Yield Curve

Executive Summary The Fed is in a tough spot. On the one hand, rising long-dated inflation expectations will incentivize it to tighten more quickly. On the other hand, the flat yield curve and poor risky asset performance point to a heightened risk of recession if it tightens too aggressively. The Fed will try to split the difference by lifting rates at a steady pace of 25 bps per meeting, starting this week. Though upside risks have increased, it remains likely that core inflation will peak within the next couple of months. This will allow the Fed to continue tightening at a steady pace, one that is already well discounted in the market. Monthly Core Inflation By Major Component Bottom Line: Investors should keep portfolio duration close to benchmark and favor yield curve steepeners. Corporate bond spreads will continue to widen in the near-term, but a buying opportunity will soon emerge. A Tough Spot For The Fed A lot has happened since we shifted our portfolio duration recommendation from “below benchmark” to “at benchmark” on February 15. The Russian invasion of Ukraine sent bond yields sharply lower the following week but yields have since recovered and are now close to where they were when we upgraded our duration view (Chart 1). That said, the round-trip in nominal yields masks some significant moves in the real and inflation components. The 10-year TIPS breakeven inflation rate is currently 2.98%, up from 2.45% on February 15, and the 5-year/5-year forward TIPS breakeven inflation rate has moved up to 2.38% from 2.05% (Chart 2). In the past two weeks we’ve also seen a further flattening of the yield curve (Chart 2, panel 3) and widening of credit spreads (Chart 2, bottom panel). Chart 2A Stagflationary Shock Chart 1Round-Trip Taken together, recent market moves are consistent with a stagflationary shock. Long-dated inflation expectations are higher, but the yield curve is flatter and risk assets have sold off. This sort of environment is a complicated one for Fed policy. On the one hand, rising long-dated inflation expectations give the Fed a greater incentive to tighten quickly. On the other hand, rapidly tightening financial conditions increase the risk that the Fed may move too aggressively and push the economy into recession. So what’s the Fed to do? For now, it will try to split the difference. In practice, this means that the Fed will start tightening policy this week and proceed with a steady rate hike pace of 25 basis points per meeting. Once this process starts, we see two possible scenarios. The first possible scenario is that the Fed achieves its “soft landing”. A steady hike pace of 25 bps per meeting proves to be slow enough that financial conditions tighten only gradually, the yield curve retains its positive slope and inflation peaks within the next couple of months, halting the upward trend in long-dated inflation expectations. This benign scenario is still more likely than many people appreciate. For starters, the bond market is already priced for close to seven 25 basis point rate hikes this year, the equivalent of one 25 bps hike per meeting (Chart 3). This means a 50 bps hike at some point this year is required for the Fed to deliver a hawkish surprise to near-term expectations. In our view, a 50 bps hike is unlikely unless long-dated inflation expectations continue to move higher and become obviously “un-anchored”. If inflation peaks within the next couple of months, in line with our base case outlook, then so will long-dated expectations. Chart 3Rate Expectations The second possible scenario is that we see no near-term relief on the inflation front. Global supply chains remain disrupted by the war in Ukraine and surging COVID cases in China, and commodity prices continue their upward march. This would initially lead to even higher long-dated inflation expectations and an even faster pace of expected Fed tightening. It could even lead to a 50 bps Fed rate hike at some point, though we think it’s more likely that it would lead to an inverted yield curve and a severe tightening of financial conditions (i.e. sell off in equities and credit markets) before the Fed even gets the chance to deliver a 50 bps hike. Investment Implications The “soft landing” scenario remains our base case view. The Fed will start tightening in line with current market expectations and core inflation will peak within the next couple of months, keeping long-dated inflation expectations in check. Related Report  US Investment StrategyQ&A On Ukraine, Financial Markets And The Economy The correct investment strategy for this outcome is to keep portfolio duration close to benchmark and to favor a 2/10 yield curve steepener (buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note). Not only is the front-end of the bond market fully priced for a steady hike pace of 25 bps per meeting, but the 5-year/5-year forward Treasury yield is close to median survey estimates of the long-run neutral fed funds rate. This suggests that the upside in long-dated bond yields is limited (Chart 4). As for the yield curve, assuming that the Fed’s well-discounted steady pace of tightening is unlikely to invert the curve, then it makes sense to grab the extremely attractive yield pick-up available in the 2-year note versus a duration-matched cash/10 barbell (Chart 5). Chart 4Close to Fair Value Chart 5A Huge Yield Pick-Up In Steepeners The investment implications of our second “un-anchored inflation expectations scenario” are more difficult to game out. However, we think the most likely outcome is that bond yields would rise initially, driven by inflation expectations, and then plunge once the yield curve inverts and it becomes clear that the Fed will be forced to tighten the economy into recession. This is not our base case scenario, but investors with a 6-12 month investment horizon who wish to position for this outcome should probably extend portfolio duration rather than shorten it. The 2022 Inflation Outlook A key pillar of the “soft landing” scenario described above is that core inflation peaks within the next couple of months and starts to head lower in H2 2022. Today, we’ll assess the likelihood of that occurring by looking at the three main components of core CPI inflation: goods, shelter, and services (excluding shelter). The first fact to consider is that month-over-month core CPI has printed between 0.5% and 0.6% in each of the past five months, almost matching the extreme inflation readings seen between April and June 2021 (Chart 6). If month-over-month core inflation continues to print at 0.5%, then year-over-year core CPI will drop between March and June before rising again to reach 6.3% by the end of the year (Chart 7). Conversely, if month-over-month core inflation declines to 0.3%, then year-over-year core inflation will fall steadily to 4.2% by the end of 2022. Chart 6Monthly Core Inflation By Major Component Chart 7Annual Inflation These two outcomes likely have different implications for policy and markets. The world where core inflation remains sticky above 6% probably coincides with expectations of rapid Fed tightening, a near-term inversion of the yield curve and rising expectations of recession. Conversely, the world where core inflation falls to 4.2% by the end of 2022 and appears to be on a downward trend probably coincides with well-contained inflation expectations and a steady pace of Fed tightening. We therefore want to know which of these outcomes is more likely. To do that we consider the outlooks for core inflation’s three main components. 1. Core Goods Chart 8Goods Inflation Goods have been the main driver of elevated inflation during the past year, especially the new and used car segments (Chart 8). Prior to the pandemic, core goods inflation tended to fluctuate around 0%. Currently, the year-over-year rate is up around 12%. We view a significant decline in core goods inflation as highly likely this year. First off, used car prices – as measured by the Manheim Used Vehicle Index – have already moderated (Chart 8, panel 2), while other measures of supply bottleneck pressures like the ISM manufacturing supplier deliveries and prices paid indexes are rolling over, albeit from high levels (Chart 8, panel 3). Reduced demand should also ease some of the upward pressure on goods prices this year. Consumer spending on goods dramatically overshot its pre-COVID trend during the past two years (Chart 8, bottom panel) as spending on services was often not possible. With US COVID restrictions on the verge of being completely lifted, some spending is likely to shift away from goods and towards services in 2022. The recent news of a surging omicron COVID wave in China and renewed lockdown measures already in place in Shenzhen province may delay the re-normalization of supply chains. As of yet, we think it’s premature for this to alter our view. The omicron experience of other countries suggests that the wave will be quick and that restrictions will not be as severe as in past COVID waves.  2. Shelter Shelter is the largest component of core CPI and it is also the most tightly correlated with the economic cycle. That is, it tends to accelerate when economic growth is trending up and the unemployment rate is falling, and vice-versa. Shelter faces two-way risk in 2022. The upside risk comes from private measures of asking rents and home prices that have already surged. The Zillow Rent Index is up 15% during the past 12 months and the Zillow Home Price Index is up 20% (Chart 9A). Recent research has shown that these private measures tend to feed into core CPI with a lag of about one year.1 The downside risk to shelter inflation this year comes from the economic cycle itself. Chart 9B shows that there is a tight correlation between shelter inflation and the unemployment rate, and between shelter inflation and aggregate weekly payrolls (employment x hours x wages). The unemployment rate’s rapid 2021 decline will not persist this year. The labor market is nearing full employment and last year’s fiscal impulse has faded. Chart 9BShelter Inflation II Chart 9AShelter Inflation I Netting it all out, we think shelter inflation will continue to trend higher for the next few months but will eventually level-off near the end of this year as economic growth slows. 3. Core Services (excluding Shelter) Services inflation printed an extremely strong 0.55% month-over-month in February, though a large portion of that increase was driven by pandemic-related services like airfares and admission to events, increases that will moderate now that the omicron wave has passed. More fundamentally, wage growth is the key driver of services inflation, and it has been extremely strong. The Atlanta Fed’s Wage Growth Tracker is up to 4.3% year-over-year, its highest since 2002, and it is showing signs of broadening out to wage earners of all levels (Chart 10). Though we see wage growth remaining strong, its acceleration is also likely to moderate in the coming months. The Census Bureau’s most recent Household Pulse Survey showed that almost 8 million people were absent from work in February because they were either sick with COVID themselves or caring for someone with COVID symptoms (Chart 11). Near-term wage demands will moderate during the next few months as the pandemic ebbs and these people return to work. Chart 10Wage Growth Is Strong Chart 11Covid Still Weighing On Labor Supply We also must grapple with the possible deflationary fall-out from the recent energy and gasoline price shock. Real household incomes are declining (Chart 12A), and while consumers have ample room to either tap their savings or increase debt to support spending (Chart 12B, top panel), the recent plunge in consumer sentiment suggests that they may behave more cautiously (Chart 12B, bottom panel). Chart 12AReal Incomes Are Falling Chart 12BConsumer Confidence Is Low Putting It Together We could see core goods inflation falling all the way back to a monthly rate of 0% this year. This would be consistent with its pre-pandemic level, but also wouldn’t incorporate any outright price declines – which are also possible. If we additionally assume some further acceleration in Owner’s Equivalent Rent and Rent of Primary Residence, to 0.6% per month, and a slight pullback in services inflation to a still-strong 0.3% per month, then overall core CPI inflation would hit a monthly rate of 0.34%, consistent with annual core CPI inflation of 4.2%. We think this is a reasonable forecast though we see risks to the upside driven by another bout of supply chain pressures in manufactured goods. In general, we expect year-over-year core CPI inflation to reach a range of 4% to 5% by the end of this year. That would be consistent with the “soft landing” scenario described earlier in this report. Corporate Bonds: Waiting For A Buying Opportunity To Emerge Chart 13Corporate Bond Valuation Finally, a quick update on our corporate bond allocation. Corporate bonds have sold off sharply versus Treasuries since February 15. The investment grade corporate bond index has underperformed a duration-equivalent position in Treasury securities by 217 bps while High-Yield has underperformed by a less dramatic 120 bps. With economic risks high and the Fed on the cusp of a tightening cycle, we think further spread widening is likely in the near-term. However, if the “soft landing” scenario described earlier in this report pans out, then we will soon see a buying opportunity in corporate bonds. The 12-month quality-adjusted breakeven spread for the investment grade corporate index has risen close to its historical median, from near all-time expensive levels only a few months ago (Chart 13). While a flat yield curve poses a risk to corporate bond returns, wide spreads may soon become too attractive to ignore. Table 1A shows average historical 12-month investment grade corporate bond excess returns given different starting points for the 3-year/10-year Treasury slope and the 12-month corporate breakeven spread. Table 1B shows 90% confidence intervals for those average returns and Table 1C shows the percentage of instances in which excess returns were above 0%. Table 1AAverage 12-Month Future Investment Grade Corporate ##br##Bond Excess Returns* (BPs) Table 1B90 Percent Confidence Interval Of 12-Month Investment Grade Corporate Bond Excess Returns* (BPs) Table 1CPercentage Of Episodes With Positive 12-Month Investment Grade Corporate Bond Excess Returns* At present, the 3-year/10-year Treasury slope is +9 bps and the 12-month breakeven spread is 18 bps. Historically, this sort of environment is consistent with positive excess corporate bond returns 59% of the time, but with a negative average return overall. That said, if the yield curve retains its positive slope, then a further 18 bps of corporate index spread widening would push the 12-month breakeven spread above the 20 bps threshold. The historical record suggests that this would be an unambiguous buy signal. Bottom Line: We are sticking with our recommended 6-12 month corporate bond allocations for now. We are neutral (3 out of 5) on investment grade and overweight (4 out of 5) on high-yield. A yield curve inversion and heightened risk of recession would cause us to turn more cautious, but we think it’s more likely that widening spreads present us with an opportunity to upgrade our corporate bond allocations within the next few months. Stay tuned. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.frbsf.org/economic-research/publications/economic-letter/2022/february/will-rising-rents-push-up-future-inflation/ Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Other Recommendations

Executive Summary On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally. But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. Fractal trading watchlist: Brent crude oil, and oil equities versus banks equities. The DAX Has Sold Off ##br##Because It Expects Profits To Plunge… …But The S&P 500 Has Sold Off ##br##Because The Long Bond Has Sold Off   Bottom Line: In the Ukraine crisis, the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market, before the cavalry of lower bond yields ultimately charges to the rescue. Feature Given the onset of the largest military conflict in Europe since the Second World War, with the potential to escalate to nuclear conflict, you would have thought that the global stock market would have crashed. Yet since Russia’s full-scale invasion of Ukraine on February 24 to the time of writing, the world stock market is down a modest 4 percent, while the US stock market is barely down at all. Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Admittedly, since the invasion, European bourses have fallen – for example, Germany’s DAX by 10 percent. And stock markets were already falling before the invasion, meaning that this year the DAX is down 20 percent while the S&P 500 is down 12 percent. But there is a crucial difference. While the DAX year-to-date plunge is due to an expected full-blooded profits recession that the Ukraine crisis will unleash, the S&P 500 year-to-date decline is due to the sell-off in the long-duration bond (Chart I-1 and Chart I-2). This difference in drivers will also explain the fate of these markets as the crisis evolves, just as in the pandemic.   Chart I-1The DAX Has Sold Off Because It Expects Profits To Plunge...   Chart I-2...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off During The Pandemic, Central Banks And Governments Saved The Day… We can think of a stock market as a real-time calculator of the profits ‘run-rate.’ In this regard, the real-time stock market is several weeks ahead of analysts, whose profits estimates take time to collect, collate, and record. For example, during the pandemic, the stock market had already discounted a collapse in profits six weeks before analysts’ official estimates (Chart I-3 and Chart I-4). Chart I-3The German Stock Market Is Several Weeks Ahead Of Analysts Chart I-4The US Stock Market Is Several Weeks Ahead ##br##Of Analysts We can also think of a stock market as a bond with a variable rather than a fixed income. Just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like when bond yields change. It turns out that the long-duration US stock market has the same duration as a 30-year bond, while the shorter-duration German stock market has the same duration as a 7-year bond. Pulling this together, and assuming no change to the very long-term structural growth story, we can say that: The US stock market = US profits multiplied by the 30-year bond price (Chart I-5 and Chart I-6). The German stock market = German profits multiplied by the 7-year bond price (Chart I-7 and Chart I-8). Chart I-5US Profits Multiplied By The 30-Year Bond Price... Chart I-6...Equals The US Stock Market Chart I-7German Profits Multiplied By The 7-Year Bond Price... Chart I-8...Equals The German Stock Market When bond yields rise – as happened through December and January – the greater scope for a price decline in the long-duration 30-year bond will hurt the US stock market both absolutely and relatively. But when bond yields decline – as happened at the start of the pandemic – this same high leverage to the 30-year bond price can protect the US stock market. When bond yields decline, the high leverage to the 30-year bond price can protect the US stock market. During the pandemic, the 30-year T-bond price surged by 35 percent, which more than neutralised the decline in US profits. Supported by this surge in the 30-year bond price combined with massive fiscal stimulus that underpinned demand, the pandemic bear market lasted barely a month. What’s more, the US stock market was back at an all-time high just four months later, much quicker than the German stock market. …But This Time The Cavalry May Take Longer To Arrive Unfortunately, this time the rescue act may take longer. One important difference is that during the pandemic, governments quickly unleashed tax cuts and stimulus payments to shore up demand. Whereas now, they are unleashing sanctions on Russia. This will choke Russia, but will also choke demand in the sanctioning economy. Another crucial difference is that as the pandemic took hold in March 2020, the Federal Reserve slashed the Fed funds rate by 1.5 percent. But at its March 2022 meeting, the Fed will almost certainly raise the interest rate (Chart I-9). Chart I-9As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As the pandemic was unequivocally a deflationary shock at its outset, it was countered with a massive stimulatory response from both central banks and governments. In contrast, the Ukraine crisis has unleashed a new inflationary shock from soaring energy and food prices. And this on top of the pandemic’s second-round inflationary effects which have already dislocated inflation into uncomfortable territory. Our high conviction view is that this inflationary impulse combined with sanctions will be massively demand-destructive, and thereby ultimately morph into a deflationary shock. Yet the danger is that myopic policymakers and markets are not chess players who think several moves ahead. Instead, by fixating on the immediate inflationary impulse from soaring energy and food prices, they will make the wrong move. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market. Compared with the pandemic, both the sell-off and the recovery will take longer to play out. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. One further thought. The Ukraine crisis has ‘cancelled’ Covid from the news and our fears, as if it were just a bad dream. Yet the virus has not disappeared and will continue to replicate and mutate freely. Probably even more so, now that we have dismissed it, and Europe’s largest refugee crisis in decades has given it a happy hunting ground. Hence, do not dismiss another wave of infections later this year. The Investment Conclusions Continuing our chess metaphor, a tactical investment should consider only the next one or two moves, a cyclical investment should be based on the next five moves, while a long-term structural investment (which we will not cover in this report) should visualise the board after twenty moves. All of which leads to several investment conclusions: On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally (Chart I-10). Chart I-10When Stock Markets Sell Off, The Dollar Rallies But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. How Can Fractal Analysis Help In A Crisis? When prices are being driven by fundamentals, events and catalysts, as they are now, how can fractal analysis help investors? The answer is that it can identify when a small event or catalyst can have a massive effect in reversing a trend. In this regard, the extreme rally in crude oil has reached fragility on both its 65-day and 130-day fractal structures. Meaning that any event or catalyst that reduces fears of a supply constraint will cause an outsized reversal (Chart I-11). Chart I-11The Extreme Rally In Crude Oil Is Fractally Fragile Equally interesting, the huge outperformance of oil equities versus bank equities is reaching the point of fragility on its 260-day fractal structure that has reliably signalled major switching points between the sectors (Chart I-12). Given the fast-moving developments in the crisis, we are not initiating any new trades this week, but stay tuned. Chart I-12The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal Fractal Trading Watchlist Biotech To Rebound US Healthcare Vs. Software Approaching A Reversal Norway's Outperformance Could End Greece’s Brief Outperformance To End Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Chart 1A Tough Balancing Act For The Fed In last week’s Congressional testimony, Fed Chair Jay Powell talked about his goal of achieving a “soft landing”. That is, the Fed will tighten enough to slow inflation but not so much that the economy tips into recession. This balancing act was always going to be difficult, and recent world events have only complicated it. On the one hand, the US labor market has essentially returned to full employment. The prime-age employment-to-population ratio is just 1% below its pre-COVID level, a gap that will soon be filled by the 1.2 million people being kept out of the labor force by the pandemic (Chart 1). On the other hand, risk-off market moves driven by the war in Ukraine have caused the yield curve to flatten (Chart 1, bottom panel). The Fed’s task is to respond to the strong US economy by lifting rates, but to also avoid inverting the yield curve. To split the difference, the Fed will proceed with a 25 bps rate hike at each FOMC meeting, but will slow down if the curve inverts. Our recommended strategy is to keep portfolio duration close to benchmark for the time being given the uncertainty in Ukraine. However, the Treasury curve is now priced for too shallow a path for rate hikes. We are actively looking for a good time to re-initiate duration shorts. Feature   Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 124 basis points in February, dragging year-to-date excess returns down to -238 bps. The index option-adjusted spread widened 16 bps on the month and it currently sits at 130 bps. Our quality-adjusted 12-month breakeven spread has moved up to its 36th percentile since 1995 (Chart 2). The corporate bond sell-off that began late last year on heightened expectations of Fed tightening has accelerated in recent weeks, this time driven by the war in Ukraine. The result of the turmoil is that a significant amount of value has returned to the corporate bond market. In fact, spreads have not been this wide since early 2021. Continued uncertainty about how the Ukrainian situation will evolve causes us to recommend a neutral stance on investment grade corporate bonds in the near term. However, enough value has been created that a buying opportunity could soon emerge. Corporate balance sheets remain healthy. In fact, the ratio of total debt to net worth on nonfinancial corporate balance sheets is at its lowest level since 2010 (bottom panel). Further, the most likely scenario is that the economic contagion from Russia/Ukraine to the United States will be limited. While Fed tightening is set to begin this month, spreads are now wide enough that a flat but positively sloped yield curve is not sufficient to justify an underweight stance on corporate bonds. Investors should stay neutral for now but look for an opportunity to turn more bullish. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 56 basis points in February, dragging year-to-date excess returns down to -213 bps. The index option-adjusted spread widened 17 bps on the month and it currently sits at 376 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also moved up to 4.6% (Chart 3). The odds are good that defaults will come in below 4.6% during the next 12 months, and as such, we expect high-yield bonds to outperform a duration-matched position in Treasuries. This warrants a continued overweight allocation to High-Yield on a cyclical (6-12 month) horizon, though we acknowledge that further spread widening is likely until the situation in Ukraine reaches a place of greater stability. High-Yield valuations continue to be more favorable than for investment grade corporates (panel 3). We therefore maintain a preference for high-yield corporate bonds over investment grade.       MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 48 basis points in February, dragging year-to-date excess returns down to -60 bps. The zero-volatility spread for conventional 30-year agency MBS widened 12 bps on the month, driven by an 11 bps widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) increased by 1 bp on the month (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.1 This valuation picture is starting to change. The option cost is now up to 44 bps, its highest level since 2016 and refi activity is slowing as the Fed moves toward rate hikes. At 30 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS. We closed our recommendation to favor high coupon over low coupon securities on February 15th, concurrent with our decision to increase portfolio duration. We will likely re-establish this position when we move portfolio duration back to below benchmark. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market bonds underperformed the duration-equivalent Treasury index by 399 basis points in February, dragging year-to-date excess returns down to -483 bps. EM Sovereigns underperformed the Treasury benchmark by 519 bps on the month, dragging year-to-date excess returns down to -646 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 323 bps on the month, dragging year-to-date excess returns down to -379 bps. Russian sovereign bonds were recently downgraded to below investment grade, but before they were removed from the index they contributed -367 bps to Sovereign excess returns in February. In other words, if Russian securities are excluded, the EM Sovereign index only lagged Treasuries by 152 bps in February and actually outperformed a duration-matched position in US corporate bonds. As a result, the EM Sovereign index now offers less yield than a credit rating and duration-matched position in US corporate bonds (Chart 5). This recent shift in valuation leads us to reduce our recommended exposure to EM Sovereigns from overweight to underweight. Russian securities also negatively influenced EM Corporate & Quasi-Sovereign returns in February, but that index still offers a significant yield premium over US corporates whether Russian bonds are included or not (bottom panel). The turmoil overseas causes us to reduce exposure to this sector as well, but we will retain a neutral allocation instead of underweight because of still-attractive valuations. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 5 basis points in February, dragging year-to-date excess returns down to -126 bps (before adjusting for the tax advantage). While the war in Ukraine introduces a great deal of uncertainty into the economic outlook, the municipal bond sector should be better placed than most to deal with the fallout. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will continue to support state & local government coffers for some time. That said, relative muni valuations have tightened significantly during the past few months and the recent back-up in corporate spreads will eventually give us an opportunity to increase exposure to that sector. With that in mind, this week we downgrade our municipal bond allocation from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 5% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 11% versus corporates (panel 2). Both figures are down considerably from their 2020 peaks. For their part, high-yield muni spreads have also not kept pace with the recent widening in high-yield corporate spreads (bottom panel). Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve flattened dramatically In February, driven by a re-pricing of Fed expectations in the first half of the month and then later by flight-to-quality flows spurred by the war in Ukraine. The 2/10 and 5/30 Treasury slopes flattened by 22 bps and 3 bps in February. They currently sit at 24 bps and 51 bps, respectively (Chart 7). As noted on the first page of this report, during the next few months the Fed will be forced to strike a balance between tightening policy fast enough to prevent a de-stabilizing increase in inflation expectations and slow enough to prevent an inversion of the yield curve. The latter would likely signal an unacceptable increase in recession risk. In the near-term, we view the risks as clearly tilted toward further curve flattening as the Fed initiates a rate hike cycle while geopolitical uncertainties keep a lid on long-dated yields. However, this dynamic will eventually give way when political uncertainties abate and/or the Fed is forced to move more slowly in response to an inverted (or almost inverted) curve. With that in mind, a position in curve steepeners continues to make sense on a 6-12 month investment horizon. We also maintain our recommendation to favor the 20-year bond over a duration-matched barbell consisting of the 10-year note and 30-year bond. This position offers an enticing 26 bps of duration-neutral carry. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 150 basis points in February, bringing year-to-date excess returns up to +127 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps. Perhaps the most interesting recent market move is that TIPS breakeven inflation rates rose during the past month, even as flight-to-safety flows surged into the US bond market. That is, while nominal Treasury yields declined, TIPS yields fell even more, and the cost of inflation compensation embedded in US bond prices increased. At present, the 10-year TIPS breakeven inflation rate is 2.70%, above the Fed’s 2.3% to 2.5% target range (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate is 2.16%, still below the Fed’s target range but significantly higher than where it was in January. The bond market has responded to the war in Ukraine and resultant surge in commodity prices by bidding up the cost of inflation compensation. While we agree that higher commodity prices increase the risk that inflation will remain elevated in the second half of the year, we still think the most likely outcome is that core inflation starts to moderate in the coming months as supply chain pressures ease and the pandemic exerts less of an impact on daily life. Upcoming Fed rate hikes will also apply downward pressure to long-maturity TIPS breakeven inflation rates. As a result, we maintain our recommended neutral allocation to TIPS versus nominal Treasuries at the long-end of the curve and re-iterate our recommendation to underweight TIPS versus nominal Treasuries at the front-end of the curve.  ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 25 basis points in February, dragging year-to-date excess returns down to -5 bps. Aaa-rated ABS underperformed by 25 bps on the month, dragging year-to-date excess returns down to -6 bps. Non-Aaa ABS underperformed by 22 bps on the month, dragging year-to-date excess returns down to -1 bp. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. This also indicates that while surging gasoline prices will weigh on consumer activity in the coming months, household balance sheets are starting from such a good place that we don’t expect a meaningful increase in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 95 basis points in February, dragging year-to-date excess returns down to -98 bps. Aaa Non-Agency CMBS underperformed Treasuries by 90 bps on the month, dragging year-to-date excess returns down to -92 bps. Non-Aaa Non-Agency CMBS underperformed by 108 bps on the month, dragging year-to-date excess returns down to -105 bps (Chart 10). Though CMBS spreads remain wide compared to other similarly risky spread products, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 24 basis points in February, dragging year-to-date excess returns down to -21 bps. The average index option-adjusted spread widened 6 bps on the month. It currently sits at 46 bps (bottom panel). The average Agency CMBS spread remains below its pre-COVID level, but it continues to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 172 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record Appendix A: The Golden Rule Of Bond Investing We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. 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 February 28, 2022) 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 February 28, 2022) 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 -29 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 29 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of February 28, 2022) Recommended Portfolio Specification Other Recommendations Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. Treasury Index Returns Spread Product Returns

Executive Summary We look at the Ukraine crisis in the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. Our high-conviction view is that the Ukraine crisis will be net deflationary, because the economic and financial sanctions imposed on Russia will lead to a generalized demand destruction. Bond yields will be lower in the second half of the year. Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Stay structurally overweight the 30-year T-bond. The ultimate low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Fractal trading watchlist: We focus on banks, add alternative electricity, and review bitcoin. Every Shock Is Always Supplanted By A New Shock Bottom Line: The recent rise in bond yields and the associated outperformance of cyclical sectors such as banks, ‘value’, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move within a much bigger structural downtrend. This structural downtrend is now set to resume. Feature Suddenly, nobody is worried about Covid and everybody is worried about nuclear war. Or as Vladimir Putin warns, “such consequences that you have never experienced in your history.” The life lesson being that every shock is always supplanted by a new shock. Hence, in this report we look at the Ukraine crisis through a wider lens. We look at the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. The Predictability Of Shocks Shocks are very predictable. This sounds like a contradiction, but we don’t mean the timing or nature of individual shocks. As specific events, Russia’s full-scale invasion of Ukraine and the global pandemic were ‘tail-events’ that did come as shocks. Yet the statistical distribution of such tail-events is very predictable. This predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term strategy for investment, or life in general. The predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term investment strategy. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent, albeit this is just one definition.1On this definition, the Ukraine crisis is not yet a far-reaching economic or financial shock, but it is certainly well-placed to become one. Applying this definition of a shock through the last 60 years, the statistical distribution of shocks over any long period is well-defined and very predictable. For example, over a ten-year period the number of shocks exhibits a Poisson distribution with parameter 3.33 (Chart I-1), while the time between shocks exhibits an Exponential distribution with parameter 3.33. Chart 1The Statistical Distribution Of Shocks Is Very Predictable Many economists and investment strategists present their long-term forecasts for the economy and financial markets, yet completely ignore this very predictable distribution of shocks – making their long-term forecasts worthless! The question to such economists and strategists is why are there no shocks over your forecasting horizon? Their typical answer is that it is not an economist’s job to predict ‘acts of god’ or ‘black swans.’ But if insurance companies can incorporate the very predictable distribution of acts of god and black swans, then why can’t economists and strategists? Over any ten-year period, the likelihood of suffering a shock is a near-certainty, at 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period, it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-2). Chart I-2On A Multi-Year Horizon, Another Shock Is A Near-Certainty Witness that since just 2016 we have experienced Brexit, and the election of Donald Trump as US president. These were binary-outcome events where we could ‘visualise’ the tail-event in advance, but many dismissed it as implausible. Then we had a global pandemic, and now Russia’s full-scale invasion of Ukraine. Therefore, the crucial question is not whether we will experience shocks. We always will. The crucial question is, will the shock be net deflationary or net inflationary? Our high-conviction view is that the Ukraine crisis will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The Danger From Higher Energy Prices: The Obvious And The Not So Obvious Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned that the Ukraine crisis has lifted the crude oil price to a near-trebling since October 2020, not to mention the massive spike in natural gas prices? Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns. Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders. The obvious way that high energy prices hurt is that they are demand destructive to both energy and non-energy consumption. In this regard, the good news is that the economy is becoming much less energy-intensive – every unit of real output requires about 40 percent less energy than at the start of the millennium (Chart I-3). Nevertheless, even if the scope to hurt is lessening, higher energy prices are still demand destructive. Chart I-3The Economy Is Becoming Less Energy-Intensive The not so obvious way that high energy prices hurt is that they risk driving up the long-duration bond yield and thereby tipping more systemically important economic and financial fragilities over the brink. This was the where the greater pain came from in both 2000 and 2008 (Chart I-4 and Chart I-5). Chart I-4Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Chart I-5Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fortunately, the recent decline in the 30-year T-bond yield suggests that the bond market is looking through the short-term inflationary impulse of higher energy prices (Chart I-6). Instead, it is focussing on the deflationary impulse that will come from the demand destruction that the higher prices will trigger. Chart I-6Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices The economic and financial sanctions imposed on Russia will only lead to additional demand destruction. Sanctions restrict trade and economic and financial activity – therefore they hurt both the side that is sanctioned and the side that is sanctioning. This mutuality of pain caused the West to balk at both the timing and severity of its sanctions. But absent an unlikely backdown from Russia, the sanctions noose will tighten, choking growth everywhere.   If bond yields were to re-focus on inflation and move higher, it would add a further headwind to the economy and markets, forcing the 30-year T-bond yield back down again from a ‘line in the sand’ at around 2.4-2.5 percent. So, the long-duration bond yield will go down directly or via a short detour higher. Either way, bond yields will be lower in the second half of the year. Given the very tight connection between bond yields and stock market sector, style, and country allocation, it will become clear that the recent outperformance of cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move in a much bigger structural downtrend (Chart I-7). This structural downtrend is set to resume. Chart I-7When Bond Yields Decline, Banks Underperform Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Yet, the over-arching message from the anatomy of shocks is that the ultimate structural low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Stay structurally overweight the 30-year T-bond.   Fractal Trading Watchlist This week’s analysis focusses on banks, adds alternative electricity, and reviews bitcoin. Supporting the fundamental arguments in the main body of this report, the recent outperformance of banks has reached the point of fractal fragility that has signalled several important turning-points through the past decade (Chart 1-8). Accordingly, this week’s recommended trade is to go short world banks versus world consumer services, setting the profit target and symmetrical stop-loss at 12 percent.  Chart I-8The Recent Outperformance Of Banks May Soon End Alternative Electricity Is Rebounding From An Oversold Position Bitcoin's Support Is Holding Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5 Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary US biotech is trading at its greatest discount to the market. Ever. Much of biotech’s underperformance is due to transient factors: specifically, the sell-off in long-duration bonds; the focus on delivering a Covid vaccine; regulatory concerns; a drought in M&A; and a flood of IPOs. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. If, as we expect, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. Fractal trading watchlist: We focus on biotech, and add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Bottom Line: Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. Feature Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. But before we go into the specifics of biotech, let’s quickly discuss the recent action in the broader market. The Past Year Has Been All About ‘Duration’ A good way to think of any investment is to compress all its cashflows into one future ‘lump-sum payment.’ The length of time to this lump-sum payment is the investment’s ‘duration.’ And the present value of the investment is just the discounted value of this lump-sum payment, where the discount factor will depend on the required return on the investment combined with its duration.1 It follows that, all else being equal, the present value of a long-duration stock must rise and fall in line with the present value of an equally long-duration bond – because their discount factors move in lockstep. And, as we have been banging on in recent weeks, this simple observation is all you need to explain market action over the past year. For the 30-year T-bond, 2.4-2.5 percent is an important resistance level. Given that long-duration indexes such as the Nasdaq, S&P 500 and MSCI Growth have the same duration as the 30-year T-bond, they have been tracking the 30-year T-bond price one-for-one (Chart I-1 and Chart I-2). Hence, when the long-duration bond rallied, these stock markets outperformed shorter-duration indexes such as the FTSE100 and MSCI Value; and when the long-duration bond sold off, they underperformed. Chart I-1The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One Chart I-2MSCI Growth Has Been Tracking The 30-Year T-Bond Price One-For-One The Russian invasion of Ukraine has catalysed a retreat in the 30-year T-bond yield from a ‘line in the sand’ at 2.4-2.5 percent, which we have previously highlighted as an important resistance level. If, as we argued in A Massive Economic Imbalance, Staring Us In The Face, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Over the longer term, the bigger driver of the stock price will not be the discount factor on the future lump-sum payment; the bigger driver will be the size of the lump-sum payment itself. For any company, industry, or stock market, this expected lump-sum payment will evolve in line with current profits multiplied by a ‘structural growth multiple.’ It turns out that while current profits are updated every quarter, the structural growth multiple does not change much from quarter to quarter, year to year, or even decade to decade. Yet occasionally, it can phase-shift violently downwards when an event, or realisation, shatters the market’s lofty hopes for structural growth. Occasionally, an event or realisation shatters the market’s lofty hopes for structural growth. For example, after the dot com bubble burst it became clear that the sky-high hopes for non-US tech companies were just pie in the sky. The result was that their structural growth multiple halved, which weighed down non-US tech stocks for the subsequent 10 years (Chart I-3). Chart I-3After The Dot Com Bust, The Structural Growth Multiple For Non-US Tech Collapsed More recently, the realisation that Facebook – or Meta Platforms as it is now known – is losing subscribers was the gestalt moment that shattered hopes for its structural growth. Note that while its 2022 profits are down slightly, the Meta share price has collapsed, indicating a big hit to the structural growth multiple (Chart I-4). Chart I-4Facebook's Structural Growth Multiple Has Collapsed Conversely, there are rare occasions when a phase-shift down in a structural growth multiple is unwarranted or has gone too far. Right now, a case in point is the biotech sector, especially the US biotech sector. Relative to the relationship of the 2010s decade, US biotech’s structural growth multiple has halved (Chart I-5). The result is that US biotech is trading at the greatest valuation discount to the market (-20 percent). Ever. It is also trading at its greatest valuation discount to the broader tech sector (-35 percent). Ever (Chart I-6 and Chart I-7). Chart I-5US Biotech's Structural Growth Multiple Has Halved, But Is Such A Massive De-Rating Justified? Chart I-6US Biotech Is Trading At Its Greatest Ever Discount To The Market... Chart I-7...And Its Greatest Ever Discount To Big-Tech Another way of putting it is that in the post-pandemic era, while the structural growth multiple for the broader tech sector is largely unchanged, the structural growth multiple for biotech has collapsed by 40 percent (Charts I-8, I-11). Begging the question, is such a massive structural de-rating justified? Chart I-8US Tech's Structural Growth Multiple ##br##Is Unchanged... Chart I-9...But US Biotech's Structural Growth Multiple Has Collapsed Chart I-10Global Tech's Structural Growth Multiple##br## Is Unchanged... Chart I-11...But Global Biotech's Structural Growth Multiple Has Collapsed Much Of Biotech’s Underperformance Is Due To Transient Factors We have identified five culprits for biotech’s recent underperformance, but they are largely transient: The sell-off in long-duration bonds: Ironically, though the market has downgraded biotech’s structural growth, it has still behaved like a long-duration sector that has tracked the sell-off in the 30-year T-bond. Hence, if the long-duration bond rallies, it will boost biotech stocks. The focus on delivering a Covid vaccine: While biotech was developing a Covid vaccine, investors became enamoured with the sector, but once the vaccine was delivered, investors fell out of love with the sector. Yet there is more to biotech than a provider of vaccines, and as we show in the final section, the sell-off has gone too far. Regulatory concerns: In the US there has been some concern about the dilution of a biotech company’s intellectual property (IP) rights – known as March-In-Rights – if government funding or research has contributed to an innovation. In practice though, the sophistication of most innovations means that IP would remain with the innovator. There has also been concern about drug pricing reform, but as is normal in any negotiation, the opening extreme position is likely to get watered down. A drought in M&A: The focus on Covid, plus the uncertainty around regulation, has led to a drought in the M&A activity that is usually the mechanism to crystallize value. Still, for long-term investors, value is value, whether it is crystallized or not. Furthermore, the drought in M&A cannot last forever. A flood of IPOs: The more than 100 biotech IPOs in 2021 was double the usual rate, creating an oversupply and indigestion for specialist investors in the sector. But given the poor performance of the sector, the IPO flood is likely to recede through 2022-23 in a self-correction. So, we come back to the question: is it right to price a structural growth outlook for biotech worse than the overall market and much worse than for big-tech? If anything, it is big-tech that faces the much greater existential risk in the form of Web 3.0 – which will remove big-tech’s current ownership of the internet, thereby wiping out its very lucrative business model. Look out for our upcoming Special Report on this major theme. To repeat, the market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market, when most of the headwinds it faces are transient. All of which leads to two investment conclusions. The market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. Fractal Trading Watchlist This week’s analysis focusses on our main theme, biotech, and we add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. Reinforcing the arguments in the preceding sections, US biotech is deeply oversold versus broader tech, reaching a point of fractal fragility that signalled several significant turning-points through the past two decades (Chart I-12). Accordingly, this week’s recommended trade is to go long US biotech versus US tech, setting the profit target and symmetrical stop-loss at 17.5 percent. Chart I-12US Biotech Is Deeply Oversold Versus Broader Tech   US Banks Are At Risk Of Reversal Norway's Outperformance Could End Greece's Snapback At A Resistance Point BRL/NZD At A Resistance Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined fully, the duration of an investment is the weighted-average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary The recent 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a downturn. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. As the 30-year T-bond rallies, so too will other long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the S&P 500 versus short-duration stock markets such as the FTSE 100. Fractal trading watchlist: We focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? Bottom Line: As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, and long-duration stock markets such as the US versus non-US. Feature My colleague Peter Berezin recently wrote that recessions tend to happen when: “1) the build-up of imbalances makes the economy vulnerable to downturn; 2) a catalyst exposes these imbalances; and 3) amplifiers exacerbate the slump.” Peter is spot on. Using this checklist, I would argue that right now: There is a massive imbalance that makes the economy vulnerable to a downturn. Specifically, a 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history – the 26 percent overspend on durables refers to the US, but other advanced economies have experienced similar binges on goods. The catalyst that exposes this massive imbalance is the realisation that durables are, well, durable. They last a long time. So, if you front-end loaded many of this year’s purchases into last year, then you will not buy them this year. If you overspent by 26 percent in 2021, then the risk is that you symmetrically underspend by 26 percent in 2022. If central banks hike rates into this demand downturn, they will amplify and exacerbate the slump. A Massive Imbalance In Spending Makes The Economy Vulnerable To A Downturn Much of the recent overspend on goods was spending displaced from the underspend on services which became unavailable in the pandemic – such as eating out, going to the movies, and going to in-person doctor’s appointments. Raising the obvious question, can a future underspend on goods be countered by a future overspend on services? The answer is no. The consumption of services is constrained by time, opportunity, and biology. For example, there is a limit on how often you can eat out, go to the movies, or go to the doctor. If you are used to eating out and going to the movies once a week, and the pandemic prevented you from doing so for a year, that does not mean you will eat out and go to the movies an extra 52 times for the 52 times you missed! Rather, you will quickly revert to your previous pattern of going out once a week. This constraint on services spending means that the underspend will not become a symmetric overspend. In fact, the underspend on certain services will persist. This is because we have made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping and online medical care. Additionally, a small but significant minority of people have changed their behaviour, shunning services that require close contact with strangers. To repeat the crucial asymmetry, an overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend (Chart I-1 and Chart I-2). Therefore, the recent massive overspend on goods at the expense of services makes the economy vulnerable to a downturn, and the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. These hikes will prove to be overkill, because inflation is set to cool of its own accord. Chart I-1An Overspend On Goods Can Be Corrected By A Subsequent Underspend...   Chart I-2...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend   Durables Are Driving Inflation, And Inflation Is Driving The 30-Year T-Bond The recent binge on goods really comprises three mini-binges, which peaked in May 2020, January-March 2021, and October 2021. With a couple of months lag, these three mini-binges have caused three mini-waves in core inflation. To see the cause and effect, it is best to examine the evolution of inflation granularly – on a month-on-month basis – which removes the distorting ‘base effects.’ The mini-binges in goods lifted the core monthly inflation rate to an (annualised) 7 percent in July 2020, 10 percent in April-June 2021, and 7 percent in January 2022 (Chart I-3). Chart I-3Spending On Durables Is Driving Inflation Worryingly, the sensitivity of inflation has increased in each new mini-binge in goods spending, possibly reflecting more pressure on already-creaking supply chains as well as more secondary effects. Nevertheless, the key driver of the mini-waves in core inflation is the demand for durables, and as that demand wanes, so will core inflation. As monthly core inflation eases back, so too will the 30-year T-bond yield. What about the 30-year T-bond yield? Although it is a long-duration asset, its yield has recently been tracking the short-term contours of core inflation. So, when monthly inflation reached an (annualised) 10 percent last year, the 30-year T-bond yield reached 2.5 percent. At the more recent 7 percent inflation rate, the yield has reached 2.35 percent. It follows that as monthly core inflation eases back, so too will the 30-year T-bond yield (Chart I-4). Chart I-4Inflation Is Driving The 30-Year T-Bond Get The 30-Year T-Bond Right, And You’ll Get Most Things Right For the past year, the story of stocks has been the story of bonds. Or to be more precise, the story of long-duration stocks has been the story of the 30-year T-bond. Through this period, the worry du jour has changed – from the Omicron mutation of SARS-CoV-2 to an Evergrande default to Facebook subscriber losses and now to Russia/Ukraine tensions. Yet the overarching story through all of this is that the long-duration Nasdaq index has tracked the 30-year T-bond price one-for-one (Chart I-5). And the connection between S&P 500 and the 30-year T-bond price is almost as good (Chart I-6). Chart I-5Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Chart I-6Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right The tight short-term connection between long-duration stocks and the 30-year T-bond makes perfect sense. The cashflows of any investment can be simplified into a ‘lump-sum’ payment in the future, and the ‘present value’ of this payment will move in line with the present value of an equal-duration bond. So, all else being equal, a long-duration stock will move one-for-one in line with a long-duration bond. The story of long-duration stocks has been the story of the 30-year T-bond. ‘Value’ stocks and non-US stock markets which are over-weighted to value have a shorter-duration. Therefore, they have a much weaker connection with the 30-year T-bond. It follows that if you get the 30-year T-bond right, you’ll get most things right: The performance of other long-duration bonds (Chart I-7). The performance of long-duration growth stocks (Chart I-8). The performance of ‘growth’ versus ‘value’ (Chart I-9). The performance of growth-heavy stock markets like the S&P 500 versus value-heavy stock markets like the FTSE100 (Chart I-10). Of course, the corollary is that if you get the 30-year T-bond wrong, you’ll get most things wrong. Observe that the 1-year charts of long-duration bonds, growth stocks, growth versus value, and S&P 500 versus FTSE100 are indistinguishable. Proving once again that investment is complex, but it is not complicated! Chart I-7Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Chart I-8Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right   Chart I-9Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Chart I-10Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Our expectation is that as the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the US versus non-US. Fractal Trading Watchlist This week we focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. Emerging markets (EM) have been a big underperformer through the past year, but it may be time to dip in again, at least relative to value-heavy developed market (DM) indexes. Specifically, MSCI Emerging Markets versus MSCI UK has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2018, and 2020 (Chart I-11). Accordingly, this week’s recommended trade is to go long MSCI EM versus UK (dollar indexes), setting the profit-target and symmetrical stop-loss at 10 percent.  Chart I-11Time To Dip Into EM Again, Selectively Financials Versus Industrials Is Approaching A Turning-Point CAD/SEK At A Top Awaiting A Major Entry-Point Into Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations I   Indicators To Watch - Interest Rate Expectations III    

Special Report

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

Executive Summary The End Of The Negative Bond Yield Era Recent price action in developed market government bond markets confirms a backdrop that has been in place for the past several years - movements in US Treasuries define the trend in global yields, but Europe sets the effective floor. Higher core European bond yields are also pushing up non-European yields, in the context of the current global monetary policy tightening cycle. The hawkish market pricing for the ECB this year has gone a bit too far, as the start of European rate hikes this year is more likely in Q4 than in the summer – and only after ECB asset purchases begin to formally wind down. In the UK, the Bank of England appears to be trying to front load policy tightening, both rate hikes and balance sheet runoff, in response to overshooting UK inflation. A shorter, sharper policy tightening cycle means that the UK Gilt curve will continue to bear-flatten.  Bottom Line: Within the “Big 3” developed market central banks, the Fed and Bank of England are more likely to deliver discounted rate hikes than the ECB over the next 6-12 months. Remain underweight US Treasuries and UK Gilts versus German Bunds in global bond portfolios. Feature Chart 1A Global Repricing Of Interest Rate Expectations Persistent elevated inflation readings are forcing policymakers to move up the timetable of expected cyclical interest rate increases, but without signaling any change to longer-term interest rate expectations. The result has been an upward move in bond yields led by a repricing of shorter-term yields, leading to bearish yield curve flattening pressure across the developed markets (Chart 1). As the global bond bear market has intensified and broadened across countries and fixed income sectors, the amount of bonds worldwide with negative yields has been slashed by $9 trillion since December (Chart 2). Some notable examples: the 10-year German Bund yield is now up to +0.26%, the 30-year US real TIPS yield is now at +0.04% and even the 5-year Japanese government bond yield climbed to +0.02% for the first time since 2016. Last week, bond markets had to digest both a 25bp Bank of England (BoE) rate hike - that was almost a 50bp move - and a huge upside surprise in the January US employment report. However, it was the more hawkish-than-expected messaging from the European Central Bank (ECB) that really rattled fixed income markets. At the February monetary policy meeting, ECB President Christine Lagarde opened the door to potential ECB rate hikes this year, a notable change from the previous forward guidance that rates would stay unchanged in 2022. This not only triggered a major decline in European government bond prices, but also notable jumps in bond volatility for both longer-term and, especially, shorter-term yields. Implied volatilities for swaptions on 2-year European swap rates now sit at the highest levels since the depths of the European Debt Crisis in 2011 (Chart 3). Chart 2The End Of The Negative Bond Yield Era​​​​​ Chart 3The Front-Ends Of Yield Curves Awaken​​​​​​ Overnight index swap (OIS) curves are now discounting multiple rate hikes from the Fed (+127bps), BoE (+125bps) and ECB (+46bps) this year. Tighter monetary policy is the inevitable consequence of the current combination of steady above-trend growth, tight labor markets and very high inflation in those countries. This mix will continue to put upward pressure on global bond yields through a blend of steady inflation expectations and higher real yields as pandemic era monetary stimulus is removed – a process that is already underway in the US and Europe (Chart 4). Our Central Bank Monitors – designed to measure the cyclical pressure to change monetary policy – are all indicating the need for tightening in the US, UK and euro area. However, the risk is that tightening perceived to be too aggressive or too rapid will be received poorly by financial markets that have grown accustomed to easy money policies during the pandemic. Given the current starting point of high equity valuations and relatively tight corporate credit spreads in the US, financial conditions are no impediment to additional Fed rate hikes in 2022 (Chart 5). The same cannot be said in the UK, where the steady appreciation of the trade-weighted pound is tightening financial conditions, on the margin. In the euro area, financial conditions remain relatively stimulative, as the euro is undervalued on a trade-weighted basis. Chart 4A Recipe For Even Higher Bond Yields Given high realized inflation, financial stability concerns are playing a secondary role in the policy deliberations of central banks facing an inflation-fighting credibility crisis. In the absence of a big fall in inflation, it will take much larger selloffs in equity and corporate credit markets than what has occurred so far in 2022 before policymakers would step back from interest rate increases over the next year. Chart 5Financial Conditions Are No Impediment To Rate Hikes​​​​​​ The ECB Will Lag The Fed On Rate Hikes Chart 6Faster Growth & Slower Inflation Expected In 2022 One of our highest conviction bond market views to begin 2022 called for US Treasuries to underperform German Bunds. Our view was based on the likelihood that the Fed would lift the fed funds rate multiple times this year and the ECB was likely to hold off on rate hikes until the first half of 2023 at the earliest. Last week’s shift in the ECB’s tone does not change that relative call. The Fed is still under far greater pressure to hike rates than the ECB, even if there is now a greater chance that the ECB could begin to tighten by the end of 2022. From an economic growth perspective, both central banks have good reasons to consider withdrawing monetary accommodation. The economic expectations in both the US and euro area have started to recover, according to the ZEW survey of financial market professionals, with a bigger bounce seen in the latter since the trough of last October (Chart 6). The fading Omicron wave is likely playing a large role in lifting economic expectations, as the variant has proven to be less lethal than previous waves of the virus. The ZEW survey also asks respondents about their views on future inflation and interest rate changes. The ZEW Inflation Expectations index has fallen back to pre-pandemic lows in both the US and euro area, indicating that a majority expect lower inflation in the US and Europe over the next year. Both the Fed and ECB also expect inflation to fall from current elevated levels this year. However, there is still a much stronger case for tightening in the US given the tight labor market that is pushing up wages. Last week’s January US payrolls data was a shocker, with employment rising +476,000 on the month when some forecasters were calling for an outright contraction in jobs due to the impact of the Omicron variant. Wage growth accelerated smartly, with average hourly earnings up 0.7% on the month and 5.7% on a year-over-year basis (Chart 7). This continues the trend of wage acceleration seen in other data series like the Employment Cost Index, confirming that the US labor market is tight enough to elicit a strong policy response from the Fed. In the euro area, the recent economic data has been a bit more mixed. The Markit manufacturing PMI rose to a five-month high of 59.0 in January, beating expectations. However, the services PMI fell to a nine-month low of 51.2 as renewed COVID lockdowns weighed on consumer confidence and spending (Chart 8). With Omicron numbers now slowing, some recovery in consumer spending is likely over the next few months as euro area governments reduce restrictions. However, the manufacturing recovery will struggle to gain significant upside momentum without stronger demand for European exports – an outcome that is not currently heralded by an upturn in reliable indicators like the global leading economic indicator or the China credit impulse (Chart 9). Chart 7Persistent US Labor Market Strength​​​​​​ Chart 8A Mixed Picture On European Growth​​​​​​ Even within the euro area inflation data, there are mixed trends that make it less clear that a major tightening cycle is necessary. Headline euro area HICP inflation hit a 37-year high of 5.1% in January, which was heavily influenced by a 28.6% rise in the energy component of the index (Chart 10). Goods price inflation reached 6.8%, its highest level since 1991, fueled by global supply chain disruptions and greater consumer demand for goods versus services during the pandemic. For the latter, services inflation reached a much more subdued 2.4% in January, in line with core HICP inflation of 2.3%. We expect goods price inflation to slow substantially, on a global basis and not just in Europe, as supply chain disruptions ease over the course of 2022 and consumers shift spending back towards services from durable goods as economies reopen post-Omicron. Chart 9A Gloomy Picture For European Exports​​​​​ Chart 10European Inflation Surge Focused On Energy & Goods​​​​​ Surging oil and natural gas prices will keep the energy component elevated over the next few months, particularly if geopolitical tensions over Ukraine result in Russia withholding natural gas supplies to Europe. Yet it is not clear how much of this will pass through to core inflation, which actually decelerated in January from the 2.6% pace seen in December 2021 despite surging energy prices. What does a typical ECB liftoff look like? Should the ECB focus more on the headline or core inflation numbers when deciding if rate hikes are necessary later this year? The answer may lie more in the breadth across countries, rather than depth across sectors, of euro area inflation pressures. In the relatively short history of the ECB, dating back to the inception of the euro in 1998, there have been only three monetary tightening episodes that involved interest rate increases: 1999-00, 2006-08 and 2011. In Chart 11, we show the percentage share of individual euro area countries that have accelerating growth momentum (measured as a leading economic indicator above the level of a year earlier), and with headline/core inflation above the ECB’s 2% target. In all three of those past ECB tightening episodes, essentially all euro area countries had to see strong growth or inflation at or above the ECB target before the ECB would hike rates. Chart 11The Growth & Inflation Conditions For An ECB Rate Hike Are In Place Chart 12Watch European Wages To Determine The ECB's Next Move(s) A similar story can be told looking at the state of the euro area labor market. The 1999-00 and 2006-08 tightening cycles occurred when nearly all euro area countries had an unemployment rate below the OECD’s estimate of the full employment NAIRU (Chart 12). Only in 2011, which was widely regarded as a major policy error, did the ECB hike rates without widespread labor market strength across the euro area. Right now, the breadth of the growth and inflation data across the euro area would indicate that the ECB will soon begin to tighten policy, if history is any guide. The one missing piece of the puzzle is faster wage growth. Euro area wage growth is severely lagging compared to other developed economies. For the last known data point in Q3/2021, wages were only growing at a 1.5% year-over-year rate. Wage growth has very likely accelerated since then, with the overall euro area unemployment rate now down to an all-time low of 7.0%, well below the OECD NAIRU estimate of 7.7%. The ECB will need to see confirmation of that faster wage growth in the data, however, before embarking on a path of rate hikes. Since last week’s ECB meeting, numerous ECB officials – including President Lagarde - have stated that asset purchases must stop before rate hikes can begin. While the ECB’s pandemic emergency bond buying program is set to end next month, the existing Asset Purchase Program is set to continue with no expiry date. If the ECB officials are to be taken at their word, it is very difficult to imagine a scenario where asset purchases would be fully wound down (i.e. net purchases of zero, with buying only to replace maturing bonds held by the ECB) before the July liftoff date now priced into the Euro OIS curve. Such a rapid removal of the ECB bid would be very disruptive to the riskier parts of European fixed income markets, like Italian and Greek sovereign debt, that have benefited from heavy ECB buying under the pandemic bond buying program. European bond strategy implications While an ECB rate hike in 2022 is now a more probable scenario, it is not yet a done deal. The European growth picture remains mixed, and inflation readings outside of supply-constrained energy and durable goods – including wages - are far less threatening than headline inflation. At the moment, underlying inflation pressures are far more intense in the US. Durable goods inflation in the US reached 16.8% on a year-over-year basis last month, but climbed to “only” 3.8% in Europe (Chart 13). The Cleveland Fed’s trimmed mean CPI index accelerated to 4.8% in January, compared to 3.0% for the euro area trimmed mean CPI inflation gauge constructed by our colleagues at BCA Research European Investment Strategy. Chart 13Stay Positioned For A Wider UST-Bund Spread The Fed has a lot more work ahead of it in terms of tightening monetary policy to rein in inflation pressures (and inflation expectations) than the ECB. This will lead to a faster pace of rate hikes in the US than in Europe and renewed widening of the US Treasury-German Bund yield spread. Financial conditions in Europe will also play a role in limiting when, and how much, the ECB can eventually tighten monetary policy. Yields and spreads on the riskier parts of the European fixed income markets like Italian government bonds have already widened substantially in response to the more hawkish guidance from the ECB (Chart 14). The euro has also stabilized after the steady depreciation seen since the May 2021 peak. Markets are obviously pricing in an end to ECB asset purchases – the precursor to rate hikes – which would force the private sector to absorb a greater share of Italian bond issuance than has been the case over the past few years. It will likely take higher yields to entice those buyers compared to the price-insensitive ECB that has been buying Italian debt as a monetary policy tool. The speed of the adjustment in Italian bond yields has no doubt alerted the ECB Governing Council to the financial stability risks of moving too fast on tightening monetary conditions. We must acknowledge that most the recent trends in the Treasury-Bund spread (narrower) and Italian bond yields/spreads (higher) go against our current strategic recommendations to overweight European fixed income. Markets have moved to price in a far more aggressive move from the ECB than we had envisioned for 2022. However, as highlighted above, it is not clear that the ECB needs to dial back monetary accommodation as rapidly as markets now expect. Thus, we are sticking with our strategic recommendations to overweight euro area government bonds, both in the core and periphery, in global bond portfolios. At the same time, we continue to recommend a below-benchmark duration stance within dedicated European portfolios, even with the 10-year German Bund yield having already reached our end-2022 yield target of 0.25% (Chart 15). European bond yields will remain under upward pressure until euro area inflation finally peaks and the ECB will be under less pressure to tighten. Chart 14ECB Facing An "Italy-vs-Inflation" Tradeoff​​​​​ Chart 15Too Much, Too Soon Priced Into Bund Yields​​​​​ Bottom Line: Markets are overestimating how quickly the ECB can begin to tighten European monetary policy. An initial rate hike can occur in Q4 of this year, at the earliest, which is later than the current mid-summer liftoff date discounted in interest rate forwards. Ride out the current European rates volatility and stay overweight European government debt versus the US. UK Update: The BoE Wants To Tighten Fast At last week's policy meeting, the BoE Monetary Policy Committee (MPC) voted 5-4 to raise Bank Rate by 25bps to 0.5%. That close vote is less dovish than it appears, though, as the four “dissenting” MPC members wanted to raise rates by 50bps instead! This was a hawkish surprise that resulted in bearish flattening of the UK Gilt yield curve. Chart 16UK Gilts: Volatile, But Underperforming We have maintained a below-benchmark strategic recommendation on Gilts since August of last year. The relative performance of Gilts versus the Bloomberg Global Treasury benchmark index has seen tremendous volatility since then, particular after the BoE delayed the expected initial rate hike last November (Chart 16) Gilts began to underperform again after the BoE hiked in December and have continued to be one of the worst performing G10 bond markets, validating our bearish call. After last week’s BoE hike, we still see value in betting on additional Gilt underperformance, as markets may still be underestimating how high the BoE will have to raise rates in the current tightening cycle. In the new set of economic projections from the BoE’s Monetary Policy Report published last week, the central bank raised its expectation for the April peak in UK inflation to 7.25% (Chart 17). This compares to the latest inflation rate of 5.4%. Higher energy and goods prices account for three-quarters of that expected inflation increase, according to the BoE. UK inflation is projected to fall rapidly from that April peak, in response to an expected deceleration of energy and goods prices and slower UK economic growth. However, the Monetary Policy Report also highlighted that domestic UK cost pressures are intensifying in response to a very tight UK labor market. The BoE’s Agents’ survey of UK businesses reported that UK firms continue to have difficulty filling job openings, while also having success in passing on rising labor costs into selling prices. Thus, the UK labor market is now the critical variable to watch to determine how many more rate hikes the BoE will need to deliver in the current cycle. On that note, the BoE expects UK wage growth to accelerate to just under 5% over the next year, which is well above the central bank’s estimate of “underlying” pre-pandemic wage growth around 3.5%. Inflation expectations in the UK remain elevated. The YouGov/Citigroup survey shows that UK consumers expect inflation to be 4.8% on year from now and 3.8% 5-10 years ahead (Chart 18, top panel). Market-based inflation expectations have been more volatile of late but CPI swaps are pricing in inflation of 5.0% in two years and 4.2% in ten years.1 Thus, by any measure – realized inflation, expected inflation or wage growth – UK inflation is too high, which justifies tighter monetary policy. The UK OIS curve now discounts a peak in Bank Rate of 1.85% in April 2023, but this is immediately followed by rate cuts that take Bank Rate to 1.5% by the end of 2024. That path over the next year is a bit more hawkish than the results from the BoE’s new Market Participants Survey of bond investors, which showed an expected peak in Bank Rate of 1.5% sometime in the latter half of 2023. In both cases, Bank Rate is expected to settle below the BoE’s 2% inflation target, or below current inflation expectations. Suggesting an implied belief that the BoE will not be able to raise real interest rates into positive territory. In terms of forward guidance, several BoE officials have noted that they expect that only a few more hikes will be needed to help bring UK inflation back down to the 2% target. Yet the OIS curve is pricing in a “policy error” scenario where the BoE pushes up rates too rapidly and is then forced to cut rates soon afterward. We see both the BoE guidance and the OIS pricing as far too cautious on the eventual peak in Bank Rate, which leads us to maintain our underweight recommendation on UK Gilt exposure, both in terms of duration and country allocation in global bond portfolios. Chart 17BoE Sees A Short, Sharp Shock From Inflation & Rates We have also been recommending a Gilt curve steepening trade in our Tactical Overlay portfolio on page 20 since last October. This trade went long a 10-year Gilt bullet versus a barbell combination of a 7-year and 30-year Gilt. Chart 18Stay Underweight UK Gilts​​​​​ Our view at the time of trade inception was that a Gilt steepener would benefit from a scenario where the market would be forced to reassess how high rates would go in the next BoE tightening cycle. However, the BoE now appears to be “front loading” the tightening cycle by moving rates sooner and more aggressively, as evidenced by the near 50bp rate hike last week, while also moving to an accelerated runoff of bonds accumulated during quantitative easing operations. The Gilt yield curve has flattened considerably in response to increasing BoE hawkishness, with the yield spread between the 10-year and 2-yield Gilt now down to a mere +17bps. While we still see the potential for the longer-end of the Gilt curve to rise in response to an eventual repricing of terminal rate expectations that appear too low, the BoE’s acceleration of its hiking timetable will make it difficult for the curve to bearishly steepen in the near term. Thus, we are closing out our tactical Gilt curve steepener at a small gain of +23bps.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      UK CPI swaps, and inflation breakevens on index-linked Gilts, reference the UK Retail Price Index (RPI) which typically runs higher than the UK Consumer Price Index (CPI). This imparts an upward bias to UK inflation expectations when compared to CPI swaps and breakevens in other countries. Currently, RPI inflation is running at 7.5% compared to CPI inflation of 5.4%. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Highlights Chart 1Most Sectors Have Fully Recovered Last week’s January employment report shocked markets by showing much greater job gains than had been anticipated. More important than the headline number, however, were the revisions to prior months that reveal a much different picture of the post-COVID labor market. In overall terms, the revised data show that employment is still significantly below where it was prior to the pandemic. Specifically, the economy is still missing about 2.9 million jobs. However, the data now reveal that more than 60% of the missing jobs come from the Leisure & Hospitality sector and that the Health Care and State & Local Government sectors account for the rest. In other words, except for the few sectors that have been most impacted by the pandemic, the US labor market has made a full recovery (Chart 1). The new data justify the Fed’s recent push toward tightening. This is because there is no longer any evidence of labor market slack beyond what we see in the select few close-contact service industries that have been most impacted by COVID. Investors should maintain below-benchmark portfolio duration as the Fed moves toward rate hikes. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 115 basis points in January. The index option-adjusted spread widened 14 bps on the month to reach 108 bps, and our quality-adjusted 12-month breakeven spread moved up to its 15th percentile since 1995 (Chart 2). This indicates that, despite the recent selloff, corporate bonds remain expensive. We discussed the intermediate-term outlook for corporate bonds in a recent report.1  Specifically, we analyzed the performance of both investment grade and high-yield corporate bonds during previous Fed tightening cycles. Our conclusion is that it will soon be appropriate to reduce our cyclical exposure to corporate credit. For investment grade corporates, this will mean reducing our recommended allocation from neutral (3 out of 5) to underweight (2 out of 5). Our analysis of past cycles suggests that the slope of the yield curve is a critical indicator of corporate bond performance. Excess corporate bond returns are generally strong when the 3-year/10-year Treasury slope is above 50 bps but take a step down when the slope shifts into a range of 0 – 50 bps. The 3/10 slope has just recently dipped below 50 bps (bottom panel). Though our fair value estimates can’t rule out a near-term bounce back above 50 bps, this will become less and less likely as Fed rate hikes approach. We maintain our current recommended allocation for now but expect to downgrade within the next few weeks. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 158 basis points in January. The index option-adjusted spread widened 59 bps in January to reach 342 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also moved up to 4% (Chart 3). The odds are good that defaults will come in below 4% during the next 12 months, which should coincide with the outperformance of high-yield bonds versus Treasuries. For context, the high-yield default rate came in at 1.24% in 2021 and we showed in a recent report that corporate balance sheets are in excellent shape.2 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). While high-yield valuations are more favorable than for investment grade, the bonds will still have to contend with a more challenging monetary environment this year as the Fed lifts rates and the yield curve flattens. For this reason, we expect to reduce our recommended allocation to high-yield corporates in the coming weeks – from overweight (4 out of 5) to neutral (3 out of 5) – though we will retain our preference for high-yield over investment grade. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in January. The zero-volatility spread for conventional 30-year agency MBS tightened 7 bps on the month, split between a 17 bps tightening of the option-adjusted spread (OAS) and a 10 bps increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.3 This valuation picture is starting to change. The option cost is now up to 36 bps, its highest level since March 2020, and refi activity is slowing as the Fed moves toward rate hikes. At 23 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS. We continue to recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Emerging Market Bonds (USD): Overweight Chart 5Emerging Markets Overview This week we officially initiate coverage of USD-denominated Emerging Market (EM) bonds. To start, we will focus on investment grade rated Sovereigns, Corporates and Quasi-Sovereigns. We plan to expand our coverage to include high-yield in the coming months. This EM section replaces the previous Government-Related section in our monthly summary. We will continue to cover Government-Related securities from time to time, but that sub-index will no longer be regularly included in our recommended portfolio allocation. Emerging Market bonds underperformed the duration-equivalent Treasury index by 88 basis points in January. EM Sovereigns underperformed the Treasury benchmark by 134 bps on the month and the EM Corporate & Quasi-Sovereign Index underperformed by 58 bps. After strong relative performance in the back-half of 2021, the EM Sovereign index eked out just 4 bps of outperformance versus the duration-equivalent US corporate bond index in January (Chart 5). Meanwhile, the EM Corporate & Quasi-Sovereign index outperformed the duration-matched US corporate index by 24 bps on the month. Yield differentials for EM sovereigns and corporates remain attractive relative to US corporates (panel 4). Additionally, EM currencies are hanging in there versus the dollar even as the Fed moves toward tightening (bottom panel). We recommend an overweight allocation to USD-denominated EM bonds in US bond portfolios, and we maintain our preference for EM sovereign and corporate bonds relative to US corporates with the same credit rating and duration. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 121 basis points in January (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.4 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 19% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk as bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened dramatically in January, and yields continued their sharp rise through the first week of February – though in a more parallel fashion. All in all, the 2-year/10-year Treasury slope has flattened 17 bps since the end of December, bringing it to 62 bps. The 5-year/30-year slope has flattened 19 bps since the end of December, bringing it to 45 bps. The aggressive flattening of the curve has occurred alongside the Fed’s increased near-term hawkishness. Our 12-month discounter has risen from 77 bps at the end of last year to 149 bps today (Chart 7). In other words, the market has gone from anticipating just over three 25 basis point rate hikes during the next 12 months to nearly six! Last week’s report argued that the most recent move to discount more than four 25 basis point rate hikes in 2022 is overdone.5  We contend that tightening financial conditions and falling inflation expectations will cause the Fed to moderate its pace of rate hikes in the second half of this year. We still see the Fed lifting rates three or four times in 2022, but this is now significantly below what’s priced in the market. Given our view, we recommend a position long the 2-year Treasury note versus a barbell consisting of cash and the 10-year note. This trade will profit as a more moderate expected pace of near-term rate hikes limits the upward pressure on the 2-year yield. TIPS: Neutral Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 23 basis points in January. The 10-year TIPS breakeven inflation rate has declined by 16 bps since the end of December while the 2-year TIPS breakeven inflation rate has fallen by 1 bp. The 10-year and 2-year rates currently sit at 2.43% and 3.21%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate is down 22 bps since the end of December. It currently sits at 2.05%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given how the market has reacted to the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in January. Aaa-rated ABS outperformed by 19 bps on the month and non-Aaa ABS outperformed by 20 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in January. Aaa Non-Agency CMBS underperformed Treasuries by 3 bps in January, but non-Aaa Non-Agency CMBS outperformed by 2 bps (Chart 10). Though returns have been strong and spreads remain relatively wide, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in January. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.     Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 31, 2022) 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 January 31, 2022) 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 -53 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 53 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of January 31, 2022) Recommended Portfolio Specification Other Recommendations Ryan Swift US Bond Strategist rswift@bcaresearch.com    Footnotes 1 Please see US Bond Strategy Weekly Report, “Positioning For Rate Hikes In The Corporate Bond Market”, dated January 25, 2022. 2 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 5 Please see US Bond Strategy Weekly Report, “The Best Laid Plans”, dated February 1, 2022.

Special Report

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Asian Inflation Has Diverged From US Inflation has been largely subdued in emerging Asia and will remain so for now. This argues for the outperformance of emerging Asian local bonds versus their EM peers, as well as DM/US bonds.   The most important macro driver of Asian domestic bond yields is inflation. Rising inflation usually also hurts local currencies – creating a toxic cocktail for bonds’ total returns in US dollar terms. Diverging currency dynamics in emerging Asia is what will determine the relative performances of individual bond markets. Chinese, Indian, and Malaysian currencies have a better outlook than currencies in Indonesia, Thailand and the Philippines. Book profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021. Recommendation   Initiation Date Return to Date Short KRW / Long USD 2021-03-25 5.2% Bottom Line: Regional fixed income managers should overweight China, Korea, India and Malaysia, and underweight Indonesia, Thailand and the Philippines within an emerging Asian bond portfolio. In an overall EM domestic bond portfolio however, Thailand and the Philippines should be accorded a neutral allocation, given their better inflation outlook compared to their peers in EMEA and Latin America. Feature US Treasury yields will likely go up further. If history is any guide, EM Asian bond yields should also rise in tandem (Chart 1). The basis is that business cycles in Asia and the US usually move together. Yet, in this cycle, inflation in emerging Asia has diverged considerably from that of the US. US core consumer price inflation has surged while in Asia, core inflation remains largely contained (Chart 2). How should bond investors position themselves in Asian domestic bond markets? Chart 1Asian Bond Yields Usually Move In Line With US Treasury Yields... Chart 2...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds Chart 3Relative Domestic Bond Performances In Asian Markets In this report, we will discuss some of the common factors that drive Emerging Asian bond markets. We will also highlight each individual market’s idiosyncrasies to explain our recommended allocation across local currency bond markets in emerging Asia for the coming year.     Our recommended allocation is as follows: China, Korea, India and Malaysia merit an overweight stance in an emerging Asia domestic bond portfolio, while Indonesia, Thailand, and the Philippines warrant an underweight allocation (Chart 3). That said, given a much more benign inflation outlook in Asia than elsewhere in EM, we recommend that Thailand and the Philippines be accorded a neutral allocation in an overall EM domestic bond portfolio. The Two Drivers For international investors in local bonds, total returns are predicated on two main drivers: (1) the direction and magnitude of change in bond yields; and (2) currency performance. In all Asian countries, the most potent macro factor that drives local bond yields is the country’s inflation. Rising inflation is usually a harbinger of higher bond yields (and hence, worsening bond performance); and falling inflation is an indicator of lower yields (Charts 4 and 5). Chart 4Inflation Is The Most Important Macro Driver … Chart 5… Of Bond Yields In Emerging Asia What’s more, rising inflation in a country is also often associated with a depreciating currency. Currencies in countries with higher/rising inflation in general do worse than in countries with lower/falling inflation. This aspect is especially important when doing a cross-country comparison. The fact that higher inflation negatively impacts both the drivers of bond performance – it pushes up yields and weakens the currency – can indeed be seen happening in Asian financial markets. Rising inflation leads to poor performance of domestic bonds’ total return in dollar terms; and falling inflation leads to a better performance. The upshot is that the potential inflation trajectory is key to any country’s domestic bond performance in both absolute and relative terms. Inflation In Asia Is Benign Most of the Asian countries have their core and trimmed mean consumer price inflation running at or well below their central banks’ targets (Charts 6 and 7). Their inflation outlook also remains largely benign.1 As such, bond yields in these countries are unlikely to rise materially in the near future. Chart 6Inflation Is Running At Or Below … Chart 7… Central Banks’ Target in Asia Notably, even the recent surge in US yields did not spook Asian bond yields. The yield differentials between individual Asian domestic and US yields have remained flattish in the past few months. All this implies that Asian domestic bonds, in general, would likely fare better relative to the rest of the EM and the US – where inflation is high and well above their central banks’ targets. Currency Is A Key Differentiator Given inflation, and therefore the bond yield trajectories among Asian economies are unlikely to deviate significantly from one another, the key differentiator of their bond market performance (on a total return basis) will be their exchange rates. In fact, Asian currencies do vary considerably in their outlooks as their fundamentals differ.  For instance, in China and Korea, higher bond yields are usually associated with an appreciating currency (Chart 8, top and middle panels). The key driver of bond yields in these economies is the business cycle. Accelerating growth often pushes up both the currency as well as interest rates. The opposite is also true: decelerating growth usually leads to a weaker currency and falling bond yields.  The consequence is that in these countries, bond performance is tempered by two opposing forces. For example, the effect of falling yields (which is a positive for total return) is often mitigated by the effect of a falling currency (which is a negative for total return), or the other way around. In contrast to China and Korea, ASEAN countries usually experience rising bond yields accompanied by a depreciating currency (Chart 9). A crucial reason for this is significantly higher foreign ownership of their domestic bonds. In periods of stress, when foreigners exit their bond holdings, this leads to both higher yields and a falling currency. During risk-on periods, foreigners’ purchases do the opposite. Chart 8Higher Bond Yields Coincide With A Stronger Currency In China And Korea Chart 9Higher Bond Yields Coincide With A Weaker Currency In ASEAN In this context, foreign ownership of domestic bonds in ASEAN countries has fallen in the past few years, but remains non-trivial: 19% in Indonesia, 24.2% in Malaysia, 19.9% in the Philippines, and 11.3% in Thailand. Hence, the currency view on ASEAN countries is crucial to get the outlook right for their domestic bond performance. Incidentally, Thailand, the Philippines and Indonesia have a weak currency outlook, while Malaysia’s is neutral. We discuss the individual currency outlooks in more detail in the respective country sections below. But in summary, this warrants a more positive stance on Malaysian domestic bonds compared to Indonesian, Thai and Filipino bonds. Finally, in case of India, bond yields and the rupee have little correlation (Chart 8, bottom panel). The main reasons for that are near absence of foreign investors in Indian government bond markets, and large captive domestic bond investors (its commercial banks). Yet, unlike China and Korea, India also has higher inflation and a persistent current account deficit. All these make the correlation of bond yields with the exchange rate different in India from both ASEAN as well as China and Korea. In the sections below, we discuss each country’s currency and overall bond outlook in more detail. We also explain the reasons behind our relative bond strategy. China: Overweight Chart 10Chinese Bond Yields Will Likely Fall More China’s economy will remain weak in the coming months. The hit to the economy from slowing property construction is material. Besides, COVID-induced rotational lockdowns are hurting consumption, income and investment in the service sector. The latest round of stimulus has so far not been sufficient to produce an immediate recovery. We expect growth to revive only in H2 2022. For now, the PBOC will reduce its policy rate further. This and the fact that the yield curve is positively slopped heralds more downside in Chinese government bond yields (Chart 10). Concerning the exchange rate, the ongoing US dollar rally could eventually cause a short period of yuan weakness. However, the latter will be small and short lived. In brief, Chinese domestic bonds will outperform both their Asian and EM peers in the coming months. Korea: Overweight The following factors argue for overweighting Korean bonds within both emerging Asian and EM domestic bond portfolios: Chart 11Korea Has No Genuine Inflation The Korean won has already depreciated quite a bit against the US dollar. While further downside is possible in the very near term, the medium-term outlook is positive. Even though headline and core inflation have exceeded the central bank’s target of 2%, trimmed mean consumer price inflation has not yet exceeded 2% (Chart 4, middle panel) and services CPI, excluding housing, seems to have rolled over. Importantly, no wage inflation spiral is evident. Unit labor costs have been falling in both the manufacturing and service sectors (Chart 11). Hence, there is little pressure for companies to hike prices. India: Overweight Indian bonds should continue to outperform other EM domestic bonds (Chart 3, middle panel). The combination of prudent fiscal policy, a benign inflation outlook and a cheap currency makes Indian bonds attractive to foreign investors. Even though yields will go up somewhat given a recovering economy, the rise will be capped as the inflation outlook remains benign. The reason for a soft inflation outlook is wages and expectations thereof are quite low (Chart 12). Global commodity prices will also likely soften in the months ahead. That will ease price pressures in India. The Indian rupee is cheap – it is now trading 12% below its fair value versus the US dollar (Chart 13). The rupee will likely be one of the best performers among EM currencies in the year ahead. Chart 12Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Chart 13Indian Rupee Is Cheap   The spread of India’s 10-year bonds over that of GBI-EM Broad index is 190 basis points. The currency performance will likely offset any possible capital loss owing to rising yields, while a positive carry will boost total returns. Stay overweight. Indonesia: Underweight Indonesian relative bond yields versus both EM and the US have already fallen massively and at multi-year lows (Chart 14). The currently low yield differential between Indonesia and the aggregate EM local bonds as well as US Treasury yields is a negative for Indonesia’s relative performance going forward. Chart 15 shows that the rupiah is also vulnerable over the next several months as the Chinese credit and fiscal impulse has fallen to its previous lows while the rupiah has not yet depreciated. We believe raw material prices will correct in the coming months, weighing on the rupiah. Hence, the country’s local bonds’ relative performance is facing a currency headwind too. Chart 14Indonesian Relative Bond Yields Are Quite Low Chart 15Indonesian Rupiah Is Vulnerable   Notably, a weaker currency by itself could cause bond yields to rise – because that may prompt foreign bond holders to exit this market. For now, investors would do well to underweight this domestic bond market in an emerging Asian or global EM portfolio. Malaysia: Overweight Chart 16Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian domestic bonds will likely fare well as the nation’s economy is still working through credit excesses of the previous decade. Domestic demand weakness has been exacerbated by a constrained fiscal policy. All of this has paved the way for a strong disinflationary backdrop.   The job market has not recovered either: the unemployment rate is hovering at a high level. That in turn has put downward pressures on wages. Average manufacturing wages are weak. Dwindling wages have contributed to depressed household incomes, leading to weak consumption and falling house prices (Chart 16). Considering the economic backdrop, Malaysia’s yield curve is far too steep (Chart 16, bottom panel). Odds are that the curve will flatten going forward – yields at the long end of the curve are likely heading lower. At a minimum, they will rise less than most other EM countries. Notably, the ringgit is quite cheap, and is unlikely to depreciate much versus the US dollar. Hence, it will outperform many other Asian/EM currencies. That calls for an overweight position in Malaysian local bonds within an Asian/EM universe.  Thailand: Underweight To Neutral Given the high correlation between Thai bond yields and the baht (rising yields coincide with a weakening currency), the total return of Thai bonds in USD terms is highly dependent on the baht’s performance. (Chart 17). The baht outlook remains weak, as the two main drivers of the currency, exports and tourism revenues, remain sluggish and absent, respectively. As such, absolute return investors in Thai domestic bonds should continue to avoid this market. Asset allocators should underweight Thai domestic bonds in an emerging Asia basket. In an overall EM domestic bond portfolio, however, Thai bonds warrant a neutral allocation. That’s because Thailand has been a defensive bond market due to its traditionally strong current account, very low inflation, and lower holding of bonds by foreigners (now at 11.3% of total). In periods of stress, the baht usually falls less than most other EM currencies; and often Thai bond yields fall more (or rise less) than overall GBI-EM yields (Chart 18, top panel). Chart 18Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Chart 17Thai Domestic Bonds' Absolute Performance Is Highly Contingent On The Baht   The net result is that Thai bonds outperform their overall EM brethren in common currency terms during risk-off periods. This is what happened during the EM slowdown of 2014-15, and again during the pandemic scare in early 2020 (Chart 18, bottom panel). Given we are entering a period of volatility in risk assets, it makes sense to have a neutral positioning on Thai bonds in an EM domestic bond portfolio. The Philippines: Underweight To Neutral The Philippines also merits an underweight allocation in an emerging Asian domestic bond portfolio, but a neutral stance within EM. This is because of this market’s dependence on the appetite of foreign debt investors for Philippine debt securities. This appetite depends on how much extra yield the country offers over US Treasuries. Chart 19 shows that whenever the yield differential between the Philippines’ local bonds and US Treasuries widens to 400 basis points or more, the Philippines typically witnesses net debt portfolio inflows over the following year. On the other end, when the yield differential narrows to around 300 basis points or less, foreign fixed income inflows typically stop, and often turn into outflows during the following year. This is what is happening now. Chart 19Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Chart 20Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Going forward, rising US yields would mean that the Philippines’ bond spreads over US Treasuries will continue to stay less than 300 basis points. Consequently, reduced foreign debt inflows will weigh on the peso. Notably, the Philippines’ current account balance has also slid back to deficit, which makes the peso more vulnerable (Chart 20). On a positive note, contained inflation means little upward pressure on bond yields. Further, there might be a lower need of new bond issuances this year as a substantial amount of proceeds from past bond issuances are lying unspent with the central bank. This would help put a cap on bond yields.  Investment Conclusions Emerging Asian local bonds will outperform their counterparts in Latin America and EMEA in common currency terms for now. In the medium and long run, emerging Asian bonds will outperform US/DM bonds on a total return basis in common currency terms. We will discuss rationale for the latter in our future reports. Considering both the overarching macro backdrop as well as their individual situations, it makes sense to overweight China, Korea, India and Malaysia in an emerging Asian domestic bonds portfolio. Whereas Indonesia, Thailand and the Philippines warrant an underweight allocation. Yet, in an overall EM domestic bond portfolio, we recommend a neutral allocation for Thailand and the Philippines. The reason is they have a much better inflation outlook compared to economies in EMEA and Latin America. Chart 21Book Profit On Our Recommended Short Korean Won Trade Notably, among the Asian currencies, we have a positive bias on the Chinese yuan and the Indian rupee. On the contrary, we have been shorting the Korean won, the Thai baht, the Philippine peso and the Indonesian rupiah vis-à-vis the US dollar. That said, this week we recommend taking profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021 (Chart 21). Our view on the won has played out well. While the exchange rate might continue depreciating in the near run, the risk/reward of staying short is not very attractive now. Finally, we recommend continuing to receive 10-year swap rates in China and Malaysia. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     For a detailed discussion on each country’s inflation dynamics, please click on our reports on China, India, Indonesia, Malaysia, Thailand, Philippines.