Fixed Income

Highlights The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view of the economy, the tax bill and the Fed. The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. Feature U.S. risk assets continued to outperform last week outside of the dollar, as S&P 500 firms started to report Q4 2017 results and provide guidance for Q1 2018 and beyond. BCA's Bank Lending Beige Book summarizes the most optimistic comments from the Big 5 banks. The Fed's Beige Book captured comments on the broad economy in December and early January that were equally ebullient. Both Beige books suggested that firms were planning to return their tax savings to shareholders in the New Year, and to continue to boost capex, which was stout even before the law was passed. Yet, despite the upbeat news, the dollar broke down last week, as the ECB sounded a hawkish note and the Japanese economy continued to improve. On balance, the Beige Book, the Q4 earnings season, the health of the U.S. economy (notably capital spending), all support BCA's stance on the U.S. stock-to-bond ratio, the Fed, duration and the dollar. However, the dollar has not behaved as we would have expected. Beige Book Barometer Bounces The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach1 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, references to the stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and President Trump's assault on regulation. Chart 1Latest Beige Book Supports##BR##The Fed's View On Rates, Economy Chart 1, panel 1 shows that at 66%, BCA's Beige Book Monitor stayed near its cycle highs in January, re-confirmation that the underlying economy was still upbeat in Q4 and early 2018. (The latest Beige Book covered the period from mid-November 2017 to January 8, 2018). The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 12 mentions of the tax bill in the January Beige Book, up from only 3 in November (not shown). The tax bill was cast in a positive light in 75% of the remarks. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Based on the minimal references to a robust dollar in the past five Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018, which is in sharp contrast with 2015 and early 2016 when there was a surge in Beige Book mentions (Chart 1, panel 4). The last time that five consecutive Beige Books had so few remarks about a strong dollar was in late 2014. Business uncertainty over government policy (fiscal, regulatory and health) ticked up in the past few Beige Books as Congress debated the particulars of the tax bill. Nonetheless, comments of uncertainty in the Beige Book have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 1, panel 5). The disconnect with the Fed on inflation is evident in the Beige Book's number of inflation words (Chart 1, panel 3). Expressions regarding inflation rose to a four-month high in January and the disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the U.S. economy is poised to grow above its long-term potential in the first half of 2018. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Likewise, the latest Beige Book confirmed that at least initially, businesses and bankers across the U.S. welcomed the Tax Cut and Jobs Act. Bankers' Beige Book Returns Chart 2Banking System Shipshape BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view: Pristine credit quality, a positive U.S. credit impulse, loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities. We introduced the Big 5 Bank Lending Beige Book2 in early 2014 to interpret the health of the banking system based on comments from leaders of the Big Five banks during earnings season. Managements were upbeat on loan demand and credit quality as they unveiled Q4 results in the past two weeks, and most expressed optimism that the positive credit trends would continue to improve in 2018. Several bank executives shared their Fed rate hike expectations for this year, with most forecasting three or four increases. One institution planned for a flatter curve, while another noted that rising rates on both the short and long ends will benefit their operations. Chart 2 shows key banking related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q4 2017. All five banks were uniformly upbeat in their assessments of the tax bill's impact on their operations, their customers' businesses or the overall economy. One bank noted that it took a repatriation charge in Q4, and another said it would return capital to shareholders via buybacks and dividends. A third said the bill will provide "immediate and ongoing benefit to our employees, customers, communities and our shareholders, as we invest a portion of our tax savings in each of these important constituencies." Bottom Line: The banking system is shipshape as 2018 begins and lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.3 A Different Lens On Earnings Chart 3Corporate Health Has Improved##BR##Since Start Of 2017 The early December release of the U.S. flow of funds report allows us to update BCA's Corporate Health Monitor (CHM) (Chart 3). The CHM's level improved slightly between Q2 and Q3, but the overall reading remains in 'deteriorating health' territory. The marginal improvement in Q3 was driven by rising profit margins. In addition, profit growth surged while debt moved up modestly in Q3. The CHM is a reliable indicator of the trend in corporate bond spreads which supports our corporate bond overweight. Given that corporate balance sheets are declining, the sole supports for corporate spreads are low inflation and accommodative monetary policy. We anticipate spreads will start to widen later this year when inflation climbs and policy turns more restrictive. BCA's U.S. Bond strategists remain overweight the U.S. high-yield bond market.4 Although spreads appear a bit more attractive than for investment-grade corporates, there is still not much room for spread compression in high-yields. We calculate that if the high-yield index spread tightens by another 117 bps, then junk bonds will be the most expensive since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Nonetheless, in view of the trends in corporate leverage, it is unlikely that there will be another 100 bps of spread tightening. More realistically, we expect excess returns between 200 bps and 500 bps (annualized) between now and the end of the credit cycle. Bottom Line: BCA's indicators suggest that we are moving into the late stages of the credit cycle, but we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will monitor to gauge the end of the cycle. An abrupt end to the positive capex or earnings cycle would also be concerns for our upbeat view on credit. Repatriation Redux The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. There are several uses for corporate cash, including capital spending, M&A, increasing compensation to employees, paying down debt and returning capital to shareholders. Chart 4 shows that through Q3 2017, share buybacks and dividends ran slightly ahead of prior cycles, while capex was about average. Investors wonder how that mix may change under the new law. Corporate behavior in the wake of the 2004 overseas tax holiday5 provides some guidance. Chart 4Comparison Of Corporate Outlays Across Four Economic Expansion Phases Corporations used cash generated from the 2004 tax break to return capital to shareholders. However, we found scant evidence that firms who benefited from the tax holiday increased capital spending, raised wages or hired more workers. A study by the National Bureau of Economic Research (NBER) noted that a dollar increase in repatriations "was associated with an increase of almost $1 in payouts to shareholders."6 Moreover, a 2008 IRS paper7 concluded that nearly half of all the cash repatriated in 2004 and 2005 came from only the tech and pharma sectors. A Congressional Research Service (CRS) found that small firms tended to benefit less than large firms from the tax holiday.8 A paper9 by the left-leaning, U.S.-based think tank, the Center For Budget and Policy Priorities (CBPP), stated that several firms that benefitted the most from the 2004 law laid off workers soon after the tax law was enacted. In 2018, BCA expects firms to return capital to shareholders, boost capex and continue to bump up wages. Chart 5 shows that buybacks will probably augment S&P 500 EPS by around 2% this year, while panel 2 shows that there was a noticeable upswing to buyback announcements as 2017 ended. Aside from the post-recession bounce in buybacks in 2010, the last big swell in buyback announcements occurred in 2004 and 2005. That said, corporate balance sheets were in much better shape in 2004/2005 than they are today (Chart 3 again). The implication is that management teams may decide to pay down debt before returning the cash windfall back to shareholders. However, with rates still low, most firms will chose to distribute the cash to shareholders, despite high corporate debt levels. The positive reading on BCA's Capital Structure Preference Indicator supports our stance on buybacks (Chart 6, third panel). This Indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Moreover, Chart 7 shows that the dividend payout ratio rebounded from the 2007-2009 financial crisis, but has moved above its pre-crisis level. However, dividend distributions remain below their pre-crisis peak reached in the early 1990s. Chart 5Still Some Room##BR##To Run For Buybacks Chart 6Buybacks Adding Almost##BR##2 Percentage Points To EPS Growth Capital spending was already on a tear in late 2017, even before the tax bill passed. Industrial production, the PMI diffusion index and advanced-economy capital goods imports, all confirm strong underlying momentum in investment spending (Chart 8). Chart 7Corporations Poised To Return##BR##Capital To Shareholders Chart 8Capital Spending Helping##BR##To Drive Growth Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM data, roaring global exports and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters (Chart 9). CEO confidence soared to a 13-year high in Q4, according to the latest Duke's Fuqua School of Business/CFO Magazine Global Business Outlook (Chart 10, panel 1). Duke noted that "Among CFOs who responded to the survey after the Senate passed its version of the tax reform bill, optimism spiked to 73, which is the highest U.S. optimism ever recorded in the history of the survey."10 Chart 9Bright Outlook##BR##For Capital Spending Chart 10CEO Confidence And##BR##Capex Plans Surging Surveys by the Conference Board and Business Roundtable show a similar pattern. (panel 1 again). Notably, the soundings on all three surveys have climbed since Trump's election, but then retreated as his pro-business agenda stalled in the summer months. The dip in sentiment reflected the lack of legislative progress in Washington in the first 10 months of the Trump administration. The dip in CEO sentiment in Q2 and Q3 was in sharp contrast to the easing of policy concerns in the Fed's Beige Book (Chart 1, bottom panel). The upbeat numbers in the regional FRBs' surveys of capital spending intentions further support escalating capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are at an all-time high (Chart 10, panel 2). Moreover, the regional Feds' capex spending plans diffusion index is close to a cycle high, despite a modest pullback last summer (panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. The tax bill will boost returns to shareholders via buybacks and dividends. In addition, rising capex will drive up GDP, employment and EPS in the coming quarters. Dollar View Revisited The dollar fell by 4% between mid-December and mid-January, amid a hawkish market interpretation of the ECB minutes, persistently strong growth in Japan and a key technical breakdown in the DXY index. The decline has some investors questioning BCA's bullish stance on the currency (Chart 11). We were correct on the direction of interest rate differentials vis-à-vis the other major economies, but this has not translated into a stronger dollar so far. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. A lot of good news on the European and Japanese economies is now discounted and investors are quite pessimistic on the dollar (which is bullish the dollar from a contrary perspective) (Chart 12). Given this technical backdrop, we would expect at least a 5% rise in the trade-weighted dollar as expectations of Fed rate hikes rise this year. We are likely to exit our long dollar position if we get such an appreciation. Chart 11We Are Sticking With##BR##Our Long Dollar View Chart 12The Case For Crisis Era Monetary Stimulus##BR##In Europe And Japan Is Weakening Bottom Line: BCA's bullish dollar trade was initiated in October 2014 and although the DXY index is up 4% since that time, we are maintaining the trade. While downside risks remain, a unilateral decision by the Trump Administration to leave NAFTA will boost the U.S. dollar versus the Canadian dollar and the peso. Italy's upcoming spring Presidential election could prompt a rally in the dollar if the Eurosceptic parties outperform expectations. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published on April 17, 2017. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments", published January 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "High Conviction Calls", published November 27, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "January Effect", published January 9, 2018. Available at usbs.bcaresearch.com. 5 https://www.congress.gov/bill/108th-congress/house-bill/4520 6 http://www.nber.org/papers/w15023 7 https://www.irs.gov/pub/irs-soi/08codivdeductbul.pdf 8 https://fas.org/sgp/crs/misc/R40178.pdf 9 https://www.cbpp.org/research/tax-holiday-for-overseas-corporate-profits-would-increase-deficits-fail-to-boost-the 10 http://www.cfosurvey.org/2017q4/press-release.html Appendix: Bankers Beige Book

Highlights Trade #1: Go Short The December 2018 Fed Funds Futures Contract. The trade has gained 64 bps since we initiated it. We are lifting the stop to 60 bps and targeting a profit of 75 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities. The trade is up 13.1%. We are targeting a profit of 15%, and are tightening the stop further to 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts. The trade is up 0.7%. We see this as a multi-year trade with significant upside potential. The unwinding of heavy short positions could cause the yen to strengthen temporarily. The euro is vulnerable to negative growth surprises. A retracement of some of its recent gains is likely. Feature Looking Back, Thinking Forward I had the pleasure of speaking at BCA's Annual Investment Conference held in New York on September 27th of last year where I offered three "tantalizing" trade ideas. Chart 1 reviews their performance. They were the following: Trade #1: Go Short The December 2018 Fed Funds Futures Contract We argued last summer that U.S. growth was likely to accelerate, taking rate expectations higher. That has indeed happened. Aggregate hours worked rose by 2.5% in Q4 over the previous quarter. Assuming that productivity increased by 1.5% in Q4 - equal to the pace recorded in Q3 - real GDP probably increased by nearly 4%. A variety of leading indicators point to continued above-trend growth in the months ahead (Chart 2). Chart 1Three Tantalizing Trades: ##br##An Update Chart 2Leading Indicators Pointing ##br##To Above-Trend U.S. Growth We think the Fed will raise rates four times this year, one more hike than projected by the dots and roughly 35 bps more in tightening than implied by current market expectations. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. We have been saying for a while that above-trend growth will take the unemployment rate down to a 49-year low of 3.5% by the end of this year. If the unemployment rate falls this much, the Fed will probably turn more hawkish. Stronger inflation numbers should also give the Fed confidence to keep raising rates once per quarter. Core inflation surprised on the upside in December. We expect this trend to continue in the coming months, as the ISM manufacturing index, the New York Fed's Inflation Gauge, and our own proprietary pipeline inflation index are already foreshadowing (Chart 3). Chart 3U.S. Inflation ##br##Should Accelerate Chart 4A Pick-Up In Wage Growth ##br##Would Put Upward Pressure On Service Inflation As we noted two weeks ago,1 service sector inflation should get a lift from faster wage growth this year (Chart 4). Goods inflation should also rise on the back of higher oil prices and the lagged effects of a weaker dollar (Chart 5). In addition, health care inflation is likely to pick up from its current depressed level, especially if the Congressional Budget Office is correct that insurance premiums will rise due to the elimination of the individual mandate (Chart 6). Housing inflation will moderate, but this is unlikely to stymie the Fed's tightening plans since excessively low interest rates could lead to even more overbuilding in the increasingly vulnerable commercial real estate sector. Chart 5Higher Oil Prices And A Weaker Dollar ##br##Are A Tailwind For Inflation Chart 6Health Care Inflation ##br##Should Move Higher Granted, four rate hikes equal four opportunities to defer raising rates. It is easy to imagine scenarios where the Fed stands pat, but hard to conjure scenarios where the Fed has to raise rates five times or more this year. Thus, the risk to our four-hike view is to the downside. As such, we will be looking to take profits of 75 bps on the trade, and are putting in a stop of 60 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities Capital spending tends to accelerate in the late innings of business-cycle expansions. We are in such a phase now, as evidenced by capital goods orders, capex intention surveys, and our global capex model (Chart 7). Increased capital spending will benefit industrial companies. Conversely, rising bond yields will hurt rate-sensitive utilities. Valuations in the industrial sector have gotten stretched, but are not at extreme levels (Chart 8). Based on enterprise value-to-EBITDA, industrials are still only slightly more expensive than utilities compared to their post-1990 average. Chart 7Capex Is Shifting Into ##br##Higher Gear Chart 8Industrial Stocks: Valuations Are Stretched, ##br## But Not Yet Extreme While we do think global growth will slow this year from the heady pace of 2017, it should remain firmly above-trend. A bigger-than-expected slowdown - especially if it is concentrated in China - would undoubtedly hurt industrials. A stronger dollar could also be a headwind. Thus, we are keeping this trade on a short leash, with a target of 15% and a stop of 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The Japanese economy is on fire. Growth almost reached 2% in 2017 and leading indicators suggest a solid start to 2018 (Chart 9). The unemployment rate has fallen to 2.7%, a full point below 2007 levels. The ratio of job openings-to-applicants has surpassed its bubble peak. The Tankan Employment Conditions Index is pointing to an exceptionally tight labor market. Wages excluding overtime pay are rising at the fastest pace in twenty years (Chart 10). Chart 9Japanese Growth Momentum Is Positive Chart 10Signs Of A Tight Labor Market Inflation is low but is starting to edge up. The most recent release surprised on the upside. Inflation expectations moved higher on the news, benefiting our long Japanese 10-year CPI swap trade recommendation (Chart 11). A simple scatterplot between the unemployment rate and core inflation suggests the Phillips curve remains intact in Japan -- amazingly, it even looks like Japan (Chart 12)! Chart 11Inflation Expectations Have Edged Higher Chart 12The Phillips Curve In Japan Looks Like Japan Still, with core inflation excluding food and energy running at only 0.3%, there is a long way to go before inflation reaches the BoJ's target -- and even longer if the BoJ honours its promise to generate a meaningful overshoot to compensate for the below-target inflation of prior years. This suggests the BoJ will not meaningfully water down its Yield Curve Control regime anytime soon. As such, five-year yields are likely to stay put while yields with maturities in excess of ten years should move higher. Our "tantalizing trade" being short 20-year JGBs versus their 5-year counterparts still has a long way to run. Too Risky To Short The Yen The exceptionally strong correlation between USD/JPY and U.S. Treasury yields has broken down this year (Chart 13). Had the relationship held, the yen would have actually weakened against the dollar. Still, we are reluctant to get too bearish on the yen (Chart 14). The yen real effective exchange rate is close to multi-decade lows. Positioning on the currency is heavily short. The current account surplus has mushroomed from close to zero in 2014 to 4% of GDP at present. And even if the BoJ keeps the Yield Curve Control regime in place, investors may still anticipate its demise, leading to a temporary bout of yen strength. Chart 13Strong Correlation Is Broken Chart 14Too Risky To Short The Yen What's Propping Up The Euro? The euro has been on a tear since last week, egged on by the ECB minutes, which hinted at a faster pace of monetary normalization. Growing confidence that Angela Merkel will be able to form a grand coalition also helped the common currency, along with hopes that the new government will loosen the fiscal purse strings. The euro is often thought of as the "anti-dollar." And sure enough, the euro's strength has been reflected in a broad-based decline in the dollar index in recent days. BCA's Global Investment Strategy service went long the dollar on October 31, 2014. We "doubled up" on this call in the fall of 2016, controversially arguing that "Trump will win and the dollar will rally." Obviously, in retrospect, I should have rung the register and declared victory on our long dollar view when I had the chance. EUR/USD fell to 1.04 on December 2016, within striking distance of our parity target. Bullish dollar sentiment had reached unsustainably lofty levels. That was the time to sell the greenback. But hubris got the best of me. While our other currency trade recommendations have delivered net gains of 11% since the start of 2017, the long DXY trade has stuck out like a sore thumb. Hindsight is 20/20. The key question is what to do today. EUR/USD is still trading below the level it was at when we went long the DXY. Relative to the IMF's Purchasing Power Parity exchange rate of 1.32, the euro is 7% undervalued. That said, PPP exchange rates may not be a reliable benchmark in this case. Given current market expectations, EUR/USD would need to strengthen to 1.41 over the next ten years just to cover the carry cost of being short the dollar. Even assuming lower inflation in the euro area, that would still leave the euro trading above its long-term fair value. It is possible, of course, that rate differentials will narrow further, but the scope for this is more limited than it might appear. The market currently expects policy rates ten years out to be 95 basis points higher in the U.S., down from a spread of nearly 180 basis points in late December (Chart 15). Given that euro area inflation expectations are 40-to-50 bps lower than in the U.S., this implies a real spread of about 50 bps - broadly in line with our estimate of the real neutral rate gap between the two regions. Ultimately, the fate of the euro in 2018 will rest on the same question that drove the currency in 2017: Will euro area growth surprise on the upside, prompting investors to price in a faster pace of monetary normalization? The bar for success is certainly higher at present. Chart 16 shows that euro area consensus growth estimates have risen significantly since the start of last year. The expected lift-off date for policy rates has also shifted in by more than a year to mid-2019. Considering that Jens Weidmann stated earlier this week that he thinks current market pricing is broadly consistent with when the ECB expects to hike rates, there is little scope for the lift-off date to move forward. Chart 15Little Scope For Rate Differentials ##br## To Narrow Further Chart 16Euro Area Growth Estimates Have Been Revised Up ##br##Since The Start Of 2017 Meanwhile, financial conditions have tightened significantly in the euro area relative to the U.S., the euro area credit impulse has turned negative, and the U.S. economic surprise index has jumped above that of the euro area (Chart 17). Euro area inflation has also dipped. Especially worrying is that core inflation in Italy has fallen back to a near record-low of 0.4% (Chart 18). How is Italy supposed to navigate its way out of its debt trap if nominal growth stays this weak? On top of all that, long speculative euro positions have soared to record-high levels (Chart 19). Given the choice of betting whether EUR/USD will first hit 1.30 or 1.15, we would go with the latter. If our bet turns out to be correct, we will use that opportunity to shift to neutral on the dollar. Chart 17The Euro Is Vulnerable ##br##To Negative Growth Surprises Chart 18Euro Area Core Inflation ##br##Has Dipped Chart 19Euro Positioning: From Deeply Short ##br##To Record Long Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Duration: Economic fundamentals indicate that U.S. TIPS breakeven inflation rates have further cyclical upside and this will drive nominal bond yields higher on a 6-12 month horizon. In the near term, however, positioning data suggest that the uptrend in U.S. bond yields is due for a pause. Maintain a below-benchmark duration stance. Oil & U.S. Bonds: The cost of inflation compensation is an important driver of U.S. bond yields and the oil price is an important driver of the cost of inflation compensation. This will continue to be true until long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%. At that point the oil price will become a less important driver of U.S. bond yields. Australia: Maintain an overweight position in Australian government debt. Economic data are still mixed and the RBA will stay on hold for the foreseeable future. Against a backdrop of Fed rate hikes, Australian debt should outperform. Feature Chart of the WeekHigher Yields, Driven By Inflation There was certainly no shortage of possible catalysts for last week's bond rout (Chart of the Week). The Bank of Japan (BoJ) reduced its buying of long-dated JGBs, there was a rumor that China plans to slow or stop its purchases of U.S. Treasury debt, and U.S. inflation expectations started to ramp back up - driven by a combination of higher oil prices and a strong December core CPI print. But of all these factors we think it is only the third that merits much attention. Once the BoJ started targeting the level of the yield curve in September 2016, its quantity targets became irrelevant. A reduction in the pace of BoJ buying only matters if it foreshadows a shift to a higher yield curve target. Our foreign exchange strategists don't think such a move is likely in the next 12-18 months.1 China, for its part, still has a highly managed currency and now that capital is no longer flowing out of the country it will start to rebuild its foreign exchange reserves. Given that the U.S. Treasury market remains the world's most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States (Chart 2). The compensation for 10-year U.S. inflation protection broke above 2% last week, after having been as low as 1.66% as recently as last June. This 34 basis point increase in inflation compensation coincided with a 36 basis point increase in the nominal U.S. 10-year yield and a Brent crude oil price that rose from $45 per barrel last June to $70 per barrel as of last Friday. We think these correlations will continue to be the most important factors driving bond yields during the next 6-12 months, and the bulk of this report is dedicated to disentangling the linkages between oil prices, inflation, inflation expectations and nominal bond yields. But first we reiterate our cyclical investment stance. Last week's U.S. CPI report provided further evidence that U.S. core inflation is in the process of bottoming-out (Chart 3). The 10-year U.S. TIPS breakeven inflation rate will settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's target. By that time the nominal 10-year yield will be in a range between 2.8% and 3.25%. Likewise, our energy strategists anticipate that an ongoing steady decline in commercial inventories will keep crude prices well supported on a 6-12 month horizon. Chart 2China's Forex Reserves Are Rising Chart 3U.S. Inflation Turns The Corner However, on a shorter time horizon (3 months or less), recent shifts in speculative positioning signal that the uptrends in bond yields and the oil price might be due for a pause (Chart 4). After having been solidly "net long" since the middle of last year, net speculative positions in the 10-year U.S. Treasury futures contract have just dipped into "net short" territory. Historically, net speculative positions have been a decent indicator of 3-month changes in the 10-year U.S. Treasury yield, and at current levels they signal that the 10-year yield could decline modestly during the next three months (Chart 5). Similarly, speculators in the oil futures market are now more "net long" than at any time since last February. While this positioning indicator does not work quite as well for the oil market as for the Treasury market, net longs at more than 20% of open interest (most recent reading is 26%) have more often than not been met with 3-month price declines since 2010 (Chart 6). Chart 4Net Speculative Positioning##BR##For Oil And Bonds Chart 5Net Speculative Positions &##BR##10-Year Treasury Yield (2010 - Present) Chart 6Net Speculative Positions &##BR##WTI Oil Price (2010 - Present) Bottom Line: The outlook for U.S. inflation suggests that TIPS breakeven rates have further cyclical upside and this will drive nominal bond yields higher. However, positioning data in both bond and oil markets suggest that the recent run-up in yields might be due for a near-term pause. Maintain a below-benchmark duration stance on a 6-12 month horizon. Oil, TIPS, Inflation And U.S. Bond Yields: Sorting Out The Mess During the post-financial crisis period two relationships have been both (i) incredibly robust and (ii) unlike relationships observed in prior periods. They are: The cost of inflation protection has been an unusually important determinant of nominal U.S. bond yields. The oil price has shown a very strong correlation with the cost of inflation protection. Both relationships can be explained by the Federal Reserve's asymmetric ability to control inflation. We consider each relationship in turn. The Importance Of Inflation Chart 7TIPS Beta Declines When##BR##Breakevens Are Low A common rule of thumb is to estimate the TIPS beta - the proportion of movement in U.S. nominal bond yields that is explained by movement in TIPS (real) yields - at around 0.8. In other words, this assumes that 80% of the movement in nominal bond yields is explained by the real component. However, we observe that since the financial crisis the 10-year TIPS beta has been a much lower 0.68, and at times it has been closer to 0.5 on a 12-month rolling basis (Chart 7). We also observe that the TIPS beta tends to be lower when TIPS breakeven inflation rates are un-anchored to the downside. There is a very good reason for this. The reason is that the Fed's ability to influence inflation is asymmetric. The Fed has a strong track record of successfully tightening to bring inflation down, but has been less successful at easing to drive it up. This asymmetric ability to influence prices is due in no small part to the zero-lower bound on interest rates. Because the Fed's ability to ease policy is constrained while its ability to tighten is not, bond market participants may at times question the Fed's ability to ease and revise their inflation expectations lower. It is also during these periods that inflation expectations become more volatile and a more important determinant of nominal bond yields. This is because they are increasingly driven by the swings in the economic data and less by the Fed's policy bias. The Importance Of Oil This is where the oil price comes in. Oil and other commodities are crucial inputs to the production process. As such, not only do these prices rise in response to stronger aggregate demand, but higher prices also signal mounting cost-push inflationary pressures. But despite this obvious truth, there is not always a strong correlation between oil prices and inflation expectations. This is because the Fed's reaction function influences the relationship. Consider the pre-crisis (2004-2008) period. Long-maturity TIPS breakeven inflation rates stayed range-bound between 2.4% and 2.5% even as the oil price increased dramatically (Chart 8). Since investors perceived that the Fed would simply tighten policy to tamp out any inflationary pressures that might arise, there was no desire to demand greater compensation for inflation. However, this logic does not work in reverse. When commodity prices fell in 2014, inflation expectations declined alongside. In fact we observe that the correlations between long-maturity TIPS breakeven inflation rates and both oil and commodity prices have been much stronger in the post-crisis period, when inflation expectations have been un-anchored (Table 1). Chart 8The Unstable Correlation: Breakevens & Oil Table 1Correlations Between TIPS Breakeven Inflation & Commodities Investment Conclusions The Fed's asymmetric reaction function leads to two crucial investment conclusions. First, long-maturity inflation expectations (as measured by the U.S. TIPS breakeven inflation rate) can fall when deflationary pressures mount, but their upside is capped in the 2.4% to 2.5% range. This is because the market has no reason to question the Fed's ability to lower inflation by lifting rates. The upside limit of 2.4% to 2.5% will remain in place unless the Fed changes its inflation target. A change to the inflation target that allows for higher inflation is an idea that is quickly gaining traction among policymakers, but is unlikely to be implemented this year. Second, when long-maturity inflation expectations are below their 2.4% to 2.5% upper-bound they become both (i) a more important driver of nominal yields - as evidenced by the lower TIPS beta - and (ii) more sensitive to swings in commodity prices. For this reason, the oil price will continue to be an important driver of inflation expectations and nominal U.S. bond yields for the next few months, but will decrease in importance as TIPS breakevens move back to their 2.4% to 2.5% range. Once inflation expectations are re-anchored, nominal bond yields will once again be predominantly driven by the real component and swings in the price of oil will be less important for bond markets. The dynamics described above are not merely theoretical. Consider the evidence from five developed countries presented in Charts 9 & 10. Chart 9 shows that the oil price is tightly correlated with inflation expectations in the U.S., Eurozone and Japan, but also that inflation expectations in the U.K. and Australia did not respond to the recent increase in oil prices. The reason is that core inflation in the U.K. and Australia is already relatively close to the central bank's target (Chart 10). It is only where core inflation is far below target (in the U.S., Eurozone and Japan) that the oil price remains an important driver of bond yields. Chart 9Oil & Inflation Expectations Highly Correlated... Chart 10...But Only When Inflation Is Low The U.K. in particular presents an interesting case study. U.K. core inflation was quite far below target throughout 2015 and 2016, and during this time period U.K. inflation expectations were tightly linked with the oil price. It is only in the past few months that U.K. core inflation has moved back above target, and not surprisingly the correlation between the U.K. 10-year CPI swap rate and the price of oil has started to break down. Bottom Line: At present, the cost of inflation compensation is an important driver of U.S. bond yields and the oil price is an important driver of the cost of inflation compensation. Both of these dynamics will continue to be true for the next few months, but will decline in importance as TIPS breakeven inflation rates rise. When long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%, then the oil price will become a less important driver of U.S. bond yields. Australia: Too Soon To Expect A Hike Chart 11Australia: A Solid Rebound In Growth... Over the last quarter much of the economic data from Australia have improved. Real GDP growth rebounded sharply to 2.8% YoY in Q3 from 1.9% the previous quarter (Chart 11). Iron ore prices have been rising since mid-October. Employment growth is robust and the unemployment rate is well below its estimated natural level. This begs the question - with so much going right is it time for the Reserve Bank of Australia (RBA) to lift rates? Our answer is an emphatic "no." First, most data improvements have been relatively minor and the overall economic picture remains mixed. As we mentioned in our recent Special Report,2 the RBA is stuck between conflicting forces. Booming house prices and rising household indebtedness on the one hand, and an economy still working off excess capacity on the other. Nevertheless, our expectation is that the RBA will allow the economy to recover further for the following reasons: Consumer health is fragile. Policymakers left cash rates unchanged at the last monetary policy meeting in December, and Governor Philip Lowe expressed concerns about household consumption. Consumption is a significant driver of economic growth and the combination of declining savings, elevated debt levels and weak income growth is worrisome (Chart 12). Since then, real income growth has dipped back into positive territory, but only barely so. Meanwhile, house prices are still surging, despite macro-prudential measures aimed at tightening lending standards, thereby supporting consumer spending through the wealth effect. Given an extreme household debt to income ratio, consumption would be very vulnerable if the RBA were to curb house price gains by raising rates. Labors markets have plenty of slack. The unemployment rate has fallen to a four year low and other labor market statistics show a broad-based improvement over the last quarter. However, the unemployment rate is still significantly higher than it was in the previous cycle and other improvements in the labor market have also occurred from extremely weak levels. In 2017Q1, the underemployment rate and part-time workers as a percentage of total workers both reached all-time highs. Those numbers have dipped slightly in Q3, with underemployment falling to 8.3% and part-time workers as a percentage of total declining to 31.7%, but those elevated levels suggest there still needs to be significant improvement before spare capacity is worked off and real wage growth starts to move higher (Chart 13). Chart 12...But Consumers Can't Afford A Rate Hike Chart 13Still Plenty Of Slack In Australian Labor Markets Inflation is still too low. Headline and core inflation readings came in at 1.8% and 1.9% respectively in Q3 (Chart 14). While headline slowed, core inflation recovered over the last quarter. Tradeable goods inflation collapsed into negative territory at -0.9%, as a result of currency strength and increased competition among retailers. Going forward, we expect consumer price growth to be muted given the lack of inflationary pressures. The output gap is wide, despite rebounding growth, and the IMF forecasts that it will be years before the Australian economy reaches capacity. The trade-weighted Aussie dollar index has risen almost 5% since it bottomed in early December, while the AUD/USD has broken above its 40-week moving average. Continued currency strength would exert even further deflationary pressure. As stated above, the labor market also requires significant improvement to work off excess capacity. All of these factors caused the RBA to dial back its inflation forecast in the November statement. It now expects that inflation will remain quite flat for the next two years, only touching the lower-end of its 2%-3% target range at the end of 2019. Consequently, inflation will not be forcing the RBA's hand in the foreseeable future. One of our key themes for 2018 is that global growth will be less synchronized. Central banks will therefore employ diverging monetary policies, presenting cross-country bond market investment opportunities. As such, we recently shifted to a slight overweight position in Australian debt within our model portfolio, arguing that it would outperform global government bond benchmarks during a year expected to be driven by Fed tightening and ECB/BoJ tapering concerns. Historically, relative yield moves have closely tracked relative shifts in monetary policy (Chart 15). In the U.S., above-trend growth, a tight labor market and the continued recovery in inflation will force the Fed to become more aggressive. If the RBA stays inactive as we expect, then this gap should continue to move in favor of Australian debt. Additionally, there is still a modest yield pickup in Australian debt relative to the global index and as we expect global bond yields to rise, low-beta Australian government bonds should offer considerable protection. Chart 14Australia: Lacking Inflationary Pressures Chart 15Australian Relative Yields Track Relative Policy This also leads us to continue holding our tactical Long Dec 2018 Australian Bank Bill futures trade from last October. We initially entered into this trade as a more focused way of expressing that the RBA will stay on hold. The trade is currently 6 bps in the money and with markets still pricing about 30 bps of rate hikes during the next 12 months, there is plenty of room for further profit as market expectations are revised down. Bottom Line: Maintain an overweight position in Australian government debt. Economic data are still mixed and the RBA will stay on hold for the foreseeable future. Against a backdrop of Fed rate hikes, Australian debt should outperform. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com 1 Please see BCA's Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com. 2 Please see BCA's Global Fixed Income Strategy Special Report, "Australia: Stuck Between A Rock And A Hard Place", dated July 25, 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Economic fundamentals indicate that TIPS breakeven inflation rates have further cyclical upside and this will drive nominal bond yields higher on a 6-12 month horizon. In the near term, however, positioning data suggest that the uptrend in bond yields is due for a pause. Maintain a below-benchmark duration stance. Oil & Bonds: The cost of inflation compensation is an important driver of bond yields and the oil price is an important driver of the cost of inflation compensation. This will continue to be true until long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%. At that point the oil price will become a less important driver of yields. Fed: The Fed will start actively discussing alternative monetary policy frameworks in 2018. While we think the Fed will eventually adopt a policy framework that tolerates higher inflation, this shift probably won't occur this year. Feature There was certainly no shortage of possible catalysts for last week's bond rout (Chart 1). The Bank of Japan (BoJ) reduced its buying of long-dated JGBs, there was a rumor that China plans to slow or stop its purchases of U.S. Treasury debt, and U.S. inflation expectations started to ramp back up - driven by a combination of higher oil prices and a strong December core CPI print. But of all these factors we think it is only the third that merits much attention. Once the BoJ started targeting the level of the yield curve in September 2016 its quantity targets became irrelevant. A reduction in the pace of BoJ buying only matters if it foreshadows a shift to a higher yield curve target. Our foreign exchange strategists don't think such a move is likely in the next 12-18 months.1 China, for its part, still has a highly managed currency and now that capital is no longer flowing out of the country it will start to rebuild its foreign exchange reserves. Given that the U.S. Treasury market remains the world's most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States (Chart 2). Chart 1Higher Yields, Driven By Inflation Chart 2China's Forex Reserves Are Rising The compensation for 10-year U.S. inflation protection broke above 2% last week, after having been as low as 1.66% as recently as last June. This 34 basis point increase in inflation compensation coincided with a 36 basis point increase in the nominal 10-year yield and a Brent crude oil price that rose from $45 per barrel last June to $70 per barrel as of last Friday. We think these correlations will continue to be the most important factors driving bond yields during the next 6-12 months, and the bulk of this report is dedicated to disentangling the linkages between oil prices, inflation, inflation expectations and nominal bond yields. But first we reiterate our cyclical investment stance. Last week's CPI report provided further evidence that core inflation is in the process of bottoming-out (Chart 3). The 10-year TIPS breakeven inflation rate will settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's target. By that time the nominal 10-year yield will be in a range between 2.8% and 3.25%. Likewise, our energy strategists anticipate that an ongoing steady decline in commercial inventories will keep crude prices well supported on a 6-12 month horizon. Chart 3U.S. Inflation Turns The Corner Chart 4Net Speculative Positioning For Oil And Bonds However, on a shorter time horizon (3 months or less), recent shifts in speculative positioning signal that the uptrends in bond yields and the oil price might be due for a pause (Chart 4). After having been solidly "net long" since the middle of last year, net speculative positions in the 10-year U.S. Treasury futures contract have just dipped into "net short" territory. Historically, net speculative positions have been a decent indicator of 3-month changes in the 10-year U.S. Treasury yield, and at current levels they signal that the 10-year yield could decline modestly during the next three months (Chart 5). Similarly, speculators in the oil futures market are now more "net long" than at any time since last February. While this positioning indicator does not work quite as well for the oil market as for the Treasury market, net longs at more than 20% of open interest (most recent reading is 26%) have more often than not been met with 3-month price declines since 2010 (Chart 6). Chart 5Net Speculative Positions & 10-Year Treasury Yield Chart 6Net Speculative Positions & WTI Oil Price Bottom Line: The outlook for U.S. inflation suggests that TIPS breakeven rates have further cyclical upside and this will drive nominal bond yields higher. However, positioning data in both bond and oil markets suggest that the recent run-up in yields might be due for a near-term pause. Maintain a below-benchmark duration stance on a 6-12 month horizon. Oil, TIPS, Inflation And Bond Yields: Sorting Out The Mess During the post-financial crisis period two relationships have been both (i) incredibly robust and (ii) unlike relationships observed in prior periods. They are: The cost of inflation protection has been an unusually important determinant of nominal U.S. bond yields The oil price has shown a very strong correlation with the cost of inflation protection Both relationships can be explained by the Federal Reserve's asymmetric ability to control inflation. We consider each relationship in turn. The Importance Of Inflation Chart 7TIPS Beta Declines When ##br##Breakevens Are Low A common rule of thumb is to estimate the TIPS beta - the proportion of movement in U.S. nominal bond yields that is explained by movement in TIPS (real) yields - at around 0.8. In other words, this assumes that 80% of the movement in nominal bond yields is explained by the real component. However, we observe that since the financial crisis the 10-year TIPS beta has been a much lower 0.68, and at times it has been closer to 0.5 on a 12-month rolling basis (Chart 7). We also observe that the TIPS beta tends to be lower when TIPS breakeven inflation rates are un-anchored to the downside. There is a very good reason for this. The reason is that the Fed's ability to influence inflation is asymmetric. The Fed has a strong track record of successfully tightening to bring inflation down, but has been less successful at easing to drive it up. This asymmetric ability to influence prices is due in no small part to the zero-lower bound on interest rates. Because the Fed's ability to cut rates is constrained by the zero-bound while its ability to lift rates is not, bond market participants may at times question the Fed's ability to ease and revise their inflation expectations lower. It is also during these periods that inflation expectations become more volatile and a more important determinant of nominal bond yields. This is because they are increasingly driven by the swings in the economic data and less by the Fed's policy bias. The Importance Of Oil This is where the oil price comes in. Oil and other commodities are crucial inputs to the production process. As such, not only do these prices rise in response to stronger aggregate demand, but higher prices also signal mounting cost-push inflationary pressures. But despite this obvious truth, there is not always a strong correlation between oil prices and inflation expectations. This is because the Fed's reaction function influences the relationship. Consider the pre-crisis (2004-2008) period. Long-maturity TIPS breakeven inflation rates stayed range-bound between 2.4% and 2.5% even as the oil price increased dramatically (Chart 8). Since investors perceived that the Fed would simply tighten policy to tamp out any inflationary pressures that might arise, there was no desire to demand greater compensation for inflation. However, this logic does not work in reverse. When commodity prices fell in 2014, inflation expectations declined alongside. In fact we observe that the correlations between long-maturity TIPS breakeven inflation rates and both oil and commodity prices have been much stronger in the post-crisis period, when inflation expectations have been un-anchored (Table 1). Chart 8The Unstable Correlation Breakevens & Oil Table 1Correlations Between TIPS Breakeven Inflation And Commodities Investment Conclusions The Fed's asymmetric reaction function leads to two crucial investment conclusions. First, long-maturity inflation expectations (as measured by the TIPS breakeven inflation rate) can fall when deflationary pressures mount, but their upside is capped in the 2.4% to 2.5% range. This is because the market has no reason to question the Fed's ability to lower inflation by lifting rates. The upside limit of 2.4% to 2.5% will remain in place unless the Fed changes its inflation target. A change to the inflation target that allows for higher inflation is an idea that is quickly gaining traction among policymakers, but is unlikely to be implemented this year (see section titled "The Fed In 2018: Contemplating A Major Change" below). Second, when long-maturity inflation expectations are below their 2.4% to 2.5% upper-bound they become both (i) a more important driver of nominal yields - as evidenced by the lower TIPS beta - and (ii) more sensitive to swings in commodity prices. For this reason, the oil price will continue to be an important driver of inflation expectations and nominal bond yields for the next few months, but will decrease in importance as TIPS breakevens move back to their 2.4% to 2.5% range. Once inflation expectations are re-anchored, nominal bond yields will once again be predominantly driven by the real component and swings in the price of oil will be less important for bond markets. The dynamics described above are not merely theoretical. Consider the evidence from five developed countries presented in Charts 9 & 10. Chart 9 shows that the oil price is tightly correlated with inflation expectations in the U.S., Eurozone and Japan, but also that inflation expectations in the U.K. and Australia did not respond to the recent increase in oil prices. The reason is that core inflation in the U.K. and Australia is already relatively close to the central bank's target (Chart 10). It is only where core inflation is far below target (in the U.S., Eurozone and Japan) that the oil price remains an important driver of bond yields. Chart 9Oil & Inflation Expectations Highly Correlated... Chart 10...But Only When Inflation Is Low The U.K. in particular presents an interesting case study. U.K. core inflation was quite far below target throughout 2015 and 2016, and during this time period U.K. inflation expectations were tightly linked with the oil price. It is only in the past few months that U.K. core inflation has moved back above target, and not surprisingly the correlation between the U.K. 10-year CPI swap rate and the price of oil has started to break down. Bottom Line: At present, the cost of inflation compensation is an important driver of bond yields and the oil price is an important driver of the cost of inflation compensation. Both of these dynamics will continue to be true for the next few months, but will decline in importance as TIPS breakeven inflation rates rise. When long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%, then the oil price will become a less important driver of bond yields. The Fed In 2018: Contemplating A Major Change? As was alluded to in the prior section, the biggest potential change for bond markets in 2018 would be if the Fed changed its monetary policy framework to one that tolerated higher levels of inflation. For example, let's imagine that the Fed suddenly lifted its inflation target from 2% to 3%. This would likewise shift the upper-bound range for long-maturity TIPS breakeven inflation rates to approximately 3.4% to 3.5%. It would mean that nominal bond yields have further upside over the course of the cycle, and also that oil and commodity prices would play an important role in bond markets for much longer. It would also lengthen the period where spread product can outperform Treasuries since the Fed would not be so quick to choke off the recovery. We still think it is unlikely that such a change will be implemented this year, but recent weeks have seen a marked increase in the number of Fed policymakers either advocating for a different policy framework or saying that the Fed should start researching alternative frameworks. What's crucial to remember is that the reason policymakers are unsatisfied with the current 2% inflation target is that it brings the zero-lower bound on interest rates into play too often. So any potential change in policy framework would be to one that tolerates higher inflation rates. Bernanke's Idea Chart 11The Implications Of A Price Level Target One potential new policy approach was put forward by ex-Fed Chairman Ben Bernanke in a recent blog post.2 Bernanke made the case for "Temporary Price Level Targeting", a policy where the Fed continues to use a 2% inflation target when the fed funds rate is sufficiently far from zero, but then switches to a price-level target when the fed funds rate is close to the zero bound. In his own words, the strategy would be communicated as follows: The Committee therefore agrees that, in future situations in which the funds rate is at or near zero, a necessary condition for raising the funds rate will be that average inflation since the date at which the federal funds rate first hit zero be at least 2 percent. Chart 11 provides an illustration of this example. Under the current framework the Fed targets 2% PCE inflation and forecasts that it will achieve this target sometime in 2019. In Bernanke's proposed framework the Fed would not target 2% inflation, but rather a price level that is consistent with 2% trend growth in prices since the zero-lower bound was hit in December 2008. In order to achieve this goal by the end of 2019 the Fed would need to tolerate a significant overshoot of inflation during the next two years (bottom panel). Who's On Board? The Appendix to this report is a list of all Fed Governors and Regional Fed Presidents. It also shows our own assessment of each committee member's policy bias. We noted from the most recent Summary of Economic Projections that 6 FOMC participants expect three rate hikes in 2018, 6 expect fewer than three rate hikes and 4 expect more than three hikes. From recent speeches we attempted to discern which member owns which forecast and then we attributed a "dovish" policy bias to those with a forecast for fewer than three hikes, a "neutral" bias to those expecting three hikes, and a "hawkish" bias to those expecting more than three hikes. We also show which FOMC participants are voters in 2018, although we do not think that distinction carries much practical importance. The Committee tends to arrive at decisions by consensus anyways, and all participants voice their opinions at every meeting whether or not it is their turn to vote. But it is the "notes" column of the Appendix that is most striking. There we highlighted all the FOMC participants who have recently made comments regarding the exploration of alternative policy frameworks. A general consensus seems to be forming that alternative frameworks should be studied this year, and a few policymakers (San Francisco Fed President John Williams, in particular) have strongly made the case that the Fed should switch to some sort of price level targeting regime. The Appendix also identifies the biggest source of uncertainty for the Fed this year. Namely that there are four vacant Governor positions that need to be filled. The New York Fed will also need a new President when William Dudley retires later this year. Who is nominated to fill those vacant positions will go a long way toward determining how aggressively the Fed pursues alternative policy frameworks. Bottom Line: The Fed will start actively discussing alternative monetary policy frameworks in 2018. While we think the Fed will eventually adopt a policy framework that tolerates higher inflation, this shift probably won't occur this year. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com 2 https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ Appendix Table 2Composition Of The FOMC Fixed Income Sector Performance Recommended Portfolio Specification

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Chart 15...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Chart 1Bond Bear On Pause? The start of a new year often brings optimism and nowhere is this more evident than in economic projections. In three of the past four years (2017 being the exception) Bloomberg consensus GDP growth expectations ended the year lower than where they began. A related pattern played itself out in the Treasury market. At the turn of each of the past four years the average yield on the Bloomberg Barclays Treasury Index increased in December only to fall back in January. In two of those instances the January decline exceeded the December increase. Should we expect a similar January bond rally this year? Our favorite short-term indicators are not sending a strong signal (Chart 1). Net speculative futures positions weakly suggest that the 10-year yield will be lower in three months, but our auto regressive model suggests the Economic Surprise Index will still be in positive territory at the end of the month. In a recent report we showed that yields tend to rise in months where the Surprise Index is above zero.1 Perhaps most importantly, our 2-factor Treasury model shows that yields are significantly lower than is suggested by global economic fundamentals. Maintain below-benchmark duration. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 49 basis points in December and by 335 bps in 2017. At 94 bps, the average index spread is 28 bps tighter than at the beginning of 2017 and investment grade corporate spreads are extremely expensive compared to history (Chart 2). After adjusting for changes in the average duration of the index over time, we calculate that A-rated corporate spreads have only been tighter 5% of the time since 1989 (panel 2), and Baa-rated spreads have only been tighter 7% of the time (panel 3). Essentially, at this stage of the credit cycle we should expect excess returns no greater than carry. As for the credit cycle itself, we noted in our last report that with corporate balance sheets deteriorating, low inflation and still-accommodative monetary policy are the sole supports for corporate spreads.2 We expect spreads will start to widen later this year once inflation rises and policy becomes more restrictive. With excess returns likely to be lower in 2018 than in 2017, we should also expect a lower marginal return from increasing the riskiness within credit portfolios.3 For investors looking to scale back on credit risk, our model shows that Financials and Technology are the most attractive low-risk sectors. Energy, Basic Industry and Communications are all attractive high-risk sectors (Table 3). 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 23 basis points in December and by 602 bps in 2017. The average index option-adjusted spread tightened 1 bp on the month and 66 bps in 2017. Though spreads appear somewhat more attractive than for investment grade corporates, there is still not much room for spread compression in high-yield. In fact, we calculate that if the high-yield index spread tightens another 117 bps, junk bonds will be the most expensive they have been since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Given trends in corporate leverage, another 100 bps of spread tightening should be viewed as unlikely. More realistically, we expect excess returns in the range of 200 bps to 500 bps (annualized) between now and the end of the credit cycle (Chart 3). Given our forecast for default losses, flat spreads translate to a 12-month excess return of 213 bps. An additional warning sign for junk spreads is that the slope of the 2/10 Treasury curve is hovering around 50 bps. We showed in a recent report that when the 2/10 slope is between 0 bps and 50 bps, junk bonds underperform Treasuries in 48% of months, and average monthly excess returns (though still positive) are much lower than when the curve is steeper.4 MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in December and by 51 bps in 2017. The conventional 30-year zero-volatility MBS spread narrowed 2 bps in December, the combination of a flat option-adjusted spread (OAS) and a 2 bps decline in the compensation for prepayment risk (option cost). The Z-spread widened 2 bps in 2017, as an 8 bps OAS widening was offset by a decline of 6 bps in the compensation for prepayment risk. The substantial OAS widening in early 2017 was almost certainly caused by investors pricing-in the eventual run-off of the securities on the Fed's balance sheet. Now that run-off has begun we see no obvious catalyst for further OAS widening in the months ahead. Turning to the compensation for prepayment risk, with Treasury yields biased higher as the Fed continues to lift rates, we see little risk of a material increase in refinancing activity. This will ensure that overall MBS spreads stay capped near historically low levels (Chart 4). All in all, with MBS OAS looking more attractive relative to Aaa-rated credit than at any time since 2015 (panel 3), we think this is an opportune time for investors looking to de-risk their portfolios to shift some of their spread product allocation away from corporate bonds and into MBS. We already upgraded our recommended allocation to MBS from underweight to neutral in October, and will likely further increase exposure as we advance toward the end of the credit cycle. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 5 basis points in December, but outperformed by 216 bps in 2017. Sovereign bonds underperformed the Treasury benchmark by 36 bps in December, Foreign Agencies and Domestic Agencies underperformed by 8 bps and 1 bp, respectively. Local Authorities outperformed the benchmark by 17 bps, and Supranationals underperformed by 1 bp. Sovereign bonds were the best performers within the Government-Related index in 2017, delivering excess returns of 538 bps relative to duration-matched U.S. Treasuries. This outperformance was concentrated early in the year and was driven by the sharp depreciation of the U.S. dollar (Chart 5). With the market still priced for a relatively modest 63 bps of Fed rate hikes during the next 12 months, further sharp dollar depreciation appears unlikely. We recommend an underweight allocation to Sovereign debt. We remain overweight Local Authority and Foreign Agency bonds, sectors that delivered excess returns of 420 bps and 248 bps, respectively in 2017. Despite the outperformance, both of these sectors still offer attractive spreads after adjusting for credit rating and duration. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 15 bps and 17 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 28 bps and 42 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 99 bps in December and by 332 bps in 2017 (before adjusting for the tax advantage). The average Aaa Municipal / Treasury (M/T) yield ratio fell 5% in December, and is 12% below where it began 2017 (Chart 6). The recent decline follows a sharp increase that was driven by fluctuating supply trends related to the passage of U.S. tax legislation. The final tax bill ends the practice of advance refunding municipal bonds. As a result, December set a new high of $55.6 billion for municipal issuance as issuers rushed to get their advance refunding deals to market before the bill was passed (panel 3). Now that the bill has passed, visible supply has evaporated and the average M/T yield ratio has fallen back to one standard deviation below its post-crisis mean. The absence of advance refunding will bias municipal bond issuance lower in 2018, thus removing one potential risk for yield ratios. The M/T yield ratio for short maturity debt has risen considerably relative to the yield ratio for long maturity debt in recent months (panel 2), and the risk/reward trade-off now appears more balanced. We close our recommendation to favor long maturities versus short maturities on the Aaa Muni curve. The third quarter update of our Muni Health Monitor showed a slight improvement (panel 5), but still no clear reversal of trend. Although health remains supportive for now - and consistent with municipal upgrades outpacing downgrades - with yield ratios close to their lows we maintain an underweight allocation to Municipal bonds.  Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in December. The 2/10 Treasury slope flattened 13 bps on the month, and the 5/30 Treasury slope flattened 15 bps. The evolution of the Treasury curve in 2018 will come down to a trade-off between how quickly inflation rises versus how quickly the Fed lifts rates. For example, in a recent report we showed that the 10-year Treasury yield will likely settle into a range between 2.80% and 3.25% by the time that core PCE inflation reaches the Fed's 2% target.5 That same report shows that if that adjustment occurs relatively quickly, and the Fed has only lifted rates once or twice between now and then, then the 2/10 Treasury slope is much more likely to steepen than to flatten. Conversely, if the Fed lifts rates three or four more times between now and the time that inflation returns to target, then the curve is more likely to flatten. For our part, we think it is wise to maintain a position long the 5-year bullet and short a duration-neutral 2/10 barbell. Such a position profits from a steeper curve, and our model shows that the butterfly spread is currently priced for significant curve flattening (Chart 7). According to our model, the 2/5/10 butterfly spread is discounting 27 bps of 2/10 flattening during the next six months.6 In other words, if the 2/10 slope steepens or flattens by less than 27 bps, then our recommended position will profit. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 41 basis points in December, but underperformed by 43 bps in 2017. The 10-year TIPS breakeven inflation rate went on a wild ride last year. It started 2017 at 1.95% and, driven by strong inflation prints and continued post-election euphoria, reached as high as 2.09% in January. The breakeven dropped to a low of 1.66% in June, as inflation started to disappoint in the second quarter, but has rebounded during the past couple of months and just recently broke back above 2%. The 10-year TIPS breakeven rate is currently 2.02%, above where it began 2017. According to our TIPS Financial Model, the recent widening in breakevens is in line with the message from other related financial market instruments (Chart 8). Specifically, oil prices, the trade-weighted dollar and the stock-to-bond total return ratio. Further, measures of pipeline inflation pressure continue to signal an increase in inflationary pressures (panels 3 and 4), and the trimmed mean PCE shows that the realized inflation data are forming a tentative bottom (bottom panel). The annualized 6-month rate of change in the trimmed mean PCE ticked up to 1.68% in November, higher than the 12-month rate of change (1.67%). The 1-month rate of change is higher still at 2.19%, annualized. We continue to see signs that inflation will start to rebound in the coming months, and this will cause long-maturity TIPS breakeven inflation rates to reach a range between 2.4% and 2.5% by the time that inflation returns to the Fed's target. Remain overweight TIPS versus nominal Treasury securities. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities performed in line with the duration-equivalent Treasury index in December and outperformed by 92 basis points in 2017. In 2017, Aaa-rated ABS outperformed the Treasury benchmark by 79 bps and non-Aaa ABS outperformed by 217 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp in December, but tightened 21 bps in 2017. It now sits at 31 bps, only 4 bps above its all-time low (Chart 9). At 31 bps, Aaa-rated ABS now offer only a 3 bps spread advantage over Agency-backed MBS, and offer 11 bps less spread than Agency-backed CMBS. With consumer lending standards tightening and delinquency rates rising, we view no more than a neutral allocation to ABS as appropriate. On lending standards, the Fed's October Senior Loan Officer's Survey showed a continued tightening in lending standards on both credit cards and auto loans (panel 4), and also that demand for credit card and auto loans was essentially unchanged from the prior quarter. It also included a set of special questions regarding the reasons for changes in the supply and demand for consumer credit. Banks cited a less favorable or more uncertain economic outlook, a deterioration in existing loan quality and a general reduced risk tolerance as reasons for tightening the supply of credit. The hard data confirm that banks are seeing a deterioration in the quality of their consumer loan books (bottom panel). Although delinquencies remain depressed compared to history, with ABS spreads near all-time tights, rising delinquencies and tightening lending standards make for a poor risk/reward trade-off in the sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in December and by 201 bps in 2017. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps in December and 13 bps in 2017. At its current level of 64 bps, the index spread is about one standard deviation below its pre-crisis mean, and only 13 bps above its all-time low reached in 2004 (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in December and by 133 bps in 2017. The index option-adjusted spread for Agency CMBS tightened 3 bps in December and 13 bps in 2017. At its current level of 42 bps, the sector offers greater option-adjusted compensation than a position in Agency-backed MBS (28 bps) and Aaa-rated consumer ABS (31 bps). Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing.   Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.94% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.92%. PMIs across the world continue to surge. December PMI data show increases in the four largest economic blocs (U.S., Eurozone, China, Japan), and more broadly show that 86% of the 36 countries with available data currently have PMIs above the 50 boom/bust line. Meanwhile, bullish sentiment toward the U.S. dollar continues to trend lower in response to strong growth in the rest of the world (bottom panel). This is also a bearish development for U.S. bonds. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.48%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights U.S. Treasuries: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in U.S. inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. Canada: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds and stay long inflation protection (both through linkers and CPI swaps). 2017 Model Portfolio Performance Wrap-Up: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps of underperformance versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Feature Chart of the WeekGlobal Bond Yields Are Too Low 2018 has started much as 2017 ended, with growth-sensitive assets rallying alongside robust economic data. Most major global equity markets are already up 2-3% after the first week of the year, with the U.S. NASDAQ, Japanese Nikkei and Italian MIB indices advancing over 4%. Global credit markets are also off to a strong start, with spreads for U.S. High-Yield corporate debt and EM hard currency corporate debt tighter by -17bps and -8bps, respectively. Even commodity markets have joined the party, with the benchmark Brent oil price hitting the highest level in nearly three years. The pro-growth, pro-risk backdrop is keeping upward pressure on global government bond yields. This is occurring primarily through the inflation expectations component of yields, which are rising in all developed economies (even Japan). Real yields, which are not rising despite the strength of the broad-based global growth upturn (Chart of the Week), have been drifting lower, providing some offset to rising inflation expectations. The primary trend for global yields remains upward, however - especially if growth remains solid and inflation expectations continue to push higher, giving central banks like the U.S. Federal Reserve the confidence to continue hiking interest rates. We continue to favor below-benchmark duration exposure, and overweight corporate bond allocations versus government debt, for global fixed income investors over the next 6-9 months. U.S. Treasuries: Still More Reasons To Sell Than Buy U.S. Treasury market participants have a lot to things to be nervous about at the moment. Likely future Fed rate hikes, the weakening U.S. dollar, rising oil prices, ongoing U.S. labor market strength, persistently booming economic growth, the never-ending equity bull market, the potential impact of the Trump fiscal stimulus, the Fed starting its balance sheet runoff - all factors that should force bond investors to expect yields to rise. Yet longer-dated Treasury yields continue to trade too low relative to the bond-bearish fundamentals. The current benchmark 10-year Treasury yield at 2.48% remains well below the fair value from our 2-factor regression model, which is now up to 2.94% (Chart 2). That valuation gap of 46bps is close to the widest levels seen in July 2016 and September 2017, which were both episodes that proved to be excellent entry points for bearish Treasury positions. The two inputs into our Treasury yield model are the global manufacturing PMI and bullish sentiment towards the U.S. dollar (USD). The PMI is included as an indicator of global growth and currently sits at 54.5 - the highest level in nearly seven years - led by strong readings in almost every major economy (Chart 3). This has been the primary driver of the fair value for the 10-year Treasury yield since global growth bottomed out and began to accelerate in mid-2016. Chart 210-Year Treasuries Are##BR##Overvalued On Our Model Chart 3Global Growth##BR##Is Booming Sentiment towards the USD is the second input to our Treasury model. It is included as a weakening greenback represents an easing of monetary conditions that could trigger a need for more Fed rate hikes that can push the Treasury curve higher from the short-end (and vice versa for a rallying USD). At the same time, a depreciating USD can drive U.S. inflation higher through higher costs of imported goods & services, which can raise bond yields through higher inflation expectations or greater Fed tightening expectations (again, the opposite holds true for a strengthening USD). Right now, both the strong PMI and weak sentiment towards the dollar are boosting the fair value of the 10-year Treasury yield. The fall in value of the greenback is particularly unusual, as it is flying in the face of widening interest rate differentials between the U.S. and the rest of the world (Chart 4, top panel). This is clearly a function of the fact that global growth is rapidly improving - especially in Europe - but very few central banks have yet to respond to that growth with interest rate hikes that match what the Fed has been delivering. So while actual interest rate differentials remain USD-supportive, expectations of some eventual tighter monetary policy outside the U.S. that could narrow those interest rate gaps are triggering speculative inflows into non-USD currencies. With the trade-weighted USD now 5% below levels of a year ago, this should lead to higher headline inflation in the U.S. in the next few months (middle panel). Combined with the continued strength in global oil prices, that means that the two biggest factors that weighed on realized U.S. inflation- the USD rally and oil price collapse of 2014/15 - are now both acting to boost inflation expectations (bottom panel). Throw in the growing body of evidence that a tight U.S. labor market that is putting gentle upward pressure on wage growth, and U.S. inflation expectations - which still remain 40-50bps below levels consistent with the Fed's inflation target - should continue to move higher in the next six months. Rising longer-term inflation expectations would typically result in bear-steepening pressures on the Treasury yield curve. That is not happening at the moment, however, with the 2-year/10-year Treasury curve still at a relatively flat 53bps at the time this report went to press. The flatness of the Treasury curve has worried investors, and even some Fed officials, given the well-known leading relationship between the yield curve and U.S. economic growth. It is too early to draw any conclusions between the shape of the curve and future U.S. economic growth, however, for several reasons: As mentioned above, inflation expectations are still well below levels consistent with the Fed's 2% inflation target on the PCE deflator (which translates to 2.5% on the CPI index used to price TIPS and CPI swaps). Both the European Central Bank (ECB) and Bank of Japan (BoJ) are still buying bonds through their asset purchase programs, although at a slower pace than previous years. This continues to depress local bond yields in Europe and Japan with spillover effects into the U.S. Treasury market - even as the Fed begins the slow runoff of Treasuries from its massive balance sheet. Data on mutual fund and ETF flows shows that there has been significant and sustained buying of bond funds by U.S. retail investors over the past couple of months. There has also been net selling of equity funds, however, suggesting that U.S. retail investors are rebalancing as the equity markets surge higher. Investor positioning in the U.S. Treasury market is very short at the moment, with the J.P. Morgan survey of "active" bond manager duration exposure at an all-time low and the net positioning on Treasury futures now slightly favoring shorts (Chart 5). It makes little sense to interpret a flattening Treasury curve as a signal that the bond market believes that the Fed was making a policy mistake if professional bond investors were running massive duration underweight positions that would benefit if bond yields rise. Chart 4Upside Pressure On U.S. Inflation##BR##From Oil & The USD Chart 5Big Duration Underweight##BR##Among U.S. Bond Managers All these factors muddy the economic signal provided by the Treasury curve at the moment. Nonetheless, we remain of the view that the Fed would not continue on its rate hiking path without U.S. inflation expectations moving sustainably back to levels consistent with the Fed's inflation target. In other words, the Treasury curve must bearishly steepen first through rising inflation expectations before bearishly flattening later through actual Fed rate hikes. The latter will dampen future U.S. growth expectations and eventually result in a cyclical peak in longer-dated Treasury yields, but from levels closer to 3% on the 10-year after inflation expectations "fully" normalize. Bottom Line: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. The Bank Of Canada Keeps On Playing Catch-Up The Canadian economic story continues to be the best within the developed world. The year-over-year growth rate for real GDP accelerated to over 3% late last year, primarily on the back of robust consumer spending (Chart 6). Even the lagging parts of the economy, like business investment and government spending, began to perk up last year. The momentum remained powerful at the end of 2017, with the unemployment rate in December hitting a 40-year low. The economic boom forced the Bank of Canada (BoC) to begin lifting interest rates last year, with two 25bp hikes occurring in July and September that unwound the easing from 2015. The rapid pace of growth has absorbed spare capacity much faster than the BoC originally projected. More hikes will be required if the current pace of growth is maintained, particularly with the BoC estimating that the neutral policy rate is around 3% and the current Overnight Rate is only at 1%. The Canadian consumer has been enjoying a powerful shopping spree. Real consumer spending growth is at 4% on a year-over-year basis - the highest level since early 2008 (Chart 7). This is led by a powerful surge in spending on consumer durables, where annual growth has surged to 10% (middle panel). Consumer confidence is booming and Canadian workers are enjoying the fastest pace of income growth since 2014 (bottom panel). Chart 6Robust Canadian Growth,##BR##Led By The Consumer Chart 7Canadian Consumers Are##BR##Confidently Spending Surprisingly, the powerful surge in consumer spending has occurred alongside some cooling of the overheated Canadian housing market. The growth rates of existing home sales and prices have both decelerated massively from the pace of the boom years in 2012-16 (Chart 8). The performance of house prices in the three biggest Canadian cities is now a mixed bag, with Vancouver prices reaccelerating, prices in Toronto decelerating and prices in Montreal growing only modestly (middle panel). Regulatory actions to limit the speculative buying of Canadian real estate by foreigners has helped dampen the surge in house prices in some markets. Although the bigger macro-prudential measures designed to tighten mortgage finance rules and reduce the amount of leverage in Canadian housing transactions has likely had a bigger effect. Canadian banks must now conduct stress tests to check if borrowers are able to pay off their mortgages if Canadian interest rates continue to rise. This represents a reduction in the marginal supply of riskier mortgage lending that will help restrain house price inflation in Canada's major cities. In addition, the supply of Canadian homes is growing with new home-building activity, both for single and multiple units, having picked up and overall residential investment growth now up nearly 5% on a year-over-year basis (bottom panel). With signs that the Canadian housing market has stopped rapidly inflating, the BoC can focus its interest rate policy on domestic growth and inflation considerations without worrying about pricking the housing bubble. On that front, the latest edition of the BoC's Business Outlook Survey, released yesterday, provided plenty of reasons to tighten monetary policy further. The overall survey indicator surged back to the peak seen last summer just before the BoC delivered its first rate hike (Chart 9). Capital spending intentions also rebounded back to the 2017 peaks, which bodes well for future gains in investment spending (second panel). Chart 8Canadian Housing Looking##BR##A Bit Less Frothy Chart 9BoC Business Outlook Survey Signaling##BR##Tightening Capacity Constraints The most interesting parts of the Business Outlook Survey were the capacity utilization measures. A greater share of companies were reporting labor shortages (third panel), with the highest percentage of firms reported difficulties in meeting unexpected increases in demand since 2007 (bottom panel). This suggests that the recent surge in employment, wage growth and price inflation are all sustainable. Headline and core CPI inflation are up to 2.1% and 1.8%, respectively, as of November. This is around the midpoint of the BoC's 1-3% target range (Chart 10). The Bank of Canada forecasts that CPI inflation will continue to rise and remain near 2% target in 2018, but all the risks are to the upside. The unemployment rate is now down to 5.7%, the lowest level since 1976 and well below the OECD's estimate of the NAIRU level at 6.5%. Average hourly earnings growth has surged in response, rising to just under 3% on a year-over-year basis since the trough in early 2017. The Phillips Curve appears to be alive and well in Canada. Canadian interest rate markets have already responded aggressively to the stronger growth and inflation data. Our interest rate discounters now show that the money markets are now expecting 61bps of BoC rate hikes over the next six months and 91bps over the next twelve months (Chart 11). With a 25bp hike at next week's BoC meeting now priced with almost full certainty, the current market pricing suggests at least one more hike will happen by June and nearly three more hikes by year-end. That would be even more hikes than we expect from the Fed in 2018, which is important for the Canadian dollar (CAD). The CAD has appreciated 16% since it bottomed out in early 2016, occurring alongside the rise in global oil prices over the same period (second panel). The price of Canada's Western Select grade of crude oil has lagged the move in other oil benchmarks massively over the past several months, due to a lack of pipeline capacity getting oil out of Alberta that has created a supply glut. This may limit the degree to which additional gains in global energy prices benefit the Canadian dollar from a terms-of-trade perspective. This will not prevent the BoC from delivering additional rate hikes, however - especially if that merely matches the 75bps of Fed rate hikes that the FOMC is projecting, and which we expect, over the rest of the year. In terms of investment strategy, the combination of robust Canadian economic growth and rising inflation pressures leads us to continue recommending an underweight stance on Canadian government bonds, as we have maintained since July 11, 2017. This week, we are introducing two new tactical trades that should benefit as Canadian inflation moves higher and the BoC tightens more aggressively in response (Chart 12): Chart 10The Canadian Phillips Curve Is Not Dead Chart 11The Market Now Expects A Lot From The BoC Chart 12Two New Tactical Trades In Canada Short the June 2018 Canada Bankers' Acceptance futures contact vs. the December 2018 contract (middle panel). The market is now discounting the likely maximum amount of tightening that the BoC can deliver by year-end, while there are only little more than two hikes priced by June. Assuming that the BoC hikes next week, that means that there is only one more hike expected by June. With three more BoC meetings scheduled between next week and June, that provides plenty of opportunities for hawkish surprises from the BoC before then. In other words, this trade is a way to play for the BoC being forced to front-load more rate hikes into the first half of 2018 versus the latter half. Long 10yr inflation expectations through linkers versus nominal government bonds, or using CPI swaps (bottom panel). Given the pickup in domestic inflation pressures currently underway, plus the rise in global inflation coming from the surge in commodity prices, there is room for Canadian market-based inflation expectations to rise from the current level of 1.7%. Bottom Line: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will likely hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds. 2017 GFIS Model Bond Portfolio Performance: A Brief Review The turn of the year marked the end of the first full calendar year for the Global Fixed Income Strategy (GFIS) model bond portfolio. This now allows us to report the performance of the portfolio on the same basis as our clients. In the future, we will publish quarterly reviews of the portfolio returns after the end of each quarter in a calendar year (in April, July, October and January). The GFIS model portfolio returned 3.45% in 2017. This underperformed our custom performance benchmark (a blend of the Barclays Global Aggregate Index with global high-yield corporate debt) by -13bps (Chart 13). That underperformance can be entirely attributed to our government bond duration allocations, which lagged the benchmark by -46bps. Our recommended credit positions were a positive contributor, generating 33bps of outperformance primarily through overweights to U.S. Investment Grade and High-Yield corporate bonds. The detailed breakdown of the 2017 returns is presented in Table 1. In terms of the government bond portion of the portfolio, the underperformance can be isolated completely to the longest maturity bucket (10+ years). The combined performance of that bucket for all countries lagged that of the benchmark by -52bps. Given our expectation that global yield curves would bear-steepen in the latter half of 2017, it is no surprise that the bulk of our underperformance came by having too little exposure at the long-end. Also, having too much exposure in Japanese government bonds offering no yield also represented a major drag on the income component of the model portfolio's returns (Chart 14). Chart 13GFIS Model Bond Portfolio##BR##2017 Return Breakdown Table 1GFIS Model Bond Portfolio##BR##2017 Return Breakdown In terms of our credit allocations, favoring U.S. corporate exposure vs. non-U.S. corporates was the right call, generally speaking (Chart 15). However, we did not have enough portfolio weight in that trade to offset the drag on the overall yield from the Japan government bond overweight. Chart 14GFIS Model Portfolio Government Bond Performance Attribution By Country Chart 15GFIS Model Portfolio Spread Product Performance Attribution Looking ahead, the new model bond portfolio allocation for 2018 that we discussed in our final report of 2017 should offer a better chance of outperforming the benchmark.1 Specifically, we dialed down the Japan overweight, increased the U.S. Investment Grade corporate bond overweight, and reduced the curve steepening exposure in Euro Area governments. This not only boosted the overall yield of the portfolio, but also moderated the overall portfolio duration underweight. This portfolio will do well in the first half of 2018 if our base case of an inflation-driven rise in global government bond yields, led primarily by the U.S. where corporate debt is also expected to outperform Treasuries, comes to fruition. Bottom Line: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps underperformance of versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Allocation In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Upbeat economic reports for December set the stage for a solid 2018. The FOMC minutes acknowledged the flatter curve and only a minority of members discounted the signal from the curve. A majority thought that a tighter labor market would lead to higher inflation. The Citi Economic Surprise Index is peaking, but risk assets should hold up as the Index rolls over. Feature The first week of 2018 brought more good news for risk assets. U.S. stocks beat bonds, oil prices rose, and credit spreads narrowed amid a solid set of economic data. Several high-profile U.S. companies announced share buybacks, and/or one-time bonuses or wage increases linked to the tax cut plan passed by Congress at the end of 2017. Moreover, there were hints of further economic stimulus as lawmakers from both sides of the aisle discussed relaxing the sequester rules that would lift federal spending this year. Markets shrugged off a fresh round of saber rattling between the U.S. and North Korea. Gold prices nudged higher and the U.S. dollar fell despite the upbeat economic news. December's reports on manufacturing and service sector ISM, vehicle sales and the labor market, along with November's numbers on construction spending, trade and factory orders, all lifted estimates for Q4 GDP and boosted the prospects for corporate earnings in Q4 2017 and beyond. Chart 1 shows that the elevated ISM figures provide a favorable backdrop for earnings and sales in 2018. Moreover, Chart 2 indicates that IP, a proxy for S&P 500 sales, is poised to advance in 2018 and provide a lift to corporate profits. We will preview the S&P 500's Q4 2017 earnings reports in next week's U.S. Investment Strategy. Chart 1Favorable Macro Backdrop For Earnings And Sales Chart 2ISM Components Suggest IP Poised To Accelerate The Atlanta Fed GDP Now estimate stood at 2.7% on January 5, while the New York Fed's Nowcast for Q4 GDP was a healthy 4% (Chart 3). Both soundings are well above the FOMC's assessment of the economy's long-term potential growth rate (1.8%) and puts GDP growth in 2017 above the Fed's forecast. The implication is that the output gap pushed deeper into positive territory as 2017 ended, setting the stage for higher inflation in 2018. The December 2017 jobs report, released last Friday, January 5, does not change BCA's outlook for the U.S. economy or the Fed. The U.S. economy added a lower than expected 148,000 new jobs in December, which left the unemployment rate unchanged at 4.1%. Despite the softer than anticipated data, the 3-month average of payrolls growth is still a very healthy 204,000. The monthly increase in wages quickened to 0.3% m/m in December, up from 0.1% m/m last month. However, annual wage inflation remains modest at just 2.5% (Chart 4). Chart 3U.S. Economic Growth Well##BR##Ahead Of Potential In Q4 Chart 4Labor Market Still Tightening Despite##BR##Soft December Report The indications for Q4 GDP growth are solid. Aggregate hours worked rose 2.5% at an annualized rate in Q4 2017. Assuming modest growth in productivity, the payrolls data are consistent with over 3% GDP growth in Q4. There is nothing in the December payroll data to suggest that the underlying trajectory in the U.S. economy has changed. The economy continues to grow above trend. Wage gains are modest at the moment, but should accelerate as the labor market keeps tightening with above-trend GDP growth. This upbeat economic outlook is also supported the December 2017 non-manufacturing ISM survey, also released last Friday. While the overall index fell from 57.4 to 55.9, it is still consistent with solid GDP growth. Moreover, the employment index rose from 55.3 to 56.3, which signals firm job gains, and the prices paid index held steady at a fairly elevated level of 60.8. Bottom Line: It's been solid start to 2018 and it's steady as she goes for the U.S. economy and the Fed. FOMC Minutes: A Rubric BCA's U.S. Bond Strategy service expects that the 2/10 yield curve will languish between 0 and 50 bps in 2018. The curve will steepen from 51 bps at the end of 2017 through mid-year 2018, and then flatten into year-end (Chart 5). Which asset classes would benefit if our curve call is accurate? BCA's "The Bucket List"1 explains our view of the curve in 2018 and details the past performance of various U.S. assets in differing yield curve environments. Chart 5A Flat Yield Curve Is OK For Most Risk Assets BCA expects that the yield curve will first steepen in 2018, then become flatter, ultimately spending most of the year between 0 and 50 bps. A flat curve is the ideal environment for the S&P 500 and the stock-to-bond ratio. However, small cap stocks struggle when the curve is flat; BCA's view is that small caps will outperform large caps in 2018. A flat yield curve raises the risk of a sell-off in high yield, but provides a favorable grounding for oil, which is in line with BCA's fundamental view. BCA expects EPS growth will be positive this year; earnings growth is higher 75% of the time when the curve is flat. The yield curve's slope was a focus of debate at the FOMC's December 12-13, 2017 meeting. Participants cited several reasons for the flat curve2: recent increases in the target range for the federal funds rate; reductions in investors' estimates of the longer-run, neutral real interest rate; lower longer-term inflation expectations; lower term premiums Fed economists recently updated their quantitative assessments of the FOMC's minutes. The note provides a guide (Table 1 in the Fed paper3 and Tables 1 and 2 below) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the committee's latest views on the yield curve and inflation. Table 1FOMC Assessment Of The Yield Curve Table 2FOMC Assessment Of Inflation In short, the FOMC acknowledged the flatter curve and only a minority of members discounted the signal from the curve. Moreover, a majority thought that a tighter labor market would lead to higher inflation. Only one participant held the view that secular trends were muting inflation. Bottom Line: BCA expects the Fed to deliver 3 to 4 rate hikes in 2018, which is still not fully priced in by the market. Investors should maintain below-benchmark duration in fixed income portfolios. Asset allocators should remain overweight stocks versus bonds. Growth is strong and the yield curve is not inverted yet. Therefore, it is still early to de-risk portfolios. Is Economic Surprise Peaking? The Citigroup (Citi) Economic Surprise Index is elevated relative to its recent history, but it may have further to run. Economic prospects were cheery following the 2016 presidential election and the economic data exceeded those lofty projections, aided by a warmer than usual winter. However, the temperate conditions borrowed activity from the spring, which was cooler and wetter than normal, and the combination of lofty expectations and seasonal distortions sent the Citi Economic Surprise Index spiraling lower through mid-year 2017. Since its bottom in June 2017 at -78.6%, the index climbed for 135 days before its peak in late December 2017 (Chart 6, panel 1). On average since 2010, the Citi Index moved from trough-to-peak in 96 days, which means the recent run-up was much longer than usual. However, that phenomenon may have been due to the raised economic expectations and variable weather patterns at the start of 2017. Chart 6Economic Surprise Index Has Surged, But Expectations Remain Muted At 80.7%, the Index has been above zero for 68 days (Chart 6, panel 1). It typically takes 46 days for it to climb from zero to its zenith. Table 3 shows the performance of financial markets and other assets after the Index moves from zero to the peak. The most recent episode (October through December 2017) matched historical averages across most asset classes, although the underperformance of small caps versus large ran counter to the past as the Surprise Index climbed from zero. Table 3Risk Assets Perform Well As Surprise Index Climbs Since 2010, the Index has stayed above 40 for an average of 51 days (Chart 6, panel 1). The Index has been over 40 since November 16, 2017, or 35 days. This suggests that it can remain elevated for another month or so before it again moves lower. However, the Index is mean reverting and investors wonder what will happen to risk assets after economic surprise rolls over. Table 4 and Chart 7 shows the performance of key financial markets and commodities when the Citi Index returned to zero from 40-plus. There have been six such intervals since 2010. On average, gold and oil perform well as the surprise index dips to zero. Stocks and credit outperform Treasuries during these episodes, and small caps beat large caps. Rising economic surprise (Table 3) is a more favorable environment for stocks, credit and oil than when the surprise index is rolling over. However, the performance of gold and small caps is better after the Citi Surprise Index peaks (Table 4). Table 4Risk Assets Hold Up When Citi Surprise Index Rolls Over Chart 7U.S. Assets As Economic Surprise Rolls Over Nonetheless, muted economic expectations will limit the downside in the Index in the coming months. Panel 3 of Chart 6 shows that the outlook for both hard and soft economic data remained muted through the end of November 2017, especially when compared with the significant improvement in economic prospects in late 2016 and early 2017. Bottom Line: Risk assets outperformed as the Citi Economic Surprise Index climbed in the second half of 2017. The Index can stay near recent peaks for several more months thanks to subdued economic forecasts, but it will roll over eventually. However, the elevated level of the Index suggests that there are near-term risks for equities and credit because a lot of good economic news is already priced in. Still, we recommend that investors ride out the volatility given our view that stocks will outperform bonds in the next 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Bucket List", published December 18, 2017. Available at usis.bcaresearch.com. 2 https://www.federalreserve.gov/monetarypolicy/fomcminutes20171213.htm 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm

Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations