Fixed Income

Special Report

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 17 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST and August 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Scheduling Note: There will be no US Bond Strategy report next week. The following week (August 31), clients will receive a report written by our Global Fixed Income Strategist Rob Robis. The regular US Bond Strategy publication schedule will resume on September 8 with the publication of September’s Portfolio Allocation Summary. Best regards, Ryan Swift, US Bond Strategist

Special Report

Please note: There will be no European Investment Strategy report Monday, August 23. Our next report will be on Monday, August 30. Feature The past year has seen an unprecedented explosion of nonfinancial corporate debt as companies took on extraordinary leverage to weather the pandemic (Chart 1). This is a risk we recently highlighted in BCA Research European Investment Strategy, arguing that while euro area debt loads are not bad enough to make us turn bearish on European credit immediately, they still represent a concern for the future.  Rising debt servicing costs are also a risk, with aggregate euro area nonfinancial corporate debt servicing costs, as a percentage of operating cash flows, now pulling ahead of global peers. This increase has been led by France, where debt servicing costs now eat up a whopping 73.2% of cash flows. At the same time, value has steadily disappeared from European credit markets, with investment grade (IG) and high-yield (HY) spreads nearing 2018 lows (Chart 2). Our 12-month breakeven spread metric, which measures the amount of spread widening required over a 12-month period for corporate bond returns to break even with a duration-matched position in government bond securities, confirms this message. Ranked against their own history, IG and HY breakeven spreads are now at only their 16th and 13th percentiles, respectively. Chart 1Euro Area Debt Loads Are Rising Chart 2Value Has Disappeared From European Credit Against this backdrop, it pays to adopt a more cautious approach towards European credit. To that end, we are introducing our new and improved bottom-up Corporate Health Monitors (CHMs) for investment grade and high-yield issuers in the euro area. The CHMs are composite indicators of balance sheet and income statement ratios that are designed to assess the financial well-being of the overall non-financial corporate sectors in major developed economies. Before we jump into the message from our new European CHMs, however, it is important to review the methodology used to construct these indicators. A Quick Note On Methodology We begin by constructing a representative sample of euro area issuers to assess broader nonfinancial corporate health in the euro area. To accomplish this, we use the list of issuers from the Bloomberg Barclays IG and HY Corporate Bond Indices. Financials (mostly banks) are excluded from the calculations as they have very different balance sheet profiles, requiring a different set of metrics to properly assess the health of that sector. As an improvement of the previous euro area CHMs, we now use a dynamic sample of issuers that is updated every year. This allows us to account for the changing compositions of these indices over time, as issuers move up and down in quality, and are added or dropped from the index. This also accounts for the survivorship bias that arises as companies that go out of business are dropped from the sample. Note that our sample is static prior to 2012. Before this date, we do not have the data on index constituents needed to construct a dynamic sample. As of Q1/2021, the sample for the euro area IG CHM consists of roughly 200 issuers, covering 50% of the index, while the sample for HY consists of 50 issuers or so, covering only 25% of the index. As we can only get bottom-up data for publicly-listed companies, we are unable to include private companies that issue corporate debt but do not necessarily tap into the public equity market.    We then pull key financial statement ratios for these issuers on a quarterly basis. Specifically, we use the following six ratios: Profit Margins: Operating profits as a percent of corporate sales Return On Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBIT divided by value of interest expense Leverage: Total debt as a percent of market value of equity Liquidity: Total current assets excluding total inventories divided by the value of total current liabilities It is important to note that we are using the same financial ratios as the CHMs that we have previously published for other developed markets. This could prove useful later when we search for relative performance relying exclusively on CHMs. To construct the CHM, we pick the medians of the individual ratios for every quarter, which we then de-trend, by subtracting out the 12-quarter moving average, and standardize. Finally, we take an equal-weighted average of all six ratios to calculate the CHM. Using median ratios precludes excessive influence from outliers, while de-trending them introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Lastly, we calculate a version of the CHM that includes only domestic issuers, which allows us to look at the health of European nonfinancial firms in isolation. This is important, as foreign issuers make up roughly 60% of both the IG and HY samples. US issuers account for most of the foreign issuers for both samples, meaning that part of the message from our overall indicator is on US corporate health. However, we include our overall indicator for the sake of completeness. Unveiling Our New European Corporate Health Monitors Chart 3 presents the all-issuer and domestic issuer versions of our new European IG corporate health monitor. A negative indicator signals improving nonfinancial corporate health and vice versa. Both indicators have shown steady improvement since Q2/2020, with the domestic indicator peaking out in Q1/2020. However, there has recently been a notable divergence between the two, with domestic issuers recovering at a significantly slower pace. The recovery in the IG CHMs has been broad-based, with all component ratios showing an improving trend (Chart 4). However, domestic firms have clearly lagged behind, with the overall indicator especially outperforming on the return on capital, leverage, and interest coverage metrics. It is important when looking at falling leverage, however, to consider the “denominator effect” of rising share prices on equity market value. Chart 3Euro Area Investment Grade Corporate Health Monitor Chart 4Euro Area IG CHM: Component Ratios The HY monitor offers a more balanced picture between the domestic and all-issuer CHMs, with both indicators signaling a modest improvement in corporate health (Chart 5). This picture is confirmed by the constituent ratios, which, in the case of HY, tend to track more closely between domestic and all-issuer (Chart 6). Again, decreasing leverage contributed positively to the situation, while rebounding profits provided a strong boost to interest coverage ratios.     Chart 5Euro Area High-Yield Corporate Health Monitor Chart 6Euro Area HY CHM: Component Ratios Overall, the underperformance of domestic issuers on corporate health can largely be explained by a delayed reopening in Europe and weaker overall European fiscal stimulus response relative to the US. However, we expect this picture to change in coming quarters as vaccination rates continue to climb, European stimulus expands, and pent-up demand is released.  For both HY and IG, metrics such as profit margins or leverage have not yet returned to pre-Covid levels. While it may appear difficult to reconcile this with the highly optimistic readings from the CHM, we note again that the ratios are de-trended before they are incorporated into the CHM. That makes the CHM a better indicator of how corporate health is turning on the margin rather than in absolute terms.    Chart 7Euro Area: CHMs Vs. Spreads Our new CHMs undoubtedly provide an important signal on corporate health, but we are interested in the implication for corporate credit spreads. Chart 7 shows that the domestic issuer CHMs have been reliable at catching periods of major spread widening/tightening. Generally speaking, the year-over-year change in the CHM is a coincident indicator and can be used to confirm if movements in spreads are in line with underlying corporate fundamentals. Clearly, the recent narrowing in spreads has not kept pace with the drastic improvement in the CHM over the past two quarters. This likely reflects how close spreads are to post-crisis lows, meaning that they have little room left to fall regardless of how much corporate health improves. This asymmetry of returns, where credit has little to benefit from improving nonfinancial corporate health while remaining exposed to a deterioration, is a longer-term concern for investors. While spreads in level terms have been on a slow and steady narrowing trend this year, they are, on a rate of change basis, moving towards a more neutral level. This message will be confirmed by the CHMs in coming quarters as the monitors revert to the mean from their most recent optimistic readings. While Chart 7 displays the coincident properties of the indicators, we can also tune into the forward-looking aspect by looking at how spreads have performed historically over different time horizons given the levels of the CHMs. Table 1 presents the performance of both IG and HY spreads over the subsequent 3-12 month period when their respective CHMs were positive or negative. Table 1CHM Direction And Subsequent Spread Performance Over 3-12 Months For both IG and HY, there are a few key conclusions. Firstly, when the domestic-only CHM is negative, spreads tend to widen in the subsequent 3-12 months. Conversely, they narrow, on average, when it is positive. This reflects the mean-reverting property of our indicators. After the indicator has been positive for a while, indicating deteriorating health, it is naturally going to trend back towards zero. Spreads tighten in the coming quarters as a reaction to this marginal improvement in corporate health. The same relationship holds in the opposite direction.    On the whole, however, the domestic-only CHM is more reliable than the overall CHM as an indicator of whether spreads are going to widen/narrow. This discrepancy is most pronounced for HY, where the all-issuer version largely provides a misleading signal, with spreads usually continuing to narrow after the CHM is negative and widening after it is positive. One possible explanation for this is that European spreads are sensitive to European events, and since the overall CHM has a large presence of US corporate issuers, it does not properly reflect how investors should be compensated with regard to nonfinancial corporate health. Beyond just looking at the change in spreads following a positive or a negative reading on the CHMs, we can also see how spreads change when the CHMs fall into different ranges. Table 2 presents spread performance for periods when the CHM was within specific ranges: below -1, between -1 and 0, between 0 and +1, and greater than +1. This analysis makes an even stronger point on the mean reverting property of the indicator. When the CHMs reach extremely stretched positive (negative) readings, spreads tend to narrow (widen) a lot. The impact is also most pronounced over a 12-month horizon, with HY spreads narrowing, on average, a whopping 452bps twelve months after the CHM hits a level greater than +1. Table 2CHM Level And Subsequent Spread Performance Over 3-12 Months Bottom Line: Our new bottom-up European CHMs have been signaling a broad-based and consistent improvement in corporate health since Q2/2020. The CHMs are coincident indicators that can be used to confirm if changes in spreads are in line with fundamentals. On a forward-looking basis, stretched positive (negative) levels of the CHM indicate potential for future spread tightening (widening). Investment Conclusions While our CHMs are currently flashing a positive message on nonfinancial corporate health, there are some reasons to be cautious on European credit. Firstly, debt loads are at historically high levels in the euro area, a message confirmed by the bottom-up data shown in Charts 4 and 6. Spreads, on an absolute and breakeven basis, are also near post-crisis lows, implying meagre prospects for further tightening and are, on the other hand, exposed to any deterioration in corporate health. Lastly, the mean-reverting property of our CHM indicates that the monitors are likely to move back towards “deteriorating” territory on the margin, a historically negative sign for spreads. However, it is hard to recommend staying out of European credit at a time when fiscal and monetary policy are overly accommodative, and growth looks poised to surprise to the upside. The European Central Bank has already marked itself as one of the most dovish developed market central banks and will likely do “whatever it takes” to prevent a blow-up in spreads and the associated tightening in financial conditions. And currently, spreads still offer a decent yield pickup over sovereigns, even if they do not have much room to tighten. Thus, balancing the positives and negatives suggests it still makes sense to hold neutral exposure to credit within a European fixed-income portfolio, but adding to this exposure is now unwarranted. In the euro area, BCA Research Global Fixed Income Strategy is currently neutral on investment grade and overweight on high-yield credit.  Within high-yield, we recommend staying up in quality, favoring Ba-rated credit and avoiding lower tiers which will be hit first if corporate health deteriorates and do not offer adequate compensation for credit risk. Likewise, our European Investment Strategy recommends a selective approach, favoring sectors with more defensive risk profiles. Bottom Line: Even though there is some cause for concern on the horizon, it is too early to pivot out of European credit with the macro backdrop still accommodative. Remain neutral on euro area investment grade and overweight high-yield while avoiding riskier sectors and credit tiers within the high-yield allocation.               Jeremie Peloso,                         Associate Editor                          JeremieP@bcaresearch.com  Shakti Sharma, Senior Analyst ShaktiS@bcaresearch.com

Highlights Since 2008, the 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. Based on the current technology earnings yield of 3.8 percent, and the 10-year T-bond yield at 1.3 percent, stock markets are on the edge of rationality. But at the limit, the elastic can briefly stretch by around 0.5 percent before it eventually snaps back. Hence, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. The labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level. The weakest performing demographic group could set the employment condition for the Fed’s lift-off, making it later than the market is pricing. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. Fractal analysis: NOK/GBP, Hong Kong versus the world, and Netherlands versus New Zealand. Feature Chart of the WeekSince 2008, The 10-Year T-Bond Yield Has Struggled to Exceed the Earnings Yield On Tech (Minus A Constant Of 2.5 Percent) Since 2008, a remarkable financial relationship has held true. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. T-bond yield ≤ technology forward earnings yield – 2.5% (Chart I-1). The upshot is that whenever, as now, the yields on tech and other high-flying growth stocks have become depressed – which is to say highly valued – the upper limit to the bond yield has been established not by the economy, but by the financial markets. On the occasions that the bond yield has attempted to breach its stock market-set upper limit, it has unleashed a self-correcting sequence of events. It has pulled up the tech sector earnings yield, which is to say pulled down the tech sector’s valuation and price. Then, to contain and reverse this sharp sell-off, the bond yield has quickly unwound its short-lived spike. Stock Markets Are On The Edge Of Rationality Earlier this year in The Rational Bubble Is Turning Irrational we highlighted that the T-bond yield was at its stock market-set upper limit. And in the subsequent six months, the markets have behaved exactly as predicted. First, tech stocks declined sharply through February-March. Then, bond yields declined sharply through May-July, allowing tech stocks to claw back their declines and then reach new highs. Indeed, since mid-February, the T-bond yield and tech stocks have moved as a near-perfect mirror image (Chart I-2). Chart I-2The T-Bond Yield And Tech Stocks Have Moved As A Near-Perfect Mirror Image In the long run, a depressed earnings yield relative to the bond yield – which is to say a high valuation – can normalise as earnings go up. But in the short term, the adjustment must come from either the equity price declining or the bond yield declining. Or some combination of the two. With the tech earnings yield now at 3.8 percent – and assuming the post-GFC 2.5 percent minimum gap still holds true – it would set the upper limit of the 10-year T-bond yield at 1.3 percent, close to where it is trading today. Still, at the limit, the elastic can briefly stretch before it eventually snaps back. Over the last thirteen years, the maximum stretch has been around 0.5 percent. This means that, based on the current earnings yield of the tech sector, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. For equity investors, a higher T-bond yield would support the value versus growth trade. But given that it would be a brief trip, the opportunity would not be cyclical (12-month) but merely tactical (3-month), as has been the case over the past ten years. Since 2012, cyclical opportunities to overweight value versus growth have been virtually non-existent, but there have been several good tactical opportunities (Chart I-3 and Chart I-4). Chart I-3Cyclical Opportunities To Overweight Value Versus Growth Have Been Virtually Non-Existent... Chart I-4...But There Have Been Several Good Tactical Opportunities We await a fractal signal that T-bonds are overbought to initiate this tactical trade. Stay tuned. The Truth About The Jobs Recovery At first glance, last week’s US employment report appeared strong. The unemployment rate continued its plunge from 14.8 percent in April 2020 to 5.4 percent in July 2021, constituting the fastest jobs recovery of all time. But the first glance doesn’t tell the true story.   Unlike in previous recessions, the number of workers put on furlough or ‘temporary layoff’ surged and then plunged as the pandemic let rip and then was brought under control. Hence, to get the true story of the jobs recovery, we must strip out the furloughed workers and focus on the unemployment rate based on those ‘not on temporary layoff’ (Chart I-5). Chart I-5To Get The True Story Of The Jobs Recovery, Focus On Those 'Not On Temporary Layoff' Based on this truer measure of labour market slack, the pace of the current recovery in jobs looks remarkably like the recoveries that followed previous downturns in 1974/75, the early 1980s, the early 1990s, dot com bust, and the GFC. The true story is that the US is little more than a third of the way on the journey to full employment (Chart I-6). Chart I-6The Pace Of The Current Jobs Recovery Looks Remarkably Like Previous Recoveries This is significant, because unlike in previous recoveries, the Federal Reserve is now explicitly targeting full employment before it lifts the policy interest rate. Furthermore, the employment recovery must be broad and inclusive of minority demographic groups, which adds further conditionality for the Fed. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for the Fed’s lift-off. On this note, the labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level (Chart I-7). This raises an interesting point. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for lift-off, if the Fed stays true to its promise of inclusivity. Which would push back lift-off to later than the market is pricing. Chart I-7The Labour Market Participation Rate For African Americans Dropped Sharply In July Shocks Do Not Have A Cycle According to the recovery in jobs then, we are still ‘early cycle.’ Some people argue that early cycle implies that a recession is a distant prospect, that stocks only underperform in a recession, and therefore that the bull market in stocks has further to run. The investment conclusion is right, but the reasoning is wrong, on two counts. First, nobody can predict the precise timing of recessions or shocks. Second, recessions or shocks do not have a ‘cycle.’ Shocks can come in quickfire succession such as the back-to-back GFC in 2008 and the euro debt crisis which started in 2010, or the back-to-back votes for Brexit and Trump in 2016 (Chart I-8). Chart I-8Shocks Do Not Have A Cycle Yet, while we cannot predict the precise timing of shocks, The Shock Theory Of Bond Yields tells us that we can predict their statistical distribution very accurately. The upshot is that in any 5-year period, the probability of (at least) one shock is an extremely high 81 percent, and in any 10-year period, it is a near-certain 96 percent.  Given the tight feedback from bond yields to stocks and then back to bond yields, we can say with high conviction that the next shock will drive down the T-bond yield to its ultimate low. This will happen directly from a deflationary shock, or indirectly from an initially inflationary shock that drives up bond yields through the upper limit set by stock valuations. The resulting sharp correction in stocks will then cause bond yields to reverse to the ultimate low. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. In turn, the ultimate low in the T-bond yield will mark the ultimate high in the stock market’s valuation, and the end of the structural bull market in stocks. Until then, long-term investors should own stocks. Fractal Analysis Update This week’s fractal analysis highlights three recent price moves that are at risk of reversal because of fragile fractal structures. First, the recent sell-off in NOK/GBP has become fragile on its 65-day fractal structure implying a likelihood of a countertrend move based on similar recent signals (Chart I-9). Chart I-9NOK/GBP Is Oversold Second, the sell-off following China’s aggressive crackdown on its technology and private education sectors has created fragility in Hong Kong’s relative performance on its composite 65-day/130-day fractal dimension. Assuming the worst of the policy crackdown is over, this would imply a countertrend reversal based on similar signals over the past decade. The recommended trade is long Hong Kong versus developed world (MSCI indexes), setting the profit target and symmetrical stop-loss at 4 percent (Chart I-10). Chart I-10Hong Kong Versus The World Is Oversold Finally, the massive outperformance of tech-heavy Netherlands versus healthcare and utility-heavy New Zealand has reached the limit of fragility on its 260-day fractal structure that signalled major turning points in 2011, 2015, 2016, and 2018 (Chart I-11). Hence the recommended trade is short Netherlands versus New Zealand, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-11Netherlands Versus New Zealand Is Overbought   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   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 US Treasuries: US Treasury yields are rising once again, in response to typical drivers – less dovish Fed commentary and upside growth surprises. The spread of the Delta variant in the US represents a potential near-term roadblock to additional yield increases, but the recent slowing of new cases in the UK and Europe is a positive sign that the US can see a similar result and avoid a major economic hit. Stay below-benchmark on US duration exposure. UK: The Bank of England is starting to prepare the markets for less accommodative monetary policy, with the UK economy holding up well as its Delta variant surge is losing momentum. UK Gilt yields are vulnerable to a hawkish repricing with only 48bps of rate hikes discounted by the end of 2024. Stay below-benchmark on UK duration exposure, and downgrade Gilts to underweight in global bond portfolios. A New Turning Point For Global Bond Yields? After seeing steady declines since the peak in late March that took the yield down to an intraday 2021 low of 1.13% last week, the 10-year US Treasury experienced a rebound back to 1.30% in a span of just three days. Yields in typically “high-beta” countries like Canada and Australia also saw significant increases. There were two main triggers for the pickup in US yields. Firstly, a speech from Fed Vice-Chair Richard Clarida was interpreted hawkishly, as he stated that he expects the conditions necessary for the Fed to begin lifting rates would be met by the end of 2022. Secondly, a better-than-expected July employment report confirmed the strength of the US labor market already evident in booming demand indicators like job openings. A third potential cause of the trough in yields can be found outside the US in the increasingly positive news on the spread of the Delta variant coming out of the UK. We would argue that the more relevant turning point for global bond yields in 2021 was not the late March peak in the US, but the mid-May peak in non-US developed market yields. The 10-year UK Gilt yield reached its 2021 apex on May 13, just as the spread of the Delta variant was starting to push UK COVID-19 case numbers sharply higher – despite the high vaccination rate in that country (Chart of the Week). This raised the fears that the “reopening boom” could stall, not only in the UK but other major economies, at a time when global growth momentum was already starting to cool off from the overheated pace in the first half of the year. Chart of the WeekThe "Delta Rally" In Bond Markets Is Fading The Delta variant wave continues to wash over the US, although primarily in regions with lower vaccination rates. There was little sign of any impact from the variant in the July US jobs data with just over one million new jobs added (including revisions to prior months) and the unemployment rate falling one-half of a percentage point to 5.4%, the lowest level since March 2020 (Chart 2). However, we will need to see more economic data from July and August to confirm that this latest wave is not having a material impact on the broad US economy beyond the regions with lower vaccination rates. New COVID-19 cases in the UK peaked in mid-July, and are rolling over in continental Europe, with relatively low hospitalization rates – a hopeful sign that the US Delta spread could also soon begin to lose momentum. We continue to believe that steady improvements in the US labor market will be the driver of higher US bond yields over at least the next 6-12 months, as falling unemployment will embolden the Fed to begin tapering asset purchases and, eventually, begin rate hikes towards the end of 2022. The technical backdrop for Treasuries has become less of a headwind to higher yields, with the 10-year yield falling back to its 200-day moving average and speculators closing a lot of short positioning in Treasury futures (Chart 3). If the US can follow the more positive news from across the Atlantic with regards to the spread of the Delta variant, this would remove another impediment to higher US bond yields. Chart 2Steady Progress Towards The Fed's Employment Goals Bottom Line: US Treasury yields are rising once again, in response to typical drivers – less dovish Fed commentary and upside growth surprises. Chart 3Technical Backdrop Less Of A Headwind To Higher US Yields The surge in Delta variant cases represents a potential near-term roadblock to additional yield increases, but the recent slowing of new cases in the UK and Europe may be a positive sign that the US will avoid a major economic hit. Stay below-benchmark on US duration exposure. A Gilt-Bearish Shift In Tone From The Bank Of England Chart 4Pressures Building On The BoE To Dial Back Stimulus BCA Research’s Global Fixed Income Strategy has had the UK on “downgrade watch” over the past few months. Improving growth momentum and recovering inflation have raised the risks of a more hawkish turn by the Bank of England (BoE), as evidenced by the elevated reading from our UK Central Bank Monitor (Chart 4). At the same time, the spread of the Delta variant injected a note of caution into an otherwise positive UK economic story. We now think it is time to move from “downgrade watch” to a full downgrade of our current neutral stance on UK Gilts. The BoE left its policy settings unchanged at last week’s policy meeting, but did provide strong indications that some removal of monetary accommodation would soon be necessary. The central bank noted that the UK economy was recovering from the pandemic shock at a faster-than-expected pace. In the August Monetary Policy Report (MPR) also released last week, the BoE maintained its 2021 real GDP growth forecast at 7.25% while slightly raising its 2022 growth estimate to 6%. UK GDP is now projected to fully recover to the pre-COVID level by the end of 2021. More importantly, the projections for the unemployment rate were lowered substantially. The central bank no longer expects much of an impact on unemployment when the UK government’s job-protecting furlough scheme expires in September. The BoE now expects unemployment to peak at 5.1% in Q3/2021 (Chart 5), a big change from the 6% projection in the May MPR, with the central bank noting that job vacancies are already back to pre-pandemic levels. The unemployment rate is projected to reach 4.25% in both 2022 and 2023. Chart 5Major Changes To The BoE's Forecasts The BoE baseline forecast now calls for UK headline CPI inflation to see a temporary surge to 4% in Q4/2021 – a significant change from the 2.5% peak in inflation projected in the May MPR - before returning back to close to 2% over the next two years. Yet the minutes of last week’s policy meeting noted that the medium-term risks surrounding inflation were “two-way”, a message that sounds a bit more concerning compared to the benign 2022/23 inflation projections. The BoE is now running the risk of underestimating how long the UK inflation uptrend can persist and force increases in interest rates – perhaps beginning as soon as mid-2022 – given the multiple factors that are pushing up inflation. A modest growth hit from the Delta variant The daily number of new cases has fallen by nearly one-half since the peak on July 20th, according to the Oxford University data (Chart 6). Hospitalizations are also rolling over at a peak that would be one-quarter the size of the January peak. If these trends continue, this latest wave of COVID will not have a lasting negative impact on the economy that would dampen inflation pressures. The modest dip in the UK manufacturing and services PMIs in June and July, when cases were rising, supports this conclusion. Accelerating wage growth UK job vacancies are now higher than the pre-pandemic peak, while the BoE’s Agents’ Survey of companies reports an increasing number of firms reporting recruitment difficulties across a broader range of industries (Chart 7). The job market frictions are similar to the dynamics currently at play in the US, where labor demand is booming but firms have struggled to fill openings because government pandemic support programs have dampened labor market participation. Chart 6The Biggest Threat To The Dovish BoE Stance Chart 7Good Help Is Hard To Find In The UK The BoE noted in the August MPR that its forecasts include the impact of labor market frictions that have temporarily raised the medium-term equilibrium rate of unemployment during the pandemic, resulting in a surge in wage growth. However, this effect is expected to fade as the economy normalizes and government support programs expire. For example, the BoE estimates that the UK government’s job retention “furlough” scheme, which pays a reduced wage to workers who cannot work because of COVID economic restrictions and which expires in September, has acted to dampen measured wage growth over the past year. At the same time, compositional effects, with pandemic job losses being skewed towards lower-paying roles, have had a far greater impact in lifting wage growth. The BoE estimates that the “underlying” pace of wage growth, excluding pandemic effects, is only 3.3% compared to the reported 7.2%, but is expected to rise towards 4.5% in Q3 as the labor market recovers. Yet if the employment frictions do not fade as rapidly as the BoE expects, perhaps due to persistent skills mismatches for existing job openings, then the inflationary pressures emanating from the UK jobs market may cause UK inflation to stay elevated for longer than the BoE is projecting. Continued recovery from the initial COVID shock Chart 8Recovering From The COVID Recession The BoE now expects UK real GDP to return to its pre-pandemic level in Q4 of this year (Chart 8). Much of the recovery in activity seen so far has been in services as pandemic restrictions have been lifted. Looking forward, consumer spending will be boosted by improving growth momentum in employment and incomes, further underpinned by a high levels of household savings accumulated during the pandemic. Business investment is also expected recover, given the robust reading from the BoE Agents’ Survey of investment intentions (bottom panel). The twin engines of consumption and investment will be enough to keep the UK economy growing at an above-trend pace in 2022, even with a modest expected drag from fiscal policy, which should help maintain some of the current cyclical inflationary pressures. Rising house prices UK house prices are experiencing another sharp uptick, with the Nationwide index up 10.3% year-over-year in Q2 (Chart 9). Demand for homes has been boosted by the UK government’s holiday on stamp duty, or housing transaction taxes, which began last year as a form of pandemic economic support. Housing transactions spiked in June as demand surged ahead of the expiry of the stamp duty holiday last month, and some payback is likely in the near-term. Yet UK housing demand has also been supported by the same factors boosting house prices in most developed economies - low interest rates, high household savings available for down payments and the increased need for space for those choosing to work from home. UK house price inflation thus could remain higher for longer than the BoE expects. Chart 9Is This House Price Surge 'Transitory' Or Policy Driven? Supply Chain Bottlenecks The BoE noted in the August MPR that overall UK import prices have risen faster than expected, especially with the British pound higher on a year-over-year basis. UK firms have faced rising input costs because of disruption to global supply chains from the pandemic. For example, the annual growth rate of import prices for manufactured components rose by 12.1% in May, a sharp contrast to the -5.4% deflation of consumer goods prices (Chart 10). The BoE projects UK overall import price inflation to turn negative in 2022 and 2023, a big part of its slowing inflation forecast. Some decrease is inevitable as price momentum in oil and other commodities cools from overheated levels seen in 2021. However, supply chain disruptions are a global phenomenon already persisting for longer than expected in other countries and could linger into 2022 if global growth stays above trend - potentially causing UK import price inflation to once again exceed the BoE’s expectations. Summing it all up, the pressure is clearly building on the BoE to dial back the massive monetary easing put in place last year in response to the pandemic. Not only is the economy now recovering far more rapidly than the BoE had been projecting, with inflation set to peak at a higher level, but there are other indications that monetary conditions may now be too loose like accelerating house prices. There are numerous upside risks to the BoE’s benign post-2021 inflation forecasts, especially with the central bank also projecting the UK to have a positive output gap in 2022 and 2023 (Chart 11). Chart 10BoE Betting On Waning Global Supply Bottlenecks Markets are not expecting much from the BoE in terms of interest rate increases. While the UK overnight index swap (OIS) curve is now discounting an initial 25bp rate hike in August 2022, only one other 25bp increase is expected by the end of 2024 (Table 1). Chart 11Domestic Price Pressures On The Rise The BoE has not been a very active central bank since the 2008 financial crisis, never raising the Bank Rate above 0.75% over that time, thus the markets now seem conditioned to think that the BoE will continue to do very little in the future. Table 1Markets Expect The BoE To Hike Before The Fed Chart 12Markets Expect Persistent Negative UK Real Rates That is evident when you look at longer-dated OIS rates compared to forward inflation rates from the UK CPI swap curve. The combined message from those markets is that the BoE is expected to maintain deeply negative real interest rates for at least the next decade, a major reason why the UK has persistently negative real bond yields (Chart 12). A lower equilibrium real interest rate (i.e. “r-star”) is consistent with the declining trend in the OECD’s estimate of UK potential real GDP growth over the past 20 years (Chart 13). Yet it is a stretch to think that the neutral UK real interest rate is now negative, especially given how rapidly UK growth and inflation have snapped back from the 2020 COVID recession. UK interest rate markets are highly vulnerable to any hawkish shift by the BoE – and outcome that the current growth and inflation dynamics suggest is increasingly likely over the next 6-12 months. The BoE has already started to process of dialing back monetary accommodation by slowing the pace of asset purchases in its quantitative easing (QE) program (Chart 14). While no decision on additional tapering was made last week, the BoE did dedicate three pages of the August MPR to a detailed discussion on how the future size of the BoE’s balance sheet would likely be reduced if the BoE were to begin raising interest rates. There has also been some political pressure on the UK to dial back QE, with the Chair of the Economic Affairs Committee in the UK House of Lords saying that the BoE was “addicted” to QE last month. BoE Governor Andrew Bailey has previously stated that he viewed QE as a regular part of a central banker’s toolkit, to be used opportunistically during periods of deep economic or financial market stress. That made sense in 2020 during the height of the pandemic, but is no longer the case now. Chart 13UK R-Star Is Still Positive We anticipate that the BoE will end the current QE program sometime in the next six months, with an initial 25bp rate hike occurring sometime in mid-2022. Chart 14UK QE: Expect More Tapering This would be a faster pace of tapering, with a quicker liftoff, than the Fed, although we expect the Fed to eventually raise rates by more than the BoE in the next interest rate cycle. Investment Conclusions Given our expectation that the BoE is starting to prepare the markets for an unwind of its pandemic policy settings, we come to the following fixed income and currency investment conclusions (Chart 15): Chart 15Summarizing Our UK Fixed Income Recommendations Chart 16A More Hawkish BoE Would Benefit The Pound Duration: Maintain a below-benchmark duration stance within dedicated UK bond portfolios, with too few rate hikes discounted Country Allocation: Downgrade UK Gilts to underweight in global bond portfolios Yield Curve: On a tactical (0-6 months) basis, the UK Gilt curve may re-steepen as UK and global growth stays resilient, but a more hawkish BoE will eventually result in a flatter Gilt curve Inflation-Linked: Inflation breakevens on UK index-linked Gilts are already quite elevated and are overvalued on our fair value models, while real yields are at deeply negative levels that are conditioned on a continually dovish BoE – a combination that suggests an underweight stance on UK linkers is appropriate. Corporate Credit: Stay neutral on a tactical basis, as solid UK growth will offset the impact of a shift to a less dovish BoE. Currency: Our currency strategists are positive on the British pound - which is undervalued on their models (Chart 16) - over the medium-term, with the BoE seemingly on a path to begin tightening monetary policy sooner than the ECB and perhaps even the Fed.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Fed: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Duration: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Labor Market: After July’s strong employment report, we calculate that average monthly nonfarm payroll growth of 431k is required to reach the Fed’s “maximum employment” liftoff criteria by the end of 2022. Feature Chart 1A Tapering Announcement Is Coming It’s finally time to talk about tapering. Several Fed governors and regional presidents made media appearances last week, each one presenting a timeline that sets up a tapering announcement before the end of this year. Federal Reserve Governor Christopher Waller: I think you could be ready to do an announcement by September. That depends on what the next two jobs reports do. If they come in as strong as the last one, then I think you have made the progress you need. If they don’t, then I think you are probably going to have to push things back a couple of months.1 St Louis Fed President James Bullard: I don’t think that we need to continue with these purchases now that we’ve got new risks on the horizon and possibly inflation risks on the horizon. […] What I think we should do here is start sooner and go faster and get finished by the end of the first quarter of next year. We don’t really need the purchases anymore.2 Dallas Fed President Robert Kaplan: As long as we continue to make progress in July (jobs) numbers and in August jobs numbers, I think we’d be better off to start adjusting these purchases soon. Doing so gradually, over a time frame of plus or minus about eight months, will help give ourselves as much flexibility as possible to be patient and be flexible on the fed funds rate.3 Fed Governor Lael Brainard presented the most detailed description of what it will take for the Fed to start paring its asset purchases.4 Since December, the Fed’s criteria for tapering has been “substantial further progress” toward its employment and price stability goals. In December, nonfarm payrolls were about 10 million below pre-pandemic levels (Chart 2A). In her speech, which was given prior to the release of July’s jobs report, Brainard noted that if employment grows at the same rate in Q3 as it did in Q2, then “about two-thirds of the outstanding job losses as of December 2020” would be made up by the end of 2021. That figure rose to 71% after July’s strong jobs number (Chart 2B). Chart 2AConditions For Tapering Chart 2BDefining "Substantial Further Progress" In other words, as long as employment growth stays solid – in the 500k/month range – then the Fed will be well over 50% of the way toward its maximum employment goal by the end of this year. This would certainly count as “substantial further progress”. Our expectation is that Q3 jobs growth will be strong enough for the Fed to make an official taper announcement in Q4, with the actual tapering starting in January 2022.5 There is an outside chance that the Fed will rush to start tapering earlier, but only if long-dated inflation expectations rise to well above the Fed’s target range (Chart 2A, bottom panel). As for market impact, we don’t expect the tapering announcement to move markets all that much. First, we mainly care about asset purchase tapering because it could signal that the Fed intends to move more quickly toward rate hikes (Chart 1). This is the concern that prompted the 2013 taper tantrum. This time around, however, the Fed has tied liftoff to explicit employment and inflation criteria. This forward guidance significantly weakens the signaling power of any tapering announcement. Second, surveys indicate that market participants already anticipate that tapering will start in early-2022 (Tables 1A & 1B). In other words, a Q4 taper announcement shouldn’t be that much of a shock to expectations. Table 1ASurvey Of Market Participants Expected Fed Timeline Table 1BSurvey Of Primary Dealers Expected Fed Timeline Interestingly, Fed Vice-Chair Richard Clarida did manage to shock markets with his speech last week, but only because he went further than just a discussion of tapering. Specifically, Clarida articulated his expected timeline for lifting interest rates: Chart 3Median FOMC Forecasts While, as Chair Powell indicated last week, we are clearly a ways away from considering raising interest rates and this is certainly not something on the radar screen right now, if the outlook for inflation and outlook for unemployment I summarized earlier turn out to be the actual outcomes for inflation and unemployment realized over the forecast horizon, then I believe that these three necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022.6 What are the economic forecasts that Clarida says would meet the conditions for liftoff by the end of 2022? It turns out that they are very close to the FOMC’s median projections (Chart 3). The Fed’s forecast calls for 3% core PCE inflation in 2021, falling to 2.1% in 2022 and 2023. The Fed also sees the unemployment rate falling to 4.5% by the end of this year, 3.8% by the end of 2022 and 3.5% by the end of 2023. Clarida said that he views this forecast as consistent with overall employment returning to its pre-pandemic levels by the end of 2022. We think Clarida’s expected timeline is reasonable. The Appendix at the end of this report presents different scenarios for when the Fed’s “maximum employment” liftoff condition might be met. We estimate that average monthly nonfarm payroll growth of 431k will get us to maximum employment by the end of 2022, in time for early-2023 liftoff. At least so far, monthly nonfarm payroll growth is tracking well above the 431k threshold. If we compare our (and Clarida’s) forecast to market prices, we conclude that market rate expectations are too low. The overnight index swap curve is priced for Fed liftoff in January 2023 but for not even three 25 basis point rate hikes in total by the end of 2023 (Chart 4). This seems too low if the Fed’s liftoff criteria are in fact met by the end of 2022, as is our expectation. Chart 4Rate Expectations Bottom Line: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Timing The Move Higher In Yields Our expectation for a return to maximum employment by the end of 2022 implies that bond yields will be significantly higher by then. Specifically, we expect that both the 5-year/5-year forward Treasury yield and the 10-year Treasury yield will be in a range between 2% and 2.25% by the time of the first rate hike (Chart 5). The 2% to 2.25% range is consistent with survey estimates of the long-run neutral fed funds rate. But a big question remains over the timing of the next move higher in yields. Are bond yields poised to jump higher immediately? Or will they remain low for the next few months and move up only in 2022? Our sense is that the catalyst for the next significant jump in bond yields will be surprisingly strong employment data. There is widespread consensus that inflation will be close to the Fed’s target (if not higher) by the end of 2022, but recent concerns about labor supply have increased the uncertainty around employment projections. Ultimately, we think that labor supply constraints will ease and that the unemployment rate will catch up to levels implied by different labor demand indicators (Chart 6). However, this may not happen during the next month or two. Chart 5A Target For Long-Dated Yields Chart 6Labor Demand Is Strong The spread of the Delta coronavirus variant has just started to ramp up in the United States (Chart 7). The UK’s experience with the variant shows that vaccination significantly limits the number of hospitalizations and suggests that economic lockdowns can be avoided. However, it took about one month for the UK’s new case count to peak once the variant started spreading. A similar roadmap could lead to hiring delays in the US during the next month or two, at least until the new case count starts to fall and concerns abate. From a market technical perspective, we also note that bond market positioning remains significantly net short and that bond market sentiment is less bullish than is often the case at major inflection points (Chart 8). This is not the ideal technical set-up for a large immediate jump in bond yields. Chart 7Delta Is A Near-Term Risk To Hiring Chart 8Positioning & Sentiment Bottom Line: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +431k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Table A2Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bloomberg.com/news/articles/2021-08-02/waller-says-strong-job-reports-may-warrant-september-taper-call?sref=Ij5V3tFi 2 https://www.stlouisfed.org/from-the-president/video-appearances/2021/bullard-washington-post-inflation-tapering 3 https://www.reuters.com/business/finance/exclusive-feds-kaplan-wants-bond-buying-taper-start-soon-be-gradual-2021-08-04/ 4 https://www.federalreserve.gov/newsevents/speech/brainard20210730a.htm 5 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021. 6 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns