Fixed Income

Highlights U.S. Bond Strategy: U.S. Treasury yields are already priced for rate cuts and lower inflation, even as U.S. (and global) growth indicators are improving and U.S. realized inflation has ticked up. Maintain a below-benchmark stance on U.S. duration, even in the face of the current U.S.-China trade tensions. Stay overweight U.S. corporates versus Treasuries as well, with global growth indicators improving and U.S. monetary policy not yet restrictive. European Bond Strategy: Government bond yields in core Europe are too low relative to tentative signs that growth has bottomed out. At the same time, tight euro area corporate bond spreads already discount better economic momentum. Stay below-benchmark on euro area duration exposure, but maintain only a neutral weighting on euro area corporate bonds. Feature Monetary & Fiscal Policy Is More Important Than Trade Policy Chart 1Government Bonds Are Overvalued The old market bugaboo from 2018, “global trade uncertainty”, returned last week after the U.S. and China failed to reach a trade deal by last Friday’s deadline. The Trump Administration followed through on its threat to raise the tariff rate on $200 billion of Chinese exports to the U.S. from 10% to 25%, effective immediately. China retaliated by announcing fresh tariffs on $60 billion of U.S. exports to China, effective June 1st. Global equities have responded negatively, with the S&P 500 down -5% since President Trump first Tweeted his threat to increase tariffs on May 5. Global bond yields have declined in a standard risk-off move. The 10-year U.S. Treasury yield dropped -13bps over the past week - despite higher-than-expected April CPI and PPI inflation releases – and now sits at 2.40%. Meanwhile, the 10-year German Bund has dipped back into negative territory despite recent data releases showing an unexpected pickup in German industrial activity in March, and a sharp increase in Euro Area core inflation in April. Despite the greater uncertainty, we do not see a case for making any changes to our recommended pro-growth medium-term fixed income recommendations on duration (below-benchmark) or asset allocation (overweight corporates versus government debt). The BCA Global Fixed Income Strategy Duration Indicator continues to climb, indicating cyclical pressures for higher global bond yields (Chart 1). Yet at the same time, the deeply negative term premium component of yields in the U.S. and Europe (and most other developed markets) suggests that there is a lot of pessimism on growth and inflation (and a big safe-haven bid from investors) embedded in the current level of yields. Despite the greater uncertainty, we do not see a case for making any changes to our recommended pro-growth medium-term fixed income recommendations on duration (below-benchmark) or asset allocation (overweight corporates versus government debt). Our colleagues at BCA Geopolitical Strategy now believe that the odds of a trade agreement being reached this year are a 50/50 coin flip. If the talks do break down completely, however, China’s policymakers will almost certainly ramp up additional stimulus measures to offset the hit to growth from the U.S. tariffs. As a reminder, China’s exports to the U.S. only account for around 3.5% of China’s GDP (Chart 2), so U.S. tariffs matter far less than domestic stimulus via fiscal and monetary easing. Thus, any additional stimulus will help sustain the current blossoming rebound in global growth, which has been fueled in part by improved economic sentiment and a pickup in Chinese credit growth (Chart 3). In addition, Chinese import demand has ticked higher, our global leading economic indicator (LEI) is bottoming out, the ZEW surveys of economic sentiment are climbing higher and even the OECD LEI for China is starting to perk up. Chart 2China-U.S. Trade Is A Small Part Of The Two Economies Dovish central banks will also help limit the damage from increased trade uncertainty. In particular, the Fed will not rock the boat and stay “patient” by keeping rates on hold for longer. Chart 3A Consistent Message On A Global Growth Recovery Although given the inflationary implications of higher tariffs and the FOMC’s belief that the recent dip in core PCE inflation was “transitory”, the current market pricing for Fed easing appears too optimistic. Dovish central banks will also help limit the damage from increased trade uncertainty. We did get our first post-tariff read on the Fed’s thinking last Friday, and it did not sound like rate cuts were on the way. Atlanta Fed president Raphael Bostic noted that the most recent CPI and PPI inflation readings suggest that “price pressures are a little hotter” and that the U.S. is “almost to the cusp where we are going to see prices move”.1 He also noted that U.S. businesses are far more likely to pass on a higher 25% tariff on Chinese imports to consumer prices, where previously they had been more willing to absorb the higher cost of the smaller 10% tariff. Of course, an even bigger near-term selloff in global equity and credit markets is possible, if the current impasse between D.C. and Beijing persists without any indication of fresh negotiations. BCA Global Investment Strategy has recommended a tactical hedge to the overall overweight allocation to global equities in our House View matrix by shorting the S&P 500 index.2 However, we do not see the need to make any similar recommendations on the U.S. fixed income side – both the below-benchmark duration stance and the overweight corporate credit tilt - for the following reasons (Chart 4): Our Fed Monitor continues to signal that no rate cuts are required in the U.S., while -31bps of cuts over the next year are already discounted in the U.S. Overnight Index Swap curve. U.S. financial conditions have only tightened modestly on last week’s moves – after the substantial easing seen year-to-date – and still point to above-trend GDP growth over the rest of 2019. U.S. inflation expectations have dipped back to recent lows, even as realized inflation has hooked up; TIPS breakevens are now 40-50bps below levels consistent with the Fed hitting its 2% PCE inflation target. The Treasury market is now very overbought from a momentum perspective, while duration positioning is now very long according to the JPMorgan Client Survey. The reaction of U.S. corporate credit spreads to the trade headlines has been relatively muted to date (Chart 5), less than what was seen last December when the market feared a hawkish Fed policy mistake – over the medium-term, monetary policy matters more than trade policy for credit markets. Chart 4Stay Below-Benchmark U.S. Duration Chart 5A Modest Reaction (So Far) To The Tariffs In other words, U.S. Treasury yields now discount a lot of bad news and, thus, have limited downside even in the event of a further breakdown of U.S.-China trade talks. On the other hand, any positive news on fresh U.S.-China negotiations could send both equities and bond yields substantially higher and tighten credit spreads. On a risk/reward basis, a below-benchmark U.S. duration stance and overweight tilt on U.S. corporates are still warranted, even with the more elevated uncertainty on U.S.-China trade. Bottom Line: U.S. bond yields are already priced for rate cuts and lower inflation, even as U.S. (and global) growth indicators are improving and U.S. realized inflation has ticked up. Maintain a below-benchmark stance on U.S. duration, even in the face of the current U.S.-China trade tensions. Stay overweight U.S. corporates versus Treasuries as well, with global growth indicators improving and U.S. monetary policy not yet restrictive. European Bond Markets – Too Much Bad News In Yields, Too Much Good News In Credit Spreads With markets now focused on the U.S.-China trade squabble, the European economic situation is garnering few headlines. Investors may be missing out on a good story, with euro area data now more frequently surprising to the upside (Chart 6). The ZEW measures of economic sentiment have been picking up in the past few months, most notably in Germany and France, even with current conditions still perceived to be soft. Improved sentiment is where economic upturns begin, however, and it looks like better days lie ahead for European growth. Investors may be missing out on a good story, with euro area data now more frequently surprising to the upside. The 2018 downturn in euro area GDP growth was a result of a sharp downturn in exports that fed into large pullbacks in industrial production. The most recent data, however, shows that exports have started growing again, and production growth is stabilizing (Chart 7). Credit growth has also hooked up in Germany and France, while the credit contraction in Italy and Spain is bottoming out. Chart 6Upside Growth Surprises In Europe? Chart 7Starting To Reverse The 2018 Downturn The improvement in global leading indicators, such as the China credit impulse and our global LEI diffusion index, points to a rebound in euro area export growth over the latter half of the year (Chart 8). The escalation in the U.S.-China trade dispute is a potential source of concern but, as discussed earlier in this report, Chinese policymakers will likely provide additional stimulus measures to offset any hit from U.S. tariffs. This will help boost European exports to China, especially if Chinese citizens are forced to divert demand away from tariffed U.S. goods towards tariff-free European products. The likely result is that a recovery in net exports will help boost overall euro area GDP growth to an above-trend pace over the next few quarters, which could generate some surprising upside pressures on inflation. Overall euro area inflation remains well below the European Central Bank (ECB) target of “just below” 2%. Looking ahead, faster rates of inflation are more likely over the next 6-12 months (Chart 9). The early “flash” estimate for April headline HICP inflation was 1.7%, but the lagged impact of higher oil prices and a soft euro should provide a lift towards Q4/2019, boosted by faster year-over-year comparisons versus the 2018 plunge in global oil prices. The flash estimate for April also showed that core HICP inflation jumped from 1% to 1.3%. That is a large move even for a data series that has always been volatile, and there may be more signal than noise this time with wage growth also accelerating. Chart 8Exports Set To Boost European Growth Chart 9A Whiff Of Inflation? In terms of bond investment strategy, the benchmark 10yr German Bund yield looks too low according to most valuation components (Chart 10): Inflation expectations are too low relative to the rising trend in euro-denominated oil prices, and with actual inflation stabilizing. Our estimate of the term premium component of the Bund yield is also depressed, within 25bps of the deeply negative levels seen during 2015/16, when inflation was near zero and the ECB was most aggressively buying government bonds in its Asset Purchase Program. Our proxy for the market’s expectation of the real neutral short-term interest rate in the euro area - the 5-year EUR Overnight Index Swap rate, 5-years forward minus the 5-year EUR CPI swap rate, 5-years forward – is now down to -0.6%. Even allowing for modest potential growth rates in the euro area, and the persistent problems of weak profitability for European banks, such deeply negative real rate expectations discount a lot of pessimism. Similar to the story for U.S. Treasury yields laid our earlier in this report, the medium term risk/reward tradeoff for German Bund yields points to a below-benchmark duration stance as most appropriate. The upside in yields will likely come almost entirely from the inflation expectations component initially, as the ECB will maintain a dovish bias until they are convinced that the economy is indeed accelerating. Thus, we continue to recommend owning inflation protection in the euro area, either through inflation-linked bonds or CPI swaps. Similar to the story for U.S. Treasury yields laid our earlier in this report, the medium term risk/reward tradeoff for German Bund yields points to a below-benchmark duration stance as most appropriate. For spread product, a combination of improving growth, moderate inflation and stable monetary policy should be ideal for the performance of credit. Unfortunately, the robust rally in euro area corporate bonds so far in 2019 has tightened spreads to levels consistent with an accelerating economy (Chart 11). In other words, European corporate credit already discounts the faster growth that is likely to be seen later this year. Just looking at the relationship between credit and the euro area manufacturing PMI, the current level of spreads is more consistent with a PMI several points above the current soft reading that is still below the expansionary 50 line. Chart 10Stay Below-Benchmark ##br##Euro Area Duration Chart 11Stay Neutral European Corporates & Underweight BTPs We continue to recommend only a neutral allocation to euro area corporates (both investment grade and high-yield), given the competing forces of cyclical improvement but stretched valuation. As for our other major tilt in Europe, we continue to recommend a cautious, below-benchmark, stance on Italian government bonds. The indicators for the Italian economy are lagging the signs of life seen in other large euro area nations, amidst ongoing fiscal squabbles with the EU. We continue to recommend a below-benchmark stance on Italian government bonds until there is more decisive evidence of a rebound in Italian growth, signaled by a rising OECD LEI for Italy (which has been negatively correlated to Italy-German spreads over the past decade). Bottom Line: Government bond yields in core Europe are too low relative to tentative signs that growth has bottomed out. At the same time, tight euro area corporate bond spreads already discount better economic momentum. Stay below-benchmark on euro area duration exposure, but maintain only a neutral weighting on euro area corporate bonds.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2019-05-09/fed-s-bostic-warns-consumers-may-feel-hit-on-china-tariff-boost 2 Please see BCA Global Investment Strategy Special Alert, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War”, dated May 10th 2019, available at gis.bcareseach.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights U.S.: The Fed remains decidedly neutral, despite market expectations (and White House pressure) for lower U.S. interest rates. Treasury yields are mispriced and should grind higher over the next 6-12 months, led first by inflation expectations and later by a more hawkish Fed. Canada: The Bank of Canada’s latest reports and commentary indicate that monetary policy will stay on hold over at least the balance of 2019. Bond markets are already priced for that outcome. Maintain a neutral stance on Canadian government bonds in global hedged fixed income portfolios. Sweden: The Riksbank’s recent dovish turn, calling for a flatter trajectory for interest rates and extending asset purchases, will keep Swedish bond yields lower for longer. Thus, we are closing our recommended tactical trades in Sweden that were positioned for rate hikes. Feature Global bond yields remain stuck in a range, seeking a new directional narrative. The downside is limited by green shoots of improving global growth (mostly from China stimulus), some commodity price reflation through higher oil prices and robust returns in most risk asset markets (i.e. an easing of financial conditions). At the same time, the upside for yields is capped by dovish forward guidance from data-dependent central banks who see below-trend economic growth and below-target inflation in the rearview mirror. Chart of the WeekForward MIS-guidance We expect these opposing forces to be resolved through faster global growth and higher realized inflation over the next 6-12 months. Major central banks will not need to turn even more dovish and begin a monetary policy easing cycle to boost growth, despite current market pricing suggesting otherwise. Global bond yields will grind upward, first through higher inflation expectations and, later, from a shift away from discounting rate cuts and, in some countries, pricing in rate hikes. The pressure for higher yields will be strongest in the U.S., where the Treasury market now discounts that the current 2.5% fed funds rate will be the cyclical peak, below the median FOMC projection, even as inflation expectations have been moving higher (Chart of the Week).  We continue to recommend pro-growth, pro-risk allocations in global fixed income markets: below-benchmark overall duration exposure, favoring global corporates over government bonds, focusing government bond exposure to countries where policymakers will be relatively less hawkish (Japan, U.K., Australia, Canada, New Zealand), and positioning for faster inflation expectations and bearish steepening of yield curves (most notably in the U.S. and core Europe). May FOMC Meeting: Sorry, Mr. President The Fed kept rates unchanged at last week’s FOMC meeting, dashing market hopes of a potential shift in language toward a future rate cut. The official statement acknowledged that U.S. inflation was running below the 2% target, but Fed Chair Jerome Powell later described that inflation shortfall as “transitory” and expected to reverse. Treasury yields got whipsawed by the mixed messaging, with the 2-year yield falling -6bps after the statement but then climbing +11bps during Powell’s press conference. Powell standing his ground so firmly was a sharp rebuke to U.S. money markets, which remain priced for rate cuts over the next year. It was also a strong sign of the Fed maintaining its political independence in the face of U.S. President Trump calling for aggressive rate cuts. From a growth perspective, the Fed is right to not panic. The employment backdrop remains solid, with the U.S. unemployment rate hitting a 50-year low in April of 3.6%. While cyclical growth indicators like the ISM Manufacturing index have trended lower, the headline index remains above the expansionary 50 level (Chart 2). The rally in U.S. equity and credit markets seen so far in 2019 has eased financial conditions, signaling an imminent rebound in the U.S. leading economic indicator (second panel). Furthermore, core measures of retail sales and capital goods orders have begun to reaccelerate after the Q1 slump impacted by the U.S. government shutdown. From a growth perspective, the Fed is right to not panic. On the inflation side, the story is more nuanced. Higher oil prices will boost headline inflation measures over the next six months. At the same time, the lagged impact of the surprising pickup in U.S. productivity growth (+2.4% year-over-year in Q1) will help dampen core inflation rates (Chart 3) via lower unit labor costs (flat year-over-year in Q1). Further complicating the issue for the Fed is the impact of lower inflation in the components that Fed Chair Powell deemed “transitory”, such as airfares, apparel and, most interestingly, the cost of financial services. Chart 2A Blossoming U.S. ##br##Rebound Chart 3Blame Equities For The Cooling Of ##br##U.S. Core Inflation The broad Financial Services and Inflation grouping, which includes market-related costs such as wealth management fees, now represents 9% of the overall U.S. core PCE deflator. The inflation rate of the Financial Services index is highly correlated to the performance of U.S. equity markets (Chart 4). This makes sense, as the costs of professional portfolio management are often tied to the size of assets under management. At a minimum, the market should be priced for the same neutral (unchanged) stance that the Fed is currently signaling, which is appropriate given signs of U.S. growth perking up. Chart 4Faster Productivity Means The Fed Can Be Patient In 2018, prior to the year-end correction in U.S. equity markets, the contribution to core PCE inflation from the Financial Services category was a steady 0.5-0.6 percentage points. After the market rout, that contribution has fallen to 0.2 percentage points, accounting for nearly all of the 40bp decline in core PCE inflation since U.S. equities peaked last September. With equity markets having now regained all the late-2018 losses, Financial Services inflation should boost core PCE inflation by at least 20-30bps by year-end – and perhaps more if stocks continue to appreciate, per the BCA House View. With our Fed Monitor now sitting just above the zero line, indicating no pressure on the Fed to hike rates, the -30bps of rate cuts now discounted over the next year is too aggressive (Chart 5). At a minimum, the market should be priced for the same neutral (unchanged) stance that the Fed is currently signaling, which is appropriate given signs of U.S. growth perking up. The Fed will remain cautious on returning to a more hawkish stance until actual U.S. inflation turns higher, which will take some time given the competing forces of falling unit labor costs and fading “transitory” disinflationary effects. Chart 5Stay Underweight USTs & Below-Benchmark UST Duration We think the 2017 experience will be useful to think about in the coming months. Then, the Fed paused its rate hiking cycle for a few months, primarily due to softer inflation readings related to unusual forces temporarily dampening core inflation (most notably, a one-time collapse in wireless phone prices related to a change in how those costs were measured). Once those “transitory” forces faded out of the data, the Fed resumed lifting the funds rate. It will likely take longer in 2019 before the Fed would feel confident enough to begin raising rates again, especially with the funds rate now much closer to neutral than two years ago. Nonetheless, we expect a similar story of rebounding inflation driving Treasury yields higher to unfold over the latter half of this year. A moderate below-benchmark U.S. duration stance, favoring shorter maturities, combined with a long position in inflation-protected TIPS over nominal Treasuries, remains appropriate. Bottom Line: The Fed remains decidedly neutral, despite market expectations (and White House pressure) for lower U.S. interest rates. Treasury yields are mispriced and should grind higher over the next 6-12 months, led first by inflation expectations and later by a more hawkish Fed. Canada Update: Stay Neutral Back in March, we upgraded our recommended Canadian government bond exposure to neutral after spending a long time at underweight.1 The rationale for our move was that the stunning loss of momentum in the Canadian economy at the end of 2018 would force the Bank of Canada (BoC) to not only stop raising rates, but stay on hold for longer than expected. After our upgrade, we noted that we would consider additional changes to our Canadian allocation after the releases of the latest BoC Business Outlook Survey (BoS) and the updated economic projections at the April 24 monetary policy meeting. None of those events makes us want to move away from the current neutral recommendation. The problem for the BoC is that its policy rate of 1.75% remains well below its own estimated neutral range, which is now 2.25%-3.25% (Chart 6). A similar message comes when looking at the neutral real rate (“r-star”) estimate for Canada produced by the New York Fed, with an r-star of 1.5% versus a current real policy rate around 0%.2 This suggests that Canadian monetary policy remains accommodative and that the BoC should be looking for opportunities to continue moving interest rates toward “neutral” when the economy is accelerating. Yet our own BoC Monitor suggests that an unchanged policy stance is currently appropriate, while -11bps of rate cuts are now discounted in the Canadian Overnight Index Swap (OIS) curve. In other words, the BoC is torn between a fundamental interest rate framework that says the hiking cycle is not done yet, and a sluggish economy that demands a dovish bias. The BoC is torn between a fundamental interest rate framework that says the hiking cycle is not done yet, and a sluggish economy that demands a dovish bias. In the press conference following the April 24 BoC policy meeting, BoC Governor Steve Poloz noted that any reference to the need for interest rates to return to the BoC’s neutral range was deliberately omitted from the official policy statement. This is a clear signal that the central bank has shifted its focus from “normalizing” rates to preventing a deeper downturn in Canadian growth. The latest BoS showed that business confidence, expected sales and future investment intentions all fell sharply in the first quarter of 2019 (Chart 7). There was a huge drop in the number of firms reporting capacity pressures and labor shortages, with more firms now expecting their prices to fall than rise over the next year. The main headwinds to the diminished outlook for future sales were related to “a more uncertain outlook in the Western Canadian energy sector, continued weakness in housing-related activity in some regions, and tangible impacts from global trade tensions”.3 Chart 6A Long Way From BoC ##br##Rate Cuts Chart 7Negative Messages From The BoC Business Outlook Survey   The BoC places a lot of weight on the BoS in determining its economic forecasts, and in setting monetary policy. Thus, it is no surprise that in the official statement following the April 24 monetary policy meeting, the BoC Governing Council noted that they were “monitoring developments in household spending, oil markets and global trade policy to gauge the extent to which the factors weighing on growth and the inflation outlook were dissipating”.4 Those were the same three concerns of businesses highlighted in the BoS, assuming that “weakness in the Canadian housing market” is related to “developments in household spending” – a logical link given the high level of Canadian household and mortgage debt. Looking at those three factors, there is nothing suggesting that the BoC needs to adjust policy anytime soon (Chart 8). Oil prices are rising, but household spending remains weak and global trade uncertainties have not completely diminished and Canadian export growth has stagnated. Given the mixed picture from the economic data, the BoC will likely remain on hold until there is a clear signal from the data. From a bond investment strategy perspective, staying at neutral also makes sense. A move to overweight Canadian bonds would require an even deeper economic downturn into recessionary territory that would push Canadian unemployment higher (Chart 9). Downgrading back to underweight, however, would require signs of a sustainable rebound in Canadian domestic demand and stronger global growth that would boost Canadian exports – an outcome that would not be visible in the data until at least the third quarter of 2019. Chart 8Watch What The BoC ##br##Is Watching Chart 9A Neutral Weight On Canada Is Still Justified   One final point on staying neutral on Canada comes from looking at cross-country spread levels between government bonds in Canada and other major developed economies. The spread levels look historically wide versus sovereign debt from Germany, the U.K., and Australia; wide versus recent history in Japan; but very narrow versus the U.S. (Chart 9). Those spreads are shown without hedging out the currency risk of going long Canadian bonds – and, by association, the Canadian dollar. Once the currency risk is hedged out of those cross-country spreads using 3-month currency forwards, the spread differentials are all far less interesting both in absolute terms and relative to history (Chart 10 & 11). Chart 10Big Differences In Canadian Bond Spreads Vs Other Major DM... Chart 11… But Those Spreads Disappear Once The C$ Exposure Is Hedged So even on an individual country basis, there is no compelling case to be anything but neutral Canadian government bonds versus global currency-hedged benchmarks – which is how we present all our fixed income recommendations in Global Fixed Income Strategy. Bottom Line: The Bank of Canada’s latest reports and commentary indicate that monetary policy will stay on hold over at least the balance of 2019. Bond markets are already priced for that outcome. Maintain a neutral stance on Canadian government bonds in global hedged fixed income portfolios. Sweden Trade Update – Time To Retreat & Regroup Exactly one year ago (May 8, 2018), we initiated trades in our Tactical Overlay portfolio to position for tighter monetary policy, and higher bond yields, in Sweden.5 Specifically, we have been recommending shorting 2-year Swedish government bonds versus German equivalents (hedging the currency exposure back into krona), while also selling 2-year Swedish bonds and buying 10-year Swedish debt in a yield curve flattening trade. The positions were chosen to benefit from an expected bearish repricing of the short-end of the Swedish curve. At this time last year, the positive upward momentum of Swedish growth and inflation had reached a point where the Riksbank was clearly – and credibly – signaling that the long process of normalizing its highly accommodative crisis-era monetary policies would begin. That meant lifting policy rates away from negative territory, as well as shutting down the bond-buying quantitative easing (QE) program. One year later, the economic backdrop has done a 180-degree turn against our original thesis (Chart 12): Swedish growth has slowed, with both the manufacturing PMI and leading economic indicator at the lowest levels since 2013. Unemployment has increased and nominal wage growth has rolled over. Headline CPIF inflation has fallen back below the Riksbank 2% target, while core CPIF inflation remains stuck near 1.5%. The Riksbank changed its forward guidance at last month’s monetary policy meeting, signaling that the benchmark interest rate will remain at -0.25% for “somewhat longer” than was indicated as recently as February (when a rate hike around the end of 2019 or in early 2020 was signaled). The Riksbank also pledged to maintain the size of its QE bond purchases from July 2019 to December 2020, a dovish surprise. Swedish money markets are still discounting 13bps of rate hikes over the next twelve months. Yet our Riksbank Monitor, on the other hand, is now indicating a need for rate cuts, driven by both softer inflation and weaker growth. The minutes from last month’s policy meeting revealed that the forward guidance was adjusted simply because headline inflation had temporarily dipped back below the 2% Riksbank target. The implication is that a return to 2% inflation would prompt the Riksbank to hike. Swedish money markets are still discounting 13bps of rate hikes over the next twelve months. Yet our Riksbank Monitor, on the other hand, is now indicating a need for rate cuts, driven by both softer inflation and weaker growth. A useful rule for investment risk management is: when the underlying rationale for a position is clearly not unfolding as expected, the best thing to do is simply close that position and look for new opportunities better aligned to the current reality. Chart 12No More Pressure On Riksbank ##br##To Hike Chart 13Time To Exit Our Recommended "Hawkish" Trades In Sweden With that in mind, we are choosing to close our tactical trades in Sweden (Chart 13). The 2-year Sweden-Germany spread trade generated a loss of -52bps (including the return from hedging the euro exposure in Germany back into Swedish krona). We were more fortunate with the curve flattening trade, which generated a return of +61bps as the Swedish curve bullishly flattened through falling 10-year yields rather than bearishly flattening through rising 2-year yields (our original expectation). Thus, we are closing out our Sweden trades at a small net gain of +9bps. We will do a deeper analysis on Sweden in an upcoming Global Fixed Income Strategy report to search for new potential trade ideas. Bottom Line: The Riksbank’s recent dovish turn, calling for a flatter trajectory for interest rates and extending asset purchases, will keep Swedish bond yields lower for longer. Thus, we are closing our recommended tactical trades in Sweden that were positioned for a faster path of rate hikes.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “March Calmness”, dated March 19, 2019, available at gfis.bcaresearch.com. 2 The NY Fed’s estimates for non-U.S. r-star rates for the euro area, Canada, and the U.K. can be found on the NY Fed website. https://www.newyorkfed.org/research/policy/rstar 3https://www.bankofcanada.ca/2019/04/business-outlook-survey-spring-2019/ 4https://www.bankofcanada.ca/2019/04/fad-press-release-2019-04-24/ 5 Please see BCA Global Fixed Income Strategy Special Report, “Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore”, dated May 8, 2018, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns