expectations at or above target levels (Chart 5, top 2 panels). Non-transitory inflation at or above target levels (Chart 5, bottom panel). Bottom Line: The FOMC is currently split right down the middle on whether it will be appropriate to lift rates in 2022, but these forecasts aren’t set in stone and next year’s economic data – particularly the five factors listed above – will determine which group is correct. Chart 4Part Rate & Wage Growth Part Rate & Wage Growth Part Rate & Wage Growth Chart 5Inflation & Inflation Expectations Inflation & Inflation Expectations Inflation & Inflation Expectations Our own view is that the labor market will be sufficiently tight for the Fed to deliver its first rate hike in December 2022, and that rate hikes will proceed more quickly than what is currently priced in the yield curve. US bond investors should maintain below-benchmark portfolio duration. The Fallout In Bond Markets Bonds sold off sharply last Thursday and again yesterday morning. At the time of publication, the 30-year Treasury yield had risen from 1.81% on Wednesday to 2.02% (Chart 6). The 10-year Treasury yield had risen from 1.30% to 1.49% (Chart 6, panel 2). The 5-year yield is up to 0.98% from 0.85% on Wednesday (Chart 6, panel 3), and the 2-year yield is up to 0.28% from 0.24% (Chart 6, panel 4). The yield curve has also steepened since Wednesday, though the 2/10 slope remains well below its March peak (Chart 7). The trend during the past few months has been one of curve steepening out to the 5-year maturity point (Chart 7, panel 2) and flattening beyond that point (Chart 7, bottom 2 panels). Recent market action has led to some steepening beyond the 5-year maturity, but so far that steepening is minor compared to the flattening move we’ve witnessed since the spring. Chart 6Treasury Yield Trends Treasury Yield Trends Treasury Yield Trends Chart 7Treasury Curve Trends Treasury Curve Trends Treasury Curve Trends Nominal Curve We have been recommending a position short the 5-year bullet and long a duration-matched barbell consisting of the 2-year and 10-year notes, and we think this trade will continue to outperform. First, the 5-year/5-year forward Treasury yield is back above 2%, consistent with median estimates of the long-run neutral fed funds rate from the New York Fed’s Surveys of Market Participants (2%) and Primary Dealers (2.25%) (Chart 6, bottom panel). We think it will be difficult for the 5-year/5-year forward yield to rise much above these levels, which makes curve flattening more likely than steepening going forward.3 Second, we updated our work on yield curve scenarios to incorporate recent market action and some new information gleaned from last week’s SEP. In this analysis we estimate fair value levels for different parts of the yield curve as of the end of 2022 based on a scenario for the path of the fed funds rate. For example, if we assume that Fed liftoff occurs in December 2022 and rate hikes proceed at a pace of 75 bps per year (the median pace in the SEP) until the fed funds rate levels-off at 2.08% (consistent with a 2%-2.25% range for the long-run neutral fed funds rate), we calculate that the 2-year yield has 74 bps of upside between now and the end of 2022. This is slightly more than the 65 bps of upside in the 5-year yield and much more than the 37 bps of upside in the 10-year yield (Table 1). Comparing this expected change to what is already discounted in the forward curve, we see that both the 2-year and 10-year yields are expected to exceed their forwards by 6 bps. The 5-year yield is expected to exceed its forward by 16 bps. Table 1Treasury Curve Scenario Analysis Damage Assessment Damage Assessment To us, the message is clear. We want to remain short the 5-year note versus a duration-matched 2/10 barbell. Real & Inflation Curves Chart 8Real & Inflation Curves Real & Inflation Curves Real & Inflation Curves The increase in the 10-year nominal yield since last Wednesday was roughly evenly split between the real and inflation compensation components. Interestingly, inflation drove a greater proportion of the increase at the front-end of the curve, and the 2-year real yield actually fell. We maintain a neutral recommendation on TIPS versus nominal Treasuries, but this week we recommend taking advantage of recent market action by implementing some curve trades across the real and inflation curves. Specifically, we note that the cost of short-maturity inflation compensation remains well above the cost of long-maturity inflation compensation (Chart 8). Going forward, the cost of front-end inflation compensation will fall as inflation moderates from its current extremely high level. Meanwhile, the cost of long-maturity inflation compensation will remain sticky near the Fed’s target levels. This will lead to a steepening of the inflation curve (Chart 8, panel 2). The combination of a steeper inflation curve and a flatter nominal curve will lead to a much flatter real yield curve (Chart 8, bottom 2 panels). The 2-year real yield, in particular, has a lot of upside if inflation moderates, as we expect, and the 2-year nominal yield rises in line with the projections shown in Table 1. Bottom Line: Investors should remain short the 5-year bullet versus a duration-matched 2/10 barbell on the nominal Treasury curve. Investors should also enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. A Quick Update On Emerging Market Bonds The collapse of Chinese real estate behemoth Evergrande dominated headlines for most of the past week, though so far there has been little contagion into USD-denominated credit markets. Unsurprisingly, the spread on Chinese corporate and quasi-sovereign bonds has widened, and there has been some passthrough into both the High-Yield EM USD Corporate & Quasi-Sovereign Index and the High-Yield EM USD Sovereign Index (Chart 9). However, investment grade EM credit spreads have been relatively unaffected by the turmoil, as have US corporate bond spreads (both IG and HY) (Chart 9, bottom 2 panels). While the Evergrande drama – and weakening Chinese economic growth in general – could weigh on USD-denominated EM bond performance in the near-term, we see an excellent buying opportunity in investment grade EM bonds on a 6-12 month horizon. Investment grade EM Sovereigns outperformed credit rating and duration-matched US corporate bonds in the early months of the recovery but have lagged during the past few months (Chart 10). The same is true for the investment grade EM Corporate and Quasi-Sovereign index (Chart 10, panel 3). This is not to say that EM bond performance has been poor – the EM Sovereign index is still up 97 bps versus duration-matched Treasuries on the year – it has simply failed to keep pace with the stellar performance of US corporate bonds. Chart 9No Contagion No Contagion No Contagion Chart 10EM Bonds Versus US Corporates EM Bonds Versus US Corporates EM Bonds Versus US Corporates But that recent stellar performance of US investment grade corporate bonds has left spreads in the sector near historically tight levels. In last week’s report we ran some scenarios for US investment grade corporate bond returns during the next 12 months and concluded that excess returns versus Treasuries are probably capped at 85 bps.4 This makes the current spread advantage in EM Sovereigns (Chart 10, panel 2) and EM Corporates & Quasi-Sovereigns (Chart 10, bottom panel) very compelling. This will be especially true if Emerging Market growth accelerates in 2022 on the back of increased Chinese stimulus and a COVID vaccination campaign that is already picking up steam.5 Bottom Line: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 2 Chart 3B shows that 4 participants expect core PCE inflation of 1.9%-2.0% in 2023, but the SEP also reveals that the minimum forecast for core PCE in 2023 is 2.0%. In other words, all 4 participants in that range are forecasting 2.0%, not 1.9%. 3 For more details on the relationship between our 5-year/5-year forward yield target and the yield curve please see US Bond Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 4  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 For a recent debate about the outlook for Emerging Market assets please see last Friday’s Webcast: https://www.bcaresearch.com/webcasts/detail/458 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Global Inflation: Most central banks, led by the Fed, have stuck to the narrative that surging inflation is a temporary phenomenon that will not require an aggressive monetary policy response. However, global supply chain disruptions are lasting for much longer than originally expected, while faster realized global inflation is feeding through into higher longer-term consumer inflation expectations, most notably in the US. This raises the risk that the 2021 inflation pickup will prove to be longer lasting, leading to higher global bond yields. Real Bond Yields: Global bond markets have made a collective bet on the “transitory” inflation narrative by driving yields on government bonds, and even the riskier parts of the corporate credit universe like US and European high-yield, below actual inflation. Markets will have to reprice those negative real bond yields higher if inflation proves to be more persistent than expected - particularly with central banks likely to respond with faster tapering and, in some cases, eventual rate hikes. Feature The month of September has often not been kind to financial markets and September 2021 is already providing many reasons for investors to be nervous. Slowing global growth momentum, uncertainty over the Delta variant, yet another US Debt Ceiling debate in D.C. and worries about excessive Chinese corporate leverage and contagion risks from the looming Evergrande default are all valid reasons for market participants to become more risk averse. On top of that, the monetary policy backdrop is threatening to become less overwhelmingly supportive for markets with the Fed set to begin tapering its asset purchases. Chart of the WeekInflation Expected To Slow But Remain Above Bond Yields Inflation Expected To Slow But Remain Above Bond Yields Inflation Expected To Slow But Remain Above Bond Yields One other source of angst that markets seem less concerned about is inflation. Markets have generally come around to the view of most major central banks, led by the Fed, that the surge in inflation seen this year has been all pandemic related - base effect comparisons to 2020 and temporary supply chain squeezes – and will not last into 2022. Yet we have seen very strong realized global inflation readings in the August data, beyond the point of maximum base effect comparisons versus a year ago, while supply squeezes and soaring shipping costs are showing no signs of slowing as we approach the fourth quarter. Global bond markets have made a collective bet that current high rates of inflation will prove to be temporary. Developed market bond yields are all trading well below actual inflation, as are riskier fixed income asset classes like US and European high-yield (Chart of the Week). While consensus expectations are calling for some rise in government bond yields in 2022, yields are expected to remain below inflation. Those persistent negative real yield expectations remain the biggest source of vulnerability for global bond markets. If inflation turns out to be “less transitory” than expected, nominal bond yields will need to move higher to reprice both real yields and the risk of more hawkish central bank responses to sustained high inflation. A Persistent Inflation Threat From Supply Chain Disruptions Chart 2A Broad-Based Surge In Global Inflation A Broad-Based Surge In Global Inflation A Broad-Based Surge In Global Inflation Our base-case view remains that global inflation will slow in 2022, but not by enough to prevent the major developed market central banks from tapering asset purchases. We expect the Fed to begin buying fewer bonds in January. Central banks that have already begun to slow the pace of quantitative easing (QE) like the Bank of Canada and Bank of England will likely continue to taper as fast, if not even faster, than the Fed. Even the ECB will likely not roll the full amount of the expiring Pandemic Emergency Purchase Program (PEPP) into the existing pre-COVID asset purchase programs, resulting in a mild form of tapering next year. Our view on global inflation has been predicated on an expected shift away from more externally-driven inflation towards more sustainable domestic price pressures stemming from tightening labor markets and the closing of pandemic output gaps (Chart 2). So the mix of inflation in most developed market countries will be more “core” and less “non-core” inflation driven by higher commodity prices and global supply chain disruptions. Yet there is little sign that those non-core inflation pressures are slowing, particular in price gauges most exposed to supply chains like producer price indices (PPI). US PPI inflation climbed to 15-year high of 8.3% on a year-over-year basis in August, while annual growth in the euro area PPI hit 12.1% in July – the fastest pace in the 30-year history of that data series (Chart 3). Surging PPI inflation reflects global price pressures, with import prices expanding at double-digit rates in both the US and Europe. Some of that more externally driven price pressure stems from commodity markets. While the prices for some notable commodities like lumber and iron ore have seen significant retracements from pandemic-era highs over the past several months, more economically sensitive commodities like aluminum and natural gas have all seen very strong price increases (Chart 4). Copper and oil prices are also holding firm, although both are off 2021 highs. Chart 3No Sign Of Slowing Global Inflation At The Producer Level No Sign Of Slowing Global Inflation At The Producer Level No Sign Of Slowing Global Inflation At The Producer Level The price momentum of overall commodity price indices like the CRB Raw Industrials has clearly rolled over, but has held up much better than would be expected given signs of slowing global growth. Chart 4Commodity Markets Still More Inflationary Than Disinflationary Commodity Markets Still More Inflationary Than Disinflationary Commodity Markets Still More Inflationary Than Disinflationary The current depressed level of the China credit impulse, and the flat year-over-year change of the global PMI, would typically be associated with flat commodity prices rather than the current 34% annual growth rate (Chart 5). A lack of sustained upward pressure on the US dollar is likely helping keep commodity prices, which are priced in dollars, more elevated than expected. Even more important, however, are the low inventories for many commodities relative to firm demand (which largely explains the current surge in aluminum and natural gas prices). This mirrors a broader global economic trend towards companies running lower inventories relative to sales, which has been exacerbated by the economic uncertainties of the COVID-19 pandemic. The US overall business inventory-to-sales ratio is now at the lowest level in the history of the series (Chart 6). Chart 5Commodity Price Inflation Peaking, But Not Slowing Much Commodity Price Inflation Peaking, But Not Slowing Much Commodity Price Inflation Peaking, But Not Slowing Much Chart 6Supply Squeezes Are Likely To Persist Supply Squeezes Are Likely To Persist Supply Squeezes Are Likely To Persist Before the pandemic, firms have gotten away with running very lean inventories because of globalized supply chains that allow firms to maintain the minimum amount of inventory to meet demand. Yet “just-in-time” inventory management only works when suppliers can deliver raw materials or finished goods in a timely fashion at low cost. The pandemic has blown up that model, making it much harder to deliver products and materials from critical countries like China. Global shipping costs have exploded higher and are showing no signs of slowing (bottom panel), while supplier delivery times remain well above historical averages according to measures like the US ISM index. Those higher costs are feeding through into overall inflation measures, particularly for the components most exposed to supply chain disruption. In Chart 7, we show a breakdown of the overall CPI inflation data for the US, euro area, UK and Canada. The groupings shown in the chart are based on an analysis done by the Bank of Canada back in August to measure pandemic impacts on Canadian inflation.1 The top panel of the chart shows the contribution to overall inflation for elements most exposed to supply constraints (like autos and durable goods). The second panel of the chart shows the contribution from sectors more exposed to increased demand as economies reopen from pandemic restrictions, like dining at restaurants and travel. The remaining panels of the chart show the contributions from energy prices and all other components not covered in the top three panels. Chart 7Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Chart 8High US Inflation May Not Prove To Be So Transitory High US Inflation May Not Prove To Be So Transitory High US Inflation May Not Prove To Be So Transitory The conclusion from our chart is that supply disruptions have added more to US and Canadian inflation so far in 2021, while reopening demand has been more meaningful for UK and US inflation. The pickup in euro area inflation has been mostly an energy price story, although reopening demand has started to contribute to the rising trend of overall inflation. The implication from this analysis is that persistent supply chain disruptions could become a bigger issue for future inflation – and monetary policy decisions – in the US and Canada. The acceleration of US realized inflation in 2021 has already begun to broaden out from the most volatile components, according to measures like the Dallas Fed Trimmed Mean PCE (Chart 8). Faster inflation is also feeding through into higher US consumer inflation expectations according to surveys from the New York Fed and the University of Michigan. Those increases are not deemed to be temporary, with longer-term inflation expectations now moving higher. The New York Fed’s survey shows that inflation is expected to be 4% over the next three years, two full percentage points above the Fed’s target, which must be ringing some alarm bells on the FOMC. Chart 9European Consumers Are Waking Up To Higher Inflation European Consumers Are Waking Up To Higher Inflation European Consumers Are Waking Up To Higher Inflation Consumer inflation expectations are also starting to perk up outside the US. The YouGov/Citigroup survey shows an expectation of UK inflation over the next 5-10 years of 3.5%, while the Bank of England/Kantar survey is at 3% over the next five years (Chart 9, top panel). Both are above the Bank of England’s 2% inflation target. The European Commission confidence surveys have shown a sharp increase in the net share of respondents expecting higher inflation in the coming months (bottom panel), while the Bundesbank’s August consumer survey shows that Germans now expect 3.5% inflation over the next 12 months, up from 2% back in March. Bottom Line: Supply chain disruptions are lasting for much longer than originally expected, while faster realized global inflation is feeding through into higher longer-term consumer inflation expectations, most notably in the US. This raises the risk that the 2021 inflation pickup will last much longer than expected and force a bond-bearish repricing of future interest rate expectations. Negative Real Yields – The Achilles Heel For Bond Markets It is clear that supply chain disruptions are having a more lasting effect on global inflation than investors, and policymakers, expected earlier this year. Yet while both market-based and survey-based measures of inflation expectations are moving higher, interest rate markets are still pricing in a very dovish future path for policy rates of the major developed market central banks. For example, our 24-month discounters, which measure the change in interest rates over the next two years discounted in overnight index swap (OIS) curves, show that only 71bps, 61bps and 13bps of rate hikes are expected in the US, UK and euro area, respectively, by September 2023 (Chart 10). This continues a trend that we have highlighted in recent reports – the persistence of negative real interest rate expectations in the developed markets that is also keeping real bond yields in sub-0% territory. In the US, the OIS forward curve shows that the first Fed rate hike is expected in early 2023 with a very slow pace of rate increases over the following 2-3 years (Chart 11). The funds rate is expected to level off at 1.75% and stay there through 2030. At the same time, the CPI swap forward curve has inflation falling steadily over the next couple of years, but leveling off around 2.35% for the rest of the upcoming decade. Combining those two forward projections comes up with an implied path for the real fed funds rate that is persistently negative for the next ten years, “settling” at -0.6% by the end of the decade. Chart 10Bond Markets Exposed To More Hawkish Central Banks Bond Markets Exposed To More Hawkish Central Banks Bond Markets Exposed To More Hawkish Central Banks Chart 11US Real Yields Priced For Extended Fed Dovishness US Real Yields Priced For Extended Fed Dovishness US Real Yields Priced For Extended Fed Dovishness An even more deeply negative real rate path is discounted in the euro area forward curves. The ECB is expected to begin lifting rates in 2023, eventually moving out of negative (nominal) territory in 2026 before climbing to +0.5% by 2030 (Chart 12). Euro area CPI swaps are priced for a fall in inflation back below 2% over the next two years, eventually stabilizing at 1.75% over the latter half of the next decade. The real ECB policy rate is therefore expected to settle at -1.25% by 2030. In the UK, markets are discounting much of what has been seen in the years since the 2008 financial crisis – a Bank of England that does very little with interest rates. The central bank is expected to begin lifting rates in 2023, but only a handful of rate hikes are expected in the following years with Bank Rate only climbing to 1% and settling there for most of the upcoming decade. The UK CPI swap curve is discounting relatively high inflation over the next decade, settling at 3.6% in 2030. Thus, the market is discounting a long-run real Bank of England policy rate of -2.6%. This pricing of negative real policy rates so far into the future goes a long way to explain why longer-term real government bond yields have also been consistently negative in the US, Germany, UK and elsewhere in the developed markets. That can be seen in Charts 11, 12 and 13, where we have added the 10-year inflation-linked (real) bond yield for US TIPS, French OATis and UK index-linked Gilts. In all three cases, the 10-year real yield has “gravitated” towards the realized path of the real policy rate – the nominal rate minus headline CPI inflation – over the past two decades. Chart 12Negative Real Rates Forever In Europe? Negative Real Rates Forever In Europe? Negative Real Rates Forever In Europe? Chart 13BoE Not Expected To Do Much Over The Next Decade BoE Not Expected To Do Much Over The Next Decade BoE Not Expected To Do Much Over The Next Decade Chart 14Nominal Yields Will Move Higher If Negative Real Yields Persist Nominal Yields Will Move Higher If Negative Real Yields Persist Nominal Yields Will Move Higher If Negative Real Yields Persist Persistent low government bond yields, both in nominal and inflation-adjusted terms, have resulted in lower yields across the global fixed income markets as investors have been forced to take on more risk to find acceptable yields. This has resulted in a situation where nominal yields on riskier assets like US high-yield corporate bonds and Italian government debt are trading below prevailing headline inflation rates in the US and Europe (Chart 14). Bond investors would likely only be comfortable accepting such negative real yields on the riskier parts of the fixed income universe if a) inflation was expected to decline, and/or b) real yields on risk-free government bonds were expected to stay negative for longer as central banks stay dovish. In either case, the “bet” made by investors is that the inflation surge seen this year will indeed prove to be transitory, as central banks are forecasting. If that benign outlook proves to be incorrect and inflation stays resilient for longer – potentially because of the risk of lingering supply chain disruptions described earlier in this report - nominal bond yields will have to reprice higher to account for faster realized inflation (and, most likely, rising inflation expectations). This process will start in government bond markets, as global central banks will be forced to respond to stubbornly high inflation by turning more hawkish, first with faster tapering of QE bond buying and, later, with interest rate hikes. We continue to see persistent negative real yields as the biggest source of risk in developed economy bond markets over the next couple of years. Those yields discount a benign path for both inflation and future monetary policy that is looking increasingly less likely – especially with tightening labor markets and rising consumer inflation expectations already forcing central banks, led by the Fed, to move incrementally towards less accommodative policy settings. Bottom Line: Global bond markets have made a collective bet on the “transitory” inflation narrative by driving yields on government bonds, and even the riskier parts of the corporate credit universe like US and European high-yield, below actual inflation. Markets will have to reprice those negative real bond yields higher if inflation proves to be more persistent than expected - particularly with central banks likely to respond with faster tapering and, in some cases, eventual rate hikes. Stay below-benchmark on overall global duration exposure in fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have attempted to match the groupings shown in the Bank of Canada analysis as much as possible for the other countries, although there are some minor differences based on how each country’s consumer price index sub-indices are defined. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What If Higher Inflation Is Not Transitory? What If Higher Inflation Is Not Transitory? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Employment Growth Will Rebound Employment Growth Will Rebound Employment Growth Will Rebound August’s weak employment growth reflects the surge of Delta variant COVID cases in the United States. This is evidenced by the fact that Leisure & Hospitality sector payrolls held flat in August after having grown by 415k in July and 397k in June (Chart 1). While Delta could still be a drag on employment growth for another month or two, there is mounting evidence that the daily new case count is close to its peak. Leisure & Hospitality employment growth will regain its prior pace as new Delta cases trend down. This will lead to a resumption of strong monthly payroll reports (500k – 1000k) as we head into the new year. For monetary policy, we calculate that average monthly nonfarm payroll growth of 414k will be sufficient for the Fed to start rate hikes before the end of 2022 (bottom panel). We anticipate that this threshold will easily be met. The Treasury curve will bear-flatten as employment growth improves and the market prices-in an earlier start and quicker pace of Fed rate hikes. Investors should maintain below-benchmark portfolio duration and stay short the 5-year Treasury note versus a duration-matched 2/10 barbell. Feature Table 1Recommended Portfolio Specification The Delta Drag The Delta Drag Table 2Fixed Income Sector Performance The Delta Drag The Delta Drag Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 5 basis points in August, dragging year-to-date excess returns down to +166 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 91 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled for corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated Emerging Market sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Delta Drag The Delta Drag Table 3BCorporate Sector Risk Vs. Reward* The Delta Drag The Delta Drag High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in August, bringing year-to-date excess returns up to +502 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.0% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first seven months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms.   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in August, dragging year-to-date excess returns down to -67 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 4 bps in August. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 2 bps in August (panel 2), and it is now starting to look attractive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 38 bps, below the 56 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 35 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to +84 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 122 bps in August, bringing year-to-date excess returns up to +7 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +44 bps. Local Authority bonds outperformed by 9 bps in August, bringing year-to-date excess returns up to +382 bps. Domestic Agency bonds outperformed by 3 bps, bringing year-to-date excess returns up to +30 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to +31 bps. USD-denominated Emerging Market (EM) Sovereign bonds outperformed US corporates in August and relative valuation between the two sectors is starting to equalize (panel 4). That said, we retain a preference for EM sovereigns over US corporates, particularly the bonds of Russia, Mexico, Saudi Arabia, UAE and Qatar where value remains attractive. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 9 basis points in August, dragging year-to-date excess returns down to +262 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 5% breakeven tax rate versus corporates with the same credit rating and duration. 12-17 year Revenue munis actually offer a before-tax yield pick-up (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 23% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields moved higher in August, with the 5-year and 7-year maturities bearing the brunt of the sell-off. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 110 bps. The 5-year/30-year slope flattened 5 bps to end the month at 115 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 1.93%, the 5-year/5-year forward Treasury yield is not that far below our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.21% in one year’s time and 1.47% in five years (Chart 7). The latter rate has 146 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 265 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell.  TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in August, leaving year-to-date excess returns unchanged at +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates both fell by 7 bps in August. At 2.37%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.21%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation continues to moderate from its current extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in August, bringing year-to-date excess returns up to +40 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +30 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +92 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in August, bringing year-to-date excess returns up to +193 bps. Aaa Non-Agency CMBS outperformed Treasuries by 10 bps in August, bringing year-to-date excess returns up to +92 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 9 bps on the month, dragging year-to-date excess returns down to +529 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 4 basis points in August, bringing year-to-date excess returns up to +91 bps. The average index option-adjusted spread held flat on the month. It currently sits at 35 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of August 31st, 2021) The Delta Drag The Delta Drag 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 August 31st, 2021) The Delta Drag The Delta Drag 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 12 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 12 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) The Delta Drag The Delta Drag Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of August 31st, 2021) The Delta Drag The Delta Drag Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.

Highlights A trio of ECB hawks raised the prospect of an ECB taper. In the past, the current set of economic conditions in the Euro Area would have prompted the ECB to tighten policy. A potential economic deceleration this fall, the transitory nature of the Eurozone’s inflation spike, and the level of inflation expectation in the region limit the ECB’s ability to taper this week. We expect a one-off return to the pre-Q2 2021 level of asset purchases couched in a very dovish forward guidance. Peripheral bonds and European corporate bonds will outperform German and other core European paper. Stay long European curve steepeners, while buying US curve flatteners. Overweight German Bunds versus US Treasury Notes, on a USD-hedged basis. European productivity will remain structurally hampered compared to that of the US. US real bond yields will rise relative to Europe. Feature Last week, a chorus of ECB Governing Council members raised the idea among investors that the central bank may soon begin to taper its asset purchases, which prompted Bund yields to hit -0.35% on Wednesday. Robert Holzmann of Austria, Klaas Knot of the Netherlands, and Jens Weidmann of Germany all suggested that monetary conditions were too accommodative for the Eurozone and that the ECB needed to remedy this problem. The complaints of this hawkish trio reflect the current environment. In August, the Eurozone HICP reached a 3% annual rate while the preliminary estimate for core CPI clicked in at 1.6%. Meanwhile, July PPI rose to 12.1%. Such robust inflation readings are at odds with the low level of interest rates in the Eurozone, where the yields on European IG credit and 10-year Italian BTPs average a paltry 0.45% (Chart 1). Beyond the level of inflation, its broad geographic nature is an additional source of concern. Headline CPI is accelerating across all the bloc’s nations, and it stands above 2% in 82% of the members’ states. Historically, this kind of inflationary backdrop resulted in either higher interest rates or some tapering of asset purchases, especially when economic activity was also improving in the Eurozone (Chart 2). Chart 1A Gap For The Hawks A Gap For The Hawks A Gap For The Hawks Chart 2In The Past, The ECB Would Have Tightened In The Past, The ECB Would Have Tightened In The Past, The ECB Would Have Tightened Will the ECB listen to its most hawkish members and follow its past script? We do not believe that the Governing Council is about to start a sustained period of decreased bond buying, even if a return to the pre-Q2 2021 pace of buying is likely this fall. Thus, a dovish taper is the most likely outcome of this week’s meeting. The ECB’s Three Constraints The outlook for growth, the temporary nature of the current spike in European inflation, and the low-level of Euro Area inflation expectations limit the ECB’s ability to remove monetary accommodation. First, European economic growth is at its apex and will decelerate over the next six months. Currently, domestic activity as approximated by the Services PMI stands at near a 15-year high of almost 60. Moreover, despite the spike in COVD-19 cases linked to the Delta variant, mobility remains very robust. If anything, the decline in cases in Spain and France should lead to further improvement in mobility (Chart 3). Nonetheless, the recent fall in consumer confidence and the recent US experience, which the European economy usually follows, point to a deceleration in the Services PMI. The case for a decline in manufacturing activity is more pronounced. The European manufacturing sector responds strongly to the fluctuation of the global industrial sector. US consumer spending on durable goods is 21% above its pre-pandemic trend and is beginning to weaken as pent-up demand for such products has been satiated and households shift their spending back toward services. Moreover, the Chinese credit cycle, which leads the Eurozone Manufacturing PMI by nine months, indicates a greater deceleration in the coming quarters, because European exports to China will slow (Chart 4, top and middle panels). In response to these two forces, Europe will not diverge from the deterioration in our Global Activity Nowcast (Chart 4, bottom panel). Chart 3So Far, No Delta Impact So Far, No Delta Impact So Far, No Delta Impact Chart 4The Coming Manufacturing Slowdown The Coming Manufacturing Slowdown The Coming Manufacturing Slowdown Chart 5Abnormal Goods Inflation Abnormal Goods Inflation Abnormal Goods Inflation Second, most evidence still suggests that the current inflation increase will be temporary, despite its violence. To begin with, the spike in inflation remains consigned to the goods sectors, while services inflation stands at 1.1%, in line with the experience of the past 10 years (Chart 5). Even within goods prices, the spike in CPI is limited to sectors facing bottlenecks or linked closely to commodity and shipping prices. As Chart 6 illustrates, the categories experiencing abnormal inflation are directly related to higher energy prices, cars, complex machinery, hotels, and fresh food. Meanwhile, underlying inflation as estimated by our trimmed-mean CPI measure is bottoming, but remains at a very low 0.2% annual rate (Chart 7). Chart 6Inflation Remains A Commodity and Bottleneck Story The ECB Taper Dilemma The ECB Taper Dilemma In the same vein, the surge in Selling Price Expectations of the European Commission Business Survey is a function of commodity inflation (Chart 8). In other words, companies feel they can increase their selling prices, because natural resource prices have spiked. However, inflation across many commodities is currently peaking, which suggests that Selling Price Expectations will soon do so as well. Moreover, this process indicates that headline inflation should hit its summit by year end, because Selling Price Expectations are a coincident indicator of inflation (Chart 8, bottom panel). Chart 7Narrow Inflation Narrow Inflation Narrow Inflation Chart 8Rising Selling Prices And Commodities Rising Selling Prices And Commodities Rising Selling Prices And Commodities A wage-inflation spiral also remains far away. Historically, rapidly accelerating wage growth marked periods of elevated inflation. Despite current fears, such a development is not taking place in the Eurozone. For the whole bloc, negotiated wages are growing at a modest 1.7% annual rate (Chart 9). Even in Germany, negotiated wages are only increasing at the same rate. While some labor shortages have been reported, total hours worked remain below the equilibrium level based on the Euro Area demographic profile (Chart 9, bottom panel). Furthermore, the past ten years reveal that labor shortages only caused stronger salary growth with a multi-year delay. Third, the market doubts the credibility of the ECB when it comes to achieving a 2% inflation target. So far, survey-based inflation expectations remain below 2% at all tenors (Chart 10, top panel). The same is true of market-based measures, which are still lower than the levels that prevailed before the sovereign debt crisis of the past decade (Chart 10, bottom panel). Chart 9No Wages/Inflation Spiral No Wages/Inflation Spiral No Wages/Inflation Spiral Chart 10The ECB's Inflation Mandate Is Not Yet Credible The ECB's Inflation Mandate Is Not Yet Credible The ECB's Inflation Mandate Is Not Yet Credible Bottom Line: Risks to growth over the winter, the transitory nature of the recent inflation shock, and inflation expectations that remain significantly below target are constraints limitating the ability of the ECB to announce a true tapering of its asset purchases this Thursday. A Dovish Taper? Considering the current set of conditions prevailing in the Eurozone, we expect the ECB to announce a return to the pace of asset purchases that existed prior to Q2 2021. However, the Governing Council (GC) will go out of its way to issue clear forward guidance that strongly indicates this is not the beginning of a taper campaign. Instead, the GC will hint at the transmutation of a large proportion of the PEPP monthly buying into the PSPP after March 2022. The inflation target change enacted at the conclusion of the ECB’s strategy review in July limits the central bank’s ability to go back to its old rule book and tighten policy at the first hint of inflation. First, the ECB must believe that inflation will overshoot 2% on a durable basis, which will necessitate an upgrade to its long-term inflation forecast above the target. Too many members of the GC do not share this view, which makes it unlikely that inflation forecasts will rise this much this week. Moreover, inflation expectations are also too low to warn of a meaningful change in the behavior of European economic agents, especially if the current spike in inflation proves to be transitory. Another problem for the ECB is the Fed. If the ECB were to announce a durable tapering of its asset purchase this week, it would be doing so ahead of the Fed. The GC fears that this action would put considerable upward pressure on EUR/USD, which would create a grave deflationary tendency in the Eurozone (Chart 11). Despite these shackles, the ECB will also acknowledge that the current emergency pace of asset purchases is no longer warranted. Starting Q2 2021, the ECB increased its average monthly purchase from EUR80 billion in the August 2020 to March 2021 period, to EUR95 billion since April 2021 (Chart 12). However, these increased purchases followed a 0.1% GDP contraction in Q1 in the wake of a spike in COVID-19 cases and deaths, which prompted a large reduction in mobility. Moreover, the larger bond buying also followed large increases in bond yields across the main economies of the continent, a rise which, if it had been left unchecked, would have exacerbated the economic malaise. Chart 11The ECB Fears A Strong Euro The ECB Fears A Strong Euro The ECB Fears A Strong Euro Chart 12Normalizing Purchases The ECB Taper Dilemma The ECB Taper Dilemma None of these factors are still present. The increasing level of vaccination has dulled the economic impact of the third wave of infection. The economy is expanding robustly and, even if it slows in the months ahead, growth will remain well above trend. Crucially, financial conditions are much more generous than in the first half of the year, with a euro that trades 4% below its January peak and with yields in the bloc’s four largest economies 25 to 45 basis points below their spring peaks. Bottom Line: In response to the aforementioned crosscurrents, we anticipate the ECB to announce a return of its monthly asset purchases to the level that prevailed in the August 2020 to March 2021 period. However, the GC will also clearly indicate, as it did last March, that this policy shift is a one-off, and that investors must not anticipate any further curtailment of asset purchases over the next six months. To reinforce this guidance, we expect the ECB’s inflation forecast to show a return of HICP below 2% by the end of 2023. The GC might also hint at the roll-over of the PEPP program into the PSPP after March 2022. Investment Implications An ECB that conducts a dovish taper on Thursday will support our main fixed-income themes in Europe. First, it will remain a tailwind behind an overweight position in peripheral government bonds versus German bonds. The combination of continued purchases of EUR80 billion a month of bonds over the foreseeable future, above-trend growth, and the fiscal risk mutualization from the NGEU and REACT EU programs means that investors can continue to safely pocket the yield premium offered by BTPs and BONOs. Moreover, our geopolitical strategists expect a left-wing coalition to govern Germany after the September 26 election, which will limit the pressures to tighten budgets in the periphery over the coming years. Chart 13European Corporates Remain Attractive European Corporates Remain Attractive European Corporates Remain Attractive Second, continued liquidity injections by the ECB are also consistent with a preference for European corporate credit over government securities, especially in Germany, France, and the Netherlands. European breakeven spreads for IG and high-yield debts are in the 18th and 13th percentile rank, respectively (Chart 13). Easy monetary conditions and above-trend growth will facilitate further yield-seeking behavior in the Eurozone. This process will allow these securities to offer continued excess returns over at least the next six months. Third, we hold on to our box trade of being long Eurozone curve steepeners and long US curve flatteners. In our base case scenario, the Fed will soon indicate the beginning of its tapering campaign and will be on track to raise rates by early 2023, while the ECB will still conduct a very easy monetary policy. In this context, the US yield curve will flatten relative to the European one, driven by a more rapid increase at the short end of the curve. Chart 14Still Favor Bunds Over T-Notes The ECB Taper Dilemma The ECB Taper Dilemma Finally, in a global bond portfolio, it still makes sense to overweight German Bunds (hedged into USD) relative to US Treasury Notes. Bunds display a significantly lower yield beta than their US counterparts, which creates an attractive defensive feature in an environment in which global yields are likely to rise. Moreover, as the model in Chart 14 highlights, the US/German 10-year yield spread is roughly 50bps below an equilibrium estimate based on relative inflation, unemployment and policy rates, and the size of the Fed and ECB balance sheets. US inflation is likely to remain perkier than that of Europe over the coming quarters, and the US unemployment rate will decline faster as well. Additionally, in the unlikely scenario that the Fed declines to taper its purchases this year, but the ECB does, inflation expectations will rise in the US relative to the Euro Area, which will put upward pressure on yield spreads. Bottom Line: A dovish ECB taper, whereby the GC executes a one-off adjustment in asset purchases with an easy forward guidance, will support our overweight in peripheral government bonds relative to bunds, our preference for European corporate credit relative to government paper, our Europe / US box trade, and BCA’s underweight in Treasurys relative to Bunds. Europe’s Productivity Deficit Is Not Over Compared to the US, GDP growth in the Eurozone has been trending lower since the introduction of the euro in 1999. While a weaker demographic profile has hurt Europe, so has slower productivity growth. Going forward, the gap between European and US productivity growth will somewhat narrow compared to last decade, but it will still favor the US. The cross-Atlantic gap in output per hour growth between has a cyclical and a structural component. The cyclical element is set to ebb. Last decade, the Eurozone suffered a double-dip recession, as the European sovereign debt crisis raged. As a result, capex and debt accumulation in Europe lagged that of the US, which hurt demand and, thus, output-per-hour worked (Chart 15, top panel). Going forward, the European debt crisis has been addressed, the ECB has demonstrated its willingness to do “whatever it takes” to support the monetary union and both the European Commission and the German government have thrown their full weight behind the integrity of Europe, even if it means bailing out their profligate southern neighbors. Despite this positive, some structural headwinds will continue to handicap European productivity. Since 2000, total factor productivity in the major Euro Area economies has lagged that of the US (Chart 15, bottom panel). Many factors suggest this will not change: Chart 15Europe’s Productivity Deficit The ECB Taper Dilemma The ECB Taper Dilemma The Eurozone’s big four economies continue to linger well behind the US in terms of ICT investment, which in recent decades has been a crucial driver of productivity. R&D represents a significantly lower share of GDP in the Eurozone than it does in the US (Chart 16). More investment in intangible assets has been linked to higher productivity growth. Additionally, Ortega-Argilés et al. have shown that EU companies do not convert R&D into productivity gains as well as US businesses do, because they generate lower return on investments.1 Confirming this insight, an empirical study using microdata on R&D spending for EU and US firms highlights that both R&D intensity and productivity are lower for EU firms than for their US counterparts.2 For a 10% increase in R&D intensity, US businesses generated a 2.7% increase in productivity, while EU firms enjoyed a much smaller 1% gain. The gap is larger for high-tech companies, where the same rise in R&D intensity produced a 3.3% productivity gain in the US, but only a 1.2% one in the EU. The European economy remains much more fragmented than that of the US, and the greater prevalence of small firms in the Euro Area results in a less efficient use of the human and capital stocks. Finally, the low rate of investments in recent years has caused the European capital stock to age faster than that of the US. An older pool of assets is further away from the technological frontier and thus weighs on TFP and overall labor productivity (Chart 17). Chart 16Lagging European R&D The ECB Taper Dilemma The ECB Taper Dilemma Chart 17The Ageing European Capital Stock The Ageing European Capital Stock The Ageing European Capital Stock Notwithstanding cyclical fluctuations related to the global debt cycle, the Eurozone profit margins and RoEs will not converge meaningfully toward US levels on a structural basis because of this productivity problem. Europe’s lower industry concentration ratios, lower markups, and greater share of output absorbed by wages will only accentuate this problem. Chart 18TIPS Yields Vs Real Bunds TIPS Yields Vs Real Bunds TIPS Yields Vs Real Bunds As a result of the lower trend growth rate caused by lower productivity and its inferior return on invested capital, Europe’s R-Star is unlikely to catch up meaningfully to US levels. Consequently, the gap between US and Germany real rates will remain wide and will drive the increase in US yields relative to those of Germany, as the Fed begins to tighten policy while the ECB stands pat (Chart 18). Bottom Line: Europe’s productivity deficit is not the only consequence of last decade’s sovereign debt crisis. Thus, the Euro Area’s potential GDP growth and return on invested capital will lingers behind those of the US. As a corollary, the Eurozone’s R-star is well below that of the US. Hence, we expect higher real rates to drive the increase in US yields over Germany as the Fed tightens policy ahead of the ECB.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1R. Ortega-Argilés, M. Piva, and M. Vivarelli, “The Transatlantic Productivity Gap: Is R&D the Main Culprit?,” Canadian Journal of Economics 47.4 (2014), pp. 1342-71. 2D. Castellani, M. Piva, T. Schubert, and M. Vivarelli, “The Productivity Impact of R&D Investment: A Comparison between the EU and the US,” IZA Discussion Papers 9937 (2016). Tactical Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Cyclical Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Structural Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Closed Trades The ECB Taper Dilemma The ECB Taper Dilemma Currency Performance Fixed Income Performance Equity Performance

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 17 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST and August 18 at 9:00 HKT, 11:00 AEST). 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. Scheduling Note: There will be no US Bond Strategy report next week. The following week (August 31), clients will receive a report written by our Global Fixed Income Strategist Rob Robis. The regular US Bond Strategy publication schedule will resume on September 8 with the publication of September’s Portfolio Allocation Summary. Best regards, Ryan Swift, US Bond Strategist

Highlights Chart 1Still Close To Fair Value Still Close To Fair Value Still Close To Fair Value Treasury yields fell significantly in July, particularly at the long end of the curve. We continue to view this move as an overreaction to mediocre economic data that will be reversed this fall when labor supply constraints ease and employment surprises to the upside. It’s important to note, however, that despite the drop in long-dated yields the 5-year/5-year forward Treasury yield remains within the bounds of its 1.75% to 2.5% fair value range (Chart 1). That is, shorter-maturity Treasury yields have much more upside than long-dated yields on a 6-12 month investment horizon. We expect the next big move in bonds to be a bear-flattening of the yield curve as the market prices in a Fed rate hike cycle that we see starting near the end of 2022. Investors should position for that outcome today by keeping portfolio duration low and by entering yield curve flatteners. Feature Table 1Recommended Portfolio Specification It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Table 2Fixed Income Sector Performance It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +172 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 89 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled about corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated EM sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Table 3BCorporate Sector Risk Vs. Reward* It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +433 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first six months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms.   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in July, dragging year-to-date excess returns down to -64 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 8 bps in July. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 3 bps in July (panel 3), and it is now starting to look more competitive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 36 bps, below the 54 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 34 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +57 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 149 bps in July, dragging year-to-date excess returns down to -113 bps. Foreign Agencies underperformed the Treasury benchmark by 11 bps on the month, dragging year-to-date excess returns down to +35 bps. Local Authority bonds underperformed by 19 bps in July, dragging year-to-date excess returns down to +372 bps. Domestic Agency bonds outperformed by 2 bps, bringing year-to-date excess returns up to +28 bps. Supranationals performed in line with Treasuries in July, year-to-date excess returns held flat at +26 bps. USD-denominated Emerging Market (EM) Sovereign bonds continue to offer an attractive spread pick-up versus investment grade US corporate bonds with the same credit rating and duration. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico and Russia. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +271 bps (before adjusting for the tax advantage). The economic and policy back-drop is favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 10% breakeven tax rate versus corporates with the same credit rating and duration. The breakeven tax rate for Revenue munis is just 2% (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in July. Bond yields were down across the curve, but by much more at the long end. The 2-year/10-year slope flattened 15 bps to end the month at 105 bps. The 5-year/30-year slope steepened 1 bp to end the month at 120 bps. While we expect the recent decline in bond yields to reverse during the next 6-12 months, we do not think this reversal will coincide with a re-steepening of the 2/10 yield curve. We noted on the first page of this report that the 5-year/5-year forward Treasury yield remains close to its fair value range. Last week’s report demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.17% in one year’s time and 1.36% in five years (Chart 7). While the latter rate has 157 bps of upside if it converges all the way back to its 2018 high, this pales in comparison to the 269 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell.   TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 112 basis points in July, bringing year-to-date excess returns up to +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose by 9 bps and 8 bps, respectively, on the month. At 2.43%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to +37 bps. Aaa-rated ABS underperformed by 3 bps on the month, dragging year-to-date excess returns down to +28 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +88 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile, pushing the savings rate higher yet again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in July, bringing year-to-date excess returns up to +187 bps. Aaa Non-Agency CMBS performed in-line with Treasuries in July, keeping year-to-date excess returns steady at +82 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 16 bps on the month, bringing year-to-date excess returns up to +539 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 28 basis points in July, dragging year-to-date excess returns down to +87 bps. The average index option-adjusted spread widened 5 bps on the month and it currently sits at 34 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners 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 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners 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 26 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 26 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) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.