Fixed Income

Feature Since the end of the first quarter, the decline in Treasury yields has been the most important trend in global financial markets. It has contributed to the return of the outperformance of growth stocks relative to value stocks, the underperformance of Eurozone equities relative to the S&P 500, and the tepid results of cyclicals relative to defensive equities. This decline in yields is a temporary phenomenon, because the global economy continues to re-open and inventory levels remain so low that further restocking is in the cards. The cyclical picture is not without blemish; COVID-19 variants remain a concern. However, if these risks were to materialize into another delayed re-opening, then further reflationary efforts by both monetary and fiscal authorities would buoy financial markets. The greatest near-term worry for the global economy and markets comes from China. The Chinese credit impulse is slowing markedly and fiscal support has yet to come to the rescue. This phenomenon is the main reason why this publication maintains a cautious tactical stance on Eurozone cyclical stocks, even if we believe these sectors have ample scope to outperform over the remainder of the business cycle. As a corollary, we believe that yields will likely remain within range this summer and Eurozone benchmarks will lag behind the US. This week, we review key charts, organized by theme, highlighting some of these key concepts. As an aside, none covers inflation. Even if the balance of evidence suggests that any sharp increase in Eurozone inflation will be temporary, the proof will only become more visible by early 2022. The Opening Is On Track… The pace of vaccination across the major Eurozone economies has picked up meaningfully since the spring. Consequently, the number of doses distributed per capita is rapidly approaching that of the US, even as it still lags behind that of the UK (Chart 1). As a result of this improvement, the stringency of lockdown measures is declining, which is allowing European mobility to recover (Chart 2). While this phenomenon is evident around the world, EM still lag in terms of vaccination rates. However, the Global Health Innovation Center at Duke University expects 10 billion vaccine doses to be produced by the year’s end, which will be enough to inoculate most (if not all) the vulnerable people in the world by early 2022. Consequently, the re-opening of the economy will remain a potent tailwind behind global growth for three or four more quarters. Chart 1Vaccination Progress... Chart 2...Leads To Greater Activity   … But Near-Term Headwinds Remain The re-opening of the global economy will allow growth to stay well above trend for the upcoming 12 months, at least. Global industrial activity could nonetheless decelerate this summer. Input costs have risen. The two most important ones, oil and interest rates, are already consistent with a peak in the US ISM manufacturing and the global PMI (Chart 3). In this context, the decelerating Chinese credit impulse is concerning (Chart 4) because it portends a hit to global trade and industrial activity. The effect of this slowdown should be most evident in the third and fourth quarters of 2021. However, it will be temporary because Beijing only wants credit to grow in line with GDP, rather than an outright deleveraging. Thus, the credit impulse will stabilize before the year’s end, which will allow the positive effect of the global re-opening to be fully experienced once again. Chart 3Rising Input Costs... Chart 4...And China's Credit Slowdown Matter   Domestic Tailwind In Europe Despite the extreme sensitivity of the European economy to the global business cycle, Europe should continue to produce positive surprises. The supports to the domestic economy are strong. The NGEU funds means that Europe will suffer one of the smallest fiscal drag among G-10 nations next year. Moreover, the re-opening will support household income and allow the positive effect of the increase in the money supply to buoy consumption (Chart 5). Finally, rising consumer confidence, and the ebbing propensity to save will reinforce the tailwinds behind consumption (Chart 6). Chart 5Europe's Domestic Activity Chart 6...Will Improve Further   Higher Bond Yields Are Coming… The environment continues to support higher yields. Our BCA Pipeline Inflation Indicator is surging, which historically translates into higher global borrowing costs (Chart 7). Most importantly, our Nominal Cyclical Spending Proxy remains very robust, which normally leads to rising yields (Chart 8). While US inflation expectations at the short end of the curve already fully reflect current inflationary pressures, the 5-year/5-year forward inflation breakeven rates will have additional upside. Moreover, the term premium and real rates remain depressed, and policy normalization will cause these variables to climb higher over time. Chart 7Higher Yields Will Come... Chart 8...Later This Year   … But Not This Summer It could take some time before the bearish backdrop for bonds results in higher bond yields. First, bonds have yet to purge fully their oversold status created by the 125 basis-point surge that took place between August 2020 and March 2021 (Chart 9). This vulnerability is even more salient in an environment in which the Chinese credit impulse is decelerating. As Chart 10 illustrates, a slowing total social financing number reliably leads to bond rallies. While the chart looks dire for bond bears, it must be placed in context, in which global fiscal policy remains accommodative considering the decline in the private sector savings rate and in which Advanced Economies’ capex will stay strong. Thus, instead of betting on a large swoon in yields in the coming quarters, we expect US yields to remain stuck between 1.20% and 1.70% for a few more months before they resume their upward path once the Chinese economy stabilizes. Chart 9But Bonds Are Still Oversold... Chart 10...And Fundamentals Cap Yields For Now   A Positive Cyclical Backdrop For The Euro The near-term forces suggest that the euro will remain range bound over the summer, between 1.16 and 1.23. EUR/USD is a pro-cyclical pair, and so the near-term lack of upside to global growth will act as a temporary ceiling on this currency. Nonetheless, the 18-month outlook continues to favor the common currency. Investors have shed Eurozone exposure for more than 10 years and are structurally underweight this region (Chart 11). Hence, EUR/USD should benefit from any positive reassessment of the growth path in the Euro Area compared to that of the US. Additionally, the euro benefits from a structural current account surplus compared to the USD, which translates into a positive basic balance of payments (Chart 12). In an environment in which US real interest rates are low in relation to foreign ones and in which the Fed wants to maintain accommodative monetary conditions to achieve maximum employment, the capital account balance is unlikely to come to the rescue of the dollar. In this context, EUR/USD still possesses significant cyclical upside and is likely to move back above 1.30 by the year’s end of 2022. Chart 11Investors Underweight Eurozone Assets... Chart 12...And The BoP Favors The Euro   The Bull Market In Global Stocks Is Not Over The cyclical outlook for equities remains supportive. To begin with, in most years, equities eke out positive returns, as long as a recession is not around the corner; we do not expect a recession anytime soon. Moreover, while the balance of valuation risk and monetary accommodation is not as supportive of stocks as it was last year, it is not pointing to an imminent deep pullback either (Chart 13). The equity risk premium echoes this message. Our ERP measure adjusts for the expected growth rate of earnings as well as the lack of stationarity of the ERP. According to this indicator, equities are not an urgent buy, but they are not at risk of a bear market either (Chart 14). This combination does not prevent corrections, but it suggests that pullbacks of 10% are to be bought. Chart 13Equities Are Not A Screaming Buy... Chart 14...Nor A Screaming Sell   Europe’s Structural Underperformance Is Intact… Eurozone stocks have been underperforming their US counterparts since the GFC. As Chart 15 highlights, this subpar performance reflects the decline in European EPS relative to US ones. There is very little case to be made for this underperformance to end on a structural basis. Europe remains saddled with an excessive capital stock and ageing assets. This combination is weighing on European profit margins and RoE (Chart 16). To put an end to this structural underperformance, either European firms will have to consolidate within each industry (allowing cuts to the excess capital stock, to increase concentration, and to boost profit margins) or the regulatory burden must rise in the US to curtail rates of returns in relation to European levels. Chart 15Europe's Underperformance... Chart 16...Reflects Profitability Problems   …But The Window For A Cyclical Outperformance Remains Open Despite a challenging structural backdrop, European equities have a window to outperform US stocks, similar to the outperformance of Japan from 1999 to 2006, which only marked a pause within a prolonged relative bear market. European stocks beat their US counterparts when global yields rise (Chart 17). This is because European benchmarks underweight growth stocks relative to US markets. The effect of higher yields on the relative performance of the Euro Area is not limited to the impact of higher discount rates. Yields rise when global economic activity is above trend. As Chart 18 highlights, robust readings of our Global Growth Indicator correlate with an outperformance of the EPS of value stocks compared to growth equities. Thus, when rates rise, Europe should enjoy both a period of re-rating relative to the US and stronger profits. Chart 17Yields Drive European Stocks... Chart 18...And So Does Global Growth   Positives For Euro Area Financials Like the broad European market, the financials’ fluctuations are linked to interest rates. Moreover, Euro Area banks also move in line with EUR/USD (Chart 19). As a result, our positive view on both yields and the euro for the next 18 months or so should translate into an outperformance of financials in Europe. Additionally, European banks are inexpensive, embedding not just depressed long-term growth expectations, but also a wide risk premium. Europe’s structural problems mean that investors are correct to expect poor earnings growth from the region’s banks. However, the risk premium is overdone. Eurozone banks are much safer than they were 10 years ago. Banks now sport significantly higher Tier 1 capital adequacy ratios and NPLs have shrunk considerably (Chart 20). Moreover, governmental supports and credit guarantees implemented during the pandemic should limit the upside to NPL in the coming quarters. Finally, the so-called doom-loop that used to bind government and bank solvency together is not as problematic as it once was, because the ECB is a willing buyer of government paper and the NGEU programs create the embryo of fiscal risk sharing that limit these dynamics. As a result, investors should overweight this sector for the next 18 months. Chart 19Financials Have A Window To Shine... Chart 20...And Are Less Risky   A Tactical Hedge Our worries about the impact on the global economy of the Chinese credit slowdown are likely to prompt some downside in European cyclical equities relative to defensive ones. Moreover, cyclicals are still significantly overbought relative to defensives, while our relative Combined Mechanical Valuation Indicator confirms the near-term threat (Chart 21). A high-octane vehicle to play this tactical underperformance of cyclicals relative to defensives is to buy Euro Area telecom stocks relative to consumer discretionary equities. Not only are the discretionary stocks massively overbought and expensive relative to telecoms (Chart 22), they also offer a lower RoE. This backdrop makes the short discretionary / long telecoms bet a great hedge for portfolios with a pro-cyclical bias over one- to two-year horizons.  Chart 21Cyclicals Are Tactically Vulnerable... Chart 22...But This Risk Can Be Hedged Away   Currency Performance Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance  

Highlights Our sense remains that the dollar is undergoing a countertrend bounce, rather than entering a new bull market. The litmus test for this view is if the DXY fails to break above the 93-94 level that marked the March highs. Stay short USD/JPY. The drop in global bond yields should give this trade a welcome fillip. Short GBP/JPY positions also make sense. We are long CHF/NZD as a play on a potential increase in currency volatility. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trigger point of -2% from today’s levels. Remain long silver both in absolute terms and relative to gold. Our limit buy on EUR/USD was triggered at 1.18. Place tight stops given the potential for the dollar rally to continue for the next few weeks. We also believe the change in the ECB’s framework portends another bullish tailwind for the euro beyond the near term. Feature In our webcast last week, we made the case that the recent FOMC meeting (perceived as hawkish by market participants) has not altered the longer-term downtrend in the US dollar. This week, we are revisiting some of the sentiment and technical indicators that could help gauge how high the dollar can rise in the interim. Our view remains that three fundamental forces will continue to dictate currency market trends into the year end and beyond. First, the Federal Reserve will lag other central banks in raising rates amidst a shift in economic momentum from the US towards the rest of the world. This will boost short-term interest rates outside the US and provide a floor for procyclical currencies. Second, US inflation will prove stickier compared to other countries such as the eurozone or Japan. This will depress real interest rates in the US relative to the rest of the world, and curb bond inflows. And finally, an equity market rotation towards non-US stocks will improve flows into cyclical currencies. The transition could prove volatile in the coming month or so. Equity markets remain overbought, bond yields are falling, PMIs have stopped rising, and cyclical stocks are lagging growth stocks. More widespread infection from the Delta variant of Covid-19 will continue to reprice risk to the downside. As a countercyclical currency, the dollar will be a critical variable to watch. Sentiment and technical indicators make up an important component of our currency framework and are usually good at gauging significant shifts in financial markets. Our sense remains that the dollar is undergoing a countertrend bounce, rather than entering a new bull market. The litmus test for this view is if the DXY fails to break above the 93-94 level that marked the March highs. Momentum Indicators Our momentum indicators suggest that while the dollar is very oversold, the bear market remains very much intact. The dollar advance/decline line is sitting below its 200-day moving average (Chart I-1). Historically, bull markets in the dollar have been characterized by our advance/decline line breaking both above its 200-day and 400-day moving averages. This suggests a rally towards these critical resistance levels is in play but will constitute more of a countertrend bounce. Speculators are only neutral the dollar while, admittedly, leveraged funds are very short (Chart I-2). Historically, whenever the percentage of leveraged funds that are short the dollar has dipped near 40%, a meaningful rally has ensued. There are two important offsets to this. First, as Chart I-1 suggests, the dollar is a momentum currency. As such, during the bull market of the last decade, speculators were either neutral or long the dollar. If indeed the paradigm has shifted to a decade-long bear market, we expect speculators to be either short or neutral. Meanwhile, leveraged funds are a small subset of overall open interest, suggesting they are not the elephant in the room when it comes to dictating dollar movements. Leveraged funds were short the dollar during most of the bull market run last decade. Chart I-1The US Dollar Downtrend Is Intact Chart I-2Leveraged Funds Are Short The Dollar Carry trades are relapsing anew, suggesting the environment may be becoming unfavorable for high-yielding developed and emerging market currencies. The dollar has been negatively correlated with the Deutsche Bank carry ETF, DBV, since investors ultimately dump carry trades and fly to the safety of Treasurys on any market turbulence (Chart I-3). High-beta carry currencies such as the RUB, ZAR, MXN, and BRL have been consolidating recent gains. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming precarious for carry trades. Our carry index tends to do well when the yield spread between US Treasuries and the indexes’ constituents’ is low. As such, there is some more adjustment underway, but one of limited amplitude (Chart I-4). Chart I-3The Carry Trade Rally Is Relapsing Chart I-4Carry Trades Have Hit An Air Pocket Chart I-5Currency Volatility Is Very Low Both expected and actual currency volatility are extremely depressed. Whenever currency volatility has been this low, the dollar has staged a meaningful rally. For example, the most significant episodes were the lows of 1996-1997, 2007-2008, and 2014-2015, and early 2020 (Chart I-5). Usually, low currency volatility is a sign of complacency, while higher volatility allows for a more balanced and healthy market rotation. The nature in which currency volatility adjusts higher this time around might be the same playbook as in previous episodes. The Asian crisis of the late 90s set the stage for the dollar bear market of the 2000s. The adjustment higher in the dollar during the Global Financial crisis jumpstarted the bull market the following decade. This time around, the Covid-19 crisis might have commenced a renewed dollar bear market. If this analogy is correct, then we should be selling the dollar on strength rather than buying on weakness. It is important to remember that the policy environment remains bearish for the dollar. These include deeply negative real rates, quantitative easing (which, admittedly, will soon end), generous liquidity swap lines to assuage any dollar funding pressures abroad (Chart I-6), and a global economy on the cusp of a renewed cycle. In our portfolio, we are long CHF/NZD since this cross has historically been a good hedge against rising currency volatility (Chart I-7). So is being short AUD/JPY. Being short the GBP/JPY cross might prove even more profitable, given that the UK has been a pandemic winner this year. Chart I-6The Fed Extended Its Swap Lines Chart I-7Buy CHF/NZD As Insurance Bottom Line: The message from our momentum indicators is that the bounce in the dollar was to be expected. We remain in the camp that believes the rally will be short-lived but are opportunistically playing what could be a more volatile environment. Equity Markets Signals A potential catalyst that could trigger further upside in the dollar is an equity market correction. Both the dollar and equities tend to be inversely correlated (Chart I-8). On this front, a few equity market indicators continue to flag that the rally in the dollar has a bit further to go.  Chart I-8The Dollar And Equities Move Opposite Ways Chart I-9Global Industrials Are Relapsing Anew The underperformance of cyclical stocks, especially global industrials, suggests equity markets could be entering a more volatile phase (Chart I-9). The dollar tends to strengthen when cyclical stocks are underperforming defensive ones. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. In more general terms, non-US markets are underperforming the US, a clear sign that the marginal dollar is rotating back towards the US (Chart I-10A and I-10B). Technology stocks have also been well bid in recent weeks, on the back of lower bond yields. These are all temporary headwinds for dollar weakness. Chart I-10ANon-US Stock Markets Are Underperforming Chart I-10BNon-US Stock Markets Are Underperforming Chart I-11US Relative Earnings Revisions Are High, But Rolling Over Earnings revisions continue to head higher across most markets, but US profit expectations are still higher compared to other countries (Chart I-11). Non-US bourses will need much higher earnings revisions to stimulate portfolio inflows, and for the dollar bear market to resume. On this front, both the euro area and emerging markets are showing only tentative improvement. The character of any selloff in equity markets will be worth monitoring. Cyclicals and value stocks are at historically bombed-out levels and could start to outperform high-flying stocks on any market reset.    Bottom Line: Whether a correction ensues, or the bull market continues, requires a change in equity market leadership from defensives to cyclicals. This is a necessary condition for the dollar bear market to resume. Commodities, Bonds, And The Dollar Commodity and bond prices give important cues about the health of the global economy. For example, rising copper prices and rising yields are a sign that industrial activity is humming, which in turn points to accelerating global growth. As a counter-cyclical currency, the dollar usually weakens in this scenario. Rising gold prices are generally a sign that policy settings remain ultra-accommodative, which also points to a weaker dollar. At the FX strategy service, we tend to focus more on the internal dynamics of commodity and bond markets, which can provide early warning signs. Chart I-12The Copper-To-Gold Ratio Is Consolidating Gains The copper-to-gold ratio is important since it indicates whether the liquidity-to-growth transmission mechanism is working. A rising ratio suggests policy settings are stimulating growth, while a falling ratio is a warning shot that the environment might be becoming deflationary. Correspondingly, this ratio has tended to track the dollar closely (Chart I-12). The copper-to-gold ratio is consolidating at very high levels. This is consistent with a healthy reset, rather than a reversal in the dollar bear market. The gold/silver ratio (GSR) tends to track the US dollar, and its recent price action also appears to be a welcome reset (Chart I-13). Like copper, silver benefits from rising industrial demand, especially in the electronics and renewable energy space. A falling GSR will be a sign that the manufacturing cycle is still humming. We are short the GSR with a target of 50, and a stop-loss at 71. The bond-to-gold ratio has bounced from very oversold levels. Both US Treasurys and gold are safe-haven assets and thus are competing assets. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early ‘70s (Chart I-14). Gold has always been considered the perfect anti-fiat asset vis-à-vis the dollar, making the bond-to-gold ratio both a good short-term and long-term sentiment indicator. For now, the bounce in the ratio is not yet worrisome. We have noticed that inflows into US government bonds have risen sharply, while those into gold are falling. This should soon reverse with the fall in US rates, and the correction in gold prices. Chart I-13The Gold-To-Silver Ratio Is Consolidating Losses Chart I-14Competing Assets And The Dollar Bottom Line: The US is ultimately generating the most inflation in the G10, which is dampening real rates, and should curtail investor enthusiasm for gold relative to US Treasurys. The underperformance of Treasurys relative to gold will be a bearish development for the dollar. A Final Word On The Euro The strategic review from the European Central Bank had three key changes. The ECB now has a symmetric 2% inflation target. This is not a game changer, since it brings it in line with other global central banks, including the Bank of Japan. House prices will meaningfully begin to impact monetary policy, as the committee eventually includes owner’s equivalent rent (OER) in the HICP index (the ECB’s preferred inflation measure) for the euro area. This could be a game changer for the ECB’s price objective. Climate change was reiterated as important for price stability. Financial stability was also repeated as an important objective. As FX strategists, the second change was the most important. Shelter constitutes 17.7% of the euro area CPI basket, but it is 32.9% of the US CPI basket (Table I-1). Meanwhile, the shelter component of both the CPI basket in the US and euro area have tracked each other (Chart I-15). Table I-1Euro Area CPI Weights Chart I-15What Will Happen To Eurozone Inflation?   An adjustment in the weight of the shelter component in the euro area will boost the European CPI relative to the US and could trigger a major policy shift from the ECB in the coming years. This will especially be the in case if the current environment generates an inflationary shock. Bottom Line: The ECB will stay very accommodative in the next 1-2 years, but the change in its mandate could portend a bullish tailwind for the euro beyond the near term. Investment Implications We expect the current dollar rebound to be short-lived. As such, our strategy is as follows: Stay long other safe-haven currencies. Our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Investors can also short GBP/JPY from current levels. Chart I-16The Euro, Yen And Real Rates Our limit-buy on EUR/USD was triggered at 1.18. Given our expectation that the dollar could rally in the near term, we are setting the stop-loss at the same level. However, the improvement in real rates in the euro area relative to the US could cushion any downside (Chart I-16). We are also long CHF/NZD, as a bet on rising currency volatility. Correspondingly, we are setting a limit buy on Scandinavian currencies relative to the euro and USD at a trigger level of -2%. Both gold and silver benefit from the current environment, but we prefer silver to gold, due to the former’s call option on continued improvement in global growth. We are short the gold/silver ratio from the 68 level. Overall, we expect the dollar to weaken towards the end of the year, as has been the case since the 1970s (Chart I-17). Chart I-17The Yen And Swiss Franc Are Usually Winners In H2   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar USD Technicals 1 USD Technicals 2 The recent data out of the US have been robust: June non-farm payrolls showed an increase of 850K jobs, versus expectations of a 700K increase. The unemployment rate was relatively flat at 5.9% in June.  Factory orders came in at 1.7% year-on-year in May, in line with expectations. The US dollar DXY index is relatively flat this week, but with tremendous volatility. It was a relatively quiet week in the US, due to Independence Day, but the key theme remained a drop in US yields, with the 10-year yield moving from a high of near 1.8% this year to 1.3% currently. This move has catalyzed rallies in lower beta currencies, such as the yen and Swiss franc. The FOMC minutes released this week continue to suggest a Fed that will remain very patient in both tapering asset purchases and lifting interest rates.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro EUR Technicals 1 EUR Technicals 2 Recent data from the euro area were mixed: The PPI print for May came in at 9.6%, in line with expectations. Both the services and composite PMI were revised higher by 0.3 in June. At 59.2, the composite PMI is the highest in over a decade. ZEW expectations for the euro area fell sharply from 81.3 to 61.2. In Germany, there was a big decline in automotive surveys. The euro was flat this week against the dollar, despite gains overnight. The big news was the change in the ECB’s monetary policy objectives, which we discussed briefly in the front section of this report. The euro rallied on the news of three fundamental drivers in our view – real rate differentials are improving in favor of Europe, the ECB’s consideration for house price inflation could allow its price stability objective to be achieved sooner, and consideration for financial stability will be less favorable for negative interest rates.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021   The Yen JPY Technicals 1 JPY Technicals 2   Recent data from Japan remains subpar, but is improving: Labor cash earnings rose 1.9% in May, in line with expectations. Household spending rose 11.6% in May, in line with expectations. The Eco Watchers Survey for June came in at 47.6 from a May reading of 38.1. The outlook component rose from 47.6 to 52.4. The yen was up by 1.6% against the USD this week, the best performer. We argued a month ago that the yen is the most underappreciated G10 currency today. The catalyst that triggered yen gains were a drop in US real rates, that favored other safe-haven currencies. Going forward, further yen gains should materialize on the back of Japan successfully overcoming the pandemic like its Western counterparts. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021   British Pound GBP Technicals 1 GBP Technicals 2 There was scant data out of the UK this week: The construction PMI rose from 64.2 to 66.3 in June. House prices remain robust, with the RICS house price balance printing an elevated 83% in June. The pound was flat this week against the USD. The new delta variant of the COVID-19 virus is gaining momentum in the UK and will likely erode some of the dividends GBP had priced in from a fast vaccine rollout. As such, short GBP positions may pay off in the near term. Shorting GBP/CHF could be an attractive near-term hedge.   Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020   Australian Dollar AUD Technicals 1 AUD Technicals 2 There was scant data out of Australia this week: The Melbourne Institute of Inflation survey came it at 3% year on year in June, from 3.3%. The RBA kept interest rates unchanged at 0.1%, reiterating its commitment to stay accommodative until inflation and wages pick up meaningfully. The AUD was down by 0.4% this week against the USD. The RBA is decisively lagging other central banks in communicating less monetary accommodation in the coming years. This will create a coiled spring response for the AUD, because the RBA will have to eventually play catchup as the global economic cycle gains momentum.   Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021   New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The was scant data out of New Zealand this week: ANZ commodity price index rose by 0.8% in June. The NZD was down 0.3% against the dollar this week. Our long CHF/NZD position paid off handsomely in this environment. We recommend holding onto this trade, as a reset in global rates hurts the hawkish pricing in the NZD forward curve. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020   Canadian Dollar CAD Technicals 1 CAD Technicals 2 Canadian data softened but remained robust: Building permits fell by 14.8% month on month in May. The Markit manufacturing PMI fell from 57 to 56.5 in June. The Canadian trade balance deteriorated from C$0.6bn to a deficit of -C$1.4bn in May. Business Outlook Survey indicator hit the highest level on record. As the Bank of Canada put it, improving business sentiment is broadening. The CAD fell by 0.8% against USD this week. The results of the BoC survey highlight that a reopening phase is categorically bullish for economic activity in general and financial prices. Until recently, the CAD was one of the best performing currencies in the G10. This is a sea change from a country that was previously a laggard in vaccination efforts. CAD should hold up well once the dollar rally fades, but other currency laggards such as SEK and JPY could do even better.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc CHF Technicals 1 CHF Technicals 2 The was scant data out of Switzerland this week: The unemployment rate was near unchanged at 3.1% in June, from 3.0%. Total sight deposits were unchanged at CHF 712 bn on the week of July 2. The Swiss franc was up by 1.1% this week against the USD. Falling yields improved the relative appeal of the franc that has bombed out interest rates. The franc is also benefiting from the rising bout of volatility as a safe-haven currency. On this basis, we are long CHF/NZD cross, which performed well this week. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020   Norwegian Krone NOK Technicals 1 NOK Technicals 2 Data out of Norway is improving: The unemployment rate fell from 3.3% to 2.9% in July. Industrial production growth came in at 2.1% year-on-year in May. Mainland GDP rose by 1.8% month on month in May. The NOK was down by 1.8% this week against the dollar, the worst performing G10 currency. The NOK is bearing the brunt of a reset in the US dollar, but our bias is that we are nearing a buy zone. NOK is cheap, would benefit from high oil prices and the economy is on the mend. We are looking to sell EUR/NOK and USD/NOK on further strength.   Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020   Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data from Sweden have been mildly positive: The Swedbank/Silf composite PMI fell from 70.2 to 66.9 in June. Industrial production came in at 24.4% year on year in May, after a rise of 26.4% in April. Household consumption jumped 8.8% year on year in April. The SEK was also up this week against the USD. Bombed-out interest rates in Sweden have also improved the appeal of the franc, given falling global bond yields. Meanwhile, the SEK remains one of the cheapest currencies in our models.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Inflation is set to decelerate, job creation has a speed limit, and super-spreaders of new-variant Covid-19 infections will create speed bumps in the economy.  This means that in the second half of the year: Bonds will rally. The US dollar will rally. Growth stocks will outperform value stocks. US stocks will outperform non-US stocks. Fractal trade shortlist: Brazilian real, Saudi Tadawul All Share, and Marine Transportation.  Feature Chart of the WeekThe 60 Percent Correction In Lumber Shows What Happens When Supply Bottlenecks Ease. Are Used Cars Next? As Supply Bottlenecks Ease, Inflation Will Cool Since mid-March, US inflation has surged to 5 percent. Yet bond yields have drifted lower, by almost 50 bps in the case of the 30-year T-bond yield, equating to a handsome return of 12 percent. The seeming contradiction between rising inflation and declining bond yields has puzzled some people, but it shouldn’t. In 2009, the same pattern occurred in reverse. Inflation collapsed, culminating in a modern era low of -2 percent in July 2009. Yet while inflation was collapsing, bond yields rose sharply (Chart I-2 and Chart I-3). Chart I-2In 2009, Bond Yields Rose When Year-On-Year Inflation Fell Chart I-3In 2021, Bond Yields Fell When Year-On-Year Inflation Rose We can explain this seeming contradiction with an analogy from driving. The inflation rate is like your average speed over the past mile. But the bond market cares much more about your average speed over the next mile, or even over the next 5-10 miles. If you are driving at a constant speed, then your speed over the past mile is a good guide to your future speed. But if you have been driving unusually fast or unusually slowly, there is a more important predictor of your future speed. That important predictor is your acceleration – meaning, what is happening to your speed over successive hundred yards stretches. In the same way, during episodes of unusually low or unusually high inflation, the bond market focusses on the monthly rate of inflation, and specifically the moment that it stops decreasing, as in early-2009, or stops increasing, as in mid-2021. In 2008, after a long sequence of declining monthly rates of inflation that went deep into negative territory, the December 2008 print marked the first substantial increase. Hence, the bond yield also bottomed in December 2008 (Chart I-4), even though annual inflation did not bottom until July 2009. Chart I-4In 2009, Bond Yields Bottomed When Month-On-Month Inflation Bottomed Similarly, in 2020-21, after a six month sequence of increasing monthly rates of inflation, the May 2021 print marked the end of the rising trend. To the extent that this was anticipated, most of the decline in the bond yield has happened since mid-May (Chart I-5). Chart I-5In 2021, Bond Yields Topped When Month-On-Month Inflation Topped Since mid-May, the 60 percent crash in the lumber price shows what happens when supply bottlenecks ease. Other prices that are being supported by temporary supply constraints – such as used car prices – are likely to suffer the same fate (Chart of the Week). Hence, so long as the coming monthly prints confirm an ongoing deceleration in inflation, the current rally in bonds will stay intact. Jobs: The Hard Work Starts Now Staying on the theme of speed, there is a well-defined speed limit to every post-recession jobs recovery. In A Fed Rate Hike By Early 2023 Is Pie In the Sky, we pointed out the remarkable consistency in the pace of post-recession US jobs recoveries. The last five recessions had different causes, severities, durations and peak unemployment rates. Yet in the recoveries that followed each recession, the unemployment rate declined at a remarkably consistent pace of 0.4-0.5 percent per year (Table I-1). Table I-1After Every Recession, The Pace Of Recovery In The Jobs Market Is Near-Identical Reassuringly at the last FOMC press conference, Jay Powell supported this thesis: Most of the act of sort of going back to one's old job – that's kind of already happened. So, this is a question of people finding a new job. And that's just a process that takes longer. There may be something of a speed limit on it. You've got to find a job where your skills match, you know, what the employer wants. It's got to be in the right area. There's just a lot that goes into the function of finding a job. Powell’s comments lead to two further points: The act of going back to one’s old job for those on ‘temporary layoff’ is relatively straightforward. For job creation, this is the low hanging fruit, most of which has already been picked. Now comes the much harder part – finding jobs for those ‘not on temporary layoff’ whose numbers have barely declined from the peak (Chart I-6). Chart I-6For Job Creation, The Low Hanging Fruit Has Already Been Picked One way of encapsulating this is to observe that the unemployment rate – including those on temporary layoff – has already made 80 percent of the journey from its recession peak to the February 2020 trough, which makes it seem that the jobs recovery is largely done. However, the unemployment rate for those not on temporary layoff has made only 25 percent of the journey (Chart I-7). Moreover, this process is not a straight line, it is a curve. The first quarter of the journey is the easiest, then it gets harder. Chart I-7The Hard Part Is Finding Jobs For Those Unemployed 'Not On Temporary Layoff' As we, and Jay Powell, have pointed out, the process to reduce this unemployment rate has a remarkably consistent speed limit of 0.4-0.5 percent per year. Starting at the current rate of 2.5 percent and a target of 1.5 percent, this means full employment will not be reached before the second half of 2023. And even this assumes clear blue skies for the world economy through the next two years, which is a tall order. We conclude that the market pricing of a Fed funds rate lift-off in December 2022 is much too optimistic, making the December 2022 Eurodollar contract a good buy. The End Of Pandemic Restrictions Will Unleash Super-Spreaders On July 19, the UK will remove all its domestic pandemic restrictions – meaning no more facemasks, social distancing, and limits on the size of gatherings. This doesn’t mean that the pandemic is over in the UK. Far from it. The delta variant of the virus is rampant. Rather, with a large portion of the population vaccinated, the government is replacing state-imposed laws and regulations with a libertarian onus on personal responsibility. Given that Covid-19 is not going away, the UK strategy raises a fundamental question. Other than implementing a vaccination program, what role should a government take in containing the virus? In Who’s Right On The Pandemic – Sweden Or Denmark? we revealed two important findings: First, it is a misunderstanding that state-imposed restrictions cause the collapse in social consumption. This is a classic confusion between correlation and causation. The true cause of the recession is that a virulent disease focuses millions of people on self-preservation, shunning crowds and public places. But to the extent that the pandemic also leads to state-imposed restrictions, many people blame the slowdown on these correlated restrictions rather than on the underlying cause – the voluntary change in behaviour. Second, without state-imposed restrictions, the majority will voluntarily change their behaviour to avoid catching and spreading the virus, but a minority will not. When a virus is spreading, this is critical because a tiny minority of so-called ‘super-spreaders’ is responsible for most infections. Put simply, economic growth depends on the behaviour of the majority and in a pandemic the majority will voluntarily reduce their social consumption. This explains why libertarian Sweden and lockdown Denmark suffered similar contractions in their economies (Chart I-8). Chart I-8Libertarian Sweden Has Not Significantly Outperformed Lockdown Denmark... In contrast, containing the virus depends on restricting the minority of super-spreaders. Which explains why libertarian Sweden suffered a much worse outbreak of the disease than lockdown Denmark (Chart I-9). Chart I-9...But Libertarian Sweden Has Suffered Many More Covid-19 Casualties The worry now is that the end of state-imposed restrictions will unleash super-spreaders and super-spreading events. This will allow the virus to replicate, mutate, and create new variants which are potentially more transmissible and resistant to existing vaccines. Pulling together our three themes for the second half of the year, inflation is set to decelerate, job creation has a natural speed-limit, and super-spreaders of new-variant Covid-19 infections will create speed bumps in the economy. This means that:  Bonds will rally. The US dollar will rally. Growth stocks will outperform value stocks. US stocks will outperform non-US stocks Candidates For Countertrend Reversal This week, we present three candidates for countertrend reversal. First, the Brazilian real’s recent surge has hit expected resistance at 65-day fractal fragility. A good way to play a continued reversal is to short BRL/COP (Chart I-10). Chart I-10The Brazilian Real Is Correcting Second, within emerging markets, the strong rally in the Saudi equity market is vulnerable to a setback, especially versus other markets. A good way to play this is to short the Saudi Tadawul All Share index versus the FTSE Bursa Malaysia KLCI, given that the 260-day fractal structure is at the point of fragility that marked the major top in 2014 (Chart I-11). Chart I-11The Saudi Stock Market Is Vulnerable To A Setback Finally, coming full circle to short-term supply bottlenecks, one major beneficiary has been the Marine Transportation sector which, since February, has outperformed the world market by 70 percent. As the supply bottlenecks ease, this is vulnerable to correction, especially as the 260-day fractal structure is at the point of fragility that marked the major top in 2007 (Chart I-12). Chart I-12Underweight Marine Transportation Hence, this week’s recommended trade is to underweight Marine Transportation versus the market, setting the profit target and symmetrical stop-loss at 16.5 percent.   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 - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - 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 Q2/2021 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -6bps during the second quarter of the year. Winners & Losers: The government bond side of the portfolio underperformed by -21bps, led overwhelmingly by our underweight to US Treasuries (-18bps). Spread product allocations outperformed by +15bps, primarily due to overweights on US high-yield (+11bps) and US CMBS (+3bps). Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Feature The trend in global bond yields so far in 2021 has been a tale of two quarters. The first three months of the year saw a surge in yields worldwide on the back of rapidly improving economic data, the rollout of COVID-19 vaccines and supply squeezes triggering rapid increases in inflation. During the second three months of the year, however, global yields drifted a bit lower in response to more mixed economic data, the spread of the Delta variant and slightly hawkish shifts from a few key central banks – most notably, the Fed – even with economic confidence measures remaining upbeat across the developed economies. The decline in yields has not been seen across the maturity spectrum, though. The yield-to-maturity of the Bloomberg Barclays Global and US Treasury 10+ year indices fell by -12bps and -30bps, respectively, from recent peaks. At the same time, shorter term bond yields have been relatively stable as central banks continue to signal that interest rate hikes are still well off into the future. In contrast to government bonds, credit markets have remained calm with spreads tight for developed market corporates and emerging market (EM) debt. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the second quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. The latter half of 2021 should prove to be even more challenging for bond investors, who must disentangle less consistent messages across countries on the Delta variant, vaccinations, inflation and the outlook for both monetary and fiscal policy. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2021 Model Bond Portfolio Performance: Mixed Returns Chart 1Q2/2021 Performance: Credit Gains & Duration Losses The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was +1.13%, slightly underperformed the custom benchmark index by -6bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -21bps of underperformance versus our custom benchmark index while the latter outperformed by +15bps. We have remained significantly underweight US Treasuries and positioned for a bearish steepening of the US Treasury curve since just before last year's US presidential election. That tilt was a big contributor to the excess return of the portfolio in Q1 (+63bps) that was partially given back (-18bps) in Q2 as longer maturity Treasury yields fell during the quarter. Our inflation-linked bond allocations in the US and Europe (+5bps) helped mitigate the loss on the government bond side from our below-benchmark duration stance and general curve steepening bias in most countries in the portfolio (Table 2). Table 2GFIS Model Bond Portfolio Q2/2021 Overall Return Attribution The sum of excess returns during the quarter from countries that we overweighted (Germany, France, Italy, Spain, and Japan) was zero. Improving growth momentum and stronger economic confidence helped push yields higher in those countries. Therefore, those positions could not offset the losses from the underweight to US Treasuries. We did make two shifts in the country allocation within the government bond portion of the portfolio during Q2, downgrading Canada to underweight on April 20 and upgrading Australia to overweight on June 9. Neither change meaningfully contributed to the return of the portfolio. Meanwhile, our moderate overall overweight tilt on spread product versus government bonds fueled the outperformance from the credit side of the portfolio, led by US high-yield (+11bps) and US CMBS (+3bps). Overall gains from spread product were impressive in both USD-hedged total return terms (+95bps) and relative to our custom benchmark (+15bps), despite spreads entering Q2 at fairly tight levels. In the second quarter, improving economic confidence and easing credit conditions allowed spreads to narrow even further for corporate debt in the US and Europe, as well as for EM USD-denominated credit. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2021 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q2/2021 Spread Product Performance Attribution By Sector Biggest Outperformers: Overweight US high-yield: Ba-rated (+5bps), B-rated (+4bps), and Caa-rated (+3bps) Overweight US TIPS (+4bps) Overweight US CMBS (+3bps) Overweight Euro Area high-yield (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10 years (-17bps), Underweight US Treasuries with a maturity between 7 and 10 years (-3bps) Underweight US Treasuries with a maturity between 5 and 7 years (-2bps) Underweight EM USD sovereigns (-1bps) Underweight UK GIlts with a maturity greater than 10 years (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2021 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. In Q2, the picture on that front was mixed. We were only neutral some of the biggest outperformers like UK Gilts (+312bps in USD-hedged duration-matched total return terms) and investment grade credit in the US (+430bps) and UK (+231bps). Our relative value allocation within EM, overweight corporates (+430bps) versus sovereigns (+527bps), also underperformed during Q2. We remained overweight government debt markets in the euro area which were the worst performers during the quarter (Germany: -25bps, Spain: -59bps, Italy: -67bps, and France: -83bps). The news was better on the credit side, where our significant overweight to US high-yield (+146bps) was a big positive contributor, as were overweights to US CMBS (+137bps) and euro area high-yield (+92bps). Bottom Line: Our model bond portfolio slightly underperformed its benchmark index in the second quarter of the year by -6bps – a negative result mainly driven by our underweight allocation to the US Treasury market but with an overweight to US high-yield providing a meaningful offset. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by swings in global government bond yields, most notably US Treasuries. Our most favored cyclical indicators for global bond yields are still, in aggregate, signaling more upside potential over at least the next six months, although the nature of the signal is changing (Chart 5). Our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, remains elevated but appears to have peaked. At the same time, the global manufacturing PMI, which typically leads global real bond yields by around six months, continues to climb to new cyclical highs. This suggests that the recent downdraft in global real bond yields could prove to be short-lived. Our Global Central Bank Monitor is climbing steadily, indicating greater upward pressure on bond yields from the combination of strong growth, rising inflation and loose financial conditions. Admittedly, bond yields are lagging the upward trajectory implied by the Monitor with central banks deliberately responding far more slowly to the cyclical pressures that would have triggered bond-bearish monetary tightening in the past. Nonetheless, the Monitor, the Global Duration Indicator and the global manufacturing PMI and all sending the same message – global bond yields remain too low, suggesting a below-benchmark overall portfolio duration stance remains appropriate. With regards to country allocation within the government bond side of our model portfolio, we continue to overweight countries where central banks are less likely to begin normalizing pandemic-era monetary policy quickly (Germany, France, Italy, Spain, Japan, Australia), while underweighting countries where normalization is expected to begin within the next 6-12 months (the US and Canada). We remain neutral the UK, although we have them on “downgrade watch” until there is greater clarity on how severely the spread of the Delta variant is impacting UK growth. The US remains the biggest underweight. The modestly hawkish turn by the Fed at the June FOMC meeting likely marked the end of the cyclical bear-steepening trend of the US Treasury curve. A full-blown turn to a bear-flattening of the US curve will be slow to develop, but we fully expect the cyclical pressures that drove the underperformance of longer-maturity US Treasuries over the past year to begin leaking into shorter-maturity bonds. That trend already appears to be underway with 5-year US yields starting to drift upward at a faster pace compared to other developed market peers (Chart 6). Chart 5Cyclical Indicators Suggest Global Yields Still Have More Upside Chart 6UST Underperformance Will Shift To Shorter Maturities This leads us to make a change to our model portfolio allocations this week, reducing the exposure to the belly of the US Treasury curve (the 3-5 year and 5-7 year maturity buckets), while modestly increasing the allocation to the 7-10 year bucket. To neutralize the duration-extending implication of that marginal shift, we added a new allocation to US Treasury bills, thus turning this US Treasury shift into a “butterfly” trade, essentially selling the 5-year bullet for a cash/10-year barbell. Longer-term Treasury yields, however, are still in the process of working off an oversold condition that developed in Q1 (Chart 7). Duration positioning remains quite short, according to the JP Morgan survey of bond investors, while speculators are still working off a huge net short position in 30-year Treasury futures according to data from the CFTC. We anticipate that it will take another month or two to work off such an extreme oversold condition for US Treasuries, based on similar episodes over the past two decades. After that, longer-maturity Treasury yields will begin to begin climbing again, to the benefit of the US underweight (and below-benchmark duration stance) in our model portfolio. Chart 7Longer-Maturity USTs Working Off Oversold Condition Chart 8A Sharply Diminished Impulse From Global QE Outside the US, the bond-friendly impact of quantitative easing programs is fading, on the margin, with the growth of central bank balance sheets slowing (Chart 8). While outright tapering of bond buying has only occurred in Canada and the UK (within our model bond portfolio universe), we expect the Fed to begin tapering in early 2022. Financial stability concerns are expected to play an increasingly important role in future tapering decisions, with house prices booming in many countries, most notably Canada which supports our underweight stance on Canadian government debt. Australia is the notable exception to this trend towards slowing balance sheet growth, with the Reserve Bank of Australia (RBA) maintaining a healthy pace of bond buying given underwhelming realized inflation. The recent wave of COVID-19 cases, which has left half of Australia under lockdowns that were largely avoided in 2020, will ensure that the RBA stays dovish for longer, to the benefit of our overweight stance on Australian government bonds. We continue to see the overall dovish stance of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt. However, inflation breakevens in most countries have largely completed the rebound from the depressed levels reached during the 2020 COVID-19 global recession. Our Comprehensive Breakeven Indicators combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. Those indicators suggest that the most attractive markets to position for further upside potential for breakevens are in Italy and France, with breakevens looking more stretched in the US, Canada and Australia (Chart 9). On the back of this, we are maintaining our allocations to inflation-linked bonds in the euro area in our model portfolio. Chart 9Less Scope For Wider Global Inflation Breakevens Chart 10Fading Support For Credit Markets From Global QE Moving our attention to the credit side of our model portfolio, we feel that a moderate overweight stance on overall global corporates versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets, as an indicator of the incremental shift away from the COVID-era monetary policies from 2020, is flashing a warning sign for the performance of global spread product. The annual growth rate of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has been an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond excess returns around February 2022 Although given the current tight level of global corporate bond spreads, both for investment grade and high-yield, we expect future return outperformance from corporates versus government debt to come from carry rather than spread compression. Our preferred measure of the attractiveness of credit spreads is the historical percentile ranking of 12-month breakeven spreads, which measure how much spreads would need to widen to eliminate the carry advantage over duration-matched government bonds on a one-year horizon. Currently, only the lower-rated high-yield credit tiers in the US and euro area offer 12-month breakeven spreads above the bottom quartile of their history, within the credit sectors of our model portfolio (Chart 11). Chart 11Lower-Rated High-Yield Offers Relatively Attractive Spreads Given the sharply reduced default risks on both sides of the Atlantic, and with nominal growth in good shape amid low borrowing rates, we are maintaining our overweights to high-yield bonds in both the US and euro area. At the same time, we are sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce the overall corporate bond exposure later this year, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that signals about the future path for global monetary policy. Within the euro area, we continue to prefer owning Italian government bonds (and to a lesser extent, Spanish government debt) over investment grade corporates, given the more explicit support for the sovereigns through ECB quantitative easing (Chart 12). We expect the ECB to be the most accommodative central bank within our model portfolio universe over at least the next year, with even tapering of any kind unlikely in 2022. Chart 12Favor Italian BTPs Over Euro Area Investment Grade One area of the spread product universe where we are starting to reduce risk in the model portfolio is EM USD-denominated credit. EM debt has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices over the past year. We have positioned for that in our model portfolio through an overall overweight stance on EM USD-denominated debt, but one that favors investment grade corporates over sovereigns. Now, all of those supportive factors for EM credit are fading. Chinese policymakers have reigned in both credit stimulus and fiscal stimulus this year, with the combined impulse suggesting a slower pace of Chinese economic growth in the latter half of 2021 (Chart 13). Given China’s huge share of the global consumption of industrial commodities, slowing Chinese growth should cool the momentum of commodity prices over the next few quarters. A slowing liquidity impulse from global central bank asset purchases is also a negative for EM debt performance, on the margin. The same can be said for the US dollar, which is no longer depreciating as markets start to pull forward the expected future path for US interest rates (Chart 14). A stronger US dollar typically correlates with softer commodity prices and wider EM credit spreads. Chart 13Major EM Risks: China Tightening & Global QE Tapering Chart 14EM Supportive USD Weakness Is Fading In response to these growing risks to the bullish EM backdrop - including the rapid spread of the Delta variant made worse by the less-effective vaccines available in those countries - we are downgrading our overall EM USD credit exposure in the model bond portfolio to underweight from neutral. We are doing this by cutting the EM corporate exposure from overweight to neutral, while maintaining an underweight tilt on EM USD sovereigns. We expect to further cut the EM exposure in the coming months by moving to a full underweight on EM corporates. Summing it all up, our overall allocations and risks in our model portfolio leading into Q3/2021 look like this: An overall below-benchmark stance on global duration, equal to nearly one full year versus the custom index (Chart 15) A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 16). This overweight comes almost entirely from overweight allocations to US and euro area high-yield corporate debt. Chart 15Overall Portfolio Duration: Stay Below Benchmark Chart 16Overall Portfolio Allocation: Small Spread Product Overweight After the changes made to our US Treasury and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 34bps (Chart 17). The main reason for this is that our positioning remains focused heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral or largely offsetting other positions in a relative value sense (overweight Australia vs underweight Canada, overweight US CMBS versus underweight US Agency MBS). This fits with our desire to maintain only a moderate level of overall portfolio risk. The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry”, hedged into USD, of 13bps (Chart 18). Chart 17Overall Portfolio Risk: Moderate Chart 18Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the US and EM, we now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. We see global growth momentum and the Fed monetary policy outlook as the two most important factors for fixed income markets in the second half of 2021, thus our scenarios are defined along those lines. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries Base Case Global growth stays above-trend in both Q3 and Q4, putting downward pressure on unemployment rates and keeping realized inflation elevated. Ongoing global vaccinations lead to more of the global economy fully reopening, with the Delta variant not having serious widespread impact on economic confidence outside of parts of the emerging world. Excess savings built up during the pandemic are run down by both consumers and businesses as optimism stays ebullient within the developed economies. China credit tightening slows growth enough to cool off upward commodity price momentum. At the same time, falling US unemployment and surprisingly “sticky” domestic US realized inflation embolden the Fed to signal a move to begin tapering its bond purchases starting in January 2022. Real bond yields globally bottom out, while inflation expectations recover some of the pullback seen in Q2/2021. The entire US Treasury curve shifts higher, led by the 10-year reaching 1.65% and a modest bear-flattening of the 5-year/30-year curve. The VIX stays near 15, the US dollar rises +3%, the Brent oil price goes nowhere and the fed funds rate is unchanged at 0% Upside Growth Surprise The Delta variant proves to be far less deadly than feared. A rapid pace of global vaccinations leads to booming growth led by the US but including a fully reopened euro area. Chinese policymakers begin to reverse some of the H1/2021 credit tightening. Unemployment rates rapidly fall worldwide, while supply bottlenecks persist, keeping upward pressure on realized inflation. Markets pull forward the timing and pace of future central bank interest rate hikes, most notably in the US when the Fed begins tapering bond purchases sooner than expected before year-end. Real bond yields drift higher globally, but inflation breakevens stay elevated with the earlier surge in realized inflation proving not to be “transitory”. The US Treasury curve modestly bear-flattens, with the 10-year reaching 1.9% and the 5-year/30-year spread narrowing by 25bps. The VIX rises to 25 as risk assets struggle in response to rising bond yields even with faster growth. The US dollar falls -5% on the back of improving global growth expectations, the Brent oil price climbs +5% and the fed funds rate stays unchanged. Downside Growth Surprise The global economy gets hit on multiple fronts: the rapid spread of the Delta variant overwhelms the positive momentum on vaccinations, most notably in EM countries; Europe struggles to fully reopen; China policy tightening results in a larger-than-expected drag on global growth; and US households are reluctant to draw down on excess savings after government income support measures expire in September. Diminished economic optimism leads to a pullback in global equity values, lower government bond yields and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.25% alongside lower inflation breakevens. The VIX rises to 30, the safe-haven US dollar rises +5%, the Brent oil price falls -10% and the fed funds rate stays at 0%. Chart 19Risk Factor Assumptions For The Scenario Analysis Chart 20US Treasury Yield Assumptions For The Scenario Analysis The inputs into the scenario analysis are shown in Chart 19 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 20. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The model bond portfolio is expected to deliver a positive excess return over the next six months of +46bps in the base case scenario and +28bps in the optimistic growth scenario, but is projected to underperform by -36bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 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 1Employment Growth June’s employment report revealed that 850 thousand jobs were added to nonfarm payrolls during the month. This is well above the 416k to 505k threshold that is required to hit the Fed’s “maximum employment” target in time for a rate hike in 2022 (Chart 1). The bond market, however, didn’t see things this way. Treasury yields fell across the entire curve following the report’s release on Friday. This is likely because, in contrast to the establishment survey’s strong +850k print, the household employment survey showed a decline of 18k jobs and an uptick in the unemployment rate from 5.8% to 5.9%. Importantly, the household survey tends to be more volatile than the establishment survey, and we expect it will catch up in the coming months. We see the bond market as overly complacent in the face of what is shaping up to be a rapid labor market recovery that will only accelerate once schools re-open and expanded unemployment benefits lapse in September. US bond investors should maintain below-benchmark portfolio duration.   Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 50 basis points in June, bringing year-to-date excess returns up to +209 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 99 bps, the 3/10 Treasury slope remains very steep and the 5-year/5-year forward TIPS breakeven inflation rate is below the Fed’s 2.3% to 2.5% target range. The message from these two indicators is that the Fed is not yet ready for monetary conditions to turn restrictive. Despite the positive macro back-drop, investment grade valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is at its lowest since 1995 (Chart 2). Last week’s report looked at what different combinations of Treasury slope and corporate spreads have historically signaled about corporate bond excess returns.1 We found that tight corporate spreads only correlate with negative excess returns once the 3/10 Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend favoring high-yield over investment grade. We also prefer municipal bonds, USD-denominated EM sovereigns and USD-denominated EM corporates over investment grade US corporates with the same credit rating and duration. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 122 basis points in June, bringing year-to-date excess returns up to +468 bps. Last week’s report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 2.8% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, slightly below what the market currently discounts. This estimate assumes 7% real GDP growth (an input we use to forecast corporate profit growth) and corporate debt growth of between 0% and 8%. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.8% through the first five months of the year, below the estimate generated by our macro model. At 267 bps, the average option-adjusted spread on the High-Yield index is at its lowest since 2007. However, our above analysis suggests that these spread levels are still consistent with earning positive excess returns versus duration-matched Treasuries because default losses will also be low. High-yield spreads also look relatively attractive compared to investment grade spreads. Investors still receive an additional 97 bps of spread as compensation for moving out of the Baa credit tier and into the Ba tier (panel 2). Given the accommodative macro environment, we advise investors to grab this extra spread. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 36 basis points in June, dragging year-to-date excess returns down to -45 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 8 bps in June. The spread remains wide compared to recent history, but it is still tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 13 bps in June (panel 3), and it is now starting to look more competitive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 34 bps, below the 49 bps offered by Aa-rated corporate bonds but above the 17 bps offered by Aaa-rated consumer ABS and the 30 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.3 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will rise during the next 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS.  Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 4 basis points in June, bringing year-to-date excess returns up to +91 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 16 bps in June, dragging year-to-date excess returns down to +36 bps. Foreign Agencies outperformed the Treasury benchmark by 10 bps on the month, bringing year-to-date excess returns up to +46 bps. Local Authority bonds outperformed by 31 bps in June, bringing year-to-date excess returns up to +392 bps. Domestic Agency bonds underperformed by 1 bp, dragging year-to-date excess returns down to +26 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +26 bps. USD-denominated Emerging Market (EM) Sovereign bonds continue to offer an attractive spread pick-up versus investment grade US corporate bonds with the same credit rating and duration. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico and Russia. Last week’s report looked at valuation within the investment grade USD-denominated EM corporate space.4 We found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. We also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 22 basis points in June, bringing year-to-date excess returns up to +309 bps (before adjusting for the tax advantage). We took a detailed look at municipal bond performance and valuation in a recent report and come to the following conclusions.5 First, the economic and policy back-drop is favorable for municipal bond performance. The recently enacted American Rescue Plan includes $350 billion of funding for state & local governments, a bailout that came after state & local government revenues already exceeded expenditures in 2020 (Chart 6). Second, Aaa-rated municipal bonds look expensive relative to Treasuries (top panel). Muni investors should move down in quality to pick up additional yield. Third, General Obligation (GO) and Revenue munis offer better value than investment grade corporates with the same credit rating and duration, particularly at the long-end of the curve. Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporates. GO munis offer a breakeven tax of just 6% (panel 2). Fourth, taxable munis offer a yield advantage over credit rating and duration-matched investment grade corporates that investors should grab (panel 3). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 20% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve underwent a massive re-shaping in June. Yields at the front-end of the curve rose significantly after the June FOMC meeting while longer-maturity yields declined. All told, the yield curve flattened dramatically on the month. The 2/10 slope flattened 24 bps to end the month at 120 bps. The 5/30 slope flattened 28 bps to end the month at 119 bps. As we wrote in a recent report, we believe that the June FOMC meeting marks an inflection point for the yield curve.6 Prior to the meeting, the yield curve up to the 10-year maturity point had generally been in a bear-steepening/bull-flattening regime, where the slope of the yield curve was positively correlated with the average level of yields (Chart 7). But bond investors appear to have left the June FOMC meeting with a sense that we are now marching toward a Fed rate hike cycle. In that new world, it makes more sense for the yield curve to be negatively correlated with the average level of yields: a bear-flattening/bull-steepening regime. Given that we expect the Fed to lift rates before the end of 2022, we are now sufficiently close to a tightening cycle that the yield curve should bear-flatten between now and then. We therefore recommend that investors short the 5-year bullet and go long a duration-matched barbell consisting of the 2-year and 10-year notes. This position offers a negative yield pick-up, but it looks modestly cheap on our fair value model (see Appendix A) and it will earn capital gains as the 2/10 slope flattens. TIPS: Neutral Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 22 basis points in June, dragging year-to-date excess returns down to +461 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates both fell 10 bps on the month. At 2.35%, the 10-year TIPS breakeven inflation rate is just within the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.18%, the 5-year/5-year forward TIPS breakeven inflation rate is below where the Fed would like it to be (panel 3). We see some upside in long-maturity TIPS breakeven inflation rates during the next 6-12 months, as we expect that the 5-year/5-year forward breakeven will find its way back into the Fed’s target range before the first rate hike. However, once the Fed starts tightening it will have a strong incentive to keep long-maturity breakevens below 2.5%. This means that a long position in TIPS versus nominal Treasuries has limited upside. We also see the cost of short-maturity inflation protection falling somewhat during the next few months, as realized inflation is likely at its peak. This will lead to some modest steepening of the inflation curve (panel 4). We do expect, however, that the inflation curve will remain inverted. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one, as the Fed will be attacking its inflation target from above rather than from below. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in June, bringing year-to-date excess returns up to +39 bps. Aaa-rated ABS outperformed by 5 bps on the month, bringing year-to-date excess returns up to +31 bps. Non-Aaa ABS outperformed by 14 bps on the month, bringing year-to-date excess returns up to +84 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile by pushing the savings rate higher yet again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in June, bringing year-to-date excess returns up to +183 bps. Aaa Non-Agency CMBS outperformed Treasuries by 4 basis points in June, bringing year-to-date excess returns up to +82 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 66 bps in June, bringing year-to-date excess returns up to a whopping +522 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Even with the economic recovery well underway, commercial real estate loan demand continues to contract and banks are not making lending standards more accommodative (panels 3 & 4). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in June, dragging year-to-date excess returns down to +116 bps. The average index option-adjusted spread widened 3 bps on the month and it currently sits at 30 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of June 30TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of June 30TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 9 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 9 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of June 30TH, 2021)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 3 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 4 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 5 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 6 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021.