Policy

Highlights The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Consumer complaints of “poor buying conditions” mean that higher prices will cause demand destruction. Hence, it is extremely dangerous for central banks to respond with the signalling of tighter policy that leads to higher bond yields. The upper limit to the 10-year T-bond yield is no higher than 1.8 percent. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary versus the market, given the very tight connection between weaker spending on durables and the underperformance of the goods dominated consumer discretionary sector. Commodities whose prices have not yet corrected are at much greater risk than those whose prices have corrected. Hence a new cyclical recommendation is to go underweight tin versus iron ore. Fractal analysis: Netflix versus Activision Blizzard, and AUD/NZD. Feature Chart of the Week"Buying Conditions Are Poor" "Buying Conditions Are Poor" "Buying Conditions Are Poor" The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Getting this diagnosis right is crucial, because responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. Responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. The current burst of inflation cannot be due to a demand shock. If it was, aggregate demand would be surging. But it is not. For example, in the US, both consumer spending and income lie precisely on their pre-pandemic trend (Chart I-2). Furthermore, consumers are complaining that high prices for household durables, homes, and cars have caused “the poorest buying conditions in decades”, according to the University of Michigan’s latest consumer sentiment survey. If a positive demand shock was boosting incomes relative to prices, consumers would not be making this complaint. Given that they are making this complaint, there is the real risk of demand destruction. Meanwhile, employment remains far below its pre-pandemic trend. For example, in the US, by about 8 million jobs (Chart I-3). How can demand be on trend, but employment so far below trend? As an economic identity, the answer is that productivity has surged. Yet this should come as no surprise, because after recessions, productivity always surges. Chart I-2Demand Is On Trend... Demand Is On Trend... Demand Is On Trend... Chart I-3...But Employment Is Well Below Trend ...But Employment Is Well Below Trend ...But Employment Is Well Below Trend After Recessions, Productivity Always Surges As we explained in What The Olympics Teaches Us About Productivity Growth, productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways to do the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways to do the same thing, is a step function whose up-steps come after disruptive changes in the economy such as recessions (Chart I-4). Chart I-4After Recessions, Productivity Always Surges After Recessions, Productivity Always Surges After Recessions, Productivity Always Surges To do things better, a recession is the necessary catalyst for the wholesale adoption of an existing technology. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression catalysed its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession finally killed the office typing pool. In the same way, the technology for remote meetings and online shopping has been around for years, but the pandemic has catalysed its wholesale adoption. Of course, it is sub-optimal to meet people remotely or shop online all the time. But it is also sub-optimal to do these things in-person all the time. The most productive way is some hybrid of remote and in-person, which will differ for each person. The pandemic has given us the opportunity to find this personally optimal hybrid, and thereby to boost our productivity. The current boost to productivity could be larger than those after previous recessions because the pandemic has reshaped the entire economy. The current boost to productivity could be larger than those after previous recessions because the pandemic has forced us all to challenge our best practices. This is different from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is reshaping the entire economy. Yet, if productivity is booming, why has inflation spiked? The answer is that we have experienced a massive and unprecedented (negative) supply shock. It’s A Supply Shock, Not A Demand Shock To repeat, there has been no positive shock in aggregate demand. Yet there has been a massive shock in the distribution of this demand. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. As spending on services slumped, consumers shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods (Chart I-5). Chart I-5A Massive Displacement In The Distribution Of Demand Led To Supply Shocks A Massive Displacement In The Distribution Of Demand Led To Supply Shocks A Massive Displacement In The Distribution Of Demand Led To Supply Shocks The problem is that modern supply chains have few, if any, built-in redundancies. They are always working ‘just in time’ and cannot cope with any surge in demand. To make matters worse, the type of goods in high demand also shifted: for example, from electronic goods during full lockdown – to cars when lockdowns eased, and people required local mobility. These shifting spikes in demand stressed and indeed snapped fragile supply chains, resulting in skyrocketing prices for durables. To assess the contribution to overall inflation, we need to gauge the deviation from the pre-pandemic trend. Relative to where they would have been, prices are higher by 0.5 percent for services, 1 percent for non- durables, but by a staggering 10 percent for durables. It follows that most of the current burst of inflation is due to the supply shock for durables (Chart of the Week). But now, consumer complaints that “buying conditions are poor” imply that high prices risk demand destruction as people wait for better conditions (lower prices) to make non-essential purchases. In any case, as we learn to live with the pandemic, the shock in the distribution of demand is easing. Meaning that the abnormally high spending on durable goods has a long way to fall. Furthermore, supply bottlenecks always clear as output responds with a lag. This risks unleashing a flood of supply just as higher prices have destroyed demand. Add to this mix a slowdown, or worse a slump, in China’s real estate and construction sector as we highlighted last week in The Real Risk Is Real Estate (Part 2). And the irony is that, for many global sectors, there could be a demand shock after all but it would be a negative demand shock. Three Investment Recommendations As consumers’ current complaints of poor buying conditions testify, the higher prices that come from a supply shock eventually lead to demand destruction. Hence, it is extremely dangerous for central banks to respond with tighter policy, including the signalling of tighter policy that leads to higher bond yields. The higher bond yields will, with a lag, choke demand just as the supply bottlenecks ease and unleash a flood of supply. Resulting in a deflationary shock for the economy, stock market, and commodities (Chart I-6). Chart I-6When Supply Shocks Ease, Prices Slump When Supply Shocks Ease, Prices Slump When Supply Shocks Ease, Prices Slump On this basis, we are making three investment recommendations: The upper limit to the 10-year T-bond is no higher than 1.8 percent, as we detailed in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary plays versus the market, given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market. As supply shocks always ultimately ease, those commodities whose prices have not yet corrected are at much greater risk than those commodities whose prices have corrected. Specifically, the price of industrial metals such as tin are at their most stretched versus iron ore in a decade (Chart I-7). Moreover, this fragility is confirmed by fractal analysis (Chart I-8 and Chart I-9). Chart I-7Tin Is Very Stretched Versus Iron Ore Tin Is Very Stretched Versus Iron Ore Tin Is Very Stretched Versus Iron Ore Chart I-8Tin Is Fragile Tin Is Fragile Tin Is Fragile Chart I-9Tin Versus Iron Ore Is Fragile Tin Versus Iron Ore Is Fragile Tin Versus Iron Ore Is Fragile Hence, as a new cyclical recommendation, go underweight tin versus iron ore. Netflix Versus Activision Blizzard, And AUD/NZD Are Susceptible To Reversal In pure entertainment plays, the strong outperformance of Netflix versus Activision Blizzard has been fuelled by the delta wave of the virus, which helped Netflix, combined with the Chinese crackdown on gaming companies, which weighed down the whole gaming sector including Activision. The gaming company was also hit by a discrimination lawsuit, which it has now settled. Fractal analysis suggests that this strong outperformance is now fragile. Accordingly, the recommended trade is to short Netflix versus Activision Blizzard, setting a profit target and symmetrical stop-loss at 10 percent (Chart I-10). Chart I-10Netflix Versus Activision Blizzard Is Susceptible To Reversal Netflix Versus Activision Blizzard Is Susceptible To Reversal Netflix Versus Activision Blizzard Is Susceptible To Reversal Meanwhile, in foreign exchange, the recent sell-off in AUD/NZD has reached fragility on the 130-day dimension which has reliably signalled previous reversal points (Chart I-11). Hence, the recommended trade is long AUD/NZD, setting a profit target and symmetrical stop-loss at 2 percent. Chart I-11AUD/NZD Is Likely To Rebound AUD/NZD Is Likely To Rebound AUD/NZD Is Likely To Rebound   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Monetary Policy: Last week’s numerous central bank meetings across the world confirmed that the overall direction for global monetary policy is shifting in a more hawkish direction. The main reason: growing fears that elevated inflation will persist for much longer than expected, even with global growth having lost some momentum. Country Allocation: The relative degrees of central banker hawkishness support our current government bond country allocation strategy. Stay underweight the US, UK, Canada, New Zealand and Norway where markets are discounting a path for future policy rates over the next two years that is too flat. Remain overweight countries where there is less need for a more aggressive tightening response: the euro area (both the core and periphery), Australia, Sweden and Japan. Still The Only Game In Town Last week was a busy one for global bond markets, with no fewer than 14 central banks within both the developed markets (DM) and emerging markets (EM) holding policy meetings. The results were eventful: Within EM, Brazil and Hungary lifted policy rates. Norway followed suit to become the first G-10 central bank to hike during the COVID era. The Fed teed up a formal announcement on tapering asset purchases at the next FOMC meeting in November. The Bank of England (BoE) gave strong hints that rate hikes could come sooner than expected, perhaps even before year-end. Chart of the WeekMonetary Policy Backdrop Turning More Bond-Bearish Monetary Policy Backdrop Turning More Bond-Bearish Monetary Policy Backdrop Turning More Bond-Bearish Global bond yields in the developed markets took notice of the change in central bank guidance, especially from the Fed and BoE. The benchmark 10-year US Treasury yield rose from a pre-FOMC low of 1.30% to an intraday high of 1.57% yesterday – a level last seen late June. Longer-dated yields in the UK also rose significantly, with the 30-year Gilt yield rising from a pre-BoE meeting low of 1.11% to an intraday high of 1.40% yesterday – also the highest level since June. The pull on yields extended to other countries, as well, with 10-year yields in Germany, Canada and Australia climbing to three-month highs. The overall message from all of those policy meetings was one of an incremental shift toward less accommodative policies, even as the pace of global economic growth has slowed in recent months. Policymakers are growing more concerned that higher inflation could linger for longer (Chart of the Week). At the same time, loose policy settings have fueled a boom in asset markets that supports growth through easy financial conditions, but also raises future stability risks that worry the central banks. The number of countries seeing actual rate hikes is growing. Our Global Monetary Policy Tightening Indicator shows that just over one-quarter of G-10 and EM central banks have lifted rates over the past three months (Chart 2). All but one (Norway) are in EM, where policymakers have had to act more mechanistically in response to high inflation, even with softening economic growth momentum. While the slower pace of growth is more visible in EM relative to DM, when looking at cyclical indicators like manufacturing PMIs, inflation rates are simply too high around the world for inflation-targeting central banks to ignore (Chart 3). Chart 2Our Global Monetary Policy Indicator Shows A More Hawkish Turn Our Global Monetary Policy Indicator Shows A More Hawkish Turn Our Global Monetary Policy Indicator Shows A More Hawkish Turn Chart 3Global CBs Growing More Worried About Inflation Risks Global CBs Growing More Worried About Inflation Risks Global CBs Growing More Worried About Inflation Risks Within the major DM countries, there has been a notable shift in interest rate expectations in a more hawkish direction. Interest rate markets are, for the most part, still underestimating the potential for tighter monetary policies over the next couple of years. This is the main reason why we continue to recommend an overall below-benchmark strategic stance on global duration exposure. However, the relative expected pace of rate hikes also informs our views on country allocation. In Table 1, we show expectations for the timing of the next rate hike, as well as the cumulative amount of rate increases to the end of 2024, that are currently discounted in DM overnight index swap (OIS) curves. We present the latest level for both, as well as the reading from earlier this month to see how expectations have changed. Table 1Markets Still Pricing Very Modest Tightening Cycles Marking-To-Market Our Bond Calls After "Central Bank Week" Marking-To-Market Our Bond Calls After "Central Bank Week" The so-called “liftoff date” for the first rate hike has been most notably pulled forward in the UK from January 2023 to May 2022, while other countries have seen more modest shifts in the timing of the next rate increase. More importantly, the discounted pace of rate hikes to end-2024 for all countries shown in the table has increased since early September (including Norway, factoring in last week’s tightening move by the Norges Bank). In our view, the biggest driver of relative government bond market yield movements and returns over the next 6-12 months will be the relative adjustments in the expected pace of rate hikes. On that front, the biggest shift higher in cumulative tightening has occurred in countries where we are more pessimistic on government bond performance on a relative basis to the global benchmark: the US, Canada, the UK and Norway. The smaller increases in the pace of hikes have occurred in our more preferred markets – Australia, Sweden, the euro area, and Japan. Assessing Our Two Biggest Government Bond Underweights: The US & UK For last week’s Fed meeting, a new set of economic and interest rate projections from the FOMC members (“the dots”) were presented (Chart 4). Compared to the forecasts from the June meeting, US real GDP growth expectations for 2021 were revised down (5.9% vs 7.6%) but were boosted for 2022 (3.8% vs 3.3%) and 2023 (2.5% vs 2.4%). A new forecast for 2024 was added, coming in at 2.0%. Importantly, none of those growth forecasts was below the median FOMC estimate of the longer-run real GDP growth rate of 1.8% (top panel). In other words, the Fed is not anticipating below-trend growth anytime in the next three years. Chart 4The Fed’s Rate Projections Look Too Low Marking-To-Market Our Bond Calls After "Central Bank Week" Marking-To-Market Our Bond Calls After "Central Bank Week" The same conclusion goes for the US unemployment rate (second panel), with the median FOMC projection for 2022 (3.8%), 2023 (3.5%) and 2024 (3.5%) all below the median longer-run “full employment” estimate of 4.0%. The forecasts for US inflation (third panel) reflect that persistent low level of unemployment. Headline PCE inflation is expected to end 2021 at 4.2%, to be followed by a somewhat slower pace – but still above the 2% Fed inflation target – in 2022 (2.2%), 2023 (2.2%) and 2024 (2.1%). Yet despite these forecasts that show US growth and inflation exceeding its longer-run estimates for the next few years, the FOMC is projecting a relatively slow upward path for interest rates. The median dot now calls for the Fed to hike the funds rate once in 2022 and three more times in both 2023 and 2024. This would bring the funds rate to 1.75% by the end of 2024 – still 75bps below the Fed’s estimate of the longer-run “neutral” funds rate of 2.5% (bottom panel). That projected path for the funds rate is higher than the June dots, which only called for 75bps of cumulative hikes to the end of 2023. There is a wide divergence of opinions on the future path of rates within the FOMC, but the hawks appear to be winning the internal battle (Chart 5). There is now a 9-9 split of FOMC members who are calling for a rate hike in 2022, compared to a 7-11 split back in June, while the number of those projecting a funds rate above 1% in 2023 rose from 5 to 9. Chart 5A Wide Dispersion Of FOMC Interest Rate Views For 2023/24 A Wide Dispersion Of FOMC Interest Rate Views For 2023/24 A Wide Dispersion Of FOMC Interest Rate Views For 2023/24 One area where there does appear to be a consensus is on the timing and pace of tapering. Fed Chair Powell noted at his post-FOMC press conference that an announcement on the reduction of Fed asset purchases could come as soon as the next FOMC meeting on November 6. Powell also signaled that there was general agreement on the FOMC that the taper should end by mid-2022, barring any economic setbacks. That would likely open the door to a rate hike in the latter half of next year, given the Fed’s longstanding view that lifting the funds rate should only occur after tapering is complete, to avoid sending conflicting signals about the Fed’s policy bias. It is clear that the Fed’s policy guidance has shifted incrementally in a more hawkish direction, and confirms our long-held expectation that tapering would be announced by year-end, with rate hikes to begin in late 2022. This dovetails with our recommended investment positioning in the US Treasury market for the next 12-18 months. Maintain a below-benchmark US duration exposure, with a curve-flattening bias, while staying underweight US Treasuries in global (USD-hedged) fixed income portfolios (Chart 6). Our other high-conviction underweight government bond call is in the UK. The BoE’s recent messaging has turned more hawkish in a very short period of time, justifying our decision to downgrade our recommended UK Gilt exposure to underweight last month.1 The BoE Monetary Policy Committee had already sharply upgraded its inflation forecast for the end of 2021 to just above 4% at the last policy meeting in August. That was categorized as just a temporary surge due to rising energy prices and goods prices elevated by shorter-term global supply chain bottlenecks. At last week’s meeting, however, the MPC noted that +4% UK inflation could persist into Q2 2022 because of the current surge in wholesale natural gas prices that has driven many UK gas suppliers out of business (Chart 7). Chart 6Our Recommended Strategy For US Treasuries Our Recommended Strategy For US Treasuries Our Recommended Strategy For US Treasuries Chart 7BoE Growing More Worried About Inflation BoE Growing More Worried About Inflation BoE Growing More Worried About Inflation Chart 8Our Recommended Strategy For UK Gilts Our Recommended Strategy For UK Gilts Our Recommended Strategy For UK Gilts The official view of the BoE has been like that of other central banks, that much of the current high inflation is supply driven and, hence, will not last. Yet within the MPC, there is clearly some growing nervousness about high realized inflation becoming more embedded in longer-term inflation expectations, which are moving higher. BoE Governor Andrew Bailey has noted in recent speeches that there was a growing case for interest rate hikes because of stubbornly higher inflation. Two members of the MPC even voted last week to reduce the size of the BoE’s QE program that is already set to end in just three months. The markets have begun to heed the more hawkish signals from the BoE. Our 24-month UK discounter, measuring the amount of rate hikes priced into the UK OIS curve, has jumped 24bps since September 7 (Chart 8). Over that same period, UK Gilts have underperformed the Bloomberg Barclays Global Treasury index by 108bps (on a USD-hedged and duration-matched basis). We are sticking with our underweight recommendation on UK Gilts, as there are still too few rate hikes priced into the UK curve relative to the BoE’s guidance and upside inflation risks. What About The BoJ? Same Old, Same Old Chart 9Reasons Why JGBs Will Outperform Reasons Why JGBs Will Outperform Reasons Why JGBs Will Outperform Lost amid the hawkish din from the Fed and BoE meetings last week was the Bank of Japan (BoJ) meeting. The message from policymakers in Tokyo was predictably dovish, as Japan has not seen anything resembling the high inflation that has pushed central bankers elsewhere in a more hawkish direction. Japanese growth has also not seen the same magnitude of recovery from the pandemic shock as the other major developed markets, despite suffering comparable losses during the 2020 recession (Chart 9). One of the main reasons has been that Japan’s vaccine rollouts were much slower than those of other major countries. This forced an extension of emergency lockdowns and other economic restrictions that depressed domestic demand and delayed a return to normal economic activity (second panel). COVID outbreaks even cost Japan the one-time economic windfall from hosting an Olympics, with the Tokyo Games first delayed by a year and then taking place with no fans. Japan has also not suffered any of the higher inflation rates witnessed elsewhere over the past year, despite presumably facing many of the same inflationary forces from global supply chain disruption (third panel). Both headline and core CPI inflation are now in deflation. Governor Haruhiko Kuroda stated last week that it will take longer for Japan to see inflation return back to its 2% target than other developed countries, with the official BoJ forecast calling for that level to be reached by 2023 – a forecast that appears too optimistic. We continue to view Japanese government bonds (JGBs) as a relative safe haven during the period of rising global bond yields that we expect over the next 6-12 months. The BoJ is nowhere close to seeing the conditions necessary to begin exiting its Yield Curve Control and negative interest rate policies, both of which have crushed JGB volatility and kept longer-term bond yields hovering near 0%. We continue to recommend a moderate overweight stance on Japan in global government bond portfolios, particularly on a USD-hedged basis to make the yields more attractive. The Scandinavian Policy Divergence Last week, the Norges Bank raised its benchmark interest rate from 0% to 0.25% (Chart 10), stating that a normalizing economy requires a gradual normalization in monetary policy. The bank’s decision reflects idiosyncratic factors unique to the Norwegian economy, but also some of the same broader themes that are forcing other central banks in a more hawkish direction.   As a small economy driven heavily by oil exports, both the Norwegian krone and the price of oil weigh heavily on the policy decisions of the Norges Bank. On that front, the rise in energy prices since the crisis has outpaced the appreciation in the krone (Chart 10, top panel). With this relative weakness in the krone comes higher import price inflation and increased export competitiveness, both of which mean that the Norges Bank must pull forward its path of rate hikes to compensate. As opposed to other G10 central banks, the Norges Bank clearly believes a pre-emptive move on rates is necessary to nip future inflation risk in the bud. The bank expects that increased capacity utilization and wage growth will help push up underlying inflation to approximately 1.9% by the end of 2024, with the ongoing supply chain disruptions creating additional upside risk to that forecast. Like other G10 banks, however, the Norges Bank is concerned about increasing financial imbalances. The Norwegian house price-to-disposable income ratio is now at all-time highs and the Norges Bank expects it to remain elevated to the end of its forecast horizon (Chart 10, bottom panel). With the growth in house prices substantially outpacing income growth during the pandemic, housing market vulnerabilities have increased as households have taken on greater leverage to enter the market. In contrast to the Norges Bank, the other major Scandinavian central bank, Sweden’s Riksbank, has hewed more closely to the prevailing global monetary policy orthodoxy – avoiding pre-emptive policy tightening in order to boost inflation. The central bank chose to hold its repo rate at 0% at last week’s policy meeting, even with a Swedish economy that has recovered the 2020 pandemic losses and is projected to return to pre-COVID growth rates in 2022 (Chart 11). In its decision, the Riksbank mirrored rhetoric from the Fed and ECB, citing that high inflation was driven by rising energy prices and supply logjams, both factors which are expected to subside over the coming year (Chart 11, middle panel). Both headline and core versions of the bank’s favored CPI-F (CPI with Fixed Interest Rate) measure are projected by the Riksbank to remain below target in 2022, reaching 2% only in 2024. Chart 10The Norges Bank Isn't Waiting Around... The Norges Bank Isn't Waiting Around... The Norges Bank Isn't Waiting Around... Chart 11...But The Riksbank Will Remain Patient ...But The Riksbank Will Remain Patient ...But The Riksbank Will Remain Patient Chart 12The Central Bank Story Will Further Widen The Norway-Sweden Spread The Central Bank Story Will Further Widen The Norway-Sweden Spread The Central Bank Story Will Further Widen The Norway-Sweden Spread The Riksbank is less willing than the Norges Bank to respond to temporarily higher inflation because of the former’s growing reluctance to return to negative nominal interest rates in response to an economic shock. The Riksbank would likely be more comfortable in lifting nominal rates only when real rates were significantly lower than current levels, which requires higher inflation. In contrast to the neighboring Norges Bank, the Riksbank has an additional tool which it can use to express shifts in monetary policy—the size of its balance sheet. The bank forecasts that holdings of securities will remain unchanged in 2022 (Chart 11, bottom panel), implying that purchases, net of redemptions, will be drawn down roughly to zero. However, the bank does believe that the existing stock of purchases will continue to support financial conditions. Chart 12 shows the impact of the Norges Bank’s relatively hawkish reaction function. Despite relatively similar underlying growth and inflation profiles, sovereign debt from Norway has markedly underperformed Swedish counterparts, a dynamic that has been even more obvious since the pandemic. On the currency side, the NOK/SEK cross has recovered much of the losses from 2020, and will likely rally further as Norway-Sweden rate differentials will turn even more favorable for the NOK. Relative to the global benchmark on a currency-hedged and duration-matched basis, Norwegian government debt has underperformed much more than Sweden following the pandemic. We see these tends continuing over the next 6-12 months, with the Norges Bank likely to remain far more hawkish than the Riksbank. Our bias is to favor Swedish sovereign debt over Norwegian government bonds.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy/European Investment Strategy Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Marking-To-Market Our Bond Calls After "Central Bank Week" Marking-To-Market Our Bond Calls After "Central Bank Week" Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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