Developed Countries

Executive Summary Energy and National Security Will Drive the Market Our 2022 key views are broadly on track. Biden’s shift from domestic to foreign policy is dominating the other views.   However, Democrats still have a 65% chance of passing a reconciliation bill that will raise taxes to pay for green energy and prescription drug caps. Then gridlock will set in. The US is developing a new national consensus. Generational change is promoting the shift to proactive fiscal policy to address the country’s social unrest and rising foreign policy challenges. Polarization is still at peak levels in the short term but will fall over the coming decade as the US pursues “nation building” at home while confronting geopolitical rivals. The return of Big Government is being priced into the bond market today. But it will be Limited Big Government, as the sharp spike in inflation today will provoke a backlash. Recommendation Inception Level Inception Date Return Long Aerospace And Defense Vs. Broad Market (Cyclical)   30-Mar-22   Long Oil And Gas Transportation And Storage Vs. Broad Market (Cyclical)   30-Mar-22   Long Refinitive Renewable Energy Vs. Broad Market (Tactical)   30-Mar-22   Bottom Line: Investors dedicated to the US market should stay tactically defensive. Cyclically favor the new US policy consensus on national defense, infrastructure, cyber security, and energy security. Feature The title of our annual outlook was “Gridlock Begins Before The Midterms.” We argued that Biden would still have some room for legislative maneuver in the first half of 2022 but that checks and balances would grow as the year went on. Checks will grow due to (1) the looming midterm elections; (2) Biden’s falling political capital and need to rely on executive action; (3) rising foreign policy challenges. Of these, foreign policy has proven decisive, with Russia invading Ukraine and the US and Europe imposing economic sanctions. The resulting energy shock is adding to inflation, weighing on consumer confidence, stock market multiples, and investor sentiment (Chart 1). Having said that, we also argued that congressional Democrats still had enough political capital to pass a watered-down fiscal 2022 budget reconciliation bill before the scene of action shifted to the White House. The second quarter is the last chance for this prediction to come true – and we are sticking with our 65% odds. The reconciliation bill will be even more watered down than we expected. But the point is that fiscal policy – especially tax hikes – can still move markets in the second quarter, even though inflation, the Fed, and the war will have a bigger influence. Chart 1US Seeks National Security And Energy Security Related Report  US Political Strategy2022 Key Views: Gridlock Begins Before The Midterms The war in Europe is clearly the most important political, geopolitical, and policy dynamic for investors this year. It is prompting some important congressional action that speaks to Biden’s room for maneuver in the first half of the year. In so doing it reinforces our long-term themes of “Peak Polarization” and “Limited Big Government.” As Americans face rising foreign policy challenges, a new bipartisanship is emerging, particularly on industrial and trade policy. Checking Up On Our Three Key Views For 2022 Here are our three key trends for 2022 with comments about their development over the past three months: 1.   From Single-Party Rule To Gridlock: We argued that the Biden administration would pass a watered-down reconciliation bill on a party-line vote by June at latest. Then Congress would grind to a halt for election campaigning, to be followed by Republicans taking one or both chambers of Congress, restoring gridlock and making it hard to pass major legislation from the second half of 2022 through 2024. This view is still generally on track. The basis for believing that a bill will still pass is that the Democrats are in trouble in the midterms and badly need a legislative victory. Public opinion polls suggest they face a beating reminiscent of President Trump and the Republicans in 2018 (Chart 2). Democrats trail Republicans in enthusiasm. Only about 45% of Democrats and 42% of Biden voters are enthusiastic to vote, while 50% of Republicans and 54% of Trump voters are enthusiastic. Men, who lean Republican, are more enthusiastic than women, by 51% to 38%, according to the pollster Morning Consult.1 With the economy and foreign policy rising as the most important issues of the election, Democrats have lost their key issues of health care and the pandemic. Notably Democrats have also lost ground on traditional strengths like education. However, the Ukraine war has put a new emphasis on energy security which Democrats are harnessing to repackage their climate agenda. Hence Democrats will make a last-ditch effort to pass a reconciliation bill before the summer campaigning gets under way. The “Build Back Better” plan was always going to be watered down but now it will be extensively revised. The bill will now have to be closer to neutral in its impact on the deficit so as not to feed inflation. Public opinion polls back in January, when the bill was primarily a social welfare bill, showed 61% of political independents in favor, not to mention 85% of Democrats. A majority of independents supported the bill even when asked about each provision separately and when the tax hikes were made plain.2 By halting progress on the left-wing version of the bill that the House of Representatives passed late last year, West Virginia Senator Joe Manchin saved his party from passing a highly stimulative fiscal bill in the middle of the biggest outbreak of inflation since the 1980s, when the output gap was virtually closed (Chart 3). Chart 2Democrats Not Faring Much Better Than Trump Republicans In 2018 Chart 3Output Gap Closed, No More Stimulus Needed Now Manchin will face a “Build Back Slimmer” bill that will be harder to oppose when Congress comes back from Easter.3 Our research over the past year suggests that Manchin is likely to vote for a bill that meets his main demands. The bill will be crafted for his approval. Manchin supports corporate tax hikes, funding for green energy transition (as long as it is not punitive toward certain sources or technologies), and a cap on prescription drug costs.4 Tax hikes, such as a minimum 15% corporate tax rate on book earnings, will be included, albeit diluted from the original proposals. Most investors have forgotten about the risk of tax hikes altogether so stock investors may not be happy that the US is hiking taxes amid inflation. Earnings estimates for the year are not reflecting any negative news, whether energy shock, or weak consumer confidence, or new taxes (Chart 4). If the bill fails to pass, equity investors may well cheer, since they are worried about inflation rather than deflation and the bill will not truly be deficit-neutral. Chart 4Inflation, War, Potentially Tax Hikes Will Weigh On Earnings Estimates Given Democrats’ thin majorities in both houses (222 versus 210 seats in the House and 50 versus 50 seats in the Senate), a single defection in the Senate can derail the bill, so we cannot have high conviction that it will pass. We are sticking with our 65% subjective odds. Passage of a reconciliation bill will slightly help Democrats’ fortunes ahead of the midterm but Republicans are still highly likely to win at least the House of Representatives. So the transition to gridlock will still occur. Only very rarely do ruling parties gain seats in the midterms. Biden’s loss of support among women voters is a tell-tale sign that trouble looms, as was the case for the Obama administration at this stage in its first term (Chart 5). The implication for financial markets is that the budget reconciliation bill will bring a negative surprise in the form of tax hikes that will weigh on bullish or pro-cyclical sentiment in the second quarter, at least marginally. Chart 5Women Like Biden Less Than Obama, Who Suffered Midterm Losses Chart 6Biden's Energy Shock 2.   From Legislative To Executive Power: Similarly we anticipated a transition from legislative action to executive action over the course of 2022. After the budget reconciliation bill is decided, the president will have to rely on executive action to achieve any policy goals. We expected this trend to derive from Biden’s regulatory aims as well as from the need to respond to rising geopolitical challenges, especially the energy shock (Chart 6). This shock is the single biggest reason for the market consensus that Democrats will lose Congress this year. The chief equity sector winner was the energy industry, as we expected. Now Biden needs to encourage rather than discourage supply. Until Biden decides whether to lift sanctions on Iran, volatility will prevail in energy markets. But Biden will condone domestic energy production, with a view to alleviating shortages prior to 2024. He will abandon his left wing and adopt the Obama administration’s permissiveness toward domestic energy, which will help oil and natural gas rig counts to rise (Chart 7). Renewable energy policy will gain traction as it will now clearly be seen in the context of national security and energy security. It also combines trade policy with national security in the form of exports to allies. The US now has a free pass to help Europe diversify away from Russian energy. Not that the US can replace Russia but merely that it can make a dent in both oil and liquefied natural gas (Chart 8). Subsidies for green energy are still likely but not a carbon tax or punitive measures toward the fossil fuel industry. Chart 7Biden Revives Obama Truce With O&G Chart 8US Helps Europe Diversify Away From Russia 3.   From Domestic To Foreign Policy: We fully expected Biden to be forced to pay attention to foreign affairs in 2022, despite his desire to focus on the voter ahead of midterms. We argued that he would maintain a defensive or reactive foreign policy since he would not want to create higher inflation ahead of the midterms and yet oil producers like Russia or Iran would go on offensive due to energy shortage. While Biden has imposed harsh sanctions on Russia, we still define his foreign policy as defensive rather than offensive. First, Biden is reacting to a Russian attack and will not sabotage a ceasefire. Second, Biden is carving out exceptions to US sanctions rather than disciplining or coercing allies into adopting US policy. The administration’s chief foreign policy aim is to refurbish US alliances. Hence the US condones the EU’s continued energy imports from Russia, thus ensuring that Russian energy makes it into the global market, unless the Russians cut natural gas exports (Chart 9). Nevertheless a risk to our view is that Biden will start to adopt a more offensive foreign policy, especially if Democrats are floundering ahead of the midterms. He could turn more aggressive about sanction enforcement if Russia starts bombarding Kyiv again. Or he could slap broad sanctions on China for helping Russia bypass sanctions. To be clear, we fully expect secondary sanctions on China, based on US record of doing so, but we expect them to be targeted rather than broad (Table 1). Chart 9Russian Energy Still Reaches Global Market Table 1US Will Slap China With Sanctions Over Russia – Sooner Or Later Foreign policy will define US politics and policy in 2022. What matters for markets is whether the energy supply shock gets worse as a result of Biden’s handling of Russia and Iran. A worse energy shock will amplify stock market volatility. On one hand, if Biden suffers a humiliating foreign policy defeat, it will reinforce the negative trends for Democrats in the 2022-24 cycle. Since Republicans, especially former President Trump, would be expected to pursue an offensive rather than defensive foreign and trade policy (e.g. toward Iran’s nuclear program and China’s economy), global economic policy uncertainty would rise and investor risk appetite would fall in this situation (Chart 10). On the other hand, investors will be surprised if Biden achieves a remarkable domestic or foreign policy success that boosts Democrats’ odds in 2022. An early ceasefire in Ukraine combined with a reconciliation bill would give Biden and Democrats a boost. Global policy uncertainty might rise anyway but it would not be super-charged and it would be flat-to-down relative to US policy uncertainty. Democrats could conceivably retain control of the Senate in the latter case. Our quantitative election model says Democrats have a 49% chance of retaining the Senate (Chart 11). This means the election is too close to call, though subjectively we would agree with the model and bet on the Republicans since they only need to gain one seat on a net basis. The model shows Georgia and Arizona flipping back to the Republican side. If the economy and opinion polling improve between now and November, the swing states will see higher probabilities of Democrats staying in power but the model is trending against Democrats and shows their odds of victory falling in every state. Chart 10US Political Outlook Affects Relative Policy Uncertainty Chart 11Senate Race Too Close To Call, But Quant Model Now Tips Republicans Anything that pares Democrats’ expected losses in Congress will cause US economic policy uncertainty to rise since it goes against the consensus view. Moreover if Republicans only win the House, they will be obstructionist and disruptive in 2023-24, whereas if they win all of Congress they will have to produce bills and try to compromise with Biden. Thus a Republican House but Democratic Senate would imply an increase in policy uncertainty. By contrast, anything that hurts the Democrats will reinforce current expectations and imply that tax hikes might fail, or that they will freeze after the reconciliation bill, which would be marginally positive for US equity investors in an inflationary context. Bottom Line: Democrats still have a 65% subjective chance of passing a reconciliation bill that raises taxes. Investors should favor defensives over cyclicals. Checking Up On Our Strategic Themes For The 2020s Our central long-term thesis is that generational change, social instability, and foreign policy threats are generating a new national consensus in the United States, particularly on economic policy. Hence US political polarization is peaking in the short run and will decline over the long run. The new consensus rests on proactive fiscal policy and a larger government role in the economy to reduce social unrest and improve national security. Table 2 shows our three strategic US political themes. The past year’s inflation surge and the Ukraine war will affect these themes, so we make the following points: Table 2US Political Strategy Structural Themes 1.   Millennials/Gen Z Rising: Labor market participation is recovering rapidly from the pandemic. However, workers older than 55 years are not rejoining rapidly, implying that retirees are staying retired and not yet chasing rising wages. Prime age women, however, are rejoining the work force, in a sign that as kids get back to school mothers can return to work (Chart 12). The implication is that the labor shortage will continue for the foreseeable future due to the generational transition but not due to any shift toward traditional values or lifestyles among young women. 2.   Peak Polarization: Polarization has fallen after the 2020 election, as expected, but will likely stay at or near peak levels over the 2022-24 election cycle (Chart 13). Chart 12Generational Shift Evident In Labor Participation Chart 13Polarization Near Peak Levels But Will Fall Over Long Run For example, Biden’s reconciliation bill will feed polarization in 2022, since it can only pass on a party-line vote. But its tax and spending programs will have majority support, will redirect funds from corporations that pay low effective tax rates toward corporations that provide renewable energy solutions. Domestic manufacturing will benefit. Another example: Another Biden-Trump showdown in 2024 will fuel polarization but 2024 or 2028 and subsequent elections will see fresh faces with updated policy platforms. The merging of trade protectionism and renewable energy exemplifies the new policy evolution. Again, with polarization at historic levels, domestic terrorism of whatever stripe is a pronounced risk in 2022 and the coming years. But any significant political violence will ultimately drive a new national consensus in favor of federalism. 3.   Limited Big Government: The story of the 2000s and 2010s was the revival of Big Government, first in the George W. Bush national security state, then in the Barack Obama liberal spending tradition, then in the big spending Republican tradition with Trump, and finally in the liberal tradition again with Biden. The combination of popular discontent at home and great power struggle abroad means that the US is unlikely to slash either social programs or defense spending. As for tax hikes, aggressive tax hikes are impractical. Biden may pass some tax hikes but the budget deficit will continue to expand over the long run (Chart 14). At the same time, the shift to Big Government is occurring with an American context. The geography, constitution, and political system militate against centralization. The return of inflation means that fiscal conservatism will also make a comeback, starting with Republicans in the House in 2023, who will oppose new spending as a standard opposition tactic. So while Big Government has returned, and bond investors are pricing this sea change by pushing up Treasury yields, nevertheless the market will also need to price the fact that the growth of government still faces structural limits. Chart 14Reconciliation Bill Will Have Miniscule Impact On Budget Outlook These structural themes face crosswinds in 2022. The Millennials and younger generations will not carry the day in the midterm election – the Baby Boomers and Greatest Generation will. Peak polarization will bring negative surprises for investors over the 2022-24 election cycle and potentially even in 2024-28 if Trump is reelected. A Democratic reconciliation bill will expand government programs in 2022, while Republicans will revert to big spending ways if they gain full control of government again in 2025. Nevertheless the evidence suggests that generational change, peak polarization, and limited big government will prevail over time. The younger generations favor more proactive fiscal policy. Fiscal policy will address social unrest and geopolitical threats. But big government will drive inflation, which will in turn force voters to impose limits on government over the long run. Bottom Line: The US will opt to inflate away its debt over the long run – but it will also need growth and some structural reform once the ills of inflation become fully absorbed by voters. The huge bout of inflation in 2022 is only the beginning of this political process, though it will also accelerate the process. Investment Takeaways Stocks tend to be flattish ahead of midterm elections. This includes elections when a united government becomes gridlocked as is likely in 2022-23. Equities tend to perform better after election uncertainty passes. The transition from single-party government to gridlock also tends to imply higher yields until after the election is over, at which point yields decline (Chart 15). Single-party governments can manipulate fiscal policy to try to stay in power. Chart 15Stocks Tend To Be Flat, Bond Yields High, Until After Midterm Elections Defensives are outperforming cyclicals on slowing growth, rising interest rates, rising labor costs and energy prices, and rising uncertainty. Our worst call for Q1 was our tactical long growth over value stocks. We made this trade knowing it went against our strategic approach, which has favored value over growth since we launched the US Political Strategy in January 2021. Our reasoning was that a geopolitical crisis would cause a temporary spike in energy prices but a longer drop in bond yields. In fact bond yields rose anyway. We still think tech is increasingly attractive, especially after the corporate minimum tax passes. The brief inversion of the 2-year/10-year yield curve suggests the US economy is flirting with recession. Other parts of the curve are not yet confirming this signal and there can be a long lead time between inversion and recession. However, there is not yet a ceasefire in Ukraine and certainly not a durable ceasefire. The US and Iran do not yet have a deal to avoid a major increase in geopolitical tensions. The risk of a bigger energy shock from Russia or Iran or both is significant and could shorten the cycle. We recommend going strategically long S&P 500 oil and gas transportation and storage relative to the broad market. We also recommend taking advantage of the lull in fighting in Ukraine to join our Geopolitical Strategy in going strategically long US defense stocks relative to the broad market. Tactically we recommend going long renewable energy since the Democrats’ pending reconciliation bill will benefit from broader public recognition of the need for the energy security of both the US and its allies (Chart 16). Chart 16Go Long Defense, Energy Storage, And Renewables Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See “National Tracking Poll,” Morning Consult and Politico, #2202029, February 5-6, 2022, assets.morningconsult.com. 2     Admittedly this poll is by a left-leaning organization but polling throughout 2021 supports the general conclusion that a majority of political independents support the key proposals. See Anika Dandekar and Ethan Winter, “Majority of Voters Still Want the Build Back Better Act Passed,” Data for Progress, January 4, 2022, dataforprogress.org. 3    See Nick Sobczyk and Nico Portuondo, “Democrats eye ‘Build Back Slimmer’ on reconciliation,” E&E News, March 24, 2022, eenews.net. 4    See Eugene Daniels, “The Left Gears Up to Take on Manchin Again,” Politico, March 29, 2022, politico.com. See also “Regan, McCarthy, Wyden talk revival of BBB,” The Fence Post, March 25, 2022, thefencepost.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary Refreshing Our Tactical Trade List Our current list of tactical trade recommendations centers around two broad themes that predate the Ukraine conflict – rising global inflation expectations and relatively stronger upward pressure on US interest rates. Both themes have been strengthened by the spillovers from the war in Eastern Europe, most notably the link between soaring commodity prices and rising inflation. We still see value in holding our recommended cross-country spread trades that will benefit from continued US bond underperformance (short US Treasuries versus government bonds in Germany, Canada and New Zealand, all at the 10-year maturity). We also maintain our bias to lean against the yield curve flattening trend in the US, but we now prefer to do it solely via our existing SOFR futures calendar spread position. Finding attractively valued inflation breakeven spread trades is more difficult after the latest oil-fueled run-up in developed market inflation expectations. Canadian breakevens, however, stand out as having the greatest upside potential according to our Comprehensive Breakeven Indicators. Bottom Line: Remain in US-Germany, US-Canada an US-New Zealand 10-year government bond yield spread widening trades. Maintain our recommended position in the US SOFR futures curve (long Dec/22 futures, short Dec/24 futures). Add a new inflation-linked bond trade, going long 10-year Canadian breakevens. Feature One month has passed since Russia invaded Ukraine, and investors are still struggling to sort out the financial market implications. Equity markets in the US and Europe have recovered the losses incurred immediately after the conflict began. Equity market volatility has also fallen back to pre-invasion levels according to the VIX index (and its European counterpart, the VStoxx index). That decline in equity volatility has also coincided with a narrowing of corporate credit spreads in both the US and Europe, with the former now fully back to pre-invasion levels. Yet while credit spread volatility has calmed down, government bond yield volatility remains elevated thanks to rising commodity prices putting upward pressure on expectations for inflation and monetary policy (Chart 1). Chart 1Global Bond Yields Are Above Pre-Invasion Levels​​​​​​ Table 1Refreshing Our Tactical Trade List We have already made some “wartime” adjustments to our global bond market cyclical recommendations, with those changes reflected in our model bond portfolio. This week, we review our shorter-term tactical trade recommendations. Our current list of tactical trades revolves around two broad themes that predate the Ukraine conflict – rising global inflation expectations and relatively stronger cyclical upward pressure on US interest rates. Both themes have been strengthened by the spillovers from the war in Eastern Europe, most notably the link between soaring commodity prices and rising inflation. We continue to see the value in holding on to most of our existing tactical trades, with only a couple of adjustments to be made to our US yield curve and global inflation-linked bond positions (Table 1). US Yield Curve Tactical Trades: Shift Focus To SOFR Steepeners We have recommended trades that lean against the aggressive flattening of the US Treasury curve discounted in forward rates since late 2021. Our view has been that markets were discounting too rapid a pace of Fed rate increases in 2022. With the Fed likely delivering fewer hikes than expected, Treasury curve steepening trades would benefit as the spot Treasury curve would flatten by less than implied by the forwards. Related Report  Global Fixed Income StrategyFive Reasons To Tactically Increase US Duration Exposure Now Needless to say, that view has not panned out as we anticipated. The spread between 10-year and 2-year US Treasury yields now sits at a mere +13bps, down from +104bps when we initiated our 2-year/10-year steepener trade last November. The forwards now discount an inversion of that curve starting in June of this year, which would be an extraordinary outcome by historical standards. Typically, the US Treasury curve inverts only after the Fed has delivered an extended monetary tightening cycle that delivers multiple rate hikes over at least a 1-2 year period (Chart 2). Today, the curve has nearly inverted with the Fed having only delivered only a single 25bp rate increase earlier this month. Chart 2The UST Curve Is Unusually Flat Right Now Of course, the Fed’s reaction function in the current cycle is different compared to the past. The Fed now follows an average inflation targeting framework that tolerates temporary inflation overshoots after periods when US inflation ran below the Fed’s 2% target. Now, however, the Fed has no choice but to respond to surging US inflation, which has been accelerating since September and is now at levels last seen in 1982. Chart 3Our SOFR Trade Is Similar To Our UST Curve Trade We still see the market pricing in too much Fed tightening this year and too few rate hikes in 2023/24. The US overnight index swap (OIS) curve now discounts 218bps of rate hikes in 2022, but 44bps of rate cuts between June 2023 and December 2024. We think a more likely scenario is the Fed doing less than discounted this year, as US inflation should show some deceleration in the latter half of 2022, but then continuing to raise rates in 2023 into 2024. We have expressed this view more specifically through an additional tactical trade that was initiated last month, going long the December 2022 3-month SOFR futures contract versus shorting the December 2024 3-month SOFR futures contract. This new trade is essentially a calendar spread trade between two futures contracts, but with a return profile that has looked quite similar to our 2-year/10-year US Treasury curve flattening trade (Chart 3). Having two tactical trades that are highly correlated, and which both are driven by the same theme of the Fed doing less this year and more over the next two years, is inefficient. We see the SOFR calendar spread trade as a more precise expression of our Fed policy view compared to the 2-year/10-year Treasury curve steepener. In addition, the SOFR trade now offers slightly better value after it has lagged the performance of the Treasury curve trade over the past couple of weeks. Thus, we are keeping this trade in our Tactical Overlay portfolio (see the table on page 15), while closing out our 2-year/10-year steepener at a loss of -92bps.1 Cross-Country Spread Trades: Keeping Betting On Relatively Higher US Yields In our Tactical Overlay portfolio, we currently have three recommended cross-country government bond spread trades that all have one thing in common – a sale of 10-year US Treasuries. The long side of the three trades are different (Germany, New Zealand and Canada), but the logic underlying all three trades is the same. The Fed will deliver more rate hikes than the central banks in the other countries. 10-year US Treasury-German Bund spread Chart 4UST-Bund Spread Is Too Low Expecting a wider US Treasury-German Bund spread remains our highest conviction view in G-10 government bond markets. This is a trade we have described as a more efficient way to position for rising US bond yields than a pure below-benchmark US duration stance. We have maintained that recommendation in both our model bond portfolio and our Tactical Overlay portfolio. For the latter, that trade was implemented using 10-year bond futures in both markets and is up 3.9% since initiation back in October 2021. The case for expecting even more Treasury-Bund spread widening remains strong, for several reasons: Underlying inflation remains higher in the US, particularly when looking at domestic sources of inflation like wages and service sector prices. Europe, which relies more heavily on Russia for its energy supplies than the US, is more at risk of a negative growth shock from the Ukraine conflict. Our fundamental model of the 10-year Treasury-Bund spread shows that the current level of the spread (+197bps) is about one full standard deviation below fair value, which itself is rising due to stronger US economic growth, faster US inflation and a more aggressive path for monetary tightening from the Fed relative to the ECB (Chart 4). The spread between our 24-month discounters in the US and Europe, which measure the amount of rate hikes priced into OIS curves for the two regions over the next two years, has proven to be good leading indicator of the 10-year Treasury-Bund spread. That discounter spread is currently at 99bps, levels last seen when the 10-year Treasury-Bund spread climbed to the 250-300bps range in 2017/18 (Chart 5). With the relative forward curves now discounting a slight narrowing of the US-German 10-year spread over the next year, betting on a wider spread does not suffer from negative carry. We are maintaining this trade in our Tactical Overlay portfolio with great conviction. 10-year US Treasury-Canada government bond spread We entered another cross-country spread trade involving a US Treasury short position earlier this month, in this case versus 10-year Canadian government bonds. This trade is a bet on relative monetary policy moves between the Fed and the Bank of Canada (BoC). Like the Fed, the BoC is facing a problem of high inflation and tight labor markets. Canadian core CPI inflation hit a 19-year high of 3.9% in January, while the Canadian unemployment rate is at a 3-year low of 5.5%. The US is facing even higher inflation and even lower unemployment, but one major difference between the two nations is the degree of household sector debt loads. Canada’s household debt/income ratio now stands at 180%, 55 percentage points higher than the equivalent US ratio, thanks to greater residential mortgage borrowing in Canada (Chart 6). Chart 5Stay Positioned For More UST-Bund Spread Widening The Canadian OIS curve is now discounting a peak policy rate of 3.1% in 2023, which is at the high end of the BoC’s estimated 1.75-2.75% range for the neutral policy rate. Chart 6The BoC Will Have Trouble Matching Fed Hawkishness​​​​​ Elevated household debt will limit the BoC’s ability to lift rates that high, as this would trigger a major retrenchment of housing demand and a significant cooling of house prices. While the US is also facing issues with robust housing demand and high house prices, this is less of a factor that would limit Fed tightening relative to the BoC because US household balance sheets are not as levered as their Canadian counterparts. We are keeping our short US/long Canada spread trade (implemented using bond futures) in our Tactical Overlay portfolio, with the BoC unlikely to keep pace with the expected Fed rate increases over the next year (Chart 7). Chart 7Stay Positioned For A Narrower Canada-US Spread 10-year US Treasury-New Zealand government bond spread The third cross-country trade in our Tactical Overlay is 10-year New Zealand-US spread widening trade. Chart 8A Big Gap In NZ-US Relative Interest Rate Expectations​​​​​​ Like the Germany and Canada spread trades, we expect the Fed to deliver more rate hikes than the Reserve Bank of New Zealand (RBNZ) which should push up US Treasury yields versus New Zealand equivalents. In the case of this trade, however, interest rate expectations in New Zealand are far more aggressive. Chart 9Stay Positioned For NZ-US Spread Tightening The RBNZ has already lifted its Official Cash Rate (OCR) by 75bps since starting the tightening cycle in mid-2021. The New Zealand OIS curve is now discounting an additional 253bps of rate hikes in this cycle, eventually reaching a peak OCR of 3.5% in June 2023. This would put the OCR into slightly restrictive territory based on the range of neutral rate estimates from the RBNZ’s various quantitative models (Chart 8). This contrasts to the pricing in the US OIS curve that places the peak in the fed funds rate at 2.8% next year before falling back to the low end of the FOMC’s 2.0-3.0% range of neutral estimates in 2024. Both the US and New Zealand are suffering from similarly high rates of inflation, with New Zealand headline inflation reaching 5.9% in the last available data from Q4/2021. However, while markets are already pricing in restrictive monetary settings in New Zealand, markets are yet to price in a similarly restrictive move in the fed funds rate. We continue to see scope for a narrowing of the New Zealand-US 10-year bond yield spread over at least the next six months. There has already been meaningful compression of the 2-year yield spread as US rate expectations have converged towards New Zealand levels (Chart 9) – we expect the 10-year spread to follow suit. Inflation Breakeven Trades: Swap Canada For Australia We currently have one inflation-linked bond (ILB) trade in our Tactical Overlay portfolio, betting on higher inflation breakevens in Australia. We initiated this trade last October, largely based on the signal from our suite of Comprehensive Breakeven Indicators (CBI) for the major developed economy ILB markets. The CBIs contain three components: the deviation from fair value from our 10-year breakeven spread models, the distance between realized headline inflation and the central bank target, and the gap between the 10-year breakeven and survey-based measures of longer-term inflation expectations. Those three measures are standardized and aggregated to form the CBI. Countries with lower CBIs have more upside potential for breakevens, and their ILBs should be favored over those from nations with higher CBIs. Chart 10Breaking Down Our Comprehensive Breakeven Inflation Indicators Chart 11Favor Canadian Inflation-Linked Bonds Vs. Australia Given the latest run-up in global inflation breakevens on the back of soaring oil prices, there are now no countries in our CBI universe that have a negative CBI (Chart 10). Canada has the lowest CBI, and thus the highest upside potential for breakeven spread widening. We are taking a modest profit of +40bps in our Australian breakeven trade, as we are approaching the self-imposed six-month holding period limit on our tactical trades and our Australian CBI is not indicating major upside for Australian breakevens.2 Based on the message from our indicators, we see a better case for entering a new tactical spread widening position in 10-year Canadian ILBs. A comparison of the CBIs between Canada and Australia shows that the Canadian 10-year inflation breakeven is well below our model-implied fair value, which incorporates both oil prices and currency levels (Chart 11). This contrasts to the Australian breakeven which is now well above fair value. A similar divergence appears when comparing breakeven spreads to survey-based measures of inflation expectations, with Canadian breakevens looking too “undervalued” compared to Australia. While realized headline inflation is above the respective central bank targets, especially in Canada, the valuation cushion makes the ILBs of the latter the better bargain of the two. The details of our new Canadian 10-year breakeven trade, where we go long the cash ILB and sell 10-year Canadian bond futures against it, are shown in our Tactical Overlay table on page 15.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The Treasury curve trade is actually a “butterfly” trade, where we have included an allocation to US 3-month Treasury bills (cash) to make the curve steepener duration-neutral. Thus, the trade is more specifically a position where we are long a 2-year US Treasury bullet and short a cash/10-year US Treasury barbell with a duration equal to that of the 2-year. 2     We have recently discovered an error in our how we have calculated the returns on the 10-year Australian futures leg of our Australian 10-year inflation breakeven widening trade. The final total return for our trade shown in the Tactical Overlay table on page 15 corrects for our error, and fortunately shows a significantly higher return than we have published in past reports. 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 Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades