Gov Sovereigns/Treasurys

Highlights 2022 Key Views & Allocations: Translating our 2022 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions to begin the year. Target a moderate level of overall portfolio risk, maintain below-benchmark overall duration exposure, make developed market government bond country allocations based on relative expected central bank hawkishness (underweight the US, UK and Canada; overweight Germany, France, Italy, Australia, Japan), and be selective on allocations to global spread product (overweight high-yield with a bias toward Europe over the US, neutral global investment grade, underweight emerging market hard currency debt). Specific Allocation Changes: Much of the current positioning in our model bond portfolio already reflects our 2022 investment themes. The only significant changes we make to begin the year are reducing emerging market USD-denominated corporate bond exposure to underweight, and shifting some high-yield corporate bond exposure from the US to Europe. Feature In our last report of 2021, we published our 2022 Key Views, outlining the themes and investment implications of the 2022 BCA Outlook for global fixed income markets. In this report, our first of the new year, we translate those views into more specific recommendations and allocations within the BCA Research Global Fixed Income Strategy model bond portfolio. The main takeaways are that another year of expected above-trend global growth, even after the risks to start the year from the Omicron variant, will further absorb spare capacity across the developed economies. Realized inflation will slow from the elevated readings of 2021, but will remain high enough to force central banks – led by the US Federal Reserve – to incrementally remove highly accommodative monetary policies put in place during the pandemic. The backdrop for global bond markets will turn far less friendly as a result, with higher bond yields (led by US Treasuries), flatter yield curves and much weaker returns on spread products that have benefited from easy monetary policies like investment grade corporate debt and emerging market (EM) hard currency debt. Against this challenging backdrop for overall fixed income returns, bond investors will need to focus more on relative exposures between countries, sectors and credit ratings to generate outperformance versus benchmarks. Our recommended portfolio allocations to begin 2022 reflect that shift (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Our Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely Our Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely A Review Of The Model Bond Portfolio Performance In 2021 Chart 12021 Performance: A Positive, Yet Volatile, Year 2021 Performance: A Positive, Yet Volatile, Year 2021 Performance: A Positive, Yet Volatile, Year Before we begin our discussion of the model bond portfolio for 2022, we will take a final look back at the performance of the portfolio in 2021. Last year, the model bond portfolio delivered a small negative total return (hedged into US dollars) of -0.51%, but this still outperformed its custom benchmark index by +36bps (Chart 1).1 It was a very challenging year for global fixed income markets, in aggregate, with significant swings in bond yields (i.e. US Treasuries were up in Q1, down in Q2/Q3, up then down in Q4) and credit spreads (US high-yield spreads fell in H1/2021 and were rangebound in H2/2021, while EM hard currency spreads were stable in H1/2021 before steadily widening during the rest of the year). Over the full year, the government bond portion of the portfolio outperformed the custom benchmark index by +27bps while the spread product segment outperformed by +9bps (Table 2). The bulk of that government bond outperformance occurred during the first quarter of the year when global bond yields surged higher as COVID-19 vaccines began to be distributed and economic optimism improved in response – trends that benefited the below-benchmark duration tilt within the portfolio. The credit market outperformance was more evenly spread out during the final nine months of the year. Table 2GFIS Model Bond Portfolio Full Year 2021 Overall Return Attribution Our Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely Our Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely In terms of specific country exposures on government debt (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) generated virtually all of the full-year outperformance of the government bond portion of the portfolio (+38bps versus the benchmark). The biggest underperformer was the UK (-9bps), concentrated at the very end of the year as Gilt yields declined on the back of the Omicron surge, to the detriment of our underweight stance. All other country allocations provided little excess return, in aggregate, over the full year in 2021 – although there was significant variance of those returns during the year. Chart 2 Within spread product (Chart 3), the biggest gains were seen in US high-yield (+19bps) where we remained overweight throughout 2021. The largest drag on performance came from UK investment grade corporates (-9bps), although this all came in Q1/2021 where we maintained an overweight stance at the time and spreads widened. Other spread product sectors delivered little in the way of excess return, although that should not be a surprise as we maintained a neutral stance on US and euro area investment grade corporates – which have a combined 18% weighting within the model bond portfolio custom benchmark index – throughout 2021. Chart 3 In the end, our recommended portfolio tilts during 2021 were generally on the right side of the market, with our overweights outperforming in an overall down year for bond returns (Chart 4). The numbers would have been even better without the drag on performance in the fourth quarter (-17bps for the entire portfolio). That came entirely from our two biggest government bond underweights – US Treasuries and UK Gilts – which saw significant bond yield declines in response to the emergence of the Omicron variant. (the detailed breakdown of the Q4/2021 performance can be found in the Appendix on pages 19-23). Chart 4 Importantly, the surge in bond yields seen in the first week of 2022 has already resulted in a full recovery of that Q4/2021 underperformance, providing a good start to the new year for our model portfolio. Top-Down Bond Market Implications Of Our Key Views We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: BELOW BENCHMARK As we concluded in our 2022 Key Views report, longer-maturity government bond yields are now too low given the mix of very high inflation and very low unemployment seen in many countries. While we expect inflation to come down this year from the very rapid pace of 2021, it will not be by enough to force central banks off the path towards rate hikes that already began at the end of last year in places like the UK and New Zealand. The Fed is now signaling that multiple US rate hikes are likely in 2022, while even some European Central Bank (ECB) officials are expressing concern over very high European inflation. Longer maturity bond yields remain too low, in our view, because investors are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. (Chart 5). An upward adjustment of global interest rate expectations is likely this year as central banks like the Fed and the Bank of England (BoE) deliver on expected rate hikes, with more tightening necessary beyond 2022. This will be the primary driver of the rise in global bond yields that we expect this year - an outcome that has already begun in the first week of 2022. Chart 5Global Government Bond Yields Vulnerable To Hawkish Repricing Global Government Bond Yields Vulnerable To Hawkish Repricing Global Government Bond Yields Vulnerable To Hawkish Repricing ​​​​​​ Chart 6Staying Below-Benchmark On Overall Duration Exposure Staying Below-Benchmark On Overall Duration Exposure Staying Below-Benchmark On Overall Duration Exposure ​​​​​​ We ended 2021 with a model bond portfolio duration that was -0.65 years below that of the custom performance benchmark (Chart 6). We feel comfortable maintaining that position, in that size, to begin the new year. Government Bond Country Allocation: OVERWEIGHT THE EURO AREA (CORE & PERIPHERY), JAPAN & AUSTRALIA; UNDERWEIGHT THE US, UK & CANADA Our country allocation decisions within our model bond portfolio entering 2022 are based on a simple framework. We are overweighting countries where central banks are less likely to raise rates this year, and vice versa. We expect the largest increase in developed market bond yields in 2022 to occur in the US, as markets are still not priced for the cumulative tightening that the Fed will likely deliver over the next couple of years. Markets are also underpricing how much the Bank of England and Bank of Canada will need to raise rates over the full tightening cycle, even with multiple hikes discounted for 2022. We see the necessary upward repricing of post-2022 rate expectations in all three of those countries – the US, UK and Canada – justifying underweight allocations in our model portfolio. Chart 7Our Recommended DM Government Bond Allocations To Start 2022 Our Recommended DM Government Bond Allocations To Start 2022 Our Recommended DM Government Bond Allocations To Start 2022 The opposite is true in core Europe and Australia. Overnight index swap (OIS) curves are discounting multiple rate hikes this year from the Reserve Bank of Australia (RBA) and even an ECB rate hike later in 2022. As we discussed in our Key Views report, there is still not enough evidence pointing to rapid wage growth in Australia or Europe that would force the RBA and ECB to turn more hawkish than their current forward guidance which calls for no rate hikes in 2022. While both central banks may talk about the possibility that monetary policy will need to be tightened, we expect the actual rate hikes to occur in 2023 and not 2022. Thus, both markets justify overweight allocations in our model bond portfolio. We are also maintaining an overweight to Japanese government bonds, as Japanese inflation remains far too low – even in an environment of high energy prices and global supply chain disruption – for the Bank of Japan to contemplate any tightening of monetary policy. The country allocations within the model portfolio as of the end of 2021 all fit with the above analysis, thus we see no major changes that need to be made to begin 2022 (Chart 7).2 The only significant move made was to slightly bump up the size of the overweights in Italy and Spain, to be funded by the reduction in EM corporate bond exposure (as we discuss below). We continue to see a positive case for owning Peripheral European government bonds for the relatively high yields within Europe, with the ECB maintaining an overall dovish policy stance in 2022 even as it scales back the size of its bond buying activity starting in March. Inflation-Linked Bond Allocations: MAINTAIN A NEUTRAL OVERALL ALLOCATION TO GLOBAL LINKERS Chart 8Our Recommended Inflation-Linked Bond Allocations To Start 2022 Our Recommended Inflation-Linked Bond Allocations To Start 2022 Our Recommended Inflation-Linked Bond Allocations To Start 2022 Inflation-linked bonds have been a necessary part of bond investors' portfolios since the lows in global inflation breakeven spreads were seen in mid-2020. Now, with inflation expectations at or above central bank inflation targets in most developed market countries, and with realized inflation likely to subside from current levels this year, the backdrop no longer justifies structural overweights to linkers across all countries. We are sticking with our end-2021 overall neutral allocation to global inflation-linked bonds, focusing more on country allocations based on our inflation breakeven valuation indicators, as discussed in our 2022 Key Views report (Chart 8). This means maintaining a neutral stance on US TIPS and linkers (vs. nominal government bonds) in Canada, Australia and Japan. We are also staying with underweight positions in linkers (vs. nominals) in the UK, Germany, France and Italy where breakevens appear too high based on our indicators. Spread Product Allocation: MAINTAIN A SMALL OVERWEIGHT TO GLOBAL SPREAD PRODUCT FOCUSED ON EUROPEAN & US HIGH-YIELD CORPORATES, WHILE UNDERWEIGHTING EM CREDIT Chart 9Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability Our expectation of above-trend global growth in 2022, with still relatively high inflation (compared to pre-pandemic levels), should be positive for spread products like corporate bonds that benefit from strong nominal economic (and revenue) growth. However, the less accommodative global monetary policy backdrop we also expect is a potential negative for credit market performance - specially as rate hikes put upward pressure on deeply negative real interest rates, most notably in the US (Chart 9). Thus, we are entering 2022 with a cautious, but still positive, overall position on spread product in our model bond portfolio. We are focusing more on credit valuation, however - both in absolute terms and between countries and sectors – to try and generate outperformance for the credit portion of the portfolio. We are maintaining a neutral stance on investment grade corporates in the US, euro area and UK given the tight spread valuations in those markets. We prefer to focus our corporate credit exposure on overweights to high-yield bonds in the US and Europe, but with a marginal preference for European junk bonds over US equivalents as we discussed in our 2022 Key Views report (Chart 10). Within EM USD-denominated credit, we remain cautious entering 2022 given the poor fundamental backdrop for EM credit: slowing momentum of Chinese economic growth and global commodity prices, a firmer US dollar, and a less-accommodative global monetary policy backdrop (Chart 11). Thus, an underweight stance on EM credit is appropriate within the portfolio to start the year. Chart 10Increase Euro High-Yield Exposure Vs US High-Yield Increase Euro High-Yield Exposure Vs US High-Yield Increase Euro High-Yield Exposure Vs US High-Yield Chart 11Reduce EM USD-Denominated Corporate Debt Exposure To Underweight Reduce EM USD-Denominated Corporate Debt Exposure To Underweight Reduce EM USD-Denominated Corporate Debt Exposure To Underweight ​​​​​​ Chart 12   Finally, we are entering 2022 with the same relative tilt within US mortgage-backed securities (MBS) that we maintained during the latter half of 2021, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Based on our outlook for 2022, we are immediately making two marginal changes to the spread product allocations to the model bond portfolio: Reducing the size of our US high-yield overweight and using the proceeds to increase the size of the European high-yield overweight Reducing our EM USD-denominated corporate bond allocation to underweight from neutral, and placing the proceeds into Italian and Spanish government bonds (hedged into USD) to limit the reduction in the portfolio yield from the EM downgrade. The above moves will lower our overall credit overweight versus government bonds from 5% to 4%, all coming from the EM to Italy/Spain switch (Chart 12). Overall Portfolio Risk: MODERATE The changes made to our spread product allocations had no material impact on the estimated tracking error of the model portfolio – the relative volatility versus that of the benchmark. The tracking error is 78bps, still below our self-imposed limit of 100bps but above the lows seen in early 2021 (Chart 13). That higher tracking error is likely related to our underweight stance on US Treasuries, given the rise in bond volatility evident in measures like the MOVE index (bottom panel). Nonetheless, a moderate level of portfolio risk is reasonable given the combination of solid global economic growth, but with tighter global monetary policy, that we expect in 2022. Chart 13Keeping Overall Portfolio Risk At Moderate Levels Keeping Overall Portfolio Risk At Moderate Levels Keeping Overall Portfolio Risk At Moderate Levels ​​​​​​ Chart 14Positive Portfolio Carry Via Selective Spread Product Overweights Positive Portfolio Carry Via Selective Spread Product Overweights Positive Portfolio Carry Via Selective Spread Product Overweights ​​​​​​ The overweights to US high-yield, European high-yield and Italian government bonds all contribute to the model bond portfolio having a yield that begins 2022 modestly higher (+14bps) than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making all the changes to our model portfolio allocations, which can be seen in the tables on pages 24-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio during the first half of 2022. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). Chart Chart For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case Omicron related economic weakness is visible in some major economies (euro area, Canada), but the US stays resiliently strong and the US labor market continues to tighten. China is a growth laggard, but this will lead to policymakers providing more macro stimulus (credit, monetary, fiscal) starting in Q2/2022. Inflation pressures from supply chain disruption remain stubbornly strong and realized global inflation rates stay elevated for longer. Developed market central banks continue dialing back pandemic-era monetary policy accommodation, led by Fed tapering and a June 2022 liftoff of the funds rate. There is a mild initial bear steepening of the US Treasury curve with additional widening of US inflation breakevens in Q1/2022, leading to bear flattening in Q2 in the run-up to liftoff – the net effect is a parallel shift higher in the entire yield curve. The VIX index stays near current levels at 20, both the US dollar and oil prices are broadly unchanged and the fed funds rate is increased to 0.25%. Hawkish Fed The Omicron wave is short-lived with limited impact on global growth, which remains well above trend. Global inflation only declines moderately from current elevated levels, both from persistent supply squeezes and faster wage growth. China loosens monetary/credit policies and announces new fiscal stimulus in late Q1/2022 – a positive surprise for global growth expectations. Developed economy central banks turn even more hawkish. Fed liftoff is in March, with another hike in June. The US Treasury curve bear-flattens as US inflation breakevens reach their cyclical peak. The VIX index climbs to 25, the US dollar depreciates by -3% (pulled in opposing directions by strong global growth but relatively higher US interest rates), oil prices climb +10% and the fed funds rate is increased to 0.5%. Pessimistic Scenario The Omicron wave persists in many major countries (including the US) and leads to extended lockdowns and weaker consumer spending. Global growth momentum slows sharply. China does not signal adequate stimulus to offset its slowdown, while a weakened Biden administration passes much smaller US fiscal stimulus. Supply chain disruptions persist and are made worse by Omicron, keeping inflation elevated even as growth slows (stagflation). Developed economy central banks, stuck between slowing growth and elevated inflation, are unable to ease in response to economic weakness. The Fed goes for a slower taper that still ends in June, but liftoff is delayed until at least September. The US Treasury curve bull steepens modestly as the front end prices out 2022 hikes. US inflation breakevens remain sticky due to persistent realized inflation. The VIX index climbs to 30, the US dollar appreciates by +5% on a safe haven bid, oil prices fall -10% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Chart Chart Chart 15Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 16US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​ The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +54bps in the Base Case and +31bps in the Hawkish Fed scenario, but is projected to underperform by -9bps in the Pessimistic scenario. Importantly, there is virtually no expected excess return from the credit side of model bond portfolio in the Hawkish Fed scenario, even with strong global growth. A faster-than-expected pace of Fed rate hikes in the first half of 2022 would be a clear signal to downgrade exposure to the riskier parts of the fixed income universe like US high-yield. Although in that Hawkish Fed scenario, greater-than-expected China stimulus and a weaker US dollar would also represent signals to begin adding back emerging market credit exposure.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We also made very slight adjustments within the US, Japan, Germany and France allocations to refine our allocations across the various maturity buckets while keeping the overall portfolio duration unchanged entering 2022. Appendix Image Image Image Image Image Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Chart 1Stick With Steepeners Stick With Steepeners Stick With Steepeners The new year promises to be one of Fed tightening. The minutes from the December FOMC meeting reinforced the notion that rate hikes will begin as early as March and the market is now priced for 85 bps of rate increases (between 3 and 4 hikes) by the end of 2022. The long-end of the curve has responded to the hawkishness with the 10-year Treasury yield moving above its previous post-pandemic high of 1.74%. Just as interesting, however, is that the 5-year/5-year forward Treasury yield has only just climbed back to the lower-end of the range of neutral fed funds rate estimates (Chart 1). This has implications for our preferred yield curve positioning. With the 5-year/5-year forward yield still below our target, it makes sense to position for a bear-steepening of the Treasury curve. A shift from steepeners to flatteners will be warranted once the 5-year/5-year is more consistent with survey estimates of the neutral rate. For now, we recommend keeping portfolio duration low and owning 2/10 Treasury curve steepeners (long 2-year, short cash/10 barbell). Feature Table 1Recommended Portfolio Specification Prepare For Liftoff Prepare For Liftoff Table 2Fixed Income Sector Performance Prepare For Liftoff Prepare For Liftoff Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in December and by 162 bps in 2021. The index option-adjusted spread tightened 7 bps on the month and our quality-adjusted 12-month breakeven spread ticked down to its 6th percentile since 1995 (Chart 2). This indicates that corporate bonds remain expensive, despite the Fed’s pivot toward tightening. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable holding corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 bps to 50 bps.1 The 3-year/10-year Treasury slope recently bounced off the 50 bps level and it currently sits at 59 bps. However, our fair value estimates for the 3/10 slope suggest that it won’t stay above 50 bps for long (bottom panel). The three scenarios we consider all suggest that the 3/10 slope will break below 50 bps within the next six months.2 We will turn more defensive on corporate bonds once that occurs. Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 216 bps in December and by 669 bps in 2021. The index option-adjusted spread tightened 54 bps on the month, ending the year at 283 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also fell back to 3.3% (Chart 3). The odds are good that defaults will come in below 3.3% in 2021, which should coincide with the outperformance of high-yield bonds versus duration-matched Treasuries. For context, the high-yield default rate came in at 1.8% for the 12 months ending in November and we showed in a recent report that corporate balance sheets are in excellent shape.3 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We recommend that investors favor high-yield over investment grade corporate bonds. While, as noted on page 3, we will turn more defensive on credit risk (including high-yield) once the 3/10 Treasury slope moves sustainably below 50 bps, we will likely retain a preference for high-yield over investment grade based on relative valuations.      MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 21 basis points in December but lagged by 69 bps in 2021. The zero-volatility spread for conventional 30-year agency MBS tightened 6 bps on the month, evenly split between 3 bps of option-adjusted spread (OAS) tightening and a 3 bps drop in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021, despite the back-up in yields.4 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refinancings to remain stubbornly high in 2022. This will put upward pressure on MBS spreads. We recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Government-Related: Overweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 34 basis points in December and by 68 bps in 2021. Sovereign debt outperformed duration-equivalent Treasuries by 216 bps in December but lagged by 10 bps in 2021. Foreign Agencies outperformed the Treasury benchmark by 6 bps on the month and by 41 bps in 2021. Local Authority bonds underperformed by 37 bps in December but beat duration-matched Treasuries by 368 bps in 2021. Domestic Agency bonds underperformed by 1 bp in December and were flat versus Treasuries on the year. Supranationals outperformed Treasuries by 2 bps in December and by 20 bps in 2021. The investment grade Emerging Market Sovereign bond index outperformed the duration-equivalent US corporate bond index by 109 bps in December. The Emerging Market Corporate & Quasi-Sovereign index outperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.5  Within EM sovereigns, attractive countries include: Philippines, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in December and by 416 bps in 2021 (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.6 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 19% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 25% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in December but reversed some of that flattening in the first week of January. All in all, the 2-year/10-year Treasury slope has flattened 2 bps since the end of November, bringing it to 89 bps. As noted on the front page of this report, the 5-year/5-year forward Treasury yield is rising but it is still only at the low-end of survey estimates of the long-run neutral fed funds rate. This argues for continuing to hold curve steepeners in the near term. It will make sense to shift into flatteners once the 5-year/5-year forward yield rises to the middle of the range of survey estimates. We also observe that the 2/5/10 butterfly spread is extremely high, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that a 2/10 curve steepening position (long 5-year bullet, short 2/10 barbell) is incredibly cheap. Indeed, the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4) and the Fed has still not raised rates off the zero bound. A trade long the 5-year bullet and short a duration-matched 2/10 barbell looks attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen. For that reason, we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. We recommend buying the 2-year bullet versus a duration-matched cash/10 barbell. We also advise investors to own a position long the 20-year bond versus a duration-matched 10/30 barbell. This latter position offers a very attractive duration-neutral yield advantage of 20 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 85 basis points in December and by 830 bps in 2021. The 10-year TIPS breakeven inflation rate rose 8 bps on the month while the 2-year TIPS breakeven inflation rate fell by 2 bps. The 10-year and 2-year rates currently sit at 2.52% and 3.17%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month. It currently sits at 2.19%, somewhat below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in December and by 31 bps in 2021. Aaa-rated ABS outperformed by 4 bps in December and by 17 bps in 2021. Non-Aaa ABS outperformed Treasuries by 9 bps in December and by 103 bps in 2021. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth is starting to rebound, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in December and by 180 bps in 2021. Aaa Non-Agency CMBS outperformed Treasuries by 17 bps in December and by 80 bps in 2021. Non-Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in December and by 513 bps in 2021 (Chart 10). Though returns have been strong and spreads remain relatively high, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in December and by 70 bps in 2021. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet.   Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31st, 2021) Prepare For Liftoff Prepare For Liftoff Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31st, 2021) Prepare For Liftoff Prepare For Liftoff Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -58 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 58 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Prepare For Liftoff Prepare For Liftoff Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  We consider three scenarios for the fed funds rate. (1) March liftoff, 100 bps per year hike pace, 2.08% terminal rate. (2) March liftoff, 75 bps per year hike pace, 2.08% terminal rate. (3) March liftoff, 75 bps per year hike pace, 2.33% terminal rate. 3  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 5  Please see US Bond Strategy Special Report, “2022 Key Views: US Fixed Income”, dated December 14, 2021. 6  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.  

Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022 Another Year Of Above Trend Growth Expected In 2022 Another Year Of Above Trend Growth Expected In 2022 ​​​​​ Chart 2Strong Fundamental Support For US Growth Strong Fundamental Support For US Growth Strong Fundamental Support For US Growth ​​​​​ Chart 3China In 2022: Deceleration Leading To Policy Easing China In 2022: Deceleration Leading To Policy Easing China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022 Global Fiscal Policy Divergence In 2022 Global Fiscal Policy Divergence In 2022 ​​​​​​ Chart 5Lower Inflation Will Help Boost Consumer Confidence Lower Inflation Will Help Boost Consumer Confidence Lower Inflation Will Help Boost Consumer Confidence ​​​​​​ The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way Some Relief On Supply-Driven Inflation On The Way Some Relief On Supply-Driven Inflation On The Way ​​​​​​ Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 Global Inflation Will Be Lower, But More Sustainable, In 2022 Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Bond Markets Vulnerable To More Hawkish Repricing Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Markets Are Pricing Short, Shallow Hiking Cycles Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years 2022 Key Views: The Story Gets More Complicated 2022 Key Views: The Story Gets More Complicated The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns Rate Hike Expectations Driving Relative Bond Returns Rate Hike Expectations Driving Relative Bond Returns ​​​​​​ Chart 11Stay Underweight US Interest Rate Exposure Stay Underweight US Interest Rate Exposure Stay Underweight US Interest Rate Exposure ​​​​​​ Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields Cyclical Upside Risk To Longer-Dated UST Yields Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure Stay Overweight European Interest Rate Exposure Stay Overweight European Interest Rate Exposure ​​​​​​ Chart 14Expect More US-Europe Spread Widening In 2022 Expect More US-Europe Spread Widening In 2022 Expect More US-Europe Spread Widening In 2022 ​​​​​​ Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 Stay O/W European Peripheral Exposure To Begin 2022 Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure Stay U/W UK & Canadian Interest Rate Exposure Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure Stay O/W Australian & Japanese Interest Rate Exposure Stay O/W Australian & Japanese Interest Rate Exposure ​​​​​​ Chart 18Our Recommended DM Government Bond Country Allocations Our Recommended DM Government Bond Country Allocations Our Recommended DM Government Bond Country Allocations ​​​​​​ In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. Chart 19 With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations Our Recommended Inflation-Linked Bond Allocations Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability ​​​​​​ Chart 22 In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom Global Corporate Bond Yields Have Reached A Cyclical Bottom Global Corporate Bond Yields Have Reached A Cyclical Bottom ​​​​​​ Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom Global Corporate Bond Spreads Have Reached A Cyclical Bottom Global Corporate Bond Spreads Have Reached A Cyclical Bottom ​​​​​​ On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Monetary Policy Backdrop Turning More Negative For Credit Markets Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling US Corporate Spread Valuations Are Not Compelling US Corporate Spread Valuations Are Not Compelling ​​​​​​ Chart 27Euro Area Corporate Spread Valuations Are Also Stretched Euro Area Corporate Spread Valuations Are Also Stretched Euro Area Corporate Spread Valuations Are Also Stretched ​​​​​​ Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022 Favor Euro Area High-Yield Over US Equivalents In 2022 Favor Euro Area High-Yield Over US Equivalents In 2022 ​​​​​​ Chart 29 When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 30 Chart 31Stay Cautious On EM Hard Currency Debt Stay Cautious On EM Hard Currency Debt Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

This is US Bond Strategy’s final report of the year. Our regular publication schedule will resume on January 11th with our Portfolio Allocation Summary for January 2022. Highlights Interest Rate Policy: The Fed will tighten policy in 2022. Our baseline expectation is that the first hike will occur in June 2022 and that rate increases will proceed at a pace of 25 basis points per quarter through the end of the year. An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations would cause the Fed to tighten more quickly. An abrupt tightening of financial conditions would cause the Fed to move more slowly. The Flexible Average Inflation Target: The re-anchoring of long-term inflation expectations suggests that the Fed’s new FAIT framework is viewed as credible and is working as intended. It is likely here to stay. The Long-Run Neutral Rate: We think it’s likely that consensus estimates of a 2.0% to 2.5% long-run neutral fed funds rate will turn out to be too low, but we don’t recommend trading on that view in 2022. The low neutral rate narrative is very well-entrenched, and it will only be questioned after several rate hikes have been delivered and their economic impact is assessed. A Year Of Tightening The Fed started 2021 with three conditions for lifting rates (Table 1). Now, as we head into 2022, the Fed has officially acknowledged that the two conditions related to inflation have been met, and Fed Chair Jay Powell said that the economy is making “rapid progress” toward the final condition of “maximum employment”. Table 1The Fed's Liftoff Criteria The Fed In 2022 The Fed In 2022 Based on this, it looks like rate hikes are imminent. The Fed recently doubled its pace of asset purchase tapering so that net purchases will reach zero by mid-March. This opens up the March 2022 FOMC meeting as the first “live meeting” where a rate hike could occur. Our base case expectation is that the Fed will wait a tad longer, but that liftoff will occur at the June FOMC meeting. Rate hikes will then proceed through the end of the year at a pace of 25 basis points per quarter. Next, we discuss why the Fed has adopted this hawkish posture. We also consider the factors that would cause tightening to proceed more quickly or more slowly in 2022. Reasons For The Fed’s Hawkish Pivot Chart 1Labor Market Indicators Labor Market Indicators Labor Market Indicators It might sound odd to say that the US economy is rapidly approaching maximum employment. After all, the labor market is still 3.9 million jobs short of where it was in February 2020 (Chart 1). What’s more, only 59.2% of the population is employed today compared to 61.1% prior to the pandemic (Chart 1, panel 2). But Fed Chair Powell wasn’t referring to either of those figures when he said that the economy is making “rapid progress” toward maximum employment. Rather, he was referring to the unemployment rate, which currently sits at 4.2% (Chart 1, panel 3). This is only 0.2% above the Fed’s estimate of the natural rate of unemployment and only 0.7% above the pre-pandemic level of 3.5%. The fact that the unemployment rate has declined sharply means that the bulk of the shortfall in the economy-wide number of jobs is the result of people dropping out of the labor force (Chart 1, bottom panel), not the result of an increase in the percentage of the labor force that is unemployed. As recently as the November FOMC meeting, the Fed wasn’t drawing a sharp distinction between these two trends. In fact, Chair Powell said in his post-meeting press conference that “there is still ground to cover to reach maximum employment, both in terms of employment and in terms of participation.” But just one month later, at the December FOMC press conference, Chair Powell struck a much different tone. He said: Chart 2Participation Trends The Demographic Downtrend In Participation Participation Trends The Demographic Downtrend In Participation Participation Trends The Demographic Downtrend In Participation But the reality is, we don’t have a strong labor force participation recovery yet and we may not have it for some time. At the same time, we have to make policy now. And inflation is well above target. So this is something we need to take into account. It appears that the Fed is no longer confident that labor force participation is about to rise. There are a few good reasons for this. First, the aging of the US population imparts a structural demographic downtrend to the labor force participation rate as an increasing number of people reach retirement age (Chart 2). In addition, there was a sharp drop in 55+ participation at the onset of the pandemic that has so far not recovered at all (Chart 2, panel 2). It is debatable whether people in this older age cohort will ever return to work. Finally, there is a shortfall in participation for people in their prime working years (ages 25-54) (Chart 2, bottom panel). These people are likely not working because of factors related to the pandemic (e.g. fear of getting sick, caregiving requirements). It is likely that prime-age participation will rise as pandemic concerns fade, but the Fed is no longer confident that these pandemic concerns will fade quickly. Faced with elevated inflation right now, the Fed has decided that it must act against inflation earlier than it had intended, before prime-age labor force participation makes a full recovery. For bond investors, the important takeaway from the recent shift in Fed policy is that a recovery in labor force participation is no longer a pre-condition for liftoff. That being the case, we are very close to the Fed pulling the trigger on rate hikes. Table 2 shows the average monthly nonfarm payroll growth required to reach different target unemployment rates by different future dates, assuming the labor force participation rate remains at its current level. With the participation rate held flat, it only takes average monthly nonfarm payroll growth of 224 thousand to reach the pre-COVID unemployment rate of 3.5% by June. That same rate of growth would cause the unemployment rate to fall below the Fed’s 4% natural rate estimate by January. Table 2Average Monthly Nonfarm Payroll Growth (Thousands) Required To Reach Unemployment Rate Target By Given Date The Fed In 2022 The Fed In 2022 The message is clear. With rising participation no longer a pre-condition for hikes, the Fed’s “maximum employment” liftoff condition will be met within the next few months. We expect this will lead to the first Fed rate hike at the June 2022 FOMC meeting. What Happened To “Transitory” Inflation? Chart 3Core CPI Components Core CPI Components Core CPI Components The Fed’s view of the labor force participation rate is very similar to its view of inflation. Both are being influenced by the pandemic, but the Fed is no longer confident that pandemic concerns will fade in a timely manner. Looking at the inflation picture, it’s easy to see the impact of the pandemic. Core goods inflation is running at a year-over-year rate of 9.4%. It was close to 0% prior to COVID (Chart 3). This is obviously the result of pandemic-related supply chain disruptions and the shift in consumer spending away from services and toward goods. Just like with labor force participation, these trends should reverse as pandemic concerns fade. However, given the pandemic’s uncertain duration, the Fed is no longer willing to wait for that to happen. The Fed’s Interest Rate Projections In line with its hawkish shift on the definition of “maximum employment”, FOMC participants revised up their interest rate projections at the December meeting. The median FOMC participant is now looking for three 25 basis point rate hikes in 2022. This is consistent with liftoff in June followed by a pace of one rate hike per quarter (Chart 4). Interestingly, the market is reasonably well priced for this near-term path for rates. The deviation between market pricing and Fed expectations occurs further out the curve. As such, we recommend that US bond investors keep portfolio duration low and favor the 2-year Treasury note over the 10-year.1 Chart 4Rate Expectations Rate Expectations Rate Expectations What Would Make The Fed Go Faster? Chart 5No Wage/Price Spiral Yet No Wage/Price Spiral Yet No Wage/Price Spiral Yet As noted above, our base case forecast is that the Fed will start lifting rates in June 2022 and continue to hike at a pace of 25 bps per quarter. This is roughly consistent with the Fed’s own median projections. However, we acknowledge that the Fed will tighten policy more quickly if it sees evidence of an emerging wage-price spiral. Specifically, the Fed has pointed to the risk that real wage growth might exceed the rate of productivity growth. If that were to occur, the Fed would be worried about a wage-price spiral where firms lift prices to meet wage demands, but that only causes employee inflation expectations to rise further, leading to even greater wage demands. So far, this is not occurring. Real wage growth is negative and long-dated inflation expectations remain well-anchored near the Fed’s target levels (Chart 5). An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations during the next few months would cause the Fed to bring forward the liftoff date and increase the pace of rate hikes in 2022. What Would Make The Fed Go Slower? The main thing that would cause the Fed to tighten more slowly in 2022 would be if its hawkish shift prompted a severe tightening in overall financial conditions. Chart 6 shows that the ends of Fed tightening cycles typically coincide with the Goldman Sachs Financial Conditions Index moving above 100. This tightening in financial conditions also typically precedes a slowdown in economic growth (Chart 6, panel 2). Chart 6Watch Financial Conditions And Treasury Slope As The Fed Tightens Watch Financial Conditions And Treasury Slope As The Fed Tightens Watch Financial Conditions And Treasury Slope As The Fed Tightens Financial conditions are incredibly easy at present. But it is conceivable that risky assets will sell-off on fears of Fed rate hikes, and a large enough sell-off would cause the Fed to pause. The slope of the Treasury curve could also be a useful indicator in this regard. The 2/10 slope is usually close to inversion when the Fed ends its rate hike cycles (Chart 6, panel 3). Bottom Line: The Fed will tighten policy in 2022. Our baseline expectation is that the first hike will occur in June 2022 and that rate increases will proceed at a pace of 25 basis points per quarter through the end of the year. An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations would cause the Fed to tighten more quickly. An abrupt tightening of financial conditions would cause the Fed to move more slowly. US bond investors should position for this outcome by keeping portfolio duration low and by favoring the 2-year Treasury note over the 10-year. FAIT Accompli It’s been roughly one year since the Fed concluded its Strategic Review and released a revised Statement on Longer-Run Goals and Monetary Policy Strategy.2 One year on, it seems appropriate to consider how much Fed policy actually changed as a result. We focus on what, in our view, are the two most significant changes to the Fed’s Statement. 1.  No More Pre-Mature Tightening First, the Fed changed its strategy to focus on “shortfalls of employment from its maximum level” rather than “deviations from its maximum level”. In the Fed’s words, “this change signals that high employment, in the absence of unwanted increases in inflation […], will not by itself be a cause for policy concern.” In the past, the Fed would tighten policy in response to a low unemployment rate on the expectation that inflation was about to increase. The new strategy is to wait for inflation to emerge before tightening, even if the unemployment rate is very low. Inflation has obviously emerged, so policy tightening is justified even under the new framework. Nonetheless, the evidence shows that the Fed has waited longer than usual to tighten. Chart 7A shows the change in the unemployment rate since the previous trough for the current cycle alongside the previous three cycles. For prior cycles, the lines end when the Fed delivers its first rate hike. While it’s notable that the unemployment rate has improved much more quickly this time around, it’s just as notable that the Fed still hasn’t lifted rates. This is despite the fact that the unemployment rate is only 0.7% above its pre-recession trough. This is more progress than was made before tightening in the 1990 and 2000 cycles, and about the same amount of progress as was made in the 107 months since the unemployment rate troughed before the Great Financial Crisis. Chart 7 A broader measure of labor market utilization, the prime-age (25-54) employment-to-population ratio, tells a similar story (Chart 7B). By this metric, the labor market has already made more progress than it did during the prior two cycles and the Fed still hasn’t increased the funds rate. Chart 7 All in all, even though inflation has emerged earlier this cycle than most expected, it’s pretty clear that the Fed’s new focus on employment “shortfalls” instead of “deviations” has made it act more dovishly. 2. Flexible Average Inflation Targeting (FAIT) The second big change that the Fed made to its Statement on Longer-Run Goals and Monetary Policy Strategy was the introduction of a Flexible Average Inflation Target (FAIT). Under the FAIT framework, the Fed will no longer view its 2% inflation target as purely forward looking. Rather, the Fed will seek to achieve average 2% inflation over time. This means that, “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” While the Fed doesn’t specify a period over which it seeks 2% average inflation, it seems clear that the new inflation target has been achieved. PCE inflation is well above where it would have been if it averaged 2% since the new framework was adopted in August 2020 (Chart 8). This is also true if we pick February 2020, the peak of the last cycle, as our starting point. In fact, PCE inflation has almost made up for the entire inflation shortfall since January 2010. Chart 8The FAIT Framework The FAIT Framework The FAIT Framework While it’s interesting to look at average inflation over different lookback periods, it’s more important to note that the actual goal of the FAIT framework is to keep long-dated inflation expectations anchored near target levels. In the Fed’s own words: By seeking inflation that averages 2 percent over time this will help ensure that longer-run inflation expectations do not drift down and remain well anchored at 2 percent.3 If we judge the effectiveness of FAIT based on trends in long-term inflation expectations, then the only reasonable conclusion is that it has been a massive success. By any measure, long-term inflation expectations were well below levels consistent with the Fed’s 2% target in fall 2020. Now, they are very close to target levels. This is true whether we look at market-based measures (Chart 9A), survey measures (Chart 9B), trend measures (Chart 9C) or a composite indicator of many different measures (Chart 9D). Chart 9AMarket-Based Inflation Expectations Market-Based Inflation Expectations Market-Based Inflation Expectations Chart 9BSurvey-Based Inflation Expectations Survey-Based Inflation Expectations Survey-Based Inflation Expectations Chart 9CTrend Measures Of Inflation ##br##Expectations Trend Measures Of Inflation Expectations Trend Measures Of Inflation Expectations Chart 9DThe CIE Index The Fed's New Index Of Common Inflation Expectations (CIE) The CIE Index The Fed's New Index Of Common Inflation Expectations (CIE) The CIE Index The Fed's New Index Of Common Inflation Expectations (CIE) The Verdict All told, it looks like the Fed has made good on its promises. It refrained from lifting rates as the unemployment rate fell and has only now moved toward tightening in response to extremely high inflation. Also, the re-anchoring of long-term inflation expectations suggests that the Fed’s new FAIT framework is viewed as credible and is working as intended. Neutral Rate Expectations In 2022 Chart 10Neutral Rate Estimates Neutral Rate Estimates Neutral Rate Estimates There is one key issue for both Fed policy and bond markets that we have not yet discussed, and that’s the long-run neutral fed funds rate. This is the interest rate that, on average, will be consistent with the Fed’s price stability and maximum employment goals in the long run. As of today, the consensus among central bankers and investors is that the neutral rate is very low compared to history. There is also a widespread belief that it will remain low for the foreseeable future. For example, here is a sentence from the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy: The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past. The top panel of Chart 10 shows that the Fed has revised its median estimate of the long-run neutral rate substantially lower since 2012, down from 4.3% to 2.5%. And it’s not just the Fed that has done so. The same downward revisions are seen in the Surveys of Market Participants and Primary Dealers (Chart 10, bottom 2 panels). Incidentally, the 5-year/5-year forward Treasury yield – a market-derived proxy for the long-run neutral rate – is below even the survey estimates. This is a key reason for our below-benchmark portfolio duration stance. Why Does The Fed Believe That The Neutral Rate Is Low And Will Stay Low? Chart 11The Demographic Effect The Demographic Effect The Demographic Effect New York Fed President John Williams has cited three key reasons for the low neutral fed funds rate: demographics, lower productivity growth and a heightened demand for safe and liquid assets.4 Of those factors, Fed research has determined that demographics are particularly important. The trend of increasing life expectancy, specifically, has been shown to be an important factor pushing interest rates down as people increase their savings in anticipation of a longer retirement (Chart 11).5 Could The Fed Be Wrong? We aren’t as confident that the neutral rate will stay low. In fact, we think it’s possible that both Fed and investor estimates understate the current long-run neutral rate. Our own Bank Credit Analyst has observed that the 5-year/5-year forward Treasury yield was very close to trend nominal GDP growth up until the 2008 financial crisis (Chart 12). Then, it dipped below as a protracted period of household deleveraging caused private sector credit demand to dry up. With household balance sheets no longer in disrepair, we are starting to see an increase in household debt, one that could eventually push bond yields back toward trend growth.6 It’s not just our own research that is starting to question the popular narrative of a low neutral fed funds rate. At the most recent Jackson Hole summit, Atif Mian, Ludwig Straub and Amir Sufi presented a paper that shows that rising income inequality is predominantly responsible for today’s low neutral rate (Chart 13), not the demographic effect previously identified by the Fed.7 Chart 13Rising Income Inequality ##br##Since 1980 Rising Income Inequality Since 1980 Rising Income Inequality Since 1980 Chart 12Household Deleveraging Kept Rates Low Post-2008 Household Deleveraging Kept Rates Low Post-2008 Household Deleveraging Kept Rates Low Post-2008 This research has important implications for the future evolution of the neutral rate. Unlike demographics, income inequality can be altered by changes in tax policy and by shifts in the power struggle between capital owners and workers. In this regard, our US Investment Strategy service has written several reports demonstrating the ongoing structural shift toward greater labor power.8 If this structural trend continues, it suggests that the long-run neutral rate may also rise. Trading The Neutral Rate While we suspect that the long-run neutral fed funds rate will turn out to be higher than both the market and Fed anticipate, we don’t think it’s wise to trade on that view in 2022. The reason is that expectations of a low neutral fed funds rate are extremely well-entrenched. It will take a lot of contrary evidence to shift those expectations, evidence we probably won’t get next year. As noted above, survey estimates of the long-run neutral rate range roughly from 2.0% to 2.5%. Our sense is that those estimates will only be revised higher if the fed funds rate gets much closer to those levels, say at least above 1%, and the economic data suggest that further rate increases will be required. This is a story for 2023, not 2022. A recent paper documented some interesting facts about the relationship between monetary policy and market expectations.9  It observed that the entire decline in the 10-year Treasury yield since 1990 has occurred during 3-day windows around FOMC meetings (Chart 14). This is not what we would expect to see if the long-run neutral rate was determined by independent macroeconomic factors that are distinct from Fed interest rate decisions. Chart 14Fed Rate Decisions Drive Long-Maturity Bond Yields Fed Rate Decisions Drive Long-Maturity Bond Yields Fed Rate Decisions Drive Long-Maturity Bond Yields We find this research very compelling. It suggests that the market changes its neutral rate expectations in response to Fed interest rate moves. In our view, this strengthens our conviction that a series of rate hikes will eventually cause the market to push its neutral rate expectations higher, leading to a sell-off in long-maturity bonds. Bottom Line: We think it’s likely that consensus estimates of a 2.0% to 2.5% long-run neutral fed funds rate will turn out to be too low, but we don’t recommend trading on that view in 2022. The low neutral rate narrative is very well-entrenched, and it will only be questioned after several rate hikes have been delivered and their economic impact is assessed.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For our full set of recommendations please see US Bond Strategy Special Report, “Key Views 2022: US Fixed Income”, dated December 14, 2021. 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-qas.htm#7 4 https://www.newyorkfed.org/newsevents/speeches/2018/wil181130#footnote3 5 https://www.frbsf.org/economic-research/files/el2017-27.pdf 6 For more details on this argument please see Bank Credit Analyst Special Report, “R-star, And The Structural Risk To Stocks”, dated March 31, 2021. 7 https://www.kansascityfed.org/documents/8337/JH_paper_Sufi_3.pdf 8 Please see January 13, January 20 and February 3, 2020 US Investment Strategy Special Reports, “An Investor’s Guide To US Labor History”, “Where Strikes Come From And Who Wins Them” and “The Public-Approval Contest”. 9 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3550593 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Dear Client, Thank you for your continued readership and support this year. This is the last European Investment Strategy report for 2021. In this piece, we review ten charts covering important aspects of the European economy and capital markets. We will resume our regular publishing schedule on January 10th, 2022. The European Investment Strategy team wishes you and your loved ones a wonderful holiday season, and a healthy, happy, and prosperous new year. Best regards, Mathieu Savary   Highlights European growth continues to face headwinds as it enters 2022. The ECB will be slow to remove more accommodation than what is implied by the end of the PEPP. Value stocks and Italian equities will enjoy a modest tailwind from rising Bund yields. The lower quality of European stocks creates a long-term headwind versus US benchmarks. The outperformance of European cyclicals relative to defensives will resume and financials will have greater upside. The relative performance of small-cap stocks will soon stabilize, but a weak euro will create a near-term risk. President Emmanuel Macron’s real contender is the center-right candidate Valerie Pécresse, not populists. Feature Chart 1: Wave Dynamics The current wave of COVID-19 infections continues to surge in Europe. As Chart 1 highlights, Austria and the Netherlands just witnessed intense waves that eclipsed those experienced earlier this year. However, these waves are already ebbing because of the containment measures implemented in recent weeks. In these two severely hit nations, hospitalization rates also increased significantly; however, they did not reach the degree experienced in France or the UK in the first half of 2021 (Chart 1, right panel). Chart 1Wave Dynamics Wave Dynamics I Wave Dynamics I Chart 1Wave Dynamics Wave Dynamics II Wave Dynamics II Europe will experience another test in the coming weeks as the highly contagious Omicron variant becomes the dominant COVID-19 strain. However, data from South Africa continues to suggest that this mutation is much less pathogenic than previous variants and will not place as much strain on the healthcare system as potential case counts would indicate. Nonetheless, it is too early to make this prognosis with great confidence. Importantly, even if a small proportion of infected people is hospitalized, a large enough a pool of infections could cause a rupture in the healthcare system. As a result, politicians will likely remain cautious until a larger share of the population receives its booster dose. Hence, Omicron still represents a near-term risk to economic activity, albeit one that will prove ephemeral. Chart 2: The Economy Is Not Out Of The Woods Yet European growth remains highly dependent on the fluctuations of the global economy because exports and capex account for a large share of the continent’s output. Consequently, global economic trends remain paramount when considering the European economic outlook. In the near-term, Europe continues to face headwinds beyond the uncertainty caused by the potential effects of the Omicron variant. Global economic activity, for instance, is likely to face some further near-term headwinds caused by the supply shock typified by elevated commodity prices and bottlenecks (Chart 2). Not only does this shock limit the ability of producers to procure important inputs, but it also increases the costs of production. Historically, this combination results in downward pressure on global manufacturing activity. Chart 2The Economy Is Not Out Of The Woods Yet The Economy Is Not Out Of The Woods Yet I The Economy Is Not Out Of The Woods Yet I Chart 2The Economy Is Not Out Of The Woods Yet The Economy Is Not Out Of The Woods Yet II The Economy Is Not Out Of The Woods Yet II The second problem remains the deceleration in the Chinese economy. Declining credit growth in China results in slower European exports, which also hurts the region’s PMI. The recent Central Economic Work Conference suggests that China is ready to inject more stimulus in its economy, which will help Europe. However, the beginning of 2022 will still witness the lagged impact of previous tightening in credit conditions on European economic indicators. Moreover, BCA’s China Investment Strategy team expects the stimulus to be modest at first and only grow in intensity later.  It is unlikely to be as credit-heavy as in the past, which also means it will be less beneficial to Europe. Chart 3: A Careful ECB Last week, the European Central Bank aggressively upgraded its inflation forecast for 2022 and announced the end of the PEPP for March, however, it will increase temporarily the APP program to EUR40bn. Moreover, President Christine Lagarde remains steadfast that the Governing Council will not raise rates in 2022. Our Central Bank Monitor points to the need for tighter policy, yet the ECB continues to adopt a cautious tone, even if the Eurozone HICP inflation has reached 4%—the highest reading in thirteen years. First, the ECB still runs the risk of dislocation in the periphery, where Italian and Spanish spreads may easily explode if monetary accommodation is removed too quickly. Second, European inflationary pressures remain significantly narrower than they are in the US (Chart 3, left panel). Our Eurozone trimmed-mean CPI continues to linger well below core CPI readings, while in the US both measures track each other closely. Third, the decline in energy prices and the ebbing transportation bottlenecks mean that odds are growing that sequential inflation will soon experience an interim peak (Chart 3, right panel). Chart 3A Careful ECB A Careful ECB I A Careful ECB I Chart 3A Careful ECB A Careful ECB II A Careful ECB II This view of the ECB implies that German yields will not rise as much as US yields next year, which BCA’s US Bond Strategy team expects to reach 2.25% by the end of 2022. Moreover, the more tepid pace of the removal of accommodation and the implicit targeting of peripheral bond markets also warrant an overweight position in Italian bonds. Spreads will be volatile, but any move upward will be self-limiting because of their role in the ECB’s reaction function. As a result, investors should continue to pocket the additional income over German paper. Chart 4: A Murky Outlook For The Euro The market continues to test EUR/USD. Any breakdown below 1.1175 is likely to prompt a pronounced down leg toward 1.07-1.08, near the pandemic lows. The euro suffers from three handicaps. First, Europe’s economic links with China are greater than those of the US with China. Consequently, the Chinese economic deceleration hurts European rates of returns more than it hurts those in the US. Second, the acceleration of US inflation is inviting investors to reprice the path of the Fed’s policy rate, which accentuates the upside pressure on the dollar. Finally, the energy crisis is ramping up anew following Germany’s suspension of the approval of the Nord Stream 2 pipeline and the buildup of Russian troops on Ukraine’s borders. Surging European natural gas prices act as a powerful headwind for EUR/USD because they accentuate stagflation risks in the Eurozone (Chart 4, left panel). While these create downside pressures on the euro, the picture is more complex. Our Intermediate-Term Timing Model shows that EUR/USD is one-sigma oversold (Chart 4, right panel). Over the past 20 years, it was more depressed only in 2010 and in early 2015. Such a reading indicates that most of the bad news is already embedded in EUR/USD and that sentiment has become massively negative. Thus, we are not chasing the euro lower, even though we will respect our stop-loss at 1.1175 if it were triggered. Instead, we will look to buy the euro at lower levels in the first quarter of 2021. Chart 4A Murky Outlook For The Euro A Murky Outlook For The Euro I A Murky Outlook For The Euro I Chart 4A Murky Outlook For The Euro A Murky Outlook For The Euro II A Murky Outlook For The Euro II Chart 5: German Yields Are Key To Value Stocks And Italian Equities The performance of European value stocks relative to that of growth stocks continues to exhibit a close relationship with the evolution of German Bund yields (Chart 5, left panel). Value stocks are less sensitive than growth stocks to higher yields because they derive a smaller proportion of their intrinsic value from long-term deferred cash flows; which suffer more from rising discount factors than near-term cash flows. Moreover, value stocks overweight financials, whose profitability increases when yields rise. The same relationship exists between the performance of Italian equities relative to the Eurozone benchmark (Chart 5, right panel). This correlation holds because of Italy’s significant value bias and its large exposure to financials. Chart 5German Yields Are Key To Value Stocks And Italian Equities German Yields Are Key To Value Stocks And Italian Equities I German Yields Are Key To Value Stocks And Italian Equities I Chart 5German Yields Are Key To Value Stocks And Italian Equities German Yields Are Key To Value Stocks And Italian Equities II German Yields Are Key To Value Stocks And Italian Equities II Based on these observations, BCA’s view that German Bund yields will rise toward 0.25% is consistent with a modest outperformance of value and Italian equities in 2022. For a more robust outperformance by value and Italian stocks, the Chinese economy will have to re-accelerate clearly and the dollar will have to fall significantly. However, these two outcomes could take more time to materialize than our bond view. Chart 6: Europe’s Quality Deficit The gyrations in the performance of European equities relative to US stocks continue to be influenced by China’s economic fluctuations. The deterioration in various measures of China’s credit impulse remains consistent with further near-term underperformance of European equities (Chart 6, left panel). Moreover, if Omicron has a significant impact on consumer behavior (via personal choices or government measures), it will once again hurt spending on services and boost the appeal of growth stocks, which Europe underrepresents. These headwinds will not be long lasting. Europe has an opportunity to outperform next year if global yields rise. However, European equity markets continue to suffer from a potent long-term disadvantage relative to those of the US. American benchmarks are composed of higher quality stocks than European ones. As a result of greater market concentration, more innovative applications of research, and the development of greater moats, US stocks generate wider profits margins than European companies and have a higher utilization of their asset base. Consequently, US shares sport significantly higher RoEs and earnings growth than European large-cap names (Chart 6, right panel). Historically, the quality factor has been one of the top performers and is an important contributor to the current strength of growth equities. Thus, even if Europe’s day in the sun arrives before the middle of 2022, it will again be a temporary phenomenon. Chart 6Europe’s Quality Deficit Europe's Quality Deficit I Europe's Quality Deficit I Chart 6Europe’s Quality Deficit Europe's Quality Deficit II Europe's Quality Deficit II Chart 7: Will the Cyclicals Outperformance Resume? For most of 2021, European cyclicals equities have not performed as well against defensive stocks as many investors hoped. In fact, the relative performance of cyclicals is broadly flat since March. Going forward, cyclicals will resume their uptrend against defensive equities and even break out of their range of the past twenty years. From a technical perspective, cyclicals have expunged many of their excesses. By the spring, European cyclicals had become prohibitively expensive compared to their defensive counterparts (Chart 7, left panel). However, their overvaluation has now passed and medium-term momentum measures are not overbought anymore, which creates a much better entry point for cyclical equities. From a fundamental perspective, cyclicals will also enjoy rising yields after being hamstrung by Treasury yields that have moved sideways for more than nine months (Chart 7, right panel). Moreover, the eventual stabilization of the Chinese economy will create an additional tailwind for these stocks. Chart 7Will The Cyclicals Outperformance Resume? Will the Cyclicals Outperformance Resume? I Will the Cyclicals Outperformance Resume? I Chart 7Will The Cyclicals Outperformance Resume? Will the Cyclicals Outperformance Resume? II Will the Cyclicals Outperformance Resume? II The biggest risk to cyclical stocks lies in inflation expectations. Ten-year CPI swaps have stopped increasing despite rising inflation. As the yield curve flattens and long-term segments of the OIS curve invert, markets register their fears that the Fed might tighten too much over the next two years. In other words, markets continue to agonize over the effect of a very low perceived terminal rate. These worries may cause the CPI swaps to decline significantly as the Fed hikes rates next year, creating a headwind for cyclicals. Chart 8: Favor Financials Financials in general and banks in particular have outperformed the European benchmark this year. This trend will persist in 2020. More than the positive impact of higher yields on the profitability of financials justifies this view. One of the key drivers supporting our optimism toward this sector is the continued improvement in the balance-sheet health of the European banking sector (Chart 8, left panel). Capital adequacy ratios remain in an uptrend and NPLs continue to be well-behaved. Meanwhile, both the governments’ liquidity support during the pandemic and the nonfinancial sector’s cash buildup over the past 18 months limit the risk that a brisk rise in insolvencies would threaten the viability of the banking system. European bank lending is also likely to remain superior to that of the post-GFC years. Consumer confidence is still sturdy, despite the recent increase in COVID cases and the tax hike created by rapidly climbing energy prices (Chart 8, right panel). Companies also benefit from an environment of low real rates and limited fiscal austerity. Unsurprisingly, capex intentions are elevated, which should support credit demand from businesses going forward. Chart 8Favor Financials Favor Financials I Favor Financials I Chart 8Favor Financials Favor Financials II Favor Financials II These factors imply that the current large discount embedded in European financials’ valuations remains excessive (even if a smaller discount is still warranted). As long as peripheral spreads do not blow out durably, financials will have scope to outperform further. Banks should also beat insurance companies. Chart 9: Small-Caps Are Nearly There Despite a sideways move followed by a 4% dip, the performance of European small-cap stocks remains in a pronounced uptrend relative to large-cap equities. The recent bout of underperformance is likely to end soon, unless a recession is around the corner. Small-cap stocks are becoming oversold (Chart 9, left panel) and will benefit from their pronounced procyclicality, especially if the recent improvement in global economic surprises continues next year. Moreover, above-trend European growth as well as an ECB that will maintain accommodative monetary conditions will combine to prevent a significant widening in European high-yield spreads, particularly once natural gas prices are turned down after the winter. This process will also help small-cap equities. The biggest risk for the European small-caps’ relative performance is the currency market. The relative performance of small-cap names is still closely correlated to the euro (Chart 9, right panel). As a result, if EUR/USD were to falter in the coming weeks, the underperformance of small-cap stocks could deepen. At the very least, small-cap stocks would languish before resuming their uptrend later in the year. Chart 9Small-Caps Are Nearly There Small-Caps Are Nearly There I Small-Caps Are Nearly There I Chart 9Small-Caps Are Nearly There Small-Caps Are Nearly There II Small-Caps Are Nearly There II Chart 10: A Risk to Macron’s Second Term The emergence of the new populist candidate Éric Zemmour has galvanized the media in recent weeks. However, he is very unlikely to pose a credible threat to French President Emmanuel Macron, unlike center-right candidate Valerie Pécresse, who just won the Les Républicains (LR) primary. In a Special Report published conjointly with our geopolitical strategists last summer, we identified the emergence of a single candidate able to unite the center-right as one of the biggest risks to Macron. As Chart 10 shows, Pécresse has made a comeback in the polls and is now expected to face Macron in the second round. According to an Elabe poll conducted after her victory in the primary, if the second round of the elections were held now, she would beat Macron. Chart 10 Chart 10 Will Pécresse manage to keep her momentum going until April 2022? First, she has to ensure the center-right remains united behind her. Up until the primaries, the center-right was divided. While she won the primary by a wide margin, her main opponent Éric Ciotti won the first round (25.6%), and Michel Barnier as well as Xavier Bertrand came close behind, with 23.9% and 22.7% respectively. Second, Pécresse must work hard to prevent voters from succumbing to the siren songs of Zemmour and Marine Le Pen, or to lean toward former Prime Minister Phillippe Edouard, a declared supporter of Macron. Investors should ignore Le Pen and Eric Zemmour. The real threat to Macron lies in Valerie Pécresse’s ability to keep the center-right united under her banner. Considering that the center-left does not represent an option and that the far-right is entangled in a tug-of-war, there is a high probability that Pécresse will reach the second round.   Footnotes Tactical Recommendations Europe In Charts Europe In Charts Cyclical Recommendations Europe In Charts Europe In Charts Structural Recommendations Europe In Charts Europe In Charts Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights Below-Benchmark Portfolio Duration: Bond investors should keep portfolio duration low in 2022. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Own Treasury Curve Steepeners: The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Sell Short-Maturity TIPS: Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. We also recommend an outright short position in 2-year TIPS, as short-maturity real yields have a lot of upside in 2022. Overweight Corporate Bonds Versus Treasuries … For Now: We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. Overweight Emerging Market Bonds Versus US Corporates: EM bonds offer an attractive spread advantage versus US corporates, and a weakening US dollar will help boost returns in 2022. A Maximum Overweight Allocation To Municipal Bonds: Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. Underweight Agency MBS: Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. Feature BCA published its 2022 Outlook on December 1st. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer seven key US fixed income views for 2022. This report is limited to the seven key investment views, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2022” report that will delve into our outlook for the Fed next year. Outlook Summary First, a summary of the main economic views presented in BCA’s 2022 Outlook.1   On Economic Growth: The COVID-19 pandemic will recede in importance in 2022 allowing US economic growth to remain above trend. Sizeable household savings and wealth will support consumer spending, the composition of which will shift away from goods and towards services. Corporate capital expenditures also look set to surge. On Inflation: A transition in consumer spending from goods to services and an increase in labor supply will cause US inflation to fall in 2022, though it will remain above the Fed’s target. On Fed Policy: The first Fed rate hike will occur between June and December 2022, depending on the paths of inflation and inflation expectations during the next few months. Fed tightening will continue into 2023. On China and Emerging Markets: Further policy easing in H1 2022 will lead to a reacceleration in Chinese economic activity in the back half of the year. The BCA house view is negative on EM equities for now but will turn more bullish when clearer signs of Chinese policy easing emerge. Risks To The Outlook: The greatest risk to the outlook is that the spread of the Omicron variant leads to the re-imposition of public health measures that will weigh on economic activity. The effect of the Omicron variant remains uncertain, but increasingly widespread vaccination and the advent of anti-viral treatments should help mitigate any negative economic impacts. Key View #1: Below-Benchmark Portfolio Duration Bond investors should keep portfolio duration low in 2022, favoring the 2-year maturity over the 10-year. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Our recommendation to keep portfolio duration low in 2022 stems directly from our assessment of Federal Reserve policy. Without going into too much detail – we will do that in next week’s “Fed In 2022” report – the Fed appears to have adopted a more hawkish reaction function during the past month. The Fed’s official forward guidance says that it will not lift rates until the labor market reaches “maximum employment”. However, Fed Chair Jay Powell weakened that commitment in recent Senate testimony. Powell said that persistently high inflation threatens the economic recovery and implied that to reach its maximum employment goal the Fed may need to act pre-emptively to tame inflation. To us, this means that the Fed’s “maximum employment” condition for lifting rates is no longer binding. The Fed will accelerate the pace of tapering when it meets this week and will start lifting rates between June and December of next year, depending on the interim trends in inflation and inflation expectations. After liftoff, Fed rate hikes will proceed at a predictable pace of 75-100 bps per year until economic growth slows significantly. We expect the fed funds rate to reach at least 2% before that occurs, consistent with survey estimates of the long-run neutral fed funds rate. Let’s compare our estimate of the future fed funds rate path with what is currently priced in the bond market (Chart 1). Chart 1The Market's Rate Expectations The Market's Rate Expectations The Market's Rate Expectations Liftoff The overnight index swap (OIS) curve is priced for Fed liftoff in May 2022. This is a tad early compared to our projections, but not by much. Pace After liftoff, the OIS curve is priced for the fed funds rate to rise 79 bps during the subsequent 12 months. Again, this is roughly consistent with our own expectations that the Fed will deliver three or four 25 basis point rate hikes per year. Terminal Rate It is the market’s pricing of the endpoint of the next tightening cycle – the terminal fed funds rate – that disagrees significantly with our forecast. The OIS curve is priced for the funds rate to reach 1.5% in 2024 and then stabilize. This is too low. It is too low compared to the last tightening cycle when the fed funds rate reached 2.45% in 2019. It is also too low compared to survey estimates from market participants and primary dealers. The median respondent to the New York Fed’s Survey of Market Participants estimates that the long-run neutral fed funds rate is 2%. The median response to the same question from the Survey of Primary Dealers is 2.25% and the median FOMC participant pegs the long-run neutral rate at 2.5%. Meanwhile, the 5-year/5-year forward Treasury yield – a rough proxy for the long-run neutral interest rate that’s priced in the Treasury market – sits at only 1.73%. Historically, the 5-year/5-year forward yield converges with survey estimates of the long-run neutral rate as the Fed moves toward tightening (Chart 2). This means the 5-year/5-year forward Treasury yield has at least 27-52 bps of upside in 2022. Chart 25y5y Has Room To Rise 5y5y Has Room To Rise 5y5y Has Room To Rise Treasury Yield Forecasts Chart 3Treasury Yield Forecasts Treasury Yield Forecasts Treasury Yield Forecasts Chart 3 shows the 2-year, 5-year and 10-year Treasury yields along with the expected paths that are discounted in the forward curve for the next 12 months. The shaded regions in each panel represent our fair value estimates of where those yields will trade if the market moves to price-in our expected future path for the fed funds rate. The upper bound of the fair value range represents the most hawkish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in June, that rate hikes proceed at a pace of 100 bps per year and that the fed funds rate levels-off at a terminal rate of 2.08% (8 bps above the lower-end of a 2%-2.25% target range). The lower bound of the fair value range represents the most dovish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in December 2022, that rate hikes proceed at a pace of 75 bps per year and that the fed funds rate levels-of at a terminal rate of 2.08%. Chart 3 shows that the 10-year Treasury yield is well below even the lower-end of our fair value range. The 5-year Treasury yield is a bit too low compared to our target range and the 2-year yield is consistent with our fair value range, though at the very upper-end. The investment conclusions are obvious. Bond investors should keep portfolio duration low in 2022. They should avoid the 10-year maturity and allocate most funds to shorter maturities like the 2-year. It should be noted that we used a conservative 2.08% terminal rate estimate in the scenarios presented in Chart 3. This is at the low-end of most survey estimates. What’s more, the BCA Outlook makes a strong case that those survey estimates will be revised higher once it becomes apparent that interest rates will have to rise to well above 2% to contain inflation. We agree that survey estimates of the long-run fed funds rate are probably too low, but we don’t expect them to be revised higher in 2022. Upward terminal rate revisions are probably a story for 2023 or 2024, sometime after the Fed has delivered a few rate hikes and it becomes apparent that more will be needed to slow an overheating economy. Appendix A at the end of this report translates different fed funds rate scenarios into 12-month expected returns for every Treasury maturity. We show scenarios where the liftoff date varies between June 2022 and December 2022, where the pace of rate hikes varies between 75 bps and 100 bps per year and where the terminal fed funds rate varies between 2.08% and 2.58%. The 10-year Treasury note is projected to deliver negative returns in every scenario we tested. Meanwhile, the 2-year Treasury note is projected to deliver a small positive return in every single scenario. These results support our conclusion from Chart 3. Investors should maintain below-benchmark portfolio duration and favor short maturities over long maturities. Risks To The View The first risk to our bearish view on US Treasuries is a resurgence of the pandemic. The 10-year Treasury yield continues to track the “pandemic trade” in the stock market. That is, the 10-year yield rises when a basket of equities that benefit from economic re-opening outperforms a basket of equities that benefit from lockdowns, and vice-versa (Chart 4). So far, the news about the virulence of the Omicron COVID variant has been encouraging, and our base case scenario assumes a further easing of pandemic concerns over the course of 2022. The second risk to our view is that the Fed moves too aggressively toward rate hikes causing an abrupt tightening of financial conditions that weighs on economic growth and sends long-dated bond yields lower. The shaded region in Chart 5 shows that this exact dynamic played out in 2018. Fed rate hikes started to pressure the dollar higher and weigh on equities. This led to tighter financial conditions and slower economic growth. The impact of tighter financial conditions was not immediately evident in the bond market, but slower growth eventually caused the Fed to back away from rate hikes leading to a late-2018 peak in the 10-year yield. Chart 410yr Tracks The "Pandemic Trade" 10yr Tracks The "Pandemic Trade" 10yr Tracks The "Pandemic Trade" Chart 5Watch Financial Conditions In 2022 Watch Financial Conditions In 2022 Watch Financial Conditions In 2022 Compared to the 2018 scenario, we see less risk of Fed over-tightening in 2022 mainly because the fed funds rate is starting out at a much lower level. However, it will be important to track financial conditions as the Fed moves toward liftoff. Undue tightening would cause us to reverse our positioning. Key View #2: Own Treasury Curve Steepeners The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. We also recommend buying the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond as an attractive duration-neutral carry trade. The scenarios presented in the prior section show that the 2-year Treasury yield is priced within the bounds of our estimated fair value range while the 10-year Treasury yield looks too low. Logically, it makes sense to position for a steepening of the 2/10 Treasury curve to profit from this divergence. Chart 6 illustrates the implications of the prior section’s fair value estimates for different Treasury slopes. Our fair value range projects that the 2/10 Treasury slope will be between 38 bps and 89 bps in 12 months, above the 37 bps that is currently priced into the forward curve. The forward curve is also priced for too much flattening in the 2/5 Treasury slope, while the 5/10 slope is consistent with the lower end of our fair value range.   The conclusion is that investors should implement 2/10 Treasury curve steepeners in 2022 on the expectation that the 2/10 slope will flatten by less than what is currently discounted in the forward curve. A comparison of the 5-year/5-year forward Treasury yield with a target range based on survey estimates of the long-run neutral fed funds rate also supports the case for 2/10 steepeners. Historically, an increase in the 5-year/5-year forward yield towards its target range corresponds with a steepening of the 2/10 slope (Chart 7). Bear-flattening moves in the 2/10 slope only occur when the 5-year/5-year forward is within its target band, as was the case in 2017/18. Given that the 5-year/5-year forward yield is currently well below its survey-derived target range, there is room for some 2/10 steepening as yields rise. Chart 6Treasury Slope Forecasts Treasury Slope Forecasts Treasury Slope Forecasts Chart 7A Rising 5y5y Will Steepen The Curve A Rising 5y5y Will Steepen The Curve A Rising 5y5y Will Steepen The Curve One way to position for a steeper 2/10 curve is to go long the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Presently, this trade looks very attractive. The 2/5/10 butterfly spread shows a significant yield advantage in the 5-year bullet over the 2/10 barbell, both in absolute terms and relative to our fair value model (Chart 8). While we view this as a good trade, we don’t think it’s the best way to position for 2/10 steepening. We prefer a position long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. This trade gives you long exposure at the 2-year maturity instead of the 5-year maturity which will boost returns if the 2/5 slope steepens, as we anticipate it will (Chart 6, panel 2). Chart 8Curve Steepeners Are Cheap Curve Steepeners Are Cheap Curve Steepeners Are Cheap In addition to our recommended 2/10 steepener, we advise clients to favor the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. While we’d expect some flattening of the 10/30 slope in 2022, this trade should still perform well because of its huge carry advantage. The tables in Appendix A show that the 20-year bond earns a massive 12-month carry (income plus rolldown return) of 3.05% compared to 1.85% for the 10-year note and 1.80% for the 30-year bond. Key View #3: Sell Short-Maturity TIPS Chart 9TIPS Breakevens TIPS Breakevens TIPS Breakevens Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Other attractive positions include: an outright short position in 2-year TIPS, an inflation curve steepener (short 2yr TIPS/long 2yr nominal/long 10yr TIPS/short 10yr nominal), and a TIPS curve flattener (short 2yr TIPS/long 10yr TIPS). As noted at the beginning of this report, we see inflation trending down in 2022. Inflation will remain high enough for the Fed to feel comfortable lifting rates, but it won’t match the elevated readings that are currently discounted in TIPS. Interestingly, long-maturity TIPS breakeven inflation rates are roughly consistent with the Fed’s 2.3%-2.5% target range (Chart 9). The 5-year/5-year forward TIPS breakeven inflation rate is a bit too low, at 2.13%, and the 10-year TIPS breakeven inflation rate is currently 2.47%. With long-dated TIPS breakevens so close to the Fed’s target, we recommend a neutral allocation to long-maturity TIPS versus long-maturity nominal Treasuries heading into 2022. In our view, the mispricing in TIPS lies at the front-end of the curve. The 2-year TIPS breakeven inflation rate has risen to 3.23%, well above the Fed’s 2.3%-2.5% target range. This year’s surge in short-maturity TIPS breakevens has also resulted in a deeply inverted inflation slope (Chart 9, bottom panel). Table 1Regression of Monthly Changes In CPI Swap Rate Versus Monthly Changes In 12-Month Headline CPI Inflation (2010 - Present) 2022 Key Views: US Fixed Income 2022 Key Views: US Fixed Income Short-maturity inflation expectations are highly sensitive to changes in CPI inflation, much more so than long-maturity expectations. In fact, monthly changes in the 2-year CPI swap rate are more than twice as sensitive to headline inflation than are monthly changes in the 10-year CPI swap rate (Table 1). This means that the cost of short-maturity inflation compensation will decline as inflation moderates in 2022. We recommend an underweight allocation to short-maturity TIPS versus short-maturity nominal Treasuries. We also think an outright short position in 2-year TIPS will be highly profitable in 2022. If we assume that the 2-year TIPS breakeven inflation rate falls to the middle of the Fed’s target range during the next 12 months, and additionally that the 2-year nominal Treasury yield converges with our fair value estimate using the scenario of a September Fed liftoff, 100 bps per year hike pace and 2.08% terminal rate, then we calculate that the 2-year TIPS yield will rise from its current -2.56% to -0.98% during the next 12 months (Chart 10). Chart 10A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS Chart 10 also shows that the anticipated rise in the 2-year TIPS yield greatly outpaces the modest expected increase in the 10-year TIPS yield. This means that a position in 2/10 TIPS curve flatteners will turn a profit in 2022 (Chart 10, bottom panel). Key View #4: Overweight Corporate Bonds Versus Treasuries … For Now We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. A key pillar of our corporate bond investment process is to split the economic cycle into three phases based on the slope of the yield curve (Chart 11). Phase 1 of the cycle is defined as the period from the end of the last recession until the 3-year/10-year Treasury slope breaks below 50 bps. Phase 2 of the cycle spans the period when the slope is between 0 bps and 50 bps. Phase 3 lasts from when the yield curve inverts until the start of the next recession. Chart 11The Three Phases Of The Economic Cycle The Three Phases Of The Economic Cycle The Three Phases Of The Economic Cycle Our historical analysis shows that excess corporate bond returns versus duration-matched Treasuries tend to be strongest in Phase 1. They are usually positive, but much lower, in Phase 2 and are often negative in Phase 3 (Table 2). Table 2Corporate Bond Returns Across The Three Phases Of The Cycle 2022 Key Views: US Fixed Income 2022 Key Views: US Fixed Income We have been firmly in Phase 1 since April 2020 and, as we would expect, excess corporate bond returns have been strong. However, we will not remain in Phase 1 much longer. The 3-year/10-year Treasury slope is currently 50 bps, right on the precipice between Phase 1 and Phase 2. We recommend an overweight allocation to corporate bonds versus Treasuries for now, but we will adopt a more defensive posture toward corporates once we transition into Phase 2. We expect this will happen sometime in the first half of 2022. Why Are We Not In Phase 2 Already? Chart 12Curve Flattening Is Overdone Curve Flattening Is Overdone Curve Flattening Is Overdone The 3-year/10-year Treasury slope is hovering right around 50 bps. However, as is noted earlier in this report, we think that recent yield curve flattening is overdone and expect it to reverse somewhat in the coming months. Chart 12 shows the 3-year/10-year slope along with an expected fair value range. This range is based on a 100 bps Fed rate hike pace, a 2.08% terminal rate and varying the liftoff date between June 2022 and December 2022. This fair value range only breaks below 50 bps between March and September of next year. Given our yield curve view, we are positioned for one last period of strong corporate bond outperformance during the next few months. But we will turn more defensive once we judge that we have sustainably transitioned into a Phase 2 environment. Why Turn More Defensive In Phase 2? Chart 13IG Corporate Valuations IG Corporate Valuations IG Corporate Valuations It’s correct to point out that excess corporate bond returns are still generally positive in Phase 2 environments, so ideally, we would remain overweight corporate bonds versus Treasuries throughout Phase 2. This makes sense theoretically, but strategically we think it will be wise to adopt a different approach this cycle. The main reason to err on the side of caution is that corporate bond valuations are extremely stretched. The 12-month breakeven spread for the investment grade corporate bond index is at its 6th percentile since 1995. This means that the investment grade corporate bond index has only been more expensive than today 6% of the time since 1995 (Chart 13). Tight spreads mean that expected returns will be modest, even in a favorable cyclical environment. In other words, we are not sacrificing much expected return by reducing exposure early in the cycle. Given that we can’t predict the start of the next Phase 3 period with exact precision, we think it makes sense to be more defensive this cycle. We will sacrifice some modest expected returns to ensure that we are well positioned for the next period of significant spread widening. Our corporate bond strategy is supported by an empirical study of historical returns. Table 3A shows average 12-month excess returns for the investment grade corporate bond index after certain combinations of the 3/10 Treasury slope and average index option-adjusted spread (OAS) are observed. Table 3B shows 90% confidence intervals for the averages presented in Table 3A. Chart Chart The tables show that a strategy of remaining overweight corporate bonds versus Treasuries after the yield curve transitions into Phase 2 only works when the corporate index OAS is above 100 bps. A transition into Phase 2 portends negative excess corporate bond returns when the OAS is below 100 bps, as it is today. Favor High-Yield Over Investment Grade Chart 14HY Corporate Valuations HY Corporate Valuations HY Corporate Valuations While investment grade corporate bonds look extremely expensive compared to history, high-yield corporate bonds look somewhat expensive, but much less so. The average High-Yield index OAS is 1 bp below its pre-COVID low, but investors still get a nice spread pickup for moving out of the Baa-rated credit tier and into the Ba-rated tier (Chart 14). Our prior research has shown that high-yield corporates tend to outperform duration-matched Treasuries when the excess index spread after accounting for default losses is above 100 bps.2 If we assume a minimum required excess spread of 100 bps and a 40% recovery rate on defaulted debt, we can calculate that the junk index is priced for a default rate of 3.4% during the next 12 months (Chart 14, bottom panel). All available evidence suggests that the default rate will come in below 3.4% during the next 12 months, leading to positive excess returns for high-yield corporate bonds. The default rate came in at 1.8% for the 12-month period ending in November and it has been dropping like a stone, consistent with the reading from our Default Rate Model (Chart 15). We also recently wrote about the exceptionally good health of corporate balance sheets.3 We expect the default rate will be in the mid-2% range in 2022, below what is priced into the junk index. Chart 15Corporate Defaults Will Stay Low In 2022 Corporate Defaults Will Stay Low In 2022 Corporate Defaults Will Stay Low In 2022 Junk’s valuation advantage leads us to recommend that investors maintain a preference for high-yield corporates over investment grade. We will turn more defensive on both investment grade and high-yield corporates once we transition into a Phase 2 environment, but we may still retain our preference for high-yield over investment grade at that time, as long as junk stays relatively cheap. Key View #5: Overweight Emerging Market Bonds Versus US Corporates Investment grade USD-denominated Emerging Market bonds (both sovereigns and corporates) will outperform US corporate bonds with the same credit rating and duration in 2022. EM bonds offer an attractive spread advantage versus US corporates, and 2022 returns will be boosted by a weakening US dollar. We see an opportunity in Emerging Market (EM) bonds for US investors in 2022. Note that we are only referring to investment grade EM bonds denominated in US dollars. We consider both investment grade USD-denominated EM sovereign bonds and investment grade USD-denominated EM corporate & quasi-sovereign bonds. EM Sovereigns Chart 16EM Sovereigns EM Sovereigns EM Sovereigns EM sovereigns have modestly outperformed Treasuries so far this year (see Appendix B for a complete breakdown of year-to-date performance for different corporate bond sectors), and yet the sector remains attractively valued in the sense that the average index OAS has still not recovered its pre-COVID low (Chart 16). A look at recent performance trends shows that EM sovereigns outperformed credit rating and duration-matched US corporates in H2 2020 when the sector benefited from a huge yield advantage and a rapidly depreciating US dollar.4 This year, EM sovereigns lagged US corporates as the dollar strengthened. Looking ahead to 2022, we think that the recent bout of dollar strength is close to its end as the bond market has already moved to price-in an extremely hawkish Fed outlook at the front-end of the curve. A flat or depreciating dollar will benefit EM bonds in 2022, as will the yield advantage in EM sovereigns versus credit rating and duration-matched US corporates (Chart 16, panel 4). This yield advantage will only look more attractive as the Treasury curve flattens and the outlook for US corporate spreads deteriorates. At the country level, we see the best EM sovereign opportunities in Mexico, Russia, Chile, UAE, Qatar and Saudi Arabia. The bonds of all these countries outperformed credit rating and duration-matched US corporate bonds during the past 12 months, and they continue to offer a sizeable spread advantage (Chart 17). Chart 17 EM Corporates & Quasi-Sovereigns The investment grade USD-denominated EM Corporate & Quasi-Sovereign index shows a similar relative return pattern to the EM Sovereign index, though overall performance has been better (Chart 18). We see that the index outperformed credit rating and duration-matched US corporates dramatically in H2 2020 when the dollar was under pressure. Relative returns have been more stable this year as the dollar has strengthened. Chart 18EM Corporates & Quasi-Sovereigns EM Corporates & Quasi-Sovereigns EM Corporates & Quasi-Sovereigns EM corporates & quasi-sovereigns should continue to outperform credit rating and duration-matched US corporates in 2022. A weaker dollar will certainly help, but the main driver of outperformance will be the very attractive yield advantage (Chart 18, panel 4). Key View #6: A Maximum Overweight Allocation To Municipal Bonds Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. US bond investors should favor tax-exempt municipal bonds relative to both Treasuries and equivalently-rated corporate bonds. Long-maturity tax-exempt municipal bonds continue to be one the most attractively priced assets in the US fixed income space. As we discussed in a recent report, one big reason for the attractive valuation is that municipal bonds tend to pay premium coupon rates.5 This significantly reduces the duration risk in long-dated munis. The first two columns of Table 4 show the yield ratios and breakeven tax rates between different municipal bond sectors and duration-matched Treasury securities. We see that the breakeven tax rate – the tax rate that equalizes after-tax yields between the two sectors – is a mere 11% for 12-17 year general obligation munis. The breakeven tax rate between 12-17 year revenue munis and duration-matched Treasuries is only 3%, and the longest-maturity munis actually offer a before-tax yield advantage versus Treasuries! Table 4Muni/Treasury And Muni/Credit Yield Ratios 2022 Key Views: US Fixed Income 2022 Key Views: US Fixed Income Table 4 shows that munis also offer excellent value compared to corporate bonds with the same credit rating and duration, especially at the long-end of the curve. Breakeven tax rates between munis and corporate credit range from 3% to 21% for maturities longer than 12 years. What’s even more impressive about municipal bonds is that their attractive valuations are buttressed by extremely high credit quality. State & local government balance sheets have received a huge boost from federal stimulus during the past two years, and this has sent net state & local government savings (revenues minus expenditures) surging into positive territory (Chart 19). But it’s not just federal stimulus that has aided state & local governments. Even if we exclude transfer payments altogether, we find that the difference between tax receipts and consumption expenditures is rising sharply relative to interest expense (Chart 19, panel 2). Ratings agencies have noticed the improvement in state & local government budgets and ratings upgrades have far outpaced downgrades during the past year (Chart 19, bottom panel). Chart 19State & Local Balance Sheets In Good Shape State & Local Balance Sheets In Good Shape State & Local Balance Sheets In Good Shape Key View #7: Underweight Agency MBS Chart 20Poor MBS Performance Will Continue Poor MBS Performance Will Continue Poor MBS Performance Will Continue Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. We noted in a recent report that Agency Mortgage-Backed Securities have performed poorly in 2021.6 The main reason for the poor performance is that the compensation for prepayment risk embedded in MBS spreads (aka option cost) started the year at a very low level, but mortgage refinancing activity has been much higher than expected (Chart 20). The conventional 30-year MBS option cost has been rising, but it is still only back to where it was in 2019 (Chart 20, panel 2). This is not sufficiently attractive for us to advocate buying MBS. While rising bond yields will be a tailwind for refi activity in 2022, we still expect the pace of refinancings to be relatively strong because the rapid run-up in home prices has made it extremely enticing for households to tap the equity in their homes through cash-out refis. Within a recommended underweight allocation to MBS, we recommend that investors favor higher coupon securities over lower coupon ones. Higher-coupon MBS carry less duration than lower-coupon MBS and also wider OAS and greater convexity. This means that high-coupon MBS will outperform low-coupon MBS if bond yields rise in 2022, as we expect they will. Appendix A: Treasury Return Forecasts Image Image Image Image Image Image Image Image Image Image Image Image   Appendix B: US Bond Sector Year-To-Date Performance Image Image Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2022: Peak Inflation – Or Just Getting Started?”, dated December 1, 2021. 2 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020. 3 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4 A weaker dollar tends to benefit USD-denominated EM bonds because it makes it easier for foreign issuers to service their dollar denominated debts. 5 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 6 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights The risk to European stocks from higher yields is overstated for 2022. Not only do equities possess a valuation cushion compared to bonds, but also the stock returns/bond yields correlation remains positive. This positive correlation is only two decades old, and it is a consequence of the stabilization of inflation and inflation expectations, which caused bond yield changes to mostly reflect adjustment in anticipated economic activity. As long as the recent inflation upsurge peters off next year, the equity/yield correlation will remain positive in 2022. Despite this sanguine short-term view, the long-term outlook is fraught with risks because next year’s inflation decline will be temporary; inflation is on a secular uptrend. The equity returns/bond yield correlation will become negative toward the middle of the decade, which will create a major headwind for the secular returns of both stocks and bonds. Feature Extremely low yields and elevated valuations constitute a potentially toxic mix for the equity outlook next year. The logic is straightforward: if yields rise enough, nosebleed multiples will become unjustifiable and the stock market will crash. Chart 1Protection Against Higher Yields Protection Against Higher Yields Protection Against Higher Yields The picture is more complex and instead, European equities are likely to withstand higher yields. To begin with, BCA Research’s US Bond strategists anticipate a modest rise in Treasury yields to 2.25% in 2022,  and our Global Fixed-Income strategists foresee an even more limited increase in German rates. Moreover, as we showed in our 2022 Key Views piece published last week, European equities embed a large valuation cushion in the form of a significant premium in their dividend yield relative to Bund yields (Chart 1). The correlation between yields and equities is another facet that will impact the effect of higher yields on the equity bull market. For now, it is premature to conclude that the positive correlation between yields and the absolute performance of European equities is poised to turn negative again in 2022. However, over the next couple of years, such a correlation reversal will take place, because inflation expectations are increasingly likely to become unmoored to the upside. Stocks Like Higher Yields Over the past two decades, one of the major financial market paradoxes has been the relationship between equity prices and bonds yields. Since 1998, the weekly returns of the MSCI Euro Area equity benchmark have correlated positively with the change in 10-year German yields (Chart 2). However, prior to the late 1990s, changes in bond yields and stocks prices were negatively correlated. Chart 2For Two Decades, Bond Yields And Stocks Prices Have Moved Together For Two Decades, Bond Yields And Stocks Prices Have Moved Together For Two Decades, Bond Yields And Stocks Prices Have Moved Together The key to the shifting relationship between stocks and bonds is the link between yields and economic activity. Stock returns have always been procyclical because earnings are the most important driver of equity returns (Chart 3). However, bond yields have become increasingly pro-cyclical over time. Today, Bund yields and the German LEI move in tandem, but, prior to 1986, their five-year rolling correlation was negative (Chart 4). Chart 3Stocks Follow Earnings Who Follow Growth Stocks Follow Earnings Who Follow Growth Stocks Follow Earnings Who Follow Growth Chart 4Shifting Link Between Bunds And German Growth Shifting Link Between Bunds And German Growth Shifting Link Between Bunds And German Growth The positive correlation between German growth and German yields sheds light on why the correlation between yields and stocks is now positive, but it does not explain why this positive link emerged in the late 1990s and not earlier. Financial asset prices reflect global phenomena. Stock indices in advanced economies overrepresent multinationals which are affected by global economic fluctuations. Meanwhile, capital is fungible and flows freely across borders. As a result, German bond yields are not the unique factor that matters to the correlation between equities and stock. Instead, the behavior of global yields and equities is critical. Chart 5Living In The Shadow Of The Asian Crisis Living In The Shadow Of The Asian Crisis Living In The Shadow Of The Asian Crisis According to this logic, the correlation between global yields and global growth becomes important. As Chart 5 illustrates, the relationship between global bond returns and global economic activity became much closer around 1998 than it was prior to this date. The key turning point was the Asian crisis of 1997/98. Why was the Asian crisis so fundamental? It was the end state of the disinflationary trend started under Federal Reserve Chairman Paul Volker. After the Asian crisis, the region’s newly industrialized economies switched from chronic current account deficits to chronic surpluses, which added to the global supply of savings. Moreover, Asian economies became hypercompetitive because of severely devalued exchange rates, which limited pricing power around the world. Finally, the Chinese economy became a force to be reckoned with and its share of global trade expanded massively. Together, these forces amplified competitive pressure around the world and made every inflation uptick self-limiting. The impact of the shock is visible in the inflation data. As Chart 6 shows, core inflation in the US and in the G7 has been stable since 1998, capped near 2.5%, except for 2021. Additionally, after the Asian crisis, the volatility of core inflation collapsed among both the G7 and Eurozone economies (Chart 7). Chart 62.5%, A 20-Year Old Ceiling 2.5%, A 20-Year Old Ceiling 2.5%, A 20-Year Old Ceiling Chart 71998: RIP CPI Volatility 1998: RIP CPI Volatility 1998: RIP CPI Volatility The effect of this steady inflation was to stabilize inflation expectations. Thus, after 1998, the most important driver of bond price annual changes has been fluctuations in anticipated real economic activity, which explains why the relationship between global bond returns and the global LEI became much tighter afterward (Chart 5, on page 4). This result is crucial to understand the impact of higher yields for equities. It suggests that, if rising yields reflect improving economic growth, then the correlation between yields and stocks will remain positive and equities may climb higher along with mounting long-term interest rates. Bottom Line: Higher yields do not necessarily portend the end of the equity bull market. Stock prices and bond yields have been positively correlated since the Asian crisis of 1997/98 because fluctuating growth expectations drive most of the change in yields. As long as this remains the case, equities can handle higher yields. Can The Correlation Shift Sign Again? The correlation between equities and bonds is not static. There are threats that could restore both temporarily or permanently the negative correlation between changes in bond yields and stock returns that prevailed prior to 1998. A Temporary Correlation Shift? Since their March 2020 lows, 10-year yields have increased 94bps and 51bps in the US and Germany, respectively. Meanwhile, the MSCI Eurozone equity benchmark is up 78%. We are clearly not yet in an environment in which rising long-term interest rates hurt stocks. In the short term, the correlation between yield changes and equity returns may turn negative if yield moves into constraining territory—this is to say, if they rise enough to risk a recession. In more academic terms, this equates to rates moving above the neutral rate of interest, or r-star. Chart 8A Long Way To Go Before Policy Becomes Tight A Long Way To Go Before Policy Becomes Tight A Long Way To Go Before Policy Becomes Tight There is little indication that interest rates are moving above this level in the short term. US and European policy rates remain well below Taylor rule estimates of equilibrium (Chart 8), which suggests that policies are still highly accommodative. The most worrisome signal comes from the slope of the yield curve. Since March 2021, the US 2-/10-year yield curve has flattened by 76bps to 81bps and, since October 2021, the same yield curve has flattened by 23bps to 35bps in Germany. Moreover, the 20-/30-year US yield curve became inverted in October 2021. These dynamics may indicate that policy is already on the verge of becoming too tight, even if only five interest rate hikes are expected in the US over the next two years.  Chart 9Term Premia Are Still Negative Term Premia Are Still Negative Term Premia Are Still Negative A curve flattening episode is the normal course of events when central banks become less accommodative; it is not a sign of impending doom. Instead, an inverted yield curve is the indication that the policy rate is above r-star. After all, if interest rates genuinely constrain growth, they will slow economic activity in the future, which will necessitate lower rates and generate a negative curve slope. We are not there yet. Moreover, the term-premium remains negative across major advanced economies, which suggests that a recessionary signal will come from a deeper yield-curve inversion than in the past (Chart 9). Chart 10Upside To The Terminal Rate Upside To The Terminal Rate Upside To The Terminal Rate Another factor likely to allow yields to rise without killing the equity market is that the expected terminal rate of interest remains too low, as we wrote in our 2022 Key Views piece last week. Historically, it is common for the expected terminal rate to rise as central banks begin to lift interest rates, especially if the economy handles the first hikes well. Today, the expected terminal rate is below the levels that prevailed after the GFC, despite a much firmer economy unburdened by private sector deleveraging and excessive fiscal tightening (Chart 10). As such, we anticipate the expected terminal rate to increase, which will limit how quickly the yield curve will flatten next year even if the Fed elevates interest rates and the ECB aggressively downshifts its pace of asset purchases once the PEPP ends. Chart 11Long-Term Inflation Expectations Are Not A Concern, Yet Long-Term Inflation Expectations Are Not A Concern, Yet Long-Term Inflation Expectations Are Not A Concern, Yet Under this aperture, the biggest risk for stocks remains inflation. Further acceleration in inflation, especially if it pushes the 5-year/5-year forward inflation breakeven rate above the Fed’s comfort zone (Chart 11), could hurt stocks. Essentially, investors would price in a shift in the monetary policy environment whereby risks of a severe tightening would increase. However, as we recently wrote, the odds are mounting that short-term inflation will soon peak. Oil inflation is ebbing, while transportation costs are declining and supply bottlenecks are beginning to ease. Moreover, money growth in the US and the Eurozone, which proved relevant variables to explain inflation this year, is also waning (Chart 12). Finally, a mounting number of global central banks are tightening policy, which implies that maximum accommodation is behind us (Chart 13) In this context, we expect the positive correlation between stock returns and yield changes to remain broadly positive. A short-term rise in yields could easily contribute to equity market volatility and may even cause a deeper stock market correction than any experienced since April 2020. However, this will prove to be a temporary phenomenon, and thus we remain buyers of the dip. Chart 12Slowing Money Supply Growth, At Last Slowing Money Supply Growth, At Last Slowing Money Supply Growth, At Last Chart 13Global Policy Is Becoming Less Easy Global Policy Is Becoming Less Easy Global Policy Is Becoming Less Easy A Longer-Term Correlation Shift? A shift in the long-term correlation between equity returns and bond yield changes is a much more meaningful risk to stocks than short-term changes. BCA expects inflation to peak in the short term, but this will only be part of a stop-and-go process. Inflation is on a structural uptrend and so, any decline in 2022 and early 2023 will morph into renewed pressure, after the global output gap becomes positive again by the end of next year. Chart 14A Deflationary Tailwind Is Gone A Deflationary Tailwind Is Gone A Deflationary Tailwind Is Gone Many structural forces are moving away from deflationary to inflationary. True, technological progress remains a deflationary anchor. However, this downward pressure on inflation is no longer buttressed by a deepening of globalization (Chart 14). Moreover, because of the rise of populism around the world over the past five years, fiscal policy is unlikely to move back to the austere Washington Consensus that dictated governance from President Reagan up to the moment President Trump took power. Additionally, ageing across advanced economies and China, as well as the so-called “Great Resignation,” will constrain the expansion of the global supply side. This background suggests that the period of flat inflation that prevailed from 1998 to 2020 is ending. As a corollary, inflation expectations will embark on a multi-year upward drift. This process is likely to loosen the correlation between economic activity and yields. As a result, the period of positive correlation between yield changes and equity returns is in its last innings. This will represent a major difficulty for asset allocators over the next ten to twenty years, as it points to poor long-term real returns for both bonds and stocks. Bottom Line: The correlation between stock returns and bond yield changes is likely to remain positive in 2022, which implies that European stocks will eke out another year of positive returns, despite BCA’s house view that yields will rise. However, the long-term outlook is more problematic. The growing likelihood that inflation is making a secular upturn means that the two-decades old positive correlation between equity returns and bond yield change will become negative again around the middle of the decade. This shift will have a profound and deleterious impact on both stocks’ and bonds’ secular returns.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations The Correlation Convolution The Correlation Convolution Cyclical Recommendations The Correlation Convolution The Correlation Convolution Structural Recommendations The Correlation Convolution The Correlation Convolution Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights Omicron vs. The Fed: The new COVID variant has thrown a growth scare into markets, but the bigger concern is the Fed belated playing catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year with the Fed threatening to taper faster, and potentially hike sooner, than markets expect. New Zealand: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade. A Year-End Bout Of Uncertainty Chart of the WeekMarkets Have Been Worried About The Fed Since September Markets Have Been Worried About The Fed Since September Markets Have Been Worried About The Fed Since September Over the past two weeks, we have published Special Reports and thus have not had an opportunity to comment on market moves and news. Needless to say, it has been an eventful period! The emergence of the new Omicron variant, and the hawkish shift in the Fed’s guidance on future policy moves, have injected fresh uncertainty and volatility into global financial markets. Since the existence of Omicron was revealed to the world on Nov 26, 30-year US Treasury yields have fallen by as much as -23bps and the S&P 500 index has been down by as much as -4.4%. Yet the evolving Fed stance, with Fed Chair Jerome Powell hinting last week that the end of tapering and start of rate hikes could begin sooner than expected next year, is having a more lasting influence on risk asset performance. Dating back to the September 23 FOMC meeting, when the Fed first signaled an imminent tapering of bond purchases and pulled forward the timing of liftoff into 2022, the 2-year US Treasury yield has gone up from 0.22% to 0.63%. Importantly, there has been little pullback on the pricing at the front-end of the US Treasury curve due to the Omicron shock. That pre-September-FOMC low in the 2-year Treasury yield also marked the peak in riskier fixed income market performance for 2021, with the Bloomberg Global High-Yield and Emerging Market USD-Denominated Sovereign total return indices down -2.0% and -1.8%, respectively, since Sept 23 (Chart of the Week). Other risk assets also appear to be responding more to news about the Fed than Omicron. Equity markets stopped climbing since the Fed announced the first taper of bond purchases at the November 3 FOMC meeting – three weeks before the world knew of Omicron - which also coincided with troughs in the VIX index and corporate credit spreads, not only in the US but in Europe and emerging markets as well (Chart 2). Of course, it is difficult to disentangle which is having a greater impact, the variant or the Fed, when details on both are evolving at the same time. Omicron Investors are understandably right to be nervous about a new COVID variant that can reportedly evade existing vaccines and even infect those who have had COVID previously. The whole idea of “putting COVID in the rearview mirror’ that has helped fuel booming equity and credit markets was predicated on vaccines being both effective and widely available. However, when investors see COVID case numbers start to pick up in the US and Europe, with vaccination rates twice that of South Africa where Omicron was first detected (Chart 3), this raises concern about a return to pre-vaccine economic restrictions and uncertainty. Chart 2A Typical Risk-Off Response To The Emergence Of Omicron A Typical Risk-Off Response To The Emergence Of Omicron A Typical Risk-Off Response To The Emergence Of Omicron Chart 3Omicron Putting A Dent In Vaccine Optimism Omicron Putting A Dent In Vaccine Optimism Omicron Putting A Dent In Vaccine Optimism The “Omicron effect” on fixed income markets has been most evident in the repricing of interest rate expectations. Since the presence of Omicron was revealed on November 26, there has been a reduction in the cumulative amount of tightening discounted to the end of 2024 in the overnight index swap (OIS) curves of the major developed economies (Table 1). The moves were most evident in the US (32bps of hikes priced out), Canada (37bps) and Australia (37bps). Table 1Pricing Out Some Rate Hikes Because Of Omicron Blame The Fed, Not Omicron, For More Volatile Markets Blame The Fed, Not Omicron, For More Volatile Markets Much is still unknown about the dangers of the Omicron variant. The admittedly very early data out of South Africa, however, indicates that there has not been a major surge in hospitalizations related to Omicron cases. A new COVID strain that proves to be more virulent, but that does not strain health care systems, should help allay investor concerns over a major economic hit from Omicron. This presents an opportunity to put on positions that will profit from a rebound in global bond yields led by higher US Treasury yields. The Fed The Omicron threat to date has not been enough to move the Fed off its plans to rein in the monetary accommodation put in place in 2020 to fight the pandemic. If Omicron is to have any impact on the US economy, it will do so at a time when the economy continues to grow well above trend. The November reading on the ISM Manufacturing survey showed strength in the overall index, with a stabilization of the New Orders/Inventory ratio that leads overall growth, and only a very modest reduction in the still-elevated Prices Paid and Supplier Deliveries indices (Chart 4). The Atlanta Fed’s GDPNow model is suggesting that US real GDP growth could come in at a whopping 9.7% in Q4. As further evidence that the US economy is growing at a pace well above trend, just look to labor market data. New US jobless claims are at the lowest level since 1969. The November US Payrolls report showed that the headline unemployment rate fell 0.4 percentage points on the month to 4.2% - within the range of full employment estimates of the FOMC - even with actual job growth falling short of consensus forecasts (Chart 5, top panel). Chart 4Nothing Bond-Bullish In US Manufacturing Nothing Bond-Bullish In US Manufacturing Nothing Bond-Bullish In US Manufacturing The improving health of the labor market is being felt more broadly, with big declines seen in unemployment rates for minorities and less-educated Americans (second panel). That point is of critical importance to the Powell Fed that has emphasized reducing racial and educational gaps in US unemployment as part of reaching its goal of “maximum employment”. Chart 5Nothing Bond-Bullish In US Labor Markets Nothing Bond-Bullish In US Labor Markets Nothing Bond-Bullish In US Labor Markets Tightening labor markets are also evident in accelerating wage momentum. Excluding the 2020 spike driven by labor force compositional effects related to COVID lockdowns, the year-over-year growth in average hourly earnings reached a 39-year high of 5.9% in November (third panel). The Fed now seems willing to finally confront high US inflation and strong economic growth with some tightening of monetary policy. Chart 6A Near-Term Break From Supply-Fueled Inflation? A Near-Term Break From Supply-Fueled Inflation? A Near-Term Break From Supply-Fueled Inflation? Powell caused some investor agita last week when he indicated that the taper could end before mid-2022, the previous FOMC guidance, which would open the door for rate hikes. We see Powell’s comments as less about signaling an intensifying hawkishness and more about giving the Fed optionality on when to start lifting rates next year in the event the US economy continues to overheat. The Fed strongly believes that tapering must end before rate hikes can begin, so a more accelerated taper allows for an earlier liftoff date, if necessary. To that end, the supply fueled surge in inflation this year, which has lingered for far longer than the Fed anticipated, may be showing some signs of easing. Several indices of global shipping container prices are off the highs, while there is a reduced backlog of container ships off key US ports like Los Angeles. Overall commodity price momentum has peaked, in line with slower, but still strong, global industrial activity (Chart 6). An easing of supply-driven price pressures would be welcome by the FOMC. It would allow time to evaluate both the Omicron threat and evolving US labor market dynamics, instead of being forced to fight a rearguard action against accelerating inflation. However, a shift away from goods/commodity inflation to more domestically driven inflation would not lessen the need for the Fed to begin lifting rates next year – in fact, it could even strengthen the case for the Fed to hike rates faster, and by more, than currently discounted in markets. Importantly, forward looking indicators are still pointing to solid US growth next year (Chart 7): The Conference Board’s leading economic indicator continues to grow at a pace signaling above-trend growth US financial conditions remain highly accommodative even with the recent market turbulence The New York Fed’s yield curve based recession probability model is indicating that the spread between the 10-year US Treasury yield and the 3-month US Treasury bill rate, currently 138bps, is consistent with only a 9% chance of a US recession over the next year (bottom panel) We continue to recommend a below-benchmark duration stance within US fixed income portfolios, with a yield target on the 10-year benchmark US Treasury yield of 2-2.25% to be reached by the end of 2022. We also continue to recommend positioning in Treasury curve steepening trades. This is admittedly a counter-intuitive suggestion given that the Fed is moving towards a rate hiking cycle, but we see too much flattening priced into the Treasury forward curve over the next year (Chart 8). Chart 7A Positive Message From US Leading Growth Indicators A Positive Message From US Leading Growth Indicators A Positive Message From US Leading Growth Indicators   Chart 8Our Favorite Bearish US Rates Trades Our Favorite Bearish US Rates Trades Our Favorite Bearish US Rates Trades For global bond investors, our favorite trade that will benefit from higher US bond yields next year is to position for a wider 10-year US Treasury-German Bund spread (bottom panel). We expect the ECB to avoid any rate increases until at least mid-2023, well after the Fed has begun to tighten. Forward curves in the US and Germany currently discount a relatively stable Treasury-Bund spread in 2022, thus there is no negative carry incurred by positioning for a wider spread. Bottom Line: Omicron has thrown a growth scare into markets, but the bigger concern is that the Fed is belated starting to play catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year. New Zealand: How Much Further Can The Bond Selloff Go? Chart 9NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness Over the past year, New Zealand bonds have sold off much faster than developed market peers (Chart 9). Markets correctly recognized the Reserve Bank Of New Zealand (RBNZ) as a central bank that would move more aggressively to tamp down on inflation and manage the financial stability and political risks arising from soaring house prices. The RBNZ has already delivered back-to-back hikes at its October and November meetings, after its plans to hike at the August meeting were thrown off by the Delta variant. Markets are now pricing in a further 172bps of tightening over the coming year, having largely faded any downside growth risk from the Omicron variant. Expectations of continued tightening have been buoyed by the response of New Zealand policymakers, who are largely looking past the Omicron variant. Restrictions have already begun to ease, with the country having entered its “Traffic Light” COVID-19 Protection Framework. The new variant is also unlikely to affect the RBNZ’s tightening path, with Chief Economist Yuong Ha stating that, given the lifting of restrictions, the RBNZ would have raised rates even if Omicron had become known before its November 24 meeting. Given the bond-bearish backdrop, New Zealand government bonds have underperformed substantially this year. On a relative hedged and duration-matched basis, New Zealand sovereigns have underperformed by -6.6% year-to-date with -4.0 percentage points of that underperformance coming after July 21 when we formally moved to an underweight stance on New Zealand debt within global government bond portfolios (Chart 9, bottom panel). However, with monetary policy entering a new phase, led by an increasingly hawkish Fed, we believe it is appropriate to re-assess our New Zealand call and judge whether this underperformance can continue into 2022. The growth picture is broadly supportive of the RBNZ’s stated policy path. Real GDP as of Q2 was above its pre-Covid trend and 2.6% over the RBNZ’s own estimate of potential GDP, supported by an easing of travel restrictions and strong consumer spending (Chart 10). On a forward-looking basis, however, the risk is now that the economy is running too hot, jeopardizing future growth. Consumer and business sentiment has been worsening as inflation expectations soar, with consumers fearing a hit to purchasing power and businesses concerned about the impact of rising input costs on profit margins. Household and business inflation fears also have a strong basis in the realized inflation data, which has soared to a 10-year high of 4.9% (Chart 11). More troublingly, underlying inflation measures such as the trimmed mean and core (excluding food and energy) are now at series highs of 4.8% and 4%, respectively, indicating that higher inflation could prove to be sticky. The RBNZ now sees headline inflation peaking at 5.7% in Q1/2022 before settling to 2% by the end of its forecast horizon in 2024. Chart 10The NZ Economy Is Overheating The NZ Economy Is Overheating The NZ Economy Is Overheating Chart 11The RBNZ Will Welcome A Slight Growth Slowdown The RBNZ Will Welcome A Slight Growth Slowdown The RBNZ Will Welcome A Slight Growth Slowdown ​​​​​​ The RBNZ clearly attributes higher inflation to an economy running above longer-term capacity rather than short-term supply factors. The Bank’s measure of the output gap is now at the most positive level since 2007, and survey measures of capacity utilization remain elevated. In contrast to the Fed, which is still nominally focused on maximum employment, the RBNZ actually believes that employment is above its maximum sustainable level, and sees a rising unemployment rate as necessary to ease capacity constraints. Given that the RBNZ is clearly comfortable with, and will likely welcome, a gradual rise in unemployment, it will take much more than a slight growth shock to deter the RBNZ from its tightening path. Chart 12Higher Rates Necessary To Stabilize The NZ Housing Market Higher Rates Necessary To Stabilize The NZ Housing Market Higher Rates Necessary To Stabilize The NZ Housing Market The newest, and most politically potent, part of the RBNZ’s remit—house prices – has further supported a bias to tighten monetary policy. However, while still dramatically elevated, house price growth looks to have peaked (Chart 12). The central bank’s hawkish shift earlier in the year has made a clear impact, with house price growth peaking shortly after mortgage rates started picking up in April of this year. Overall household mortgage credit has also begun to decelerate, indicating that the passthrough from monetary policy to credit demand and housing via the mortgage rate is working as intended. However, there is likely further to go. The last time house price growth was somewhat stable around 6.6% in the 2012-2019 period, benchmark 5-year mortgage rates averaged 6.1%. Assuming the spread between the 5-year mortgage and policy rates remains around 4%, history indicates that we would need to see the policy rate rise to at least 2% to cool down the housing market. That 2% level is also the RBNZ’s mean estimate of a “neutral” cash rate—a level at which policy would be neither accommodative nor restrictive (Chart 13). Current market pricing is quite consistent with the RBNZ’s own projected path of rates as of the November meeting—both of which are set to exceed the neutral rate by the end of 2022. Historical experience from the pre-crisis period indicates that this is not uncommon, and that a bout of restrictive policy might be needed to cool down an overheating economy. Chart 13 Indeed, if the RBNZ’s historical reaction to inflation is any guide, it seems likely that policymakers will want to push rates above inflation. The top two panels of Chart 14 show how anomalous deeply negative real policy rates are in New Zealand. Even if we make the case that developed market real rates are in a structural downtrend, as realized real rates have peaked out at successively lower levels with each tightening cycle, the current gap between the cash rate and core inflation seems obviously unsustainable and requires a tightening of policy. Chart 14NZ Real Rates Are Too Low NZ Real Rates Are Too Low NZ Real Rates Are Too Low ​​​​​​ Chart 15Go Long The 10-Year NZ Government Bond/US Treasury Spread Go Long The 10-Year NZ Government Bond/US Treasury Spread Go Long The 10-Year NZ Government Bond/US Treasury Spread ​​​​​​ Another way to think about where policy rates are in relation to a “neutral” level is to look at the yield curve (Chart 14, bottom panel). Typically, the yield curve inverts when markets judge that monetary policy is too restrictive and that short rates are too high relative to a long-run average. However, the New Zealand government bond curve has historically remained inverted for extended periods of time, troughing at around -100bps. This again indicates that the RBNZ is comfortable raising rates above neutral and keeping policy restrictive when needed. Putting together the four factors we have looked at—growth, inflation, asset prices, and the RBNZ’s reaction function—it looks likely that the RBNZ will continue along the tightening path it has set out and chances of any dovish surprise seem slim. At the same time, markets are priced to perfection in terms of the pace and amount of tightening discounted. For New Zealand sovereigns to continue underperforming, however, we will need to see markets price in, on the margin, even more tightening from the RBNZ relative to its peers. With the Fed and other central banks having become more focused on responding to US inflation dynamics, bond-bearish upside shocks to market rate expectations will increasingly come from outside New Zealand. At the same time, in the event of a negative global growth shock, perhaps relating to COVID-19, there is relatively more room for hikes to be priced out in New Zealand. Given our view that bond and rates markets have appropriately priced in the extent of the RBNZ’s likely tightening cycle, we are upgrading New Zealand sovereign debt to neutral, taking profits on our current underweight stance. While we do not include New Zealand debt in our model bond portfolio, we are expressing our view via a new tactical cross-country spread trade: long New Zealand 10-Year government bonds vs. US 10-Year Treasuries (Chart 15). Forwards are currently pricing in a flat spread between the two countries, meaning that any future spread tightening will put our trade in the black. Given that there is more space for markets to price in increased hawkishness from the Fed, we believe that spread compression is likely. We are implementing this trade by going long New Zealand cash bonds and shorting 10-year US Treasury futures. Details can be found on Page 18. Bottom Line: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

Highlights Chart 1Curve Flattening Is Overdone Curve Flattening Is Overdone Curve Flattening Is Overdone Fed Chair Jay Powell made big news last month. During Senate testimony, Powell not only signaled that the Fed is likely to accelerate the pace of asset purchase tapering when it meets in December, he also suggested that the Fed won’t necessarily wait until “maximum employment” is achieved before lifting rates. Powell’s comments suggest that the first Fed rate hike could come as early as June 2022 and as late as December 2022, and the exact timing will depend on how inflation and inflation expectations move during the next few months. The front-end of the Treasury curve is fairly priced for either scenario. The 2-year Treasury yield is currently 0.60%. If we assume that the Fed eventually lifts rates at a pace of 100 bps per year until reaching a 2.08% terminal rate, we calculate a fair value range for the 2-year yield of 0.39% to 0.74%, depending on whether Fed liftoff occurs in June or December. In contrast, the same assumptions give us a fair value range of 1.69% to 1.79% for the 10-year Treasury yield, well above its current level of 1.40% (Chart 1). The investment implications are clear. Investors should maintain below-benchmark portfolio duration and put on Treasury curve steepeners, overweight the 2-year note and underweight the 10-year. Feature Table 1Recommended Portfolio Specification Powell’s Pivot Powell’s Pivot Table 2Fixed Income Sector Performance Powell’s Pivot Powell’s Pivot Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 89 basis points in November, dragging year-to-date excess returns down to +102 bps. The index option-adjusted spread widened 12 bps on the month and our quality-adjusted 12-month breakeven spread is now at its 7th percentile since 1995. This indicates that valuations remain stretched even after the recent widening (Chart 2). The back-up in spreads was driven by the combination of the Fed’s shift toward a more hawkish policy stance and concerns about the new omicron COVID variant. This led to a large flattening of the yield curve in addition to wider corporate bond spreads. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable owning corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 – 50 bps.1  The 3-year/10-year Treasury slope currently sits at 49 bps, just below our 50 bps threshold. However, our range of fair value estimates suggests that the 3/10 slope should be between 63 bps and 86 bps today, and that it should only break below 50 bps between March and September of next year (bottom panel). All in all, we expect the pace of Treasury curve flattening to abate during the next couple of months and this will allow spreads to tighten back to their recent lows. We will turn more cyclically defensive on corporate bonds next year when the break below 50 bps in the 3/10 slope is confirmed by our fair value readings. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Powell’s Pivot Powell’s Pivot Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 121 basis points in November, dragging year-to-date excess returns down to +444 bps. The index option-adjusted spread widened 50 bps on the month, leading to a significant rise in the spread-implied default rate. The spread-implied default rate is the 12-month default rate that is priced into the junk index, assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps. At present, the spread-implied default rate sits at 3.8% (Chart 3). For context, defaults have come in at an annualized rate of 1.6% so far this year and we showed in a recent report that corporate balance sheets are in excellent shape.2  Specifically, the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We conclude that the default rate will be comfortably below 3.8% during the next 12 months, allowing high-yield bonds to outperform duration-matched Treasuries. We recommend that investors favor high-yield over investment grade corporate bonds, and we expect that last month’s spread widening will reverse in relatively short order. However, as noted on page 3, we will turn more defensive on credit risk (including high-yield bonds) next year once we are confident that the 3/10 Treasury curve has sustainably moved into a flatter regime (0 – 50 bps). MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 46 basis points in November, dragging year-to-date excess returns down to -90 bps. The zero-volatility spread for conventional 30-year agency MBS widened 13 bps on the month, driven by an 11 bps widening of the option-adjusted spread and a 2 bps increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in last week’s report that MBS’ recent poor performance is attributable to an option cost that is too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index has been slow to fall this year despite the back-up in yields.3 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refi activity will remain sticky going forward. This will put upward pressure on MBS spreads. We recommend adopting an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel).  Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-neutral Treasury index by 35 basis points in November, dragging year-to-date excess returns down to +33 bps. Sovereign debt underperformed duration-equivalent Treasuries by 157 basis points in November, dragging year-to-date excess returns down to -220 bps. Foreign Agencies underperformed the Treasury benchmark by 9 bps on the month, dragging year-to-date excess returns down to +36 bps. Local Authority bonds underperformed by 16 bps in November, dragging year-to-date excess returns down to +406 bps. Supranationals outperformed by 2 bps, bringing year-to-date excess returns up to +18 bps. The investment grade Emerging Market Sovereign bond index outperformed the equivalent-duration US corporate bond index by 42 bps in November. The Emerging Market Corporate & Quasi-Sovereign index underperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.4 Within EM sovereigns, attractive countries include: Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in November, bringing year-to-date excess returns up to +371 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuation.5 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue Munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 22% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve flattened dramatically in November. Increasingly hawkish rhetoric from the Fed pushed front-end yields higher as news about the omicron COVID strain pressured long-dated yields lower. The 2-year/10-year Treasury slope flattened 16 bps on the month, it currently sits at 75 bps. The 5-year/30-year Treasury slope flattened 11 bps on the month, it currently sits at 56 bps. As noted on the front page, long-dated Treasury yields have fallen to well below levels consistent with a reasonable Fed rate hike cycle. This drop in long-maturity yields has pushed the 2/5/10 butterfly spread to extremely high levels, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that 2/10 yield curve steepeners are incredibly cheap. Indeed, we observe that the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4). A trade long the 5-year bullet and short a duration-matched 2/10 barbell does indeed look attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen during the next 6-12 months, and we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. This leads us to recommend a position long the 2-year note and short a duration-matched barbell consisting of cash and the 10-year note. We also advise investors to own a position long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This latter position offers a very attractive duration-neutral yield advantage of 24 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in November, leaving year-to-date excess returns unchanged at +739 bps. The 10-year TIPS breakeven inflation rate fell 8 bps on the month while the 2-year TIPS breakeven inflation rate rose 17 bps. The 10-year and 2-year rates currently sit at 2.44% and 3.24%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 8 bps on the month. It currently sits at 2.16%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve, where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long-end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect it will. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 9 basis points in November, dragging year-to-date excess returns down to +26 bps. Aaa-rated ABS underperformed by 11 bps on the month, dragging year-to-date excess returns down to +13 bps. Non-Aaa ABS performed in line with Treasuries in November, keeping year-to-date excess returns steady at +93 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). The result is that the collateral quality backing consumer ABS is exceptionally high. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in November, dragging year-to-date excess returns down to +155 bps. Aaa Non-Agency CMBS underperformed Treasuries by 30 bps in November, dragging year-to-date excess returns down to +63 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 70 bps, dragging year-to-date excess returns down to +469 bps (Chart 10). Though returns have been strong this year and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 47 basis points in November, dragging year-to-date excess returns down to +58 bps. The average index option-adjusted spread widened 9 bps on the month. It currently sits at 40 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.     Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -62 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 62 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 30th, 2021) Powell’s Pivot Powell’s Pivot Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 30th, 2021) Powell’s Pivot Powell’s Pivot Table 6Discounted Slope Change During Next 6 Months (BPs) Powell’s Pivot Powell’s Pivot Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11 Footnotes 1   Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 5  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.

Highlights Fed: Until more is learned about the omicron variant, our base case view remains that the Fed will lift rates later than what is currently priced in the market. We think a September or December 2022 liftoff date is reasonable. Treasuries: Our main Treasury curve investment recommendations: below-benchmark portfolio duration and 2/10 curve steepeners, are not that sensitive to the timing of Fed liftoff. Both positions should be profitable whether the first rate hike occurs in June 2022 or December 2022. Corporates: Investors should remain overweight spread product versus Treasuries in US bond portfolios, maintaining a preference for high-yield corporates over investment grade. The recent bout of spread widening caused by expectations of more restrictive monetary policy and news about the omicron variant will reverse in the coming months. MBS: Agency MBS are unattractive relative to other US spread products, and current MBS valuations may understate the future pace of mortgage refi activity. Remain underweight Agency MBS within US bond portfolios. Feature Chart 1Curve Flattening Is Overdone Curve Flattening Is Overdone Curve Flattening Is Overdone Up until Friday, the bear-flattening of the Treasury curve was a well-established trend, one that even accelerated early last week before revelations about the new omicron COVID variant sent yields sharply lower (Chart 1). Large swings in expectations about the timing of Fed liftoff have been responsible for the recent volatility in Treasury yields. Back in September, the market was priced for no rate hikes at all until 2023. Just two months later we find the fed fund futures market pricing Fed liftoff in July 2022 with 75% odds of three rate hikes before the end of next year (Chart 2A). At one point early last week the market was priced for Fed liftoff in June 2022, with 32% chance of liftoff in March 2022 (Chart 2B). Chart 2ALiftoff Expectations: H2 2022 Liftoff Expectations: H2 2022 Liftoff Expectations: H2 2022 Chart 2BLiftoff Expectations: H1 2022 Liftoff Expectations: H1 2022 Liftoff Expectations: H1 2022   Pre-Omicron Market Moves June and March liftoff dates came into play early last week because of mounting evidence that the Fed is considering accelerating the pace of its asset purchase tapering. As it stands now, the current pace of tapering gets net asset purchases to zero by June of next year. Given the Fed’s stated preference for lifting rates only after tapering is finished, the current pace means that Fed liftoff is only possible in H2 2022 or later. However, if the pace of tapering is increased it would make earlier liftoff dates possible. It was speculation about an announcement of accelerated tapering at the December FOMC meeting that caused the market to bring June and March 2022 liftoff dates into play last week. Speculation about an accelerated taper really got going after an interview by San Francisco Fed President Mary Daly. Daly is widely regarded as one of the most dovish members of the FOMC, and indeed in last week’s report we highlighted her November 16th speech that called for patience in the face of high inflation.1 But last week, Daly said in an interview that “if things continue to do what they’ve been doing, then I would completely support an accelerated pace of tapering.”2 With one of the most dovish FOMC members seemingly on board, we see a good chance that the committee will announce an accelerated taper at the next meeting. As of today, we’d put the odds of an accelerated taper announcement in December at 50%, with still one more CPI report and one more employment report that will tip the scales in one direction or the other before the Fed meets. An accelerated taper doesn’t necessarily mean that the Fed will move toward earlier rate hikes, it simply gives the committee the option to hike sooner if inflation remains stubbornly high. In fact, we’ve been expecting a later liftoff date (December 2022) on the view that inflationary pressures will wane between now and the middle of next year. We continue to think that a September 2022 or December 2022 liftoff date is the most likely outcome, as we expect that falling inflation during the next six months will allow the Fed to focus more on the employment side of its mandate. However, if inflation doesn’t fall as we expect, then the Fed may move more quickly. The Impact Of The Omicron Variant Chart 3Households Have Ample Savings Households Have Ample Savings Households Have Ample Savings Friday’s revelation that a new COVID variant (the omicron variant) has been identified sent yields lower and caused the market to push out its liftoff expectations. As of today, available evidence suggests that the omicron variant will out-compete the delta variant and quickly become the world’s dominant COVID strain. There is some evidence to suggest that current vaccines will offer less protection against omicron. However, it is still unknown whether the omicron variant causes more (or less) severe illness than prior strains. Even in a severe scenario where the new strain leads to the re-imposition of lockdown measures, we are puzzled by Friday’s bond market moves. The market seems to be saying that a prolonged pandemic will be deflationary and lead to a later Fed liftoff date. We aren’t so sure that’s the case. US households continue to enjoy a large buffer of accumulated savings compared to the pre-COVID trend (Chart 3) and they have ample room to increase consumer debt (Chart 3, bottom panel). This suggests that aggregate demand will stay well supported next year, even in the face of greater pandemic concerns. The re-imposition of lockdown measures, however, will hamper the supply side of the economy and prolong the economy’s issues with supply chain bottlenecks and labor shortages. It will also prevent consumers from shifting demand away from over-heating goods sectors and towards services. All of this will only keep inflation higher for longer, a development that could actually encourage the Fed to act more quickly. Bottom Line: Until more is learned about the omicron variant, our base case view remains that the Fed will lift rates later than what is currently priced in the market. We think a September or December 2022 liftoff date is reasonable. However, if inflation refuses to fall during the next 3-6 months there is a risk that the Fed will be tempted to move earlier. The Treasury Market Implications Of Earlier Liftoff Tables 1A – 1C show expected 12-month returns for different Treasury maturities. Each table assumes that the market moves to fully price-in a specific expected path for the fed funds rate during the 12-month investment horizon. Chart Chart Chart The scenario presented in Table 1A assumes that the Fed starts to lift rates in June 2022. It then proceeds with rate increases at a pace of 100 bps per year before the fed funds rate levels-off at 2.08%, 8 bps above the lower-end of a 2.0% - 2.25% target range.3 The scenarios presented in Tables 1B and 1C use the same rate hike pace and terminal rate as in Table 1A. However, we vary the expected liftoff dates. Table 1B assumes that liftoff occurs at the September 2022 FOMC meeting and Table 1C assumes that liftoff occurs at the December 2022 FOMC meeting. The first big conclusion we draw is that expected Treasury returns are negative for most maturities in all three scenarios. This justifies sticking with below-benchmark portfolio duration. Second, expected returns are better at the short-end of the curve (2yr) than at the long-end (10yr) in all three scenarios. This justifies sticking with our recommended 2/10 yield curve steepener. Specifically, we advise clients to buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Finally, the 20-year bond continues to offer greater expected returns than the 10-year and 30-year maturities. We view this as an attractive carry trade opportunity and advise clients to buy the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. Bottom Line: Our main Treasury curve investment recommendations: below-benchmark portfolio duration and 2/10 curve steepeners, are not that sensitive to the timing of Fed liftoff. Both positions should be profitable whether the first rate hike occurs in June 2022 or December 2022. Corporate Spreads: Just A Tremor, Not The Big One Chart 4IG Spreads Troughed In September IG Spreads Troughed In September IG Spreads Troughed In September Corporate bond spreads had already been widening before Friday’s news sent them even higher (Chart 4). Prior to Friday, the most likely reason for spread widening was a concern about a quicker pace of Fed tightening. As we highlighted in last week’s report, corporate balance sheet health is sublime and all signs point to default risk remaining low for some time.4 In fact, up until Friday, investment grade corporates were performing worse than high-yield as spreads widened. This suggests that the widening had more to do with perceptions of monetary accommodation than with perceptions of default risk. Then, on Friday, spreads widened sharply and high-yield underperformed investment grade. This is consistent with the market pricing-in an increase in expected default risk due to the emergence of the omicron variant. Our view is that the recent bout of spread widening will reverse in the near-term. Spreads will tighten back down to their recent lows giving investors an opportunity to reduce exposure sometime next year. We posit three possible scenarios: In the first scenario, the omicron COVID variant turns out to be less economically impactful than the recent delta strain. In this case, the recent spike in default expectations will reverse and inflation will moderate during the next six months as pandemic fears recede. In this scenario, the Fed will be able to wait until September or December 2022 – when its “maximum employment” target will be met – before lifting rates. Spreads will tighten on expectations of more accommodative monetary policy. Chart 5Pace Of Curve Flattening Will Moderate Pace Of Curve Flattening Will Moderate Pace Of Curve Flattening Will Moderate In the second scenario, the omicron COVID variant turns out to be inflationary. US consumer demand is not curbed significantly, but supply chains remain under pressure and labor shortages persist. This will encourage the Fed to move more quickly, possibly lifting rates as early as June. However, even this scenario would only see the 3-year/10-year Treasury slope dip below 50 bps in March of next year (Chart 5). Our prior research has shown that excess corporate bond returns tend to be strong when the 3-year/10-year Treasury slope is above 50 bps, as this suggests a highly accommodative monetary environment.5 We would likely see another period of spread tightening between now and March, even in this worst-case scenario for corporate spreads. The final possible scenario is one where the omicron COVID variant turns out to be deflationary. Growth and inflation both slow and the Fed significantly delays tightening, possibly into 2023. Given the robust health of corporate balance sheets, this scenario would be excellent for corporate bond returns. The deflationary shock would have to be very severe, much worse than the delta wave, to push the default rate meaningfully higher. Further, a shift toward more accommodative Fed policy would lengthen the runway for strong corporate bond returns. That is, it would be some time before the 3-year/10-year slope dips below 50 bps. Bottom Line: Investors should remain overweight spread product versus Treasuries in US bond portfolios, maintaining a preference for high-yield corporates over investment grade. The recent bout of spread widening caused by expectations of more restrictive monetary policy and news about the omicron variant will reverse in the coming months. Investors will be able to reduce cyclical corporate bond exposure at more attractive levels sometime next year. Stay Negative On Agency MBS We have been recommending an underweight allocation to Agency MBS in US bond portfolios for quite some time, and that is not likely to change anytime soon. Since the March 23rd 2020 peak in credit spreads, conventional 30-year Agency MBS have outperformed a duration-matched position in Treasuries by 0.59% while Aaa and Aa-rated corporate bonds have outperformed by 16% and 15%, respectively (Chart 6). MBS performance has been particularly poor since the spring. A big reason why is that MBS spreads did not adequately compensate investors for the magnitude of mortgage refinancings. Chart 7 shows that the compensation for prepayment risk embedded in MBS spreads (the option cost) plunged in mid-2020 as interest rates were cut to zero and mortgage refis spiked. In fact, the option cost embedded in MBS spreads was the lowest it had been in several years (Chart 7, panel 2), signaling that the market was priced for a big drop in refi activity. However, that big drop in refi activity never materialized. The MBA Refinance Index has remained elevated in 2021 (Chart 7, bottom panel), despite the back-up in bond yields. Chart 6MBS Returns Have Lagged Corporates MBS Returns Have Lagged Corporates MBS Returns Have Lagged Corporates Chart 7Option Cost Must Rise Option Cost Must Rise Option Cost Must Rise An increase in cash-out refinancings is a big reason for the stickiness in refi activity this year. Home prices have been on a tear and households have an increasing incentive to tap the equity in their homes (Chart 8). Freddie Mac recently noted an increase in both the share of refinancings that are for “cash-out” and the aggregate dollars of equity that borrowers are extracting from their homes.6 They also noted, however, that the amount of equity extraction as a percent of property values has trended down. This suggests that this trend toward cash-out refinancings is not yet exhausted. In fact, we expect refi activity will remain elevated during the next 6-12 months, even as bond yields move modestly higher. Chart 8Households Can Tap Their Home Equity Households Can Tap Their Home Equity Households Can Tap Their Home Equity Against this back-drop, our sense is that the compensation for prepayment risk embedded in MBS spreads remains too low. But, even if we assume that the MBS option cost is exactly right, it still wouldn’t make Agency MBS look attractive compared to alternative investments. The option-adjusted spread (OAS) offered by conventional 30-year Agency MBS is below the OAS offered by Aaa and Aa-rated corporate bonds (Chart 9). It is only slightly above the OAS offered by Agency CMBS and Aaa-rated consumer ABS. Chart 9OAS Differentials OAS Differentials OAS Differentials Bottom Line: Agency MBS are unattractive relative to other US spread products, and current MBS valuations may understate the future pace of mortgage refi activity. Remain underweight Agency MBS within US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 2 https://news.yahoo.com/san-francisco-fed-mary-daly-certainly-see-a-case-for-speeding-up-taper-142328227.html 3 The effective fed funds rate currently trades 8 bps above the lower-end of its target range, and we assume that this will continue to be the case. 4 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 5 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 6 http://www.freddiemac.com/research/insight/20211029_refinance_trends.page Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns