Developed Countries

Highlights Fed Policy: The Fed’s move to a more dovish posture is positive for global risk assets in the near-term. This is setting up for a revival of volatility later in 2019, however, with U.S. growth unlikely to slow enough to justify a continuation of the Fed’s dovish stance. With the market now discounting no change in Fed policy rates over the next year, the risks for U.S. Treasury yields are now tilted to the upside. ECB Policy: Growth has slowed in Europe, but the ECB is limited in its ability to ease policy further given tight labor markets and rising wage growth. Policy rates will stay on hold over at least the next year. U.S. & European Duration: Keep global duration exposure below benchmark, with a more defensive stance on U.S. Treasuries over German Bunds given that the Treasury-Bund spread has overshot to the downside. Feature “In fact, our policy works through changing financial conditions, so it’s sort of the essence of what we do” – Federal Reserve Chairman Jerome Powell Have central bankers now turned TOO dovish? That is a question that will be answered in the coming weeks and months after the Federal Reserve and European Central Bank (ECB) signaled a more cautious outlook on growth and inflation. Both central banks cited common causes for the increased caution, such as financial market instability related to geopolitical uncertainty (U.S.-China trade tensions, Brexit, the U.S. government shutdown). Importantly, neither the Fed nor ECB expressed conviction that monetary policy settings were now too restrictive. The sharp selloff in global stock and credit markets at the end of 2018 did tighten financial conditions which, in and of itself, should result in slower growth on either side of the Atlantic in the first half of 2019 (Chart of the Week). Yet we do not expect a move to a below-trend pace of growth that would trigger rising unemployment and weaker inflation pressures. Chart of the WeekFed Too Dovish, ECB Not Dovish Enough The shift to a more dovish posture by the Fed and ECB has already induced some easing of financial conditions to help support growth in the U.S. and Europe until the uncertainties over geopolitics and the Chinese economy are resolved. This appears to be providing more stimulus to economies that may not necessarily need it. That is a risk that policymakers have decided to take to protect against the downside tail risks to economic growth and confidence from global uncertainty. In terms of fixed income markets, more dovish policymakers have created a pro-risk backdrop that will support the outperformance of corporate bonds versus government debt over the next 3-6 months. Without a deeper slowdown of global growth beyond what is currently expected, however, this will only be a temporary respite as central banks revert back to fighting inflation pressures instead of calming financial markets. The result will be a return to monetary tightening and higher bond yields, although that is a far more likely scenario in the U.S. than in Europe over the next 6-12 months given the relative signals from our Central Bank Monitors (bottom panel). Fed Outlook – A Temporary Dovish Turn, Nothing More The quote at the beginning of this report was taken from Fed Chair Powell’s press conference after last week’s FOMC meeting, in response to a question on how the Fed thinks about financial conditions. We can think of no cleaner way to explain the Fed’s understanding of how its monetary policy actions get transmitted to the real economy. By inducing changes in financial asset values (equity prices, corporate bond yields, the value of the U.S. dollar) through adjustments in the fed funds rate – and perceptions about its forward path – the Fed is able to impact the cost of financing across much of the U.S. economy. The goal is either to slow or stimulate growth, as needed, to allow the Fed to reach its dual mandate of maximizing employment while keeping inflation stable. Viewed from this perspective, the Fed’s “dovish” turn last week was a necessary step to not only stabilize financial markets, but to induce a pro-growth rally in risk assets that had sold off too aggressively. On that front, the Fed can say “Mission Accomplished”. Year-to-date, the S&P 500 is up 8% while U.S. investment grade and high-yield corporate bond spreads have fallen by 26bps and 110bps, respectively. The U.S. dollar is also down 1.6% since the start of the year, providing further stimulus to the U.S. economy. U.S. Treasury yields, which had fallen thanks to lower real and inflation components, have also helped ease financial conditions. Real yields have declined as the market has moved to price out all Fed rate hikes for 2019 in response to some signs of cooling U.S. growth (i.e. housing) and the big fall in asset prices. At the same time, inflation expectations have drifted lower as markets now expect the plunge in oil prices seen in 2018 to filter though more broadly into lower realized inflation (Chart 2). Chart 2Too Much Pessimism In UST Yields The ability for yields to decline further is now limited, however, with U.S. economic growth likely to continue at an above-trend pace in the next few quarters, based on the readings from reliable indicators. The ISM Manufacturing index rebounded to 56.6 in January, still well above the 50 level indicating an expanding U.S. economy, even after the decline that began last September. Within the sub-components of the index, the New Orders series also rose last month by 6.9 points, suggesting that the bounce in the overall ISM series could persist. The 10yr UST yield broadly tracks the ISM Manufacturing index (Chart 3), with the post-crisis relationship indicating that the bond yield will have difficulty falling below 2.5% if the ISM remains above 55. Chart 3U.S. Treasuries Vulnerable To Better U.S. Data U.S. economic data continues to broadly meet expectations, and the momentum in U.S. Treasury yields has overshot to the downside versus data surprises (bottom panel). Admittedly, there have been far fewer data releases of late because of the U.S. government shutdown last month. Yet even if the bulk of the unreleased data was weak, Treasury yields at current levels already seem to be discounting very soft growth. Forward-looking indicators of growth - the Conference Board leading economic indicator and BCA’s U.S. employment and capital spending models – are all pointing to the U.S. economy continuing to expand at a solid, above-trend pace in the coming months (Chart 4). Chart 4No Signs Pointing To Slower U.S. Growth The U.S. labor market remains tight, as evidenced by continued low unemployment and solid growth in wage measures like Average Hourly Earnings and the Wages and Salaries component of the Employment Cost Index (Chart 5). At the same time, readings from leading inflation indicators like the New York Fed’s Underlying Inflation Gauge remain elevated (bottom panel). The combined message is that U.S. core inflation rates will remain surprisingly sticky in the coming months, even given the lagged impact of last year’s drop in oil prices. Chart 5Persistent U.S. Inflation Pressures Many have made the case that the current cycle looks a lot like the Fed’s 2016 pause on policy tightening, which ended up lasting one full year after the December 2015 initial post-QE rate hike. Back then, the Fed’s more dovish posture helped generate easier financial conditions through a weaker U.S. dollar, tighter U.S. corporate credit spreads and higher U.S. equity values. U.S. Treasury yields fell sharply as the market aggressively covered a large bearish tilt towards U.S. interest rates while removing all rate hikes that were discounted for 2016 (Chart 6). There is one major difference between then and now, however – the U.S. economy is growing at a much faster pace, with far less spare capacity (bottom panel). Chart 6This Is NOT A Repeat Of 2016 When looking at all the U.S. data objectively, we conclude that the Fed’s latest dovish turn will not last anywhere near as long as the 2016 episode. The current easing of U.S. (and global) financial conditions alongside still-solid U.S. growth will eventually set up a return to the Fed rate hiking cycle, at a time when no interest rate increases are discounted in U.S. money markets. This supports our current recommendation to be tactically overweight U.S. corporate debt versus U.S. Treasuries on a 3-6 month horizon, during this window when the Fed is deliberately easing financial conditions by being overly dovish. On a more medium term 6-12 month horizon, however, we are maintaining a below-benchmark stance on U.S. duration exposure. The only way Treasury yields can move lower from here is if a Fed rate cutting cycle starts to be discounted – a highly unlikely scenario given the signals from leading growth and inflation indicators. Bottom Line: The Fed’s move to a more dovish posture is positive for global risk assets in the near-term. This is setting up for a revival of volatility later in 2019, however, with U.S. growth unlikely to slow enough to prevent inflation pressures from surfacing. With the market now discounting a stand-pat Fed over the next year, with minimal expected inflation, the risks for U.S. Treasury yields are now tilted to the upside. ECB Outlook – Firmly Neutral The euro area is currently facing a fairly significant growth slowdown. The manufacturing PMI has fallen for 13 consecutive months and now sits just above the 50 line indicating expanding growth. The OECD’s leading economic indicator (LEI) has also declined over that same period. Both indicators are now back to levels last seen prior to the 2009 and 2012 recessions (Chart 7). Chart 7Euro Area LEI and PMI Overstating The Downturn? Yet at the same time, surveys of business and consumer confidence from the European Commission suggest that the current downturn is nothing like those previous slumps. Even the Commission’s indicator of exporter order books (bottom panel) suggests that things do not appear as bad as indicated by the PMI and LEI. So where does the truth lie about the euro area economy? When looking at the hard data on exports (using the IMF’s Direction of Trade statistical database that includes both goods and services), it is obvious that there was a sharp slowing of euro area exports last year (Chart 8). Slumping Chinese demand was a major reason for that slowdown, but exports to the rest of the world also took a major hit. For the more export-intensive economies of Europe, last year’s global growth deceleration was a major punch to the gut. Chart 8European Export Shock Should Bottom Out Later In 2019 Looking ahead, there is still likely to be some pain coming from weaker export demand in the first half of 2019. The Chinese credit impulse (measured as a 12-month change in Total Social Financing as a % of GDP) is still negative, while our global LEI measure continues to drift lower. However, there are some tentative signs that things may be stabilizing. The shorter 6-month China credit impulse has hooked up (the “x’ in the top panel of Chart 8). Our diffusion index of countries within our global LEI – itself a leading indicator of the global LEI – has also begun to move higher, meaning there are fewer countries within the euro area with falling LEIs. While it is still too early to draw firm conclusions, there is a chance that euro area export growth will bottom out by mid-year. This is especially true if a U.S.-China trade detente is soon reached and Chinese policymakers deliver some additional growth stimulus measures, which is BCA’s base case scenario. ECB President Mario Draghi noted last week that a stabilization of global trade tensions would reduce much of the perceived uncertainty within the euro area economy. The U.S.-China trade spat has not been the only thing weighing on euro area growth, though. In our framework for analyzing the ECB’s policy decisions, we look at how broad-based are the trends in growth and inflation within the euro area to determine the next likely move on monetary policy. The way we do that is by looking at diffusion indices of economic data, constructed using figures from as many euro area countries as possible, given data availability. We show those diffusion indices for real GDP growth, manufacturing PMIs, headline inflation and core inflation in the euro area in Chart 9. Chart 9No Pressure On The ECB To Adjust Interest Rates The diffusion indices show that the vast majority of euro area countries are now suffering slowing real GDP growth and falling PMIs, with levels seen during recessions. Yet the actual pullbacks in real GDP growth and the PMIs have been shallower than those past episodes. It is as if today, all countries are suffering a slump, but no deep downturn. This is consistent with the ECB’s belief that Europe has suffered a bunch of one-off triggers for slowing growth – cutbacks in German auto production related to new emission standards, large-scale French street protests, the Italian fiscal policy debate with the EU, slowing exports from global trade tensions – but no broad-based decline that can be attributed to, or solved by, monetary policy. This is especially true with the diffusion index for core euro area inflation which now rising, suggesting that core inflation could remain surprisingly sticky in the coming months. The diffusion indices for euro area labor markets provide additional information as to why the ECB has not shifted to an even more dovish stance, despite the signs of weaker growth. Not only is the overall euro area unemployment rate now below the OECD’s estimate of the full employment NAIRU, the vast majority of countries within the euro area are at full employment (Chart 10). That diffusion index correlates strongly with a traditional Taylor Rule estimate of the equilibrium ECB policy rate, and suggests that the ECB should be raising rates right now. That can also be seen in the diffusion index for wage growth (bottom panel), which shows that the majority of euro area countries are seeing higher wage inflation. Chart 10Tightening Labor Markets In Europe Given the readings on the core inflation and labor market related diffusion indices, the current backdrop is not one where the ECB should be shifting to a more dovish posture. Yet when looking at market-based measures of inflation expectations like CPI swaps, investors clearly do not believe that the ECB’s optimistic inflation forecasts will be achieved over the next two years – typically a sign of policy settings that appear too tight (Chart 11). Chart 11Bund Yields Will Stay Subdued Without More Euro Area Inflation It will require some signs of euro area growth reacceleration, and maybe some upside surprises on core inflation and wage growth, before inflation expectations (and Bund yields) begin rising again. Those are unlikely to become visible until at least the latter half of 2019, and the ECB is likely to keep policy rates unchanged over the balance of the year. Given our relative views on the Fed and ECB, we see the scope for the yield spread between the benchmark 10-year U.S. Treasury and German Bund to widen from current levels. That spread is wide on a long-term basis because of the relative policy stance of the two central banks, with the current 255bps gap roughly equal to the gap between the fed funds rate and ECB refi rate. Yet the momentum of that spread is closely correlated to the difference in the data surprise indices for the U.S. and euro area, and a divergence has opened up between those two measures on the back of better U.S. growth (Chart 12). Chart 12UST-Bund Spread Has Overshot To Downside With the forward curves currently pricing in some additional tightening of the Treasury-Bund spread, betting on some renewed spread widening is a positive carry trade that also makes sense on a fundamental basis. Bottom Line: Growth has slowed in Europe, but the ECB is limited in its ability to ease policy further given tight labor markets and rising wage growth. Policy rates will stay on hold over at least the next year.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy 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 Chart 1Look For Rate Hikes In H2 2019 First things first: The Fed’s rate hike cycle is not over. Last week’s FOMC statement told us that the Fed will be “patient” and Chairman Powell cited slower global growth and tighter financial conditions as reasons to keep the funds rate steady. However, both of those reasons could soon evaporate. With the market now priced for 8 bps of rate cuts during the next 12 months and the dollar off its highs, there is scope for financial conditions to ease and global growth to improve in the first half of the year. According to our Fed Monitor, only tight financial conditions warrant a pause in rate hikes (Chart 1). The economic growth and inflation components of our Monitor (not shown) continue to recommend a tighter policy stance. The message is that if risk assets rally during the next six months causing financial conditions to ease, then all else equal, the Fed will have the green light to re-start rate hikes in the second half of the year. Investors should maintain below-benchmark duration in U.S. bond portfolios. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 183 basis points in January. The index option-adjusted spread tightened 25 bps on the month and currently sits at 127 bps. We upgraded our recommended allocation to corporate bonds three weeks ago because spreads had become too wide given the current phase of the credit cycle.1 Presently, we observe that the 12-month breakeven spread for Baa-rated corporate bonds has been tighter 43% of the time since 1989 (Chart 2). In the phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps, corporate breakeven spreads are typically in the lower third of their distributions.2 Chart 2Investment Grade Market Overview Baa-rated bonds currently offer better value than higher-rated credits. The 12-month breakeven spread for A-rated debt has been tighter 29% of the time since 1989 (panel 2). Aa and Aaa-rated credits clock in at 25% and 4%, respectively. With the Fed in a holding pattern, we are comfortable taking credit risk for the next six months and recommend that investors move down in quality to capture the extra return. The Fed’s Q4 Senior Loan Officer Survey, released yesterday, showed that a net 3% of banks reported tightening lending standards on C&I loans. Tighter lending standards correlate with higher defaults and wider spreads, so this tentative development bears close monitoring going forward.   High-Yield: Overweight High-yield outperformed the duration-equivalent Treasury index by 408 basis points in January. The index option-adjusted spread tightened 103 bps, and currently sits at 416 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 224 bps, slightly below the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast for the next 12 months, high-yield bonds will return 224 bps in excess of duration-matched Treasuries, assuming no change in spreads. Chart 3High-Yield Market Overview Moody’s revised its baseline 12-month default rate forecast higher last month, from 2.6% to 3.4%, and as was discussed in last week’s report, the revised forecast looks reasonable given our economic outlook.3 Specifically, our measure of nonfinancial corporate sector gross leverage – calculated as total debt over pre-tax profits – is roughly consistent with a 4% default rate. This leverage measure improved rapidly during the past year, but should start to stabilize during the next few quarters as profit growth decelerates. All in all, baseline default rate expectations have moved higher in recent months, but junk spreads still offer adequate compensation for that risk. In fact, if we assume excess compensation equal to the historical average, then junk spreads embed an expected default rate of 3% (panel 4), not far from the Moody’s base case. While junk spreads offer adequate compensation given our 12-month default outlook, the near-term outlook for excess returns is somewhat brighter as the Fed’s dovish turn should lead to spread compression during the next few months. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The conventional 30-year zero-volatility spread tightened 3 bps on the month, driven by a 3 bps decline in the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The drop in the 30-year mortgage rate to 4.46%, from 4.94% in November, led to a sharp spike in mortgage refinancings. However, refi activity remains very low relative to history (Chart 4). With the longer-run uptrend in mortgage rates still intact, the recent spike in refinancings is bound to reverse in the coming months. This will keep MBS spreads capped near historically low levels. Chart 4MBS Market Overview Outside of refi activity, MBS spreads are also influenced by changes in mortgage lending standards. The Federal Reserve’s Senior Loan Officer Survey showed no change in residential mortgage lending standards in Q4 2018 (bottom panel), while reported mortgage demand took a significant dip. Periods of tightening lending standards tend to coincide with MBS spread widening, but faced with weaker demand banks are much more likely to ease standards going forward. This is particularly true because very little progress has been made easing lending standards since the financial crisis. The median FICO score for new mortgages peaked at 781 in Q1 2011, but had only fallen to 758 as of Q3 2018. With relatively little risk of spread widening we are comfortable with a neutral allocation to Agency MBS, though tight spreads make the sector less appealing than corporate bonds from a return perspective. Later in the cycle, when the risk of corporate spread widening is more pronounced, MBS will likely warrant an upgrade. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 53 basis points in January. Sovereign debt led the way, outperforming the Treasury benchmark by 221 bps. Foreign Agencies outperformed by 65 bps, Local Authorities outperformed by 32 bps, and Supranationals outperformed by 3 bps. Domestic Agency bonds were the sole laggard, underperforming Treasuries by 3 bps on the month. The Fed’s pause and the accompanying weakness in the dollar spurred last month’s outperformance of USD-denominated Sovereign debt. But given the current attractiveness of U.S. corporate credit, we are not eager to chase the outperformance in Sovereigns. The option-adjusted spread advantage in Baa-rated U.S. corporate credit relative to the Sovereign index is as wide as it was in mid-2016 (Chart 5), a period when corporate bonds outperformed Sovereigns by a significant margin. Chart 5Government-Related Market Overview At the country level, our analysis of USD-denominated Emerging Market Sovereign spreads shows that only Argentina, Mexico, Saudi Arabia, Qatar, UAE and Poland offer excess spread compared to equivalently-rated U.S. corporates.4 We continue to view the Local Authority sector as very attractive. The sector offers similar value to Aa/A-rated corporate debt on a breakeven spread basis (bottom panel), and it is also dominated by taxable municipal securities that are insulated from weak foreign economic growth. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 7 basis points in January (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 2% in January, and currently sits at 84% (Chart 6). This is about one standard deviation below its post-crisis mean but above the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and +50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of -14 bps. In contrast, municipal bonds have delivered annualized excess returns of +47 bps (before adjusting for the tax advantage).5  Given strong historical returns during the current phase of the cycle and the fact that our Municipal Health Monitor remains in “improving health” territory (bottom panel), we advocate an overweight allocation to municipal bonds. Long maturity municipal debt continues to offer a substantial yield advantage relative to the short-end of the curve. For example, a muni investor needs an effective tax rate of 35% to equalize the after-tax yields between a 5-year Aa-rated municipal bond and the equivalent-duration U.S. credit index. For a 20-year muni the same breakeven tax rate is between 10% and 17%. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields declined in January, with the 5-year and 7-year maturities falling more than the short and long ends of the curve. The 2/10 slope flattened 3 bps on the month, from 21 bps to 18 bps. The 5/30 slope steepened 5 bps on the month, from 51 bps to 56 bps. In a recent report we looked at the correlations between different yield curve slopes and our 12-month Fed Funds Discounter.6 We found that the 5-year and 7-year maturities are most sensitive to changes in the discounter, while the short and long ends of the curve tend to be more stable. In other words, a decline in our 12-month discounter, like the one seen during the past two months (Chart 7), will tend to flatten the curve out to the 5-year/7-year maturity point and steepen the curve beyond that point. An increase in the discounter has the opposite effect. Chart 7Treasury Yield Curve Overview We expect the market to price some Fed rate hikes back into the curve as financial conditions ease during the next few months. Based on that view, we recommend adopting a yield curve strategy that benefits from a rise in our 12-month discounter. A position short the 7-year bullet and long a duration-matched 2/30 barbell provides the appropriate exposure and is attractively valued by our yield curve models (panel 4).7 TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 84 basis points in January. The 10-year TIPS breakeven inflation rate rose 14 bps on the month, and currently sits at 1.88%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps, and currently sits at 2.04%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. The 10-year TIPS breakeven inflation rate also remains below the fair value reading from our Adaptive Expectations Model (Chart 8).8 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value reading will trend steadily higher as long as core CPI inflation remains above 1.83%. The 1.83% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in our model.   Chart 8Inflation Compensation On that note, core CPI has increased at an annual rate of 2.48% during the past 3 months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 4), this is largely a reaction to the recent drop in energy prices. A drop that should reverse as global growth improves in the coming months. ABS: Neutral Asset-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 8 bps on the month, and currently sits at 40 bps, 6 bps above its pre-crisis low. The Excess Return Bond Map in Appendix C shows that consumer ABS offer greater expected return than Domestic Agencies and Supranationals, though with a commensurate increase in risk. The Map also shows that Agency CMBS offer very similar return potential with much less risk. The Fed's Senior Loan Officer Survey for Q4 2018 showed that banks tightened lending standards slightly for both credit cards and auto loans. This is consistent with a continued gradual uptrend in consumer credit delinquencies (Chart 9). Chart 9ABS Market Overview Rising household interest expense further confirms that the consumer credit delinquency rate is biased higher, albeit from a low starting point (panel 4). All in all, ABS still offer a reasonable risk/reward trade-off but could warrant a downgrade in the coming quarters as credit quality worsens. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 67 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 11 bps on the month and currently sits at 105 bps. The Fed’s Senior Loan Officer Survey showed that banks tightened lending standards on commercial real estate (CRE) loans in Q4 and witnessed falling demand (Chart 10). This is a typical negative environment for CMBS spreads. Decelerating CRE prices are also a cause for concern (panel 3). Investors should maintain an underweight allocation to non-Agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The index option-adjusted spread tightened 4 bps on the month and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector continues to make sense. Chart 10CMBS Market Overview Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 8 basis points of rate cuts during the next 12 months. Given that we expect the Fed to deliver rate hikes in the second half of this year, we recommend that investors maintain below-benchmark portfolio duration. Appendix B- Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury yield curve. The models are explained in detail in the following two Special Reports: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of January 31, 2019)   Table 5Butterfly Strategy Valuation: Standardized Residuals (As of January 31, 2019)   Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 2 For further details on how we divide the credit cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Oil Supply Shock Is A Risk For Junk”, dated October 9, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearh 6 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 7 The output from all of our yield curve models is shown in Appendix B of this report. 8 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation