Inflation Protected

Highlights Inflation Breakeven Trades: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, as breakevens in both countries are no longer below the fair values implied by our models. We are initiating a new trade this week, going long French 10-year inflation-linked bonds versus French nominal OATs, as French breakevens remain below fair value. Yield Curve Butterfly Trades: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Cross-Country Spread Trades: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months. Feature Dear Client, Next week, we will be jointly publishing our semi-annual Central Bank Monitor Chartbook along with our colleagues at BCA Research Foreign Exchange Strategy. You will receive that report a few days later than usual on Friday, December 11. We will return to our regular publishing schedule on Tuesday, December 15 with our 2021 Key Views report outlining our main investment themes and ideas for the upcoming year. Best Regards, Rob Robis As we enter the final weeks of an incredibly eventful and (unfortunately) all too memorable 2020, our attention now turns to investment ideas for the coming New Year. This week, all BCA Research clients will receive the 2021 Outlook report, detailing the key themes and recommendations from all our strategists. We will follow that up with our own 2021 Global Fixed Income Strategy outlook report later this month. The waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio. In addition, the waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio (Table 1). Several of our suggested trades have generated a solid profit (like inflation breakeven wideners) but have now outlived their original rationale. Others, like some of our yield curve trades in Europe, have not gone as we expected and should therefore be closed out. Table 1Changes To Our Tactical Overlay Portfolio A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades As a reminder to our regular readers, our Tactical Overlay is a portfolio of individual trade ideas within the global fixed income space with an investment horizon of six months or less. These differ from our more typical strategic (6-12 month) recommendations that also populate our model bond portfolio. Ideas for our Tactical Overlay trades often stem from our fair value models, but can also be plays on events that we expect will be market relevant on a near-term basis, like central bank meetings. All recommended trades are implemented using specific securities, rather than generic Bloomberg tickers or bond indices. This allows for a more transparent process where clients can follow along with the performance of our trades. Evaluating Our Tactical Inflation-Linked Breakeven Trades We currently have two open tactical trade recommendations involving inflation-linked bonds: Long 10-year Italian inflation-linked bonds vs short 10-year Italian bond futures Long 10-year Canadian inflation-linked bonds vs short 10-year Canadian bond futures We initiated both of these trades back in June of this year, as well as an additional trade involving US TIPS, based on the output of our inflation breakeven fair value framework. In our models, we regress 10-year inflation breakevens on the annual rate of change of oil prices in local currency terms and a multi-year moving average of realized headline inflation.1 At the time of our mid-year report, inflation breakevens were too low on our models in the majority of developed market countries with inflation-linked bonds – a lingering after-effect of the COVID-19 shock to global growth in the second quarter of 2020 (Chart 1). Since then, 10-year inflation breakevens have caught up to fair value in the US, Germany, Italy and Canada, and have even moved above fair value in the UK and Australia. Chart 1A Big Shift In Inflation Breakeven Valuations A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades In June, we also entered into a US 10-year TIPS breakeven widening trade, but we took profits on the trade once US breakevens returned back to our model fair value estimate in September. We now see a similar situation in Canada (Chart 2) and Italy (Chart 3) where breakevens have converged to our model-implied fair value. Chart 2Canadian 10-Year Inflation Breakeven Model Canadian 10-Year Inflation Breakeven Model Canadian 10-Year Inflation Breakeven Model A move above fair value is possible, but could be harder to achieve with the Canadian dollar and euro steadily trending higher which could weigh on the market’s view on future inflation in Canada and Italy. We are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively.  Thus, we are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively. The Italian returns were boosted considerably by the long side of this trade, as we entered the position when the 10-year real yield was +1.05% and which has since collapsed to -0.05% on the back of the massive rally in Italian bonds. One place where breakevens still look attractively cheap, trading close to one standard deviation below our model fair value, is in France (Chart 4). This contrasts with the breakevens in Italy and Germany that have fully converged to fair value. Thus, we are entering a new trade this week, going long the on-the-run 10yr French inflation-linked bond (OATi) and shorting French bond futures (Euro-OATs). The hedge ratio used for this trade to keep both legs duration matched, given the much shorter duration of the OATi relative to nominal French bonds, is 0.49 (see the Tactical Overlay table on page 17 for specific details on the securities used in the trade). Chart 3Italian 10-Year Inflation Breakeven Model Italian 10-Year Inflation Breakeven Model Italian 10-Year Inflation Breakeven Model Chart 4French 10-Year Inflation Breakeven Model French 10-Year Inflation Breakeven Model French 10-Year Inflation Breakeven Model Bottom Line: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, while initiating a new breakeven widening position in France, based on the output of our breakeven fair value models. Evaluating Our Yield Curve/Butterfly Spread Trades Back in July, we initiated a series of yield curve butterfly spread trades in the US, UK, Italy and France.2 Butterfly spreads compare the yield of a single bond (bullets) to that of a duration-neutral combination of bonds with shorter and longer maturities relative to the bullet (barbells). Our valuation models produce fair value estimates of various butterfly combinations based on the relation of the butterfly spreads to the slope of the yield curve. We then combine those valuations with our own macro views on the future slope of yield curves to come up with potential value-based curve trades.3 We now evaluate our four existing curve trades in turn. Long UK 3/20 Barbell vs. 10-Year Bullet Our original rationale for entering this trade was two-fold. Firstly, this position was the most attractive butterfly combination in terms of the standardized deviation of the spread from its model-implied fair value. Secondly, there was a relatively low correlation between nominal UK bond yields and inflation breakevens--meaning that we could see a rise in long-dated inflation expectations that did not also push up nominal bond yields by a proportional amount. This made the trade consistent with our overall macro view back in July that the Gilt curve would flatten (the same rationale applies to the other two long barbell versus short bullet trades, or “flatteners”, in France and Italy that we discuss below). Unfortunately, our rationale did not play out as expected (Chart 5). Instead of reverting to fair value, the butterfly spread was mostly flat while the bullet grew more expensive relative to the barbell, driven by a rise in the model fair value. This in turn was due to significant steepening in the underlying 3/20 curve, contrary to our expectations. We also saw a significant overall upward shift in the overall UK Gilt curve, which generated losses on our long barbell position (which has a higher interest rate convexity) that overwhelmed the profits on our short bullet position. Going forward, there are good technical and strategic reasons to exit this trade. The butterfly spread is not yet at levels where it tends to mean-revert (second panel). In addition, Joe Biden’s US election victory has also increased the odds of a Brexit deal, which would put bear-steepening pressure on the UK Gilt curve. With that in mind, we are closing our Long UK 3/20 Barbell vs. 10-Year Bullet for a loss of -0.17%. Long France 2/30 Barbell vs. 5-Year Bullet Our rationale for entering this flattener was the same as in the UK. However, we fared quite a bit better here. The underlying 2/30 curve did flatten, as we expected, however, the butterfly spread itself moved further away from fair value, with the bullet component becoming relatively more expensive (Chart 6). So, as with the UK, the returns on this trade can be largely explained by the relative outperformance of the barbell component due to its higher convexity. In France, however, the effect worked to our favor as the yield curve shifted downwards significantly. The positive returns on the long French 30-year OAT component, where yields have been nearly slashed in half since July, dominated the other parts of the trade - even with the 30-year bond only being a small piece (11%) of the duration-weighted barbell Chart 5UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model Chart 6France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model Although we did make profits on the flattener, it turned into a convexity bet that was not our original intention. Seeing as our underlying logic did not work out as expected, we are not comfortable remaining in this position. Thus, we are closing our France butterfly trade for a profit of 0.56%. Long Italy 5/30 Barbell vs. 10-Year Bullet As with the UK and France, we entered this trade based on its attractive model-based valuation and the relatively low correlation between inflation breakevens and nominal yields in France. Our expectation of flattening in the underlying 5/30 curve did not bear out as it remained mostly flat (Chart 7). We did see some reversion in the butterfly spread towards our model-implied fair value, which helped us make profits on our trade. Again, we cannot ignore the effect of convexity when looking at the outperformance of the barbell component. Yields fell dramatically across the Italian curve in one of the clearest examples of the yield-chasing behavior we have been describing this year.4 As Italian yields continue their race to the bottom, supported by ECB asset purchases and perceptions of more fiscal co-operation between the countries of Europe, there is a chance that this trade will continue to perform by virtue of its exposure to the long end of the Italian curve. However, as our original bias towards curve flattening did not play out, we prefer to maintain our exposure to Italian government debt via an overweight allocation in our model bond portfolio instead. We therefore close our Long Italy 5/30 Barbell vs. 10-Year Bullet for a profit of 0.83% Long US 7-Year Bullet vs. 5/10 Barbell The US was the only region where we initiated a “steepener” trade, with a long bullet versus short barbell combination that does well when the yield curve steepens. We chose this particular 5/7/10 butterfly as it was the most attractive steepener available based on our model-implied valuation that also fit our fundamental macro bias back in July towards US Treasury curve steepening – a view that we still hold today. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Our rationale for initiating the trade was borne out, with the underlying 5/10 Treasury curve steepening and the butterfly spread tightening towards fair value (Chart 8). Our trade was supported by a continued rebound in long-dated US inflation expectations as well as the US election result, the most bond-bearish event of the year. Chart 7Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Chart 8US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model Going forward, we see good reasons to maintain this trade. The butterfly spread, after briefly reaching expensive levels, is back to being attractively valued. Even if the residual were to dip back below zero, it would still have room to become more expensive, shoring up our trade. This trade also remains the most attractive of all the steepener trades on a model-implied valuation basis, removing any incentive to rotate towards another part of the curve. The odds favor more reflationary Treasury curve steepening after the US election. President-elect Biden has a stated goal of more fiscal stimulus, while his selection of Janet Yellen as Treasury Secretary signaling increased cooperation between monetary and fiscal authorities. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Bottom Line: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Evaluating Our Cross-Country Yield Spread Trades We currently have two recommended trades involving plays on the spread between government bonds: Long 5-year New Zealand government bonds versus short 5-year UK Gilts, currency-hedged into GBP We initiated this trade on August 25, and to date the trade is severely underwater with a total return of -1.8%.5 That loss comes from the long New Zealand leg of the trade, as the 5-year NZ bond yield has increased by 34bps from our entry level. Chart 9A Rapid Shift Upward In NZ Rate Expectations A Rapid Shift Upward In NZ Rate Expectations A Rapid Shift Upward In NZ Rate Expectations The rationale for this trade was based on our assessment of the relative probability of the Bank of England (BoE) and Reserve Bank of New Zealand (RBNZ) moving to a negative interest rate policy. Both central banks hinted strongly at such a move throughout the summer months as part of their efforts to support pandemic-stricken economies. Our view back in late August was that it was more likely that the RBNZ would choose negative rates, as New Zealand had far lower inflation expectations than the UK and, unlike the British pound, the New Zealand dollar was not undervalued. This trade was initially profitable, but all that changed rapidly during the month of November. The RBNZ disappointed investor expectations on a move to negative rates at the November 11 monetary policy meeting. The central bank elected instead to increase the size of its existing quantitative easing program, while giving no hint that negative rates were coming soon. The response was a sharp move higher in both New Zealand bond yields and the New Zealand dollar (Chart 9). There was an even more violent adjustment in yields and the currency last week, after New Zealand Finance Minister Grant Robertson wrote a letter to RBNZ Governor Adrian Orr asking the central bank to change its policy remit to include controlling New Zealand house price inflation. Markets interpreted this blatant political pressure on the central bank as the end of any hopes of negative rates in New Zealand, with bond yields and the currency spiking higher once again. House prices have surged after the RBNZ aggressively cut interest rates earlier this year, with a rapidly rising share of new mortgages having higher loan-to-value ratios (Chart 10). House price inflation is now running at 19.8%, and Finance Minister Robertson did cite deteriorating housing affordability and inequality as the basis for his letter to the RBNZ. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. This shatters the underlying rationale for our long New Zealand/short UK yield spread trade (Chart 11). Chart 10RBNZ-Fueled Boom In House Prices RBNZ-Fueled Boom In House Prices RBNZ-Fueled Boom In House Prices Thus, we are choosing to cut our losses and close out our recommended trade. Long 10-year German Bunds versus short 10-year US Treasuries Chart 11Time To Cut Our Losses On The NZ-UK Trade Time To Cut Our Losses On The NZ-UK Trade Time To Cut Our Losses On The NZ-UK Trade We initiated this recommendation on October 27, and to date the trade is running a small loss of -0.17%.6 The rationale behind the trade was two-fold: Our valuation model for the 10-year UST-Bund yield spread showed that the spread was far below fair value; We turned more bearish on US Treasuries just before the US presidential election, downgrading our recommended allocation to underweight while also upgrading more defensive Germany – with its low yield-beta to US Treasuries - to overweight. The trade initially performed well, driven by faster growth and inflation in the US versus the euro area (Chart 12). The Treasury selloff has stalled of late, but we view this as more a consolidative pause than a near-term peak in yields. Chart 12Fundamentals Justify A Wider UST-Bund Spread Fundamentals Justify A Wider UST-Bund Spread Fundamentals Justify A Wider UST-Bund Spread With our Treasury-Bund valuation model still showing that the spread is too tight, and with the spread not looking overly stretched versus its 200-day moving average (Chart 13), we are keeping our US versus Germany trade in our Tactical Overlay portfolio. Chart 13Valuation & Momentum Point To A Wider UST-Bund Spread Valuation & Momentum Point To A Wider UST-Bund Spread Valuation & Momentum Point To A Wider UST-Bund Spread Bottom Line: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, " How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Yield Curve Trades: Netting Returns With Butterflies", dated July 7, 2020, available at gfis.bcaresearch.com. 3 Readers looking for more detailed background on butterfly trades and our yield curve modelling framework should refer to the July 7, 2020 Strategy Report where we initiated these trades. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rates Club", dated August 26, 2020, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Global Bond Implications Of Rising Treasury Yields", dated October 27, 2020 available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights US Election & COVID-19: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Fixed Income Strategy: The big news announcements do not motivate us to change our fixed income investment recommendations. Stay below-benchmark on overall duration, and underweight the US in global bond portfolios. Stay overweight global inflation-linked bonds versus nominal government debt, particularly in the US and Italy. Maintain an overweight stance on global spread product, focused on US corporates (investment grade and Ba-rated high-yield) and emerging market US dollar denominated corporates. Feature Chart of the WeekUS Yields Leading The Way Higher US Yields Leading The Way Higher US Yields Leading The Way Higher Investors have digested two major pieces of news over the past few days – the projected election of Joe Biden as the 46th US President and the positive results of Pfizer’s COVID-19 vaccine trial. Both outcomes are bond-bearish, but the bigger response came after the news of a potential vaccine, with the 10-year US Treasury yield hitting an 8-month high of 0.96% yesterday. Yields in other countries rose by a lesser amount, continuing the recent trend of US Treasury underperformance (Chart of the Week). After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios.  The introduction of a successful vaccine would obviously be a game-changer for all financial markets, not just fixed income, as it would allow investors to see an end to the pandemic and a return to more normal economic activity. While we are heartened by the vaccine trial announcement, there are still many hurdles that need to be cleared before any vaccine is approved and distributed around the world. It is still too soon to adjust our bond investment strategy in anticipation of a post-COVID world. After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios. While a Biden victory combined with the Republicans likely keeping control of the US Senate was the least bond-bearish outcome - thus avoiding the big surge in government spending likely after a Democratic “blue wave” - there is clear upward momentum in US economic growth that suggests more upside for Treasury yields on both an absolute basis and relative to other countries. Cross-Country Divergences Are Starting To Appear Our recent decision to cut our recommended overall global duration stance to below-benchmark was motivated by our more bearish view on US Treasuries. However, a more defensive duration posture was justified by the rapid rebound in global growth seen since the depths of the COVID-19 recession. Our Global Duration Indicator, comprised of leading economic data, has been calling for a bottom in global bond yields toward the end of 2020 (Chart 2). The rise in global yields we are witnessing now appears to be right on cue. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. Chart 2Global Yields Are Bottoming Global Yields Are Bottoming Global Yields Are Bottoming Importantly, inflation expectations across the developed world have yet not risen by enough to force central banks to become less dovish. This suggests that global yield curves will have a steepening bias over at least the next six months, with longer-term yields rising more on the back of faster growth (and additional increases in inflation expectations) than shorter-maturity yields which are more sensitive to monetary policy shifts. Those trends will not be seen equally across all countries, though. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. For example, the October US manufacturing ISM and Payrolls data released last week showed robust strength, even in a month where new US COVID-19 cases rose sharply. Europe, on the other hand, has seen an even bigger surge in new cases, resulting in a wave of national lockdowns that has already begun to weigh on domestic economic activity. Thus, core European bond yields have remained stable, even with the euro area manufacturing PMI remaining elevated (Chart 3). We see similar divergences in other developed economies, with generally strong manufacturing PMIs and mixed responses from bond yields. When looking at the breakdown of nominal bond yields into the real yield and inflation expectations components, even more divergences are evident (Chart 4).1 Chart 3Mixed Responses To Rebounding Growth Mixed Responses To Rebounding Growth Mixed Responses To Rebounding Growth Chart 4Real Yield Trends Are Starting To Diverge Real Yield Trends Are Starting To Diverge Real Yield Trends Are Starting To Diverge Chart 5Discounting An Extended Period Of Negative Real Rates Discounting An Extended Period Of Negative Real Rates Discounting An Extended Period Of Negative Real Rates The real yields on benchmark 10-year inflation-linked bonds are slowly rising in the US and Canada, but remain stable in Germany, the UK and Australia. Market expectations for central bank policy rates, extracted from overnight index swap (OIS) curves, are currently priced for an extended period of low policy rates over the next few years. This is no surprise, as central banks have told the markets this would be the case via dovish forward guidance. Yet central banks are also projecting inflation rates to move higher between 2021 and 2023, even as they are signaling unchanged interest rates over that same period (Chart 5). Central banks are effectively telling markets that they want an extended period of negative real policy rates - a major reason why real bond yields are negative across the developed world. At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. Unemployment in the US and Canada has already declined sharply since spiking during the first wave of COVID-19 lockdowns. In the US, the unemployment rate has fallen from a peak of 14.7% to 6.9%; in Canada, the decline has been from 13.7% to 8.9% (Chart 6). This contrasts sharply to trends in Europe and Australia, where unemployment rates remain elevated. Chart 6Diverging Trends In Unemployment A Vaccine For Uncertainty A Vaccine For Uncertainty At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. With the Fed and Bank of Canada (BoC) projecting additional declines in unemployment over the next few years, markets are starting to discount a less dovish stance from both central banks. The US and Canadian OIS curves are now discounting one full 25bp policy rate hike by Aug 2023 and May 2023, respectively. This is a bit sooner than signaled by the forward guidance of the Fed and BoC. Thus, markets are now pricing in a less negative path for real policy rates – and, by association, real bond yields. Chart 7Markets Still Discounting Low Yields For Longer A Vaccine For Uncertainty A Vaccine For Uncertainty This contrasts to the euro area, Australia and the UK, where unemployment rates remain elevated. The recent surge in coronavirus cases across Europe means that the ECB and Bank of England will be under no pressure by markets to reconsider their current easy money policies. While in Australia, persistently weak inflation and, more recently, worries about an appreciating Australian dollar are keeping expectations for Reserve Bank of Australia (RBA) policy ultra-dovish. Given the likely hit to longer-term potential growth from the COVID-19 pandemic, coming at a time of elevated debt levels (both government and private), markets are justified in pricing in a structurally lower level of policy rates for longer (Chart 7). Yet even in such a world, there will be cyclical upswings in growth and inflation that will upward pressure on bond yields. At the moment, those pressures seem greatest in the developed world in the US and Canada. This suggests that global bond investors should underweight both the US and Canada. However, the Fed seems more willing to accept a period of rising bond yields than the BoC, which has been very aggressive in the expansion of its quantitative easing (QE) program, which leaves us to only consider the US as a recommended underweight. Bottom Line: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Recommended Fixed Income Strategy After A Busy Few Days Joe Biden’s election victory and the potential COVID-19 vaccine do not lead us to make any changes to our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On duration, we continue to recommend a moderate below-benchmark overall exposure. Our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On country allocation, we remain underweight the US, neutral Canada and Australia, and overweight the UK, core Europe, Italy, Spain and Japan. The country allocations are determined by each country’s sensitivity to changes in US Treasury yields, particularly during periods of rising yields. We are overweight the countries with a lower “yield beta” to changes in US yields. We view Italy and Spain as credit instruments, supported by large-scale ECB purchases and more fiscal cooperation within Europe. We are not recommending underweights to higher-beta Canada and Australia, however, with both the BoC and RBA being very aggressive with bond purchases (Chart 8). On credit, the backdrop remains very conducive to spread product outperformance versus government bonds, particularly with the monetary policy backdrop remaining highly accommodative (Chart 9). Chart 8Global QE Has Been Aggressive Global QE Has Been Aggressive Global QE Has Been Aggressive We expect some additional spread tightening for developed market corporate debt as well also emerging market US dollar denominated corporates. In terms of regions and credit tiers, we prefer US investment grade and Ba-rated high-yield to euro area credit. Chart 9Central Bank Liquidity Still Supportive For Global Credit Central Bank Liquidity Still Supportive For Global Credit Central Bank Liquidity Still Supportive For Global Credit Chart 10More Global QE Is Good For Inflation-Linked Bonds More Global QE Is Good For Inflation-Linked Bonds More Global QE Is Good For Inflation-Linked Bonds Finally, we continue to recommend overweight allocations to inflation-linked bods versus nominal government debt in the US, Italy and Canada. Central banks will continue to err on the side of maintaining stimulative monetary policy settings to keep financial conditions easy to support economic growth. That means no hawkish surprises on the interest rate front, while also continuing to buy bonds via quantitative easing (Chart 10) – reflationary policies that should help boost inflation expectations.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have deliberately left Japan out of this analysis, as the Bank of Japan’s Yield Curve Control policy has effectively short-circuited the link between Japanese economic growth, inflation and bond yields. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Vaccine For Uncertainty A Vaccine For Uncertainty Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Economy: The Democrats did not sweep the US election, but the Democratic House and Republican Senate will likely find some middle ground on a stimulus deal. This will keep the economic recovery on track. A highly effective COVID vaccine that becomes widely available would supercharge it. Rates: Investors should continue to position for a bear-steepening nominal Treasury curve on a 6-12 month horizon. They should also overweight TIPS versus nominal Treasuries, favor inflation curve flatteners and real yield curve steepeners. Treasury Supply & Fed Demand: The Treasury department will continue to increase coupon issuance at the expense of bills. If current policy remains in place, Fed purchases will decline as a percent of coupon issuance in the coming quarters. But the Fed could take steps to modify its asset purchase strategy during the next few months. Feature We’ve seen enough. After a week of checking and re-checking the numbers, BCA’s US Bond Strategy service has concluded that a moderate bear-steepening of the Treasury curve remains the most likely outcome for the next 6-to-12 months. Of course, the dust has not completely settled on the US election. President Trump has issued several legal challenges and control of the Senate won’t be decided until early January when two run-off elections take place in Georgia. However, it now looks safe to assume that Joe Biden will take over as President next year. We also expect, with slightly less conviction, that the Republican party will keep control of the Senate, as Democrats need to win both Georgia races in order to secure a majority. In this week’s report, we assess the fall-out from the election on different sectors of the US bond market. We also consider how the election result impacts the outlook for fiscal stimulus and provide an update on supply and demand trends in the Treasury market. The Election Fall-Out In Bond Markets Nominal Yields Chart 1A Moderate Bear-Steepening A Moderate Bear-Steepening A Moderate Bear-Steepening The 10-year Treasury yield got as high as 0.90% in advance of election day, as the market was pricing-in a Democratic sweep that would have led to a substantial increase in government spending. This outcome is still technically possible, but it now looks unlikely. The 10-year Treasury yield fell back to 0.78% as the election results came in but returned to 0.90% yesterday morning on news that Pfizer’s COVID vaccine was 90% effective in phase 3 trials. This market action affirms our recommended positioning. The Bloomberg Barclays Treasury Index has been underperforming cash since August, the uptrend in the 10-year Treasury yield remains intact and the yield curve continues to steepen (Chart 1). All these trends will remain in place as long as the economic recovery continues, and timely distribution of an effective COVID vaccine will certainly speed that process up. The biggest risk to our view is that a Democrat-controlled House and Republican-controlled Senate are unable to agree on a follow-up fiscal stimulus package during the next few months, and that the economic recovery stalls as a result. This is possible, but our base case scenario is that a compromise will be easier to reach now that the election is over. We expect a moderately-sized relief bill to be delivered relatively soon, possibly even before the end of the year. The Inflation Curve Chart 2Own Inflation Curve Flatteners... Own Inflation Curve Flatteners... Own Inflation Curve Flatteners... The 10-year TIPS breakeven inflation rate fell 8 bps immediately after the election, but unlike with nominal yields, the trend in the cost of inflation compensation had been relatively flat heading into election day (Chart 2). It’s not hard to see why. Inflationary pressures in the economy have clearly moderated compared to the summer. The oil price has taken a step down (Chart 2, panel 3) and month-over-month CPI growth has been trending lower (Chart 2, bottom panel). We don’t expect this deceleration in inflation to continue. Global economic recovery will keep commodities well bid, and core inflation will slowly recover back to target. This argues for staying overweight TIPS versus nominal Treasuries. We also recommend owning inflation curve flatteners. The inflation curve has been steepening since August, as the short-dated cost of inflation compensation has fallen by more than the long-dated cost (Chart 2, panel 2). This steepening is typical for periods when TIPS breakeven rates are falling, and it will reverse when breakevens start rising again. Looking further out, the Fed’s commitment to allow a temporary overshoot of its 2% inflation target means that we should expect the inflation curve to invert. This means that inflation curve flatteners have a lot of room to run. Real Yields With almost no volatility in short-maturity nominal yields, short-maturity real yields are simply the mirror image of short-maturity inflation expectations. For this reason, the 2-year real yield has been moving up since August as the 2-year cost of inflation compensation has declined (Chart 3). This dynamic doesn’t hold for long maturities, where nominal yields have been rising as markets price-in eventual Fed tightening (Chart 3, top panel). Inflationary pressures in the economy have clearly moderated compared to the summer. The different behavior of long- and short-maturity real yields gives us high conviction in recommending a real yield curve steepener (Chart 3, bottom panel). A recovery in inflation expectations will push short-maturity real yields lower but will not have the same impact at the long-end where nominal yields will also rise. Chart 3…And Real Yield Curve Steepeners ...And Real Yield Curve Steepeners ...And Real Yield Curve Steepeners Corporate Credit Chart 4Credit Spreads Welcomed The Election Results Credit Spreads Welcomed The Election Results Credit Spreads Welcomed The Election Results Interestingly, the election result of a Biden presidency and divided House and Senate was viewed positively by both the “risk-free” Treasury market and risky credit spreads (Chart 4). Treasury yields fell on expectations of less fiscal stimulus, but credit spreads also tightened because a Republican Senate will keep corporate tax hikes at bay and a Biden presidency will ratchet down trade tensions with China. We maintain our positive outlook on credit and continue to recommend overweight allocations to corporate bonds rated Ba and higher. We remain underweight low-rated junk bonds (B & below) for now, because those spreads are pricing-in a rapid drop in the default rate. We may soon shift into low-rated junk as well, depending on how quickly an effective vaccine can be distributed. One less discussed risk for corporate spreads is the expiration of the Fed’s emergency lending facilities at the end of the year. The facilities are currently scheduled to expire on December 31st, though Fed Chair Powell seemed to imply last week that he would like to extend them. The one hitch could be that the Treasury department will also have to sign-on to an extension. It is currently unclear whether it is interested in doing so. Municipal Bonds Chart 5Munis Still Very Attractive Munis Still Very Attractive Munis Still Very Attractive The strong relative performance of municipal bonds since election day has been the most confounding market move (Chart 5). All logic tells us that Municipal / Treasury yield spreads should have widened as it became clear that the Republicans will likely keep control of the Senate. A Republican Senate will prevent Joe Biden from raising income taxes, which would have made tax-advantaged munis look more attractive on a relative basis. A Republican Senate has also been staunchly opposed to providing federal aid to cash-strapped state & local governments. But munis have outperformed Treasuries despite these obvious negative catalysts, possibly in part due to Mitch McConnell’s post-election comments that suggested he is open to compromise on a fiscal relief bill and would even be open to including some funds for state & local governments. Despite McConnell’s comments, the prospect of federal funds for state & local governments is uncertain at best. But we nonetheless maintain an overweight allocation to municipal bonds due to continued extraordinary valuations relative to both Treasuries (Chart 5, panel 2) and corporates (Chart 5, bottom panel). The Stimulus Risk As we alluded to above, the biggest risk to our bond-bearish view is that the failure to pass a follow-up to the CARES act results in a spate of negative economic data that spooks investors. This negative data would likely first show up in consumer spending, which so far continues to recover (Chart 6). However, we think the odds are that, in the absence of stimulus, we will see a disappointing consumer spending report within the next few months. How markets react to that news will depend on the status of stimulus talks at that time, as well as news about a potential vaccine roll-out. Disposable personal income was still above pre-COVID levels in September, but it continues to be buttressed by income support from the federal government. Notice that non-transfer income remains below pre-COVID levels (Chart 6, panel 3). Further, the drop in the savings rate during the past few months has outpaced the improvement in consumer sentiment (Chart 6, bottom panel). This suggests that any excess savings that households may have accumulated in the spring are now close to being exhausted. In the absence of stimulus, we will see a disappointing consumer spending report within the next few months. Elsewhere, the labor market continues to make steady improvements, but it could also use some help from policymakers. Excluding temporary census employment, nonfarm payrolls rose 786k in October, slightly above September’s pace but below the rapid gains seen in May and June (Chart 7). Further, initial jobless claims remain above 700k per week and real-time employment data from Homebase has been steady at a low level. All this to say that the labor market is making only modest gains and there remains a gap of 10 million jobs between current nonfarm payrolls and those from February (Chart 7, top panel). Chart 6Keep Monitoring Consumer Spending Keep Monitoring Consumer Spending Keep Monitoring Consumer Spending Chart 7A Slow Recovery In Employment A Slow Recovery In Employment A Slow Recovery In Employment The bottom line is that, without further fiscal stimulus, the odds are high that the economic data will disappoint at some point during the next few months. This will cause bond yields to fall and credit spreads to widen, unless it looks like Congress is close to a deal or like a vaccine will be available in a timely manner. Fortunately, we do think the odds are relatively high that a Republican Senate and Democratic House will be able to reach a compromise stimulus deal, albeit a modest one in the range of $700 billion to $1 trillion. The political incentives against compromise have faded now that the election is over, and we expect a deal either this year or early next year. Treasury Supply And Fed Demand The Treasury department recently released its financing estimates for the next two quarters. A few trends are worth mentioning. First, the Treasury will continue to increase coupon issuance as it seeks to extend the average maturity of the outstanding debt (Chart 8, top panel). Chart 8The Path For Treasury Supply And Fed Demand Bond Bear Intact Bond Bear Intact Second, the Treasury will continue to operate with an historically elevated cash balance, but it will seek to reduce its cash holdings to $800 billion from $1.6 trillion currently (Chart 9). Chart 9Treasury Will Deploy Some Cash Treasury Will Deploy Some Cash Treasury Will Deploy Some Cash Third, the Treasury assumed in its projections that Congress will deliver another $1 trillion of stimulus. The combination of (i) increased coupon issuance, (ii) a falling cash balance and (iii) stimulus projections that may be too high, points to a continued drop in T-bill issuance (Chart 10). In fact, the Treasury acknowledged that bill issuance will likely fall going forward and said that it would be comfortable with a distribution where bills account for 15%-20% of the outstanding debt (Chart 11). Chart 10Expect T-Bill Issuance To ##br##Keep Falling… Expect T-Bill Issuance To Keep Falling... Expect T-Bill Issuance To Keep Falling... Chart 11…And To Settle At Around 15-20% Of Outstanding Debt ...And To Settle At ArouNd 15-20% Of Oustanding Debt ...And To Settle At ArouNd 15-20% Of Oustanding Debt Fed Chairman Powell also addressed the media last week, after the conclusion of the November FOMC meeting, and announced that the Fed made no changes to its asset purchases. For the time being, the Fed will continue to purchase “at least” $80 billion of Treasuries and $40 billion of MBS per month. However, Powell did indicate that FOMC participants discussed different ways in which they might modify the asset purchase program in the future. Presumably this means that if the Committee feels the need to deliver further monetary stimulus it will do so by either shifting its Treasury purchases to the long-end of the curve – in order to remove more duration risk from the market – or by increasing the outright pace of purchases. Powell made it clear that he sees these sorts of balance sheet moves as viable forms of monetary stimulus, though the tone of the questions he received during the press conference suggests that the consensus increasingly senses that the Fed might be out of ammo. Several questioners noted Powell’s repeated calls for fiscal stimulus and asked directly whether the Fed has done all it can. In conclusion, if the Fed maintains the current pace and distribution of Treasury purchases (Chart 8, panel 2), its asset purchases will continue to trend down compared to gross Treasury issuance (Chart 8, bottom panel). However, we could see the Fed taking a step to mitigate that decline at the long-end of the curve by shifting the maturity distribution of its asset purchases towards longer maturities. This move could occur as early as next month. The Treasury will continue to operate with an historically elevated cash balance, but it will seek to reduce its cash holdings to $800 billion from $1.6 trillion currently. The bar for actually increasing the monthly pace of purchases is likely much higher, and it would require a significant tightening of financial conditions or drop in economic activity to push the Fed into action. The bigger question, however, is whether the market even cares anymore about tweaks to the Fed’s asset purchase program. The tone of questions at last week’s press conference suggests it might not. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Bond Bear Intact Bond Bear Intact Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Bond Yields Have Upside In A Blue Sweep Bond Yields Have Upside In A Blue Sweep Bond Yields Have Upside In A Blue Sweep Today’s US election has important implications for the near-term path of bond yields. In particular, a “blue sweep” outcome where the Democrats win control of the House, Senate and White House will probably cause yields to jump (Chart 1), as such an outcome virtually guarantees a large fiscal relief package early next year. Fiscal negotiations will be more contentious if the Republicans maintain control of the Senate, and yields could decline this evening if that occurs. However, no matter the election outcome, our 6-12 month below-benchmark portfolio duration recommendation will not change tomorrow. The economic recovery appears to be on track and some further fiscal stimulus is likely next year no matter who prevails tonight. The stimulus will just be smaller if a divided government necessitates compromise. In any case, bond investors should keep portfolio duration below-benchmark and stay overweight TIPS versus nominal Treasuries. They should also maintain positions in nominal and real yield curve steepeners and inflation curve flatteners. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 99 basis points in October, bringing year-to-date excess returns up to -300 bps. Corporate bonds are certainly not as cheap as they were back in March, but we still see acceptable value in the sector. The corporate index’s 12-month breakeven spread is at its 20th percentile since 1995 and the equivalent Baa spread is at its 28th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further tightening. Corporate bond issuance increased in September, though it remains well below the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have enough cash to cover their investment needs (bottom panel). This will keep issuance low in the coming months. At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,1  Healthcare and Energy bonds.2  We also advise underweight allocations to Technology3 and Pharmaceutical bonds.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* A Big Night For The Bond Market A Big Night For The Bond Market Table 3BCorporate Sector Risk Vs. Reward* A Big Night For The Bond Market A Big Night For The Bond Market High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 86 basis points in October, bringing year-to-date excess returns up to -373 bps. Ba-rated bonds outperformed lower-rated credits in October, and they remain the best performing corporate credit tier since the March 23 peak in spreads (See Appendix A). In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate cannot be ruled out completely, but it would necessitate a rapid pace of economic recovery. We are not yet confident enough in the recovery to position for such a fast drop-off in defaults, especially with Job Cut Announcements still well above pre-COVID levels (bottom panel). We therefore continue to recommend an overweight allocation to the Ba-rated credit tier – where access to the Fed’s emergency lending facilities is broadly available – and an underweight allocation to bonds rated B and below. At the sector level, we advise overweight allocations to high-yield Technology5 and Energy bonds.6 We are underweight the Healthcare and Pharmaceutical sectors.7   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to -39 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 11 bps on the month to land at 72 bps. This is now slightly below the 76 basis point spread offered by Aa-rated corporate bonds but well above the 62 bps offered by Agency CMBS and the 29 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we remain concerned that the elevated primary mortgage spread is a warning that refinancing risk is greater than what is currently being priced in the market (Chart 4). Yes, the mortgage spread has tightened during the past few months, but it remains 35 bps above its average 2019 level. This suggests that the mortgage rate could fall another 35 bps due to spread compression alone, even if Treasury yields are unchanged. Such a move would lead to a significant increase in prepayment losses. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 30 basis points in October, bringing year-to-date excess returns up to -284 bps. Sovereign debt outperformed duration-equivalent Treasuries by 151 bps on the month, bringing year-to-date excess returns up to -420 bps. Foreign Agencies outperformed the Treasury benchmark by 18 bps in October, bringing year-to-date excess returns up to -690 bps. Local Authority debt underperformed Treasuries by 21 bps in October, dragging year-to-date excess returns down to -362 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to -33 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -7 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, this year’s dollar weakness has been relative to other Developed Market currencies. In recent months, the dollar has actually strengthened versus EM currencies (Chart 5). Value also remains poor for EM Sovereigns, which continue to offer a lower spread than Baa-rated corporate debt (panel 4). We looked at EM Sovereign valuation on a country-by-country basis in a recent report.8 We concluded that Mexican and Russian bonds offer the most compelling risk/reward trade-offs relative to the US corporate sector. Of those two countries, Mexican debt offers the best opportunity as US politics remain a concern for the Russian currency. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 41 basis points in October, bringing year-to-date excess returns up to -464 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened in October, but value remains exceptional with most maturities trading at a positive before-tax spread. As we showed in a recent report, municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum.9 On a duration-matched basis, the Bloomberg Barclays General Obligation and Revenue Bond indexes trade at before-tax premiums relative to corporate bonds of the same credit rating, an extremely rare occurrence (Chart 6). Extraordinary valuation is the main reason for our recommendation to overweight municipal bonds. The severe ongoing state & local government credit crunch is a concern, but it is a risk we are willing to take. If the Democrats win the House, Senate and White House this evening – a fairly likely scenario – federal aid for state & local governments will be delivered in January. This would alleviate a lot of concern. But even in the absence of federal assistance, the combination of austerity measures (bottom panel) and all-time high State Rainy Day Fund balances should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in October, largely due to rising expectations of a “blue sweep” election outcome. The 2/10 and 5/30 Treasury slopes steepened 18 bps and 9 bps, respectively, to reach 74 bps and 127 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. More bear steepening is likely if the Democrats win the House, Senate and White House tonight, as this would mean that a large amount of fiscal stimulus is coming early next year. But we will stick with our curve steepening recommendation regardless of the election outcome. No matter who wins the election, some further fiscal stimulus is likely on a 6-12 month horizon. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 38 basis points in October, bringing year-to-date excess returns up to -93 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 7 bps and 5 bps on the month. They currently sit at 1.71% and 1.82%, respectively. Core CPI rose 0.19% in September and the year-over-year rate held steady at 1.73%. The 12-month trimmed mean CPI ticked down from 2.48% to 2.37%, so the gap between core and trimmed mean continued to narrow (Chart 8). We anticipate further narrowing in the months ahead, and therefore expect core CPI to come in relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).10 Inflation pressures may moderate once core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure sometime next year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +72 bps. Aaa-rated ABS outperformed the Treasury benchmark by 6 bps on the month, bringing year-to-date excess returns up to +59 bps. Non-Aaa ABS outperformed by 29 bps, bringing year-to-date excess returns up to +157 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.11  We noted that stimulus received from the CARES act caused disposable income to increase significantly since February. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. 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 9 basis points in October, bringing year-to-date excess returns up to -250 bps. Aaa Non-Agency CMBS underperformed Treasuries by 10 bps on the month, dragging year-to-date excess returns down to -73 bps. Non-Aaa Non-Agency CMBS outperformed by 72 bps, bringing year-to-date excess returns up to -738 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate (CRE) continues. Without Fed support, non-Aaa CMBS will struggle to deal with tightening CRE lending standards and falling demand (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 29 basis points in October, bringing year-to-date excess returns up to +17 bps. The average index spread tightened 6 bps on the month. It currently sits at 62 bps, well above typical historical levels (bottom panel). At its last meeting, the Fed decided to slow its pace of Agency CMBS purchases. It will no longer seek to increase its Agency CMBS holdings, but will instead purchase only what is “needed to sustain smooth market functioning”. This is nonetheless a Fed back-stop of the market, and it does not change our overweight recommendation. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities A Big Night For The Bond Market A Big Night For The Bond Market Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 30TH, 2020) A Big Night For The Bond Market A Big Night For The Bond Market 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 October 30TH, 2020) A Big Night For The Bond Market A Big Night For The Bond Market 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 63 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 63 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 Big Night For The Bond Market A Big Night For The Bond Market Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of October 30TH, 2020) A Big Night For The Bond Market A Big Night For The Bond Market   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Political Risk Will Dominate In A Pivotal Month For The Bond Market”, dated October 13, 2020, available at usbs.bcaresearch.com 10 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Your feedback is important to us. Please take our client survey today. Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals November 2020 November 2020 According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).6 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus November 2020 November 2020 According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights Does it still make sense to use historical yield betas for fixed income country allocation? Yes, favoring countries with higher government bond yield betas when global yields are falling, and vice versa, is still an appropriate way to manage fixed income risk – although betas do vary between global bond bull and bear markets. Can inflation breakevens and real yields continue moving in opposite directions? Yes, but that negative correlation will become less intense, especially in the US, with rising inflation expectations eventually becoming the more dominant influence on nominal bond yields. Will inflation breakevens continue to have a strong positive correlation with oil prices? Yes, but only for as long as non-energy inflation remains low and stable, which has made energy prices the only source of inflation variability in most developed countries. Feature Sleepy bond markets got a bit of a jolt over the past couple of weeks, with longer-maturity government bond yields moving higher across the developed markets, led by the US where the 30-year Treasury yield is now back to levels last seen in June. The move higher in US Treasury yields may be a sign that investors are taking the US election polling numbers – which now signal not only a Joe Biden victory on November 3, but also a swing of the US Senate to Democratic Party control – seriously. A so-called “Blue Sweep”, resulting in the full implementation of the Biden policy platform including a massive fiscal stimulus, is potentially bond bearish, and not only for US Treasuries, given the close correlation of US yields to other bond markets. There is a strong correlation between the level of bond yields, and the yield beta, for the major developed market countries. This brief burst of global bond market volatility, stemming from developments in the US, is a reminder that investors should always be aware of the importance of cross-market correlations when making trading and portfolio construction decisions. With that in mind, this week we ask some important questions about the critical correlations across global government bond markets that support our current investment recommendations – and under what conditions they could possibly change. Does It Still Make Sense To Use Historical Yield Betas For Fixed Income Country Allocation? Chart 1Developed Bond Yields Relative To The 'Global' Bond Yield Developed Bond Yields Relative To The 'Global' Bond Yield Developed Bond Yields Relative To The 'Global' Bond Yield One of the key elements underlying our bond country allocation recommendations is the concept of “yield beta”. Simply put, this is a measure of the sensitivity of changes in individual country bond yields to changes in the overall level of global bond yields. The way we measure yield betas is by using a regression (over a three-year rolling window) of monthly changes for an individual country’s 10-year bond yield on the monthly change of the Bloomberg Barclays Global Treasury index yield for the 7-10 year maturity bucket (as the proxy for the “global” 10-year yield). The regression coefficient on the individual country yield change is the yield beta. There is a strong correlation between the level of bond yields, and the yield beta, for the major developed market countries. Currently, the list of “high-yielders” – with 10-year government bond yields above the benchmark index yield – includes the US, Italy, Canada, Australia and New Zealand (Chart 1). The low-yielders, with 10-year yields below the benchmark index yield, are Germany, France, Spain, the UK and Japan. When we look at the yield betas for that same list of countries, we can also break up the list into high-beta and low-beta bond markets. When we rank the ten countries by their rolling three-year yield betas, the five highest betas belong to the same five countries with the highest yields, and vice versa (Chart 2). This is an intuitive correlation, as countries with higher yield betas are, by definition, more volatile and should require higher yields from investors to compensate for that additional volatility. Chart 2The Higher-Yielding Countries Also Have Higher Yield Betas The Higher-Yielding Countries Also Have Higher Yield Betas The Higher-Yielding Countries Also Have Higher Yield Betas The yield betas are not stable over time for all countries, however. The US has consistently remained the highest beta market, and Japan the lowest beta market, over the past twenty years. Other countries have seen their yield betas evolve over time. For example, France, Spain and, more recently, the UK have seen their yield betas decline in recent years, while Italy has gone from being low-beta to one of the higher-beta markets. In our view, the evolution of yield betas relates to the “activism” of policymakers in each country. Higher-beta, higher-yield countries also have central banks that move interest rates higher and lower with more frequency compared to the low-beta, low-yield countries. In our view, the evolution of yield betas relates to the “activism” of policymakers in each country. That high-beta group includes bond markets linked to the Federal Reserve, the Bank of Canada, the Reserve Bank of Australia and the Reserve Bank of New Zealand – all central banks that are not shy about aggressively cutting or hiking interest rates. The low-beta markets have central banks that move rates very infrequently, like the European Central Bank and the Bank of Japan. Table 1Yield Betas For The Major Developed Markets Some Important Questions Regarding Bond Yield Correlations Some Important Questions Regarding Bond Yield Correlations One other interesting point on yield betas is that they do vary depending on the overall direction of global bond yields. As a way to show this, we estimated “upside” and “downside” yield betas for the same ten countries shown earlier. Those betas were calculated by sorting the monthly yield changes for all countries by months when the benchmark global bond index yield was rising or falling. Thus, upside yield beta comes from a regression of monthly yield changes for individual countries on changes in overall global bond yields, but only using data for months when global yields increased. The opposite is true for downside beta, where only data from months when the global benchmark index yield declined are used. The individual yield betas – for the overall sample and the upside and downside groupings – are presented in Table 1. One conclusion that comes from breaking up the data this way is that countries that were in the low-beta group when looking at the full set of data have relatively high yield betas during periods of rising global yields, like France and the UK (Chart 3). In addition, when looking at downside betas, US Treasuries have the highest beta, by far, when global yields are falling – with yields for euro area countries having relatively lower betas (Chart 4). Chart 3Yield Betas During Periods Of Rising Global Yields Yield Betas During Periods Of Rising Global Yields Yield Betas During Periods Of Rising Global Yields Chart 4Yield Betas During Periods Of Falling Global Yields Yield Betas During Periods Of Falling Global Yields Yield Betas During Periods Of Falling Global Yields Our conclusion from this analysis is that yield betas do have a useful role in making country allocation decisions for global fixed income investors. Specifically, adjusting allocations based on a view on the overall direction of global bond yields should help better manage portfolio risk and, potentially, improve returns. Chart 5Italy Has Become High-Beta As Spreads Have Narrowed Italy Has Become High-Beta As Spreads Have Narrowed Italy Has Become High-Beta As Spreads Have Narrowed A final point on Italy – the reason Italy has had such a high yield beta over the past few years is because Italian government bond yields have been driven more by the reduction of Italian sovereign credit risk – including the redenomination risk from a potential Italian exit from the euro (Chart 5). As Italian credit spreads have melted away from the levels reached during the 2011/12 European Debt Crisis, yields have fallen faster than others during periods of falling global yields, and vice versa. Looking ahead, with the ECB continuing to be an aggressive buyer of Italian bonds in its various asset purchase programs, and with the COVID-19 pandemic forcing the European Union into a deeper level of economic co-operation – which now includes grants to Italy – the sovereign risk premium on Italian government debt should continue to narrow. That means Italy will continue to trade as a high-beta market when global yields are falling, and a low-beta market when yields are rising, making Italy an ideal overweight candidate in global bond portfolios. Bottom Line: Favoring countries with higher government bond yield betas when global yields are falling, and vice versa, is still an appropriate way to manage fixed income risk – although betas do vary between global bond bull and bear markets. Can Inflation Breakevens And Real Yields Continue Moving In Opposite Directions? The behavior of real bond yields over the past few months garnered a lot of attention in 2020, particularly the sharp fall in US TIPS yields into deeply negative territory. This has occurred at the same time as a widening of inflation breakevens, which exhibited a deeply negative correlation with real yields. The result: narrow trading ranges for nominal government bond yields in most developed countries, with moves in real yields and inflation breakevens largely offsetting each other. Adjusting allocations based on a view on the overall direction of global bond yields should help better manage portfolio risk and, potentially, improve returns. Looking at the history of real yields and inflation breakevens, periods of a negative correlation between the two are not unusual. In Chart 6, we show the range of historic correlations between 10-year inflation-linked bond yields, and 10-year inflation breakevens, for the US, UK, Germany, France, Italy, Australia, Canada and Japan since 2010. The dark bars represent the range of rolling correlations over a three-year period, while the red diamonds are a more recent correlation over the past thirteen weeks. All countries shown have seen periods of negative correlation, with only Australia and France having the most recent correlation be far lower than the historic experience. Chart 6Negative Real Yield/Breakevens Correlations Are Not Unprecedented Some Important Questions Regarding Bond Yield Correlations Some Important Questions Regarding Bond Yield Correlations So if a negative real yield/inflation breakeven correlation is not that unusual, then what is the cause of it? We see two drivers: the amount of spare capacity in an economy and the central bank policy response to it. We can see this by looking at the data from the countries with the two largest inflation-linked bond markets, the US and UK. In the US, real TIPS yields and inflation breakevens have generally been positively correlated only during Fed tightening cycles, specifically after the Fed has raised the fed funds rate above the rate of realized core inflation (Chart 7). This was the case in the tightening cycles of the mid-2000s and 2016-18. During those episodes, the Fed pushed the real funds rate steadily higher, which also had the effect of pushing real TIPS bond yields higher, even as inflation expectations were stable-to-rising. Looking at the history of real yields and inflation breakevens, periods of a negative correlation between the two are not unusual. The opposite held true during Fed easing cycles since the advent of the TIPS market in the late 1990s, when the Fed always lowered the funds rate below realized inflation. The result was a period of a falling real funds rate, leading to lower real TIPS yields and eventually triggering an increase in inflation breakevens. In other words, the correlation between breakevens and real yields became negative. In the UK, the negative correlation between real index-linked Gilt yields and inflation breakevens has been consistently negative since the 2008 financial crisis (Chart 8). The Bank of England has barely moved policy rates since that crisis, while keeping nominal policy rates below 1% - a level that was consistently below core UK inflation. Thus, the Bank of England has maintained negative real policy rates for the past twelve years, with real Gilt yields declining steadily and inflation breakevens rising – a negative correlation - over that period. Chart 7Fed Policy Influences The US Real Yield/Breakevens Correlation Fed Policy Influences The US Real Yield/Breakevens Correlation Fed Policy Influences The US Real Yield/Breakevens Correlation Chart 8A Persistently Negative Correlation Of UK Real Yields & Breakevens A Persistently Negative Correlation Of UK Real Yields & Breakevens A Persistently Negative Correlation Of UK Real Yields & Breakevens   For both the US (Chart 9) and UK (Chart 10), the rolling 3-year correlation between real yields and breakevens has itself been correlated to the unemployment gap, or the difference between the unemployment rate and the full-employment NAIRU rate, over the past two decades. This suggests that the ebbs and flows of labor market slack, and how the Fed and Bank of England have responded to them by easing or tightening monetary policy, also play a role in determining the real yield/breakevens correlation. Chart 9Real Yield/Breakevens Correlation Will Stay Negative In The US Real Yield/Breakevens Correlation Will Stay Negative In The US Real Yield/Breakevens Correlation Will Stay Negative In The US Chart 10Real Yield/Breakevens Correlation Will Stay Negative In The UK Real Yield/Breakevens Correlation Will Stay Negative In The UK Real Yield/Breakevens Correlation Will Stay Negative In The UK   In the case of the US, a more extended UK-like period of negative real policy rates and real bond yields is likely if the Fed is to be taken at their word that they will keep rates low to engineer a US inflation overshoot. We suspect that the correlation will not be perfectly negative, as has occurred at times this year, with inflation expectations rising alongside stable-to-falling real TIPS yields as the US economy recovers from the COVID-19 shock – especially if there is a major boost from fiscal stimulus after next month’s elections. Bottom Line: We continue to see a case for inflation breakevens and real yields to stay negatively correlated in the developed economies over at least the next few years, as the labor market slack created by the 2020 COVID-19 global recession is slowly absorbed. That negative correlation will become less intense, especially in the US, with rising inflation expectations eventually becoming the more dominant influence on nominal bond yields. Will Inflation Breakevens Continue To Have A Strong Positive Correlation With Oil Prices? While the negative correlation between real inflation-linked bond yields and real yields has gotten attention this year, the positive correlation between breakevens and oil prices has become familiar to investors over the past several years. That correlation has been persistently high and positive across all developed economies since the 2008 financial crisis. Prior to that, oil prices and inflation breakevens moved together less frequently and, at times, were even uncorrelated (Chart 11). In both the US and euro area, the lack of non-energy inflation is the main reason why breakevens and oil are so correlated. In our view, the reason why breakevens and oil became strongly correlated is relatively straightforward. Since the 2008 crisis and ensuing Great Recession, swings in oil prices have been the main driver of changes in realized inflation, with ex-energy inflation rates staying very low and stable. We can see that in the US, where ex-energy CPI inflation has been broadly stable around 2% for the past decade, even as headline CPI inflation has seen more variability and has even approached 0% after the collapse in oil prices in 2014/15 and 2020 (Chart 12). Chart 11A Persistent Strong Correlation Of Global Breakevens To Oil Real Yield/Breakevens Correlation Will Stay Negative In The UK Real Yield/Breakevens Correlation Will Stay Negative In The UK Chart 12Strong Oil/Breakevens Correlation While US Ex-Energy Inflation Is Low Strong Oil/Breakevens Correlation While US Ex-Energy Inflation Is Low Strong Oil/Breakevens Correlation While US Ex-Energy Inflation Is Low Chart 13Energy Has Become The Only Source Of Euro Area Inflation Energy Has Become The Only Source Of Euro Area Inflation Energy Has Become The Only Source Of Euro Area Inflation The same dynamics, only more intense, exist in the euro area. Ex-energy inflation has struggled to stay above 1% over the past decade, leaving changes in energy prices as an even greater determinant of realized headline inflation than in the US (Chart 13). In both the US and euro area, the lack of non-energy inflation is the main reason why breakevens and oil are so correlated. Until there is evidence of a more broad-based move higher in inflation rates outside of oil - which will almost certainly require an extended period of above-trend global growth and accommodative global fiscal and monetary policies - trading inflation breakevens off oil will still be a successful strategy. Bottom Line: Global inflation breakevens will maintain a strong positive correlation to oil prices, but only for as long as non-energy inflation remains low and stable, which has made energy prices the only source of inflation variability in most developed countries Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes   Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Q3/2020 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark by +19bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +10bps, led by overweights in US (+13bps), Canada (+2bps) and Italy (+4bps) that favored allocations to inflation-linked government bonds out of nominals. Spread product generated a similar-sized outperformance (+9bps), led by overweights to US investment grade corporates (+8bps). Portfolio Positioning For The Next Six Months: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar. Feature As we enter the final quarter of 2020, global financial markets are dealing with many near-term uncertainties related to the upcoming US presidential election, potential next moves in global policy stimulus and, perhaps most worrying, a second wave of coronavirus infections in Europe and the US. That means the “easy money” has been made in global fixed income from the unwind of the blowout in credit spreads, and collapse of government bond yields, seen following the COVID-19 related market turbulence of February and March. Investors should expect substantially lower fixed income returns in the coming months. Relative performance between countries and sectors will be the more dominant influence on bond portfolio returns in the absence of big directional moves in yields or spreads. Alternatively put, expect alpha to win out over beta. This week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation 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. Q3/2020 Model Portfolio Performance Breakdown: Another Positive Quarter, Led By Linkers & Corporates Chart of the WeekQ3/2020 Performance: Gains From Both Sides Of The Portfolio Q3/2020 Performance: Gains From Both Sides Of The Portfolio Q3/2020 Performance: Gains From Both Sides Of The Portfolio The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was 3.14%, modestly outperforming the custom benchmark index by +19bps (Chart of the Week).1 This is the second consecutive positive quarter, lifting the year-to-date outperformance into positive territory (+12bps) – an impressive accomplishment given the sharp drawdown that occurred during the market volatility of February and March. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +10bps of outperformance versus our custom benchmark index while the latter outperformed by +9bps. That government bond return includes a substantial gain (+17bps) from inflation-linked bonds, which we added as a new asset class in our model portfolio framework back on June 23.2 In a world of very low bond yields (Table 2), our preference for the relatively higher-yielding government bond markets in the US, Canada and Italy was an important source of outperformance, delivering a combined excess return of +19bps (including inflation-linked bonds). This was only partially offset by the negative active returns from underweights in low-yielding countries such as Germany, France, and Japan (a combined drag of -9bps). Table 2GFIS Model Bond Portfolio Q3/2020 Overall Return Attribution GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation In spread product, our overweights in US investment grade corporates (+8bps), UK investment grade corporates (+3bps) and US Agency CMBS (+4bps) were the main sources of outperformance, while the negative active return from underweighting Euro Area high yield (-2bps) was minimal. Our preference to favor higher-rated US high-yield relative to lower-rated US junk bonds, even as riskier credit rallied, did little damage to portfolio performance, with a combined excess return across all three US junk credit tiers of just -2bps. The moderate outperformance of the model bond portfolio versus the benchmark in Q3 is in line with our cautious recommended stance on what are always the largest drivers of the portfolio returns: overall duration exposure and the relative allocation between government debt and spread product. We have stuck close to benchmark exposures on both, eschewing big directional bets on bond yields or credit spreads while focusing more on relative opportunities between countries and sectors – particularly in sectors most strongly supported by central bank easing actions, like US investment grade 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 Q3/2020 Government Bond Performance Attribution GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 3GFIS Model Bond Portfolio Q3/2020 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Biggest Outperformers: Long US TIPS (+12bps) Overweight US investment grade industrials (+5bps) Overweight US Agency CMBS (+4bps) Overweight UK investment grade corporates (+3bps) Overweight US high-yield Ba-rated corporates (+3bps) Biggest Underperformers: Underweight French government bonds with maturity greater than 10 years (-4bps) Underweight US high-yield B-rated corporates (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2020. 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 Q3/2020 (red for underweight, dark green for overweight, gray for neutral).3 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. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q3/2020 GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation The top performing sectors within our model bond portfolio universe in Q3 were well distributed among government bonds and spread products: Italian government bonds (relative index return of +3.8), New Zealand government bonds (+3.0%), EM USD-denominated sovereign (+2.6%), US high-yield corporates (2.4%), Spanish government bonds (+2.3%), and investment grade corporates in the UK (+2%) and US (1.9%). Importantly, we were overweight or neutral all of those markets during the quarter, driven by our main investment themes of “buying what the central banks are buying” and “yield chasing.”4 On the other side, we had limited exposure to the worst performing sectors during Q3, with underweights to government bonds in Germany and Japan, US Agency MBS and euro area high-yield. Cutting our long-standing overweight on UK Gilts to neutral in early August also benefitted the portfolio performance, with Gilts being the worst performer in our model bond universe by far in Q3. Bottom Line: Our model bond portfolio modestly outperformed its benchmark index in the second quarter of the year by +19bps – a positive result driven by our relative positioning that favored higher yielding government debt and spread product sectors directly supported by central bank purchases. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. This is in line with the current strategic investment recommendations of the BCA Research fixed income services. Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. The overall duration of the portfolio is in line with that of the custom benchmark index (Chart 5), consistent with our strategic investment recommendation to be neutral on exposure to changes in interest rates. With central banks actively seeking to keep policy rates as low as possible until inflation returns – i.e. aiming to push real rates even lower - we expect the negative correlation seen between global inflation breakevens and real bond yields to persist over at least the next 6-12 months. Offsetting moves in both will continue to dampen the volatility of nominal bond yields, as has been the case over the past six months (Chart 6). Chart 5Overall Portfolio Duration Exposure: At Benchmark Overall Portfolio Duration Exposure: At Benchmark Overall Portfolio Duration Exposure: At Benchmark Central banks aiming for an inflation overshoot and negative real rates will also continue to boost the relative performance of inflation-linked bonds versus nominal equivalents. Chart 6Within Governments, Continue Overweighting Linkers Vs Nominals The Strategic Case For Inflation-Linked Bond Outperformance The Strategic Case For Inflation-Linked Bond Outperformance We see this as a similar environment to the years following the 2008 financial crisis, with central banks keeping rates at 0% while rapidly expanding their balance sheets via quantitative easing and cheap liquidity provision for banks. The result was a multi-year period where linkers outperformed nominal government bonds (Chart 7). Thus, we are maintaining a large core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy and Canada. Chart 7The Strategic Case For Inflation-Linked Bond Outperformance Within Governments, Continue Overweighting Linkers Vs Nominals Within Governments, Continue Overweighting Linkers Vs Nominals Chart 8Overall Portfolio Allocation: Moderately Overweight Credit Vs Governments GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation In terms of country allocations on the government bond side of the portfolio, we continue to favor overweights in higher-yielding markets with overall global yield volatility likely to remain subdued. Chart 9Global QE Continues To Support Credit Markets Global QE Continues To Support Credit Markets Global QE Continues To Support Credit Markets That means overweighting the US, Canada, Australia, Italy and Spain, while underweighting Germany, France and Japan. The UK belongs in that latter list, but we are maintaining a neutral stance on the UK, for now, given the near-term uncertainty surrounding final Brexit negotiations and the surge in new UK COVID-19 cases. Turning to spread product, we are maintaining only a moderate aggregate overweight allocation versus government bonds, equal to 4% of the portfolio (Chart 8). The same aggressive easing of global monetary policy and expansion of central bank balance sheets that is good for relative inflation-linked bond performance also benefits global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has proven to be an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 9). With the combined balance sheet now expanding at a 40% pace, corporate bonds are likely to continue to outperform government debt over the next 6-12 months. Thus, our allocation to inflation-linked bonds and corporate credit, both out of nominal government bonds, are both motivated by the same factor – monetary policy reflation. The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. At the same time, we continue to maintain a cautious stance on allocations to countries and sectors within that overall overweight tilt towards spread product in the model bond portfolio. We prefer to stay relatively up-in-quality within global corporate debt, even with high-yield bonds in the US and Europe offering relatively high spreads using our 12-month breakeven spread metric (Chart 10).5 Chart 10US & European HY Offer Relatively Wide Breakeven Spreads GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 11US & European HY Offer No Spread Cushion Against Rising Defaults US & European HY Offer No Spread Cushion Against Rising Defaults US & European HY Offer No Spread Cushion Against Rising Defaults The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. Our measure of the default-adjusted spread, calculated by taking the option-adjusted spread of the Bloomberg Barclays high-yield index and subtracting default losses, shows that high-yield spreads on both sides of the Atlantic will be dwarfed by expected default losses over the next year, assuming a typical pattern of defaults after recessions (Chart 11). We continue to prefer staying up-in-quality within our recommended corporate allocations, favoring Ba-rated US high-yield over B-rated and Caa-rated credit while also underweighting euro area high-yield relative to euro area investment grade corporates. This strategy lowers the yield of the model portfolio, which is currently in line with that of the custom benchmark index (Chart 12), at the expense of stretching for yields in riskier credit that may not be sustainable over the medium-term. Chart 12Overall Portfolio Yield: At Benchmark Overall Portfolio Yield: At Benchmark Overall Portfolio Yield: At Benchmark Chart 13Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate At the same time, our measured stance on relative corporate exposure also acts to reduce portfolio risk – a useful outcome as we are targeting a relatively moderate tracking error (relative portfolio volatility versus that of the benchmark) within the model portfolio (Chart 13). Given the near-term uncertainties over the US elections and the potential second wave of COVID-19 in the US and Europe, staying relatively cautious on the usage of the “risk budget” of the portfolio seems prudent. Scenario Analysis & Return Forecasts In past quarterly reviews of our model bond portfolio, we have presented forecasts for the performance of the overall portfolio based off scenario analysis and some simple quantitative model-based predictions of various fixed income sectors. Given the unprecedented nature of the COVID-19 shock, we chose to avoid such model driven forecasts based on historical coefficients and correlations that may not be applicable. As it turns out, we may have been too cautious in that decision. The “risk-factor” models that we have used 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) - have actually done a reasonable job of predicting yield changes over the past year. This can be seen in the charts shown in the Appendix on pages 18-20. Only in the case of US Caa-rated high-yield and EM USD-denominated corporates – two sectors where we are underweight given our concerns about valuation - have yields fallen by a far greater amount than implied by our models. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. For the government bond side, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those into changes in non-US bond yields by applying a historical yield beta (Table 2B). Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 14Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs (Chart 14): Base Case: The US election result is initially uncertain, but a clear winner is determined within a few days. COVID cases continue to increase, but with less severe economic restrictions than during the first wave. Global growth continues to show steady improvement. There will be some additional global fiscal stimulus, with central banks keeping foot on monetary accelerator. There is mild bear steepening of the US Treasury curve with moderate widening of US inflation breakevens. The VIX reaches 25, the USD dollar depreciates by -5%, oil prices climb 10% and the fed funds rate remains at 0%. Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. Optimistic Scenario: The US election goes smoothly and a clear winner is declared on election night. The current uptick in global COVID cases does not turn into a full-blown second wave requiring severe economic restrictions. Global growth continues to steadily improve, with additional global fiscal stimulus and central banks staying highly dovish. The US Treasury curve bear steepens as US inflation expectations steadily increase. The VIX falls to 20, the USD dollar depreciates by -7%, oil prices climb 20%, and the fed funds rate stays at 0%. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 15US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis Pessimistic Scenario: There is a contested US election result taking weeks to resolve, leading to major US social unrest. A full-blown second COVID-19 wave hits the world and severe economic restrictions are implemented. Governments become more worried about debt/deficits and deliver underwhelming stimulus. Central banks do not provide enough additional stimulus to offset the shocks. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX soars to 35, the USD dollar rise by 5%, oil prices fall -20%, while the fed funds rate remains at 0%. 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 and Chart 15). The model bond portfolio is expected to deliver an excess return over the next six months of +17bps in the base case and +27bps in the optimistic scenario, but is only projected to underperform by -1bp in the pessimistic scenario. Bottom Line: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar.   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 Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of lobal Inflation Expectations", dated June 23 2020, available at gfis.bcaresearch.com. 3 Note that sectors where we made changes to our recommended weightings during Q3/2020 will have multiple colors in the respective bars in Chart 4. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 The 12-month breakeven spread measures the amount of spread widening that must take place for a credit product to have the same return over a one-year horizon as a duration-matched position in government bonds. We compare those breakeven spreads to their own history in a percentile ranking to determine the relative attractiveness of a credit product strictly from a spread and spread volatility perspective. Appen dix Appendix Chart 1US Investment Grade Sectors US Investment Grade Sectors US Investment Grade Sectors Appendix Chart 2US High-Yield Credit Tiers US High-Yield Credit Tiers US High-Yield Credit Tiers Appendix Chart 3US MBS & CMBS US MBS & CMBS US MBS & CMBS Appendix Chart 4Euro Area And UK Credit Euro Area and UK Credit Euro Area and UK Credit Appendix Chart 5Emerging Markets USD-Denominated Debt Emerging Markets USD-Denominated Debt Emerging Markets USD-Denominated Debt Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Spending Held Up In August Spending Held Up In August Spending Held Up In August The bulk of the CARES act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August, but at least so far, absolute calamity has been avoided (Chart 1). The failure of consumer spending to collapse has caused some, like St. Louis Fed President Jim Bullard, to question whether more stimulus is even necessary.1 We are less optimistic. The most recent personal income report shows that households still received $867 billion (annualized) of CARES act stimulus in August and the recovery in consumer confidence has been tepid at best (see page 12), suggesting that the savings rate will not drop quickly. We expect Congress to ultimately deliver more fiscal support, which will lead to a bear-steepening Treasury curve and spread product outperformance on a 6-12 month horizon. But continued brinkmanship warrants a more cautious near-term stance. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 40 basis points in September, dragging year-to-date excess returns down to -394 bps. Last month’s sell-off caused some value to return to the sector. The overall index’s 12-month breakeven spread is back up to its 31st percentile since 1995 and the equivalent Baa spread is at its 38th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further spread tightening. Corporate bond issuance was up in August, but nowhere near the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have sufficient cash to cover their investment needs, and that further debt issuance is unnecessary (bottom panel). At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,2 Healthcare and Energy bonds.3 We also advise underweight allocations to Technology4 and Pharmaceutical bonds.5   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Weathering The Storm … For Now Weathering The Storm … For Now Table 3BCorporate Sector Risk Vs. Reward* Weathering The Storm … For Now Weathering The Storm … For Now High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 107 basis points in September, dragging year-to-date excess returns down to -455 bps. Oddly, Ba-rated was the worst performing credit tier on the month and the lowest-rated (Caa & below) credits actually beat the Treasury benchmark by 42 bps. As we wrote last week, this suggests that there remains scope for low-rated junk to sell off in the event of a shock to economic growth expectations.6 Such a development could arise if Congress fails to pass a new stimulus bill. In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate would necessitate a rapid economic recovery and we are not yet confident that such a recovery can be achieved. Job Cut Announcements – a variable that correlates tightly with the default rate – ticked higher in September and they remain well above pre-COVID levels (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology7 and Energy bonds.8 We are underweight the Healthcare and Pharmaceutical sectors.9   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in September, dragging year-to-date excess returns down to -51 bps. The conventional 30-year MBS index option-adjusted spread (OAS) widened 4 bps on the month, and it continues to trade at a premium compared to other similarly risky sectors. The MBS index OAS is currently 80 bps. This compares to an OAS of 79 bps for Aa-rated corporate bonds, 66 bps for Agency CMBS and 30 bps for Aaa-rated consumer ABS. Despite the OAS advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare during the next few months (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk.   Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to -313 bps. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, dragging year-to-date excess returns down to -562 bps. Foreign Agencies underperformed the Treasury benchmark by 13 bps in September, dragging year-to-date excess returns down to -706 bps. Local Authority debt underperformed Treasuries by 4 bps in September, dragging year-to-date excess returns down to -341 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -39 bps. Supranationals underperformed by 3 bps, dragging year-to-date excess returns down to -12 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, most of this year’s dollar depreciation has occurred against other Developed Market currencies, not EMs (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM Sovereigns (panel 4). We looked at EM Sovereign valuation on a country-by-country basis two weeks ago and concluded that Mexican and Russian Sovereigns offer the most compelling risk/reward trade-offs relative to the US corporate sector.10 Of those two countries, Mexican debt offers the best opportunity as the peso is on an appreciating trend versus the dollar. The Russian Ruble has been depreciating versus the dollar, and is vulnerable in the case of a Democratic sweep in November.     Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in September, dragging year-to-date excess returns down to -503 bps (before adjusting for the tax advantage). Short-dated municipal bond spreads versus Treasuries were stable in September, but long-maturity spreads widened. The entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum. Aaa munis offer more after-tax yield than Aaa corporates for investors facing an effective tax rate above 15%. The breakeven effective tax rates for Aa, A and Baa-rated munis are 11%, 13% and 17%, respectively. Extremely attractive valuation causes us to stick with our municipal bond overweight, even as state and local governments face a credit crunch. State & local government payrolls shrank in September and, without federal support, cutbacks will no doubt continue (bottom panel). However, we expect that the combination of austerity measures and all-time high State Rainy Day Fund balances will be sufficient to prevent a wave of municipal ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened somewhat in September, though even the 30-year yield only fell 3 bps on the month. The 2/10 and 5/30 Treasury slopes flattened 2 bps and 3 bps, reaching 56 bps and 118 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the fed funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening on a 6-12 month horizon. That is, the Fed will keep a firm grip on the front-end of the curve but long-maturity yields will rise as investors price-in eventual Fed tightening in response to higher inflation. We recommend positioning for this outcome by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. We expect the economic recovery to be maintained over the next 6-12 months, allowing this steepening to play out. However, we also see near-term risks related to the passage of a follow-up stimulus bill. Those not already invested in steepeners are advised to wait until a deal is struck. Valuation is a concern with our recommended curve steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year yield looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in September, dragging year-to-date excess returns down to -130 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates fell 18 bps and 16 bps on the month. They currently sit at 1.65% and 1.83%, respectively. Core CPI printed a strong +0.4% in August and the large divergence between core and trimmed mean inflation measures leads us to conclude that inflation will continue to rise quickly during the next few months (Chart 8). For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).12 We could see inflation pressures moderating once core and trimmed mean inflation measures re-converge.13 This could give us an opportunity to reduce our exposure to TIPS sometime later this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +63 bps. Aaa-rated ABS outperformed the Treasury benchmark by 7 bps on the month, bringing year-to-date excess returns up to +53 bps. Non-Aaa ABS outperformed by 32 bps, bringing year-to-date excess returns up to +128 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.14 We noted that stimulus received from the CARES act caused disposable income to increase significantly between February and July. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. 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 63 basis points in September, bringing year-to-date excess returns up to -259 bps. Aaa Non-Agency CMBS outperformed Treasuries by 46 bps on the month, bringing year-to-date excess returns up to -63 bps. Non-Aaa Non-Agency CMBS outperformed by 119 bps, bringing year-to-date excess returns up to -803 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to Non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, Non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in September, dragging year-to-date excess returns down to -12 bps. The average index spread widened 2 bps on the month to 68 bps, well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Weathering The Storm … For Now Weathering The Storm … For Now Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now 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 October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now 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 63 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 63 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) Weathering The Storm … For Now Weathering The Storm … For Now Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-09-30/fed-s-bullard-says-debate-on-fiscal-aid-can-be-delayed-to-2021?sref=Ij5V3tFi 2 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Bond Yields & Growth: Developed market bond yields have ignored improving cyclical economic data over the past few months, remaining stuck in narrow trading ranges at low levels. That broken correlation will persist until central banks become less concerned about supporting pandemic-ravaged economies and begin worrying more about rising inflation, financial stability or the size of their balance sheets. That shift will not happen anytime soon. Inflation-Linked Trades: Our models suggest US TIPS breakevens are now at fair value. We are taking profits on our tactical long US 10-year inflation breakevens trade for a return of 2.88%. Stay long 10-year breakevens in Italy and Canada until we see further shrinkage in the gap between inflation breakevens and model-implied fair value and watch for a selling opportunity in UK 10-year breakevens. Feature Do bond investors even care about economic growth anymore? This is a valid question to ask, given how government bond yields in the developed markets have stayed in very narrow trading ranges over the past few months, even as economic data has rebounded from the global COVID-19 recession in the first half of 2020. Investors should get used to the current backdrop of rock-bottom interest rates and bond yields, which is unlikely to change anytime soon.  Chart of the WeekBond Yields Are Responding To Inflation, Not Growth Bond Yields Are Responding To Inflation, Not Growth Bond Yields Are Responding To Inflation, Not Growth For example, the benchmark 10-year US Treasury yield has stayed between 0.65% and 0.75% since June 11, even though the US ISM Manufacturing index rose from 43 in May to 56 in August. Yields are also ignoring the ups and downs of the equity market. The 10-year Treasury yield now sits at 0.66% - the same level as on September 2 even though the NASDAQ equity index has fallen 12% from the all-time peak seen on that day. Our own Global Duration Indicator, comprised of cyclical measures like the global ZEW index and our global leading economic indicator, has surged to the highest level since 2008 (Chart of the Week). Given the usual lead time between broad turns in the Duration Indicator and the level of global bond yields (around 6-9 months), this suggests that yields have bottomed and should soon begin rising. Yet the reality is that the usual factors that typically drive yields higher during a cyclical upturn – namely, rising inflation expectations and a clearly understood signal from central banks that such a move would lead to tighter monetary policy – are not currently in place. Investors should get used to the current backdrop of rock-bottom interest rates and bond yields, which is unlikely to change anytime soon. Four Potential Triggers For A Rise In Bond Yields Chart 2A Breakdown Of The PMI/Yield correlation A Breakdown Of The PMI/Yield correlation A Breakdown Of The PMI/Yield correlation The breakdown of the positive correlation between growth and bond yields is not just visible in the US. For example, yields on German Bunds and UK Gilts also remain stuck at low levels despite sharp improvements in the German and UK manufacturing PMIs (Chart 2). Yet in China – where there is no zero interest rate policy (ZIRP) or large-scale quantitative easing (QE) programs - bond yields have steadily risen since the China manufacturing PMI bottomed back in April (bottom panel). What could change this backdrop? We see four potential catalysts, ranked below in our own subjective order of importance: Inflation Sustainably Returning Back To Central Bank Targets It may seem obvious, but it still needs to be said – dovish central bank policies are the biggest reason why developed market bond yields have de-linked from economic growth. That includes not only ZIRP or QE, but also forward guidance on future changes in interest rates. Central banks are telling markets they will not raise rates for a period measured in years, and will continue to expand their balance sheets to purchase assets and support bank lending, all in an effort to push undershooting inflation back to policy targets. This is a different message than bond investors have grown accustomed to hearing from central banks, most notably in the US. The Fed is trying to do something that it has never intentionally done before – erode some of its hard-earned inflation fighting credibility. The Fed is trying to do something that it has never intentionally done before – erode some of its hard-earned inflation fighting credibility. The recent shift by the Fed to an Average Inflation Targeting framework – where above-target inflation would be tolerated if inflation was below target for an extended period – is intended to change the perception that the Fed will hike rates preemptively based on a forecast of inflation, as they have done in the past. Chart 3Latest FOMC Projections Justify Years Of 0% Rates Latest FOMC Projections Justify Years Of 0% Rates Latest FOMC Projections Justify Years Of 0% Rates The latest set of Fed economic projections is consistent with this new framework (Chart 3): the unemployment rate is forecasted to fall back to the FOMC median estimate of full employment (4.1%) by 2023; headline PCE inflation is also projected to climb back to 2% by 2023; the fed funds rate is projected to stay unchanged near 0% until at least 2023. In many ways, the Fed is trying to atone for the mistakes made while normalizing policy after the extraordinary easing measures taken after the 2008 crisis. From signaling a slowing of QE bond purchases in 2013, to the 250bps of rate hikes and tapering of its balance sheet during 2016-18, the Fed moved aggressively relative to what was actually happening with US inflation. Core PCE inflation only inched above 2% for a few months in 2018 – towards the end of the normalization process - as did market-based inflation measures like TIPS breakevens (Chart 4). The Fed ended up raising the real fed funds rate during that tightening cycle to above its own estimate of neutral (r-star), even with inflation still not close to its target. Unsurprisingly, real US bond yields also rose during that same period, which tightened monetary conditions even further by boosting the value of the US dollar. No wonder US inflation could not stay at the 2% target for very long. This time around, the Fed is sending a much different signal to markets – that it wants to see inflation rise before raising rates, thus keeping real policy rates in negative territory for an extended period. If the Fed is looking for a real world case study of such an approach, it can look across the Atlantic to the Bank of England (BoE). On the surface, the BoE has been acting like a typical inflation-targeting central bank over the past several years, turning more hawkish in its commentary when the UK economy was improving and becoming more dovish when the economy was languishing. Yet since the 2008 crisis, the BoE has kept the Bank Rate in a range of 0.1% to 0.75%, well below realized UK inflation. While it has been difficult for the BoE to attempt to raise rates given the Brexit uncertainty since 2016 – which has also weakened the British pound, helping boost UK inflation - real UK policy rates have now been negative for 12 years (Chart 5). The result: steadily declining UK real bond yields with inflation expectations rising to levels well above the BoE 2% inflation target. Chart 4The Fed Is Trying To Erode Its Hard-Earned Credibility The Fed Is Trying To Erode Its Hard-Earned Credibility The Fed Is Trying To Erode Its Hard-Earned Credibility Chart 5Lessons From The BoE On How To Not Be Credible Lessons From The BoE On How To Not Be Credible Lessons From The BoE On How To Not Be Credible The experience of the ECB provides a cautionary tale for central banks not appearing dovish enough, even when policy settings are already extraordinarily accommodative. The message from central banks on future rate increases – namely, that there will not be any without sustainably higher inflation – must change before bond yields can have any hope of climbing higher. Chart 6Does The ECB Have Any Credibility Left? Does The ECB Have Any Credibility Left? Does The ECB Have Any Credibility Left? Inflation expectations have stayed below the ECB’s “just below 2%” target since 2013 (Chart 6), which forced the central bank into cutting nominal rates into negative territory while aggressively expanding its balance sheet through QE and long-term bank liquidity provision (i.e. LTROs). Yet the ECB has always put an expiration date on each of these programs, which sent a message to the markets that the central bank was not fully committed to keeping policy easy until inflation was back to target – however long that would take. In sum, the message from central banks on future rate increases – namely, that there will not be any without sustainably higher inflation – must change before bond yields can have any hope of climbing higher. A Shift From Central Banks To Concerns About Asset Price Bubbles Chart 7When Will CBs Start Worrying About Financial Market Valuations? When Will CBs Start Worrying About Financial Market Valuations? When Will CBs Start Worrying About Financial Market Valuations? Policymakers are paying lip service to the notion of the “financial stability” risks inherent in their new promises to keep rates low for a lot longer while intervening in financial markets more aggressively through asset purchase programs. Given the signs of froth in many important asset classes like US equities or global corporate debt, policymakers should at least be somewhat concerned that easy money policies are fueling asset bubbles (Chart 7). A big enough decline could erode confidence and spill over into the real economy, defeating the original purpose of easy money policies. However, given the still fragile state of much of the global economy that remains dependent on fiscal support amid ongoing COVID-19 restrictions, concerns over asset values will take a backseat to maintaining adequate monetary stimulus. Asset bubbles would have to become much larger before a central bank would even consider turning more hawkish to prick them through higher policy rates that would push up bond yields. The Announcement Of A Trustworthy COVID-19 Vaccine That Is Ready For Widespread Distribution Markets have already begun to worry about the “second wave” of the coronavirus that health officials had warned would happen in the cooler autumn months. The development of an effective, and safe, vaccine would thus be a game-changer for financial markets, particularly after the recent surge in new COVID-19 cases in Europe and the still elevated level of new cases in the US (Chart 8). Chart 8A Second Wave Of COVID-19 A Second Wave Of COVID-19 A Second Wave Of COVID-19 BCA Research’s Chief Global Strategist, Peter Berezin (a big fan of interesting data sets!), noted in his most recent report that, according to The Good Judgement Project, around 60% of “superforecasters” now expect a vaccine ready for mass distribution to be available by Q1/2021 (Chart 9).1 A vaccine appearing that rapidly – much faster than the usual multi-year process leading to a vaccine declared safe for use – would help boost business and consumer confidence and raise the odds of a return to pre-virus levels of economic activity. Bond yields would likely get a lift, as well, as markets would price in a shorter period of super low policy rates and a faster return of inflation to central bank targets. Yet even if a vaccine is presented to the world by next spring, there is no guarantee that a large enough share of the population will deem the vaccine safe enough to take to ensure “herd immunity”. A recent Economist/YouGuv survey noted that only 36% of American adults would choose to get vaccinated when a COVID-19 vaccine becomes available, 32% would not get vaccinated, while 32% were unsure (Chart 10). Thus, a vaccine would be a bond-bearish development only if it is trusted to be safe to use – the mere announcement of a vaccine will not be enough to declare an “end” to the pandemic. Chart 9High Odds Of A Vaccine In 6-To-12 Months What Would It Take To Get Bond Yields To Rise Again? What Would It Take To Get Bond Yields To Rise Again? Chart 10Will Enough People Take The Vaccine? What Would It Take To Get Bond Yields To Rise Again? What Would It Take To Get Bond Yields To Rise Again? Central Banks Slowing QE Purchases Relative To Increased Fiscal Issuance Chart 11Still Room For The Fed, ECB and BoE To Expand QE Still Room For The Fed, ECB and BoE To Expand QE Still Room For The Fed, ECB and BoE To Expand QE Right now, it is easy for the major central banks to aggressively expand their balance sheets and provide additional monetary stimulus through asset purchases. Yet there may come a point where a capacity constraint is reached on buying government bonds if it impairs market functionality. That is currently the case in Japan, where the Bank of Japan now owns 49% of the Japanese government bond (JGB) market after years of aggressive QE purchases of JGBs. This has damaged the day-to-day liquidity of JGBs, where there have been instances of days where no single JGB has traded in the secondary market. A move by central banks to buy fewer bonds because they own too many of them could potentially push bond yields higher by worsening the demand/supply balance for government bonds - assuming private investors do not pick up the slack and buy more bonds, of course. Currently, the Fed only owns 22% of the US Treasury market with little evidence suggesting that its purchases are impairing the trading of Treasuries (Chart 11). The BoE and ECB own much larger shares of the UK and euro area government bond markets – 37% and 38%, respectively – suggesting that those central banks are closer to a BoJ-like capacity constraint. However, given the rising budget deficits and surging government bond issuance seen in Europe (and the US) so far in 2020, the odds of a capacity constraint soon being reached that could result in slower QE purchases are low. Bottom Line: Developed market bond yields have ignored improving cyclical economic data over the past few months, remaining stuck in narrow trading ranges at low levels. That broken correlation will persist until central banks become less concerned about supporting pandemic-ravaged economies and begin worrying more about rising inflation, financial stability or the size of their balance sheets. That shift will not happen anytime soon. Reviewing Our Tactical Inflation Breakeven Trades Back in June, we initiated a series of recommended inflation-focused trades in our Tactical Overlay portfolio. Specifically, we went long 10-year inflation breakevens in the US, Italy, and Canada by buying on-the-run inflation-linked bonds and selling government bond futures.2 We chose those trades based on the output of our fundamental valuation models for 10-year inflation breakevens in eight inflation-linked bond (ILB) markets: the US, UK, France, Italy, Japan, Germany, Canada, and Australia. Our fair value models use two inputs for all regions: a) a long-run moving average of headline inflation, representing the medium-term trend that anchors inflation expectations; and b) the annual percentage change of the Brent oil price in local currency terms, which creates shorter-term deviations from the trend to account for moves in oil and currencies. There looks to be little remaining upside to our tactical long TIPS breakeven position. The past few months have seen a sharp rise in global inflation expectations, owing to the extraordinary monetary policy actions taken by the major developed market central banks and recovering growth prospects coming out of the COVID-19 recession. This has led to a convergence between 10-year inflation breakevens and their model-implied fair values in the aforementioned ILB markets (Chart 12). Most notably, breakevens in the US are now at fair value, while breakevens in the UK and Australia are trading above fair value. In the US, 10-year breakeven inflation rates are now back to the long-run average of realized headline inflation, while the -8% decline in the Brent oil price so far this month has lowered the model-implied fair value (Chart 13). Therefore, there looks to be little remaining upside to our tactical long TIPS breakeven position with most of the easy gains following the pandemic-induced collapse having already been realized. Chart 12Global Inflation Breakevens Have Moved Higher Global Inflation Breakevens Have Moved Higher Global Inflation Breakevens Have Moved Higher Our colleagues over at BCA Research US Bond Strategy have reached a similar conclusion, noting that the Fed’s Jackson Hole announcement of the move to Average Inflation Targeting supercharged the rising trend in TIPS breakevens.3 Chart 13US Breakevens Are At Fair Value US Breakevens Are At Fair Value US Breakevens Are At Fair Value Although they also note the likelihood of stronger US CPI prints over the next few months should keep US breakevens well supported heading into year-end. The time horizon for trades that enter our Tactical Overlay portfolio is limited to no longer than six months. Thus, with TIPS breakevens reverting back to fair value after just three months in the trade, we are choosing to take profits on our long 10-year US inflation breakeven trade for a total return of 2.88%. Chart 14UK Breakevens Are Above Fair Value UK Breakevens Are Above Fair Value UK Breakevens Are Above Fair Value In other ILB markets, UK breakevens are now an intriguing case, and not only for the monetary policy driven interplay between UK real yields and breakevens discussed earlier in this report. The overshoot of UK breakevens relative to our fair value model may be related to growing market speculation that the BoE will move to negative interest rates – an outcome we deem to be unlikely, as we discussed in a recent report.4 Alternatively, the higher breakevens may be a reflection of UK political uncertainty. The risk of a hard Brexit has resurfaced as UK Prime Minister Boris Johnson’s Conservatives have now backed a bill that includes powers for the government to override its withdrawal agreement with the European Union; understandably, this has caused a sell-off in the pound. Within our fundamental fair value framework, the UK 10-year breakeven inflation rate has overshot both the 3-year moving average of headline inflation and the growth of GBP-denominated oil prices, leaving breakevens 0.72 standard deviations expensive (Chart 14). One possible explanation is that markets are pricing in a significant further depreciation in the pound given this resurfacing of Brexit risk. Within our model, GBP/USD impacts the fair value of breakeven inflation via Brent oil prices, which are denominated in local currency terms. Thus, we can back out an implied change in GBP/USD that would make the model-derived fair value breakeven rate equal to the actual 10-year UK inflation breakeven rate, holding all other variables in the model constant. This does produce some extreme results during periods of very rapid moves in UK breakevens, but we can standardize the data to use as an indicator of ILB market-implied views on the currency (Chart 15). With that in mind, pound bearishness in ILB markets is nearing levels where it has historically troughed. A favorable development in Brexit negotiations could cause a reversal in this pound-bearish trend and a sharp downward correction in UK inflation breakevens. We see a potential opportunity to play for narrower UK breakevens if our view on Brexit and negative rates in the UK prove to be correct. On that front, BCA Research’s Chief Geopolitical Strategist, Matt Gertken, sees a no-deal Brexit by year-end as the less likely outcome, with odds of only 35%, given the political calculus that PM Johnson faces with the decision.5 Polls show that the UK public does not support a no-deal Brexit (Chart 16), which would severely hurt a UK economy that remains fragile due to the coronavirus, and would raise the odds of a new independence referendum in Scotland in 2021. Chart 15UK Breakevens Already Discount A Big Fall In GBP UK Breakevens Already Discount A Big Fall In GBP UK Breakevens Already Discount A Big Fall In GBP Chart 16Only 25% In The UK Think A No-Deal Brexit Is A Good Outcome What Would It Take To Get Bond Yields To Rise Again? What Would It Take To Get Bond Yields To Rise Again? We will monitor the situation closely in the coming weeks, but we see a potential opportunity to play for narrower UK breakevens if our view on Brexit and negative rates in the UK prove to be correct. Finally, although the majority of the gains from our long inflation breakeven trades in Canada and Italy have likely been realized, there are still some chips left on the table. Canadian breakeven inflation rates have risen in lockstep with Brent prices but have yet to converge with the long-run moving average of inflation (Chart 17). In Italy, the increases in oil prices in euro terms has outstripped the rise in breakevens, pushing up the model-implied fair value and leaving breakevens remain more than one standard deviation under fair value (Chart 18). We will look for the gap between breakevens and fair values to shrink further in these two countries before closing these trades, even though we are substantially in the green on both (see the Tactical Overlay table on page 19). Chart 17Canadian Breakevens Are Just Below Fair Value Canadian Breakevens Are Just Below Fair Value Canadian Breakevens Are Just Below Fair Value Chart 18Italian Breakevens Are Well Below Fair Value Italian Breakevens Are Well Below Fair Value Italian Breakevens Are Well Below Fair Value Bottom Line: Our models suggest US TIPS breakevens are now at fair value. We are taking profit on our tactical long US 10-year inflation breakeven trade for a return of 2.88%. Stay long 10-year breakevens in Italy and Canada until we see further shrinkage in the gap between inflation breakevens and model-implied fair value and watch for a selling opportunity in UK 10-year breakevens.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Global Investment Strategy Weekly Report, "Pivot To Value", dated September 18, 2020, available at gis.bcaresearch.com. You can also learn more about The Good Judgement Project here: https://goodjudgment.com/about/ 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research US Bond Strategy Portfolio Allocation Summary, "The Fed’s New Framework Is Bond Bearish…But Not Yet", dated September 8, 2020, available at usbs.bcaresearch.com. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rate Club", dated August 26, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "The End-Game For Trump And Brexit", dated September 18, 2020, available at gis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What Would It Take To Get Bond Yields To Rise Again? What Would It Take To Get Bond Yields To Rise Again? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns