Gov Sovereigns/Treasurys

Highlights Barring major surprises, President Macron will be re-elected in 2022. Any dramatic reversal in the pandemic that leads to a new recession would benefit the opposition candidate. Otherwise, Macron will remain the frontrunner. A second term for President Macron would see a continuation of the structural reforms started in 2017, but with a longer process for coalition-building in the National Assembly. This is bullish for France. Reducing the size of the state will go a long way to improve France’s economic competitiveness over the long run. Tactically, favor the more defensive Spanish market over the highly cyclical French market. Underweight French consumer discretionary equities relative to their European and global peers. Longer term, overweight French industrials equities relative to German ones, and overweight French tech equities relative to European ones. Ahead of the election, buy the dip on any euro weakness and French OAT/German bund spread widening. Feature The French presidential election is nine months away, and it is already starting to catch investors’ attention as one of the main political events in Europe in 2022. In talks with clients, we’ve been asked repeatedly about the odds we assign to a Marine Le Pen victory and the market implications. Those concerns are understandable but overrated. Le Pen’s personal approval rating is on the rise, and, in most polls, the far-right candidate beats President Emmanuel Macron in the first round vote, although not the critical second round. Although the same polls see Macron being re-elected, the gap between the two has narrowed considerably since the 2017 election, which Macron won by 66 percent of the vote.   Still, Macron is favored for re-election. He has several strong advantages over Le Pen, and it is unlikely she will be able to close the gap further before the election. Macron’s first term has been eventful. Neoliberal structural reforms started with drums beating in the first 18 months of his term. But the pace and breadth of reform eventually became too ambitious or painful for France to bear, and protests erupted in 2018. First came the “Yellow Vest Movement,” and then came protests against pension reform. Macron tried to compromise and continue with his agenda, but COVID-19 forced his hand. Since then, Macron has focused on crisis management, benefiting from the large state sector’s role as an automatic stabilizer amid the downturn. A second term under President Macron would see a reboot of the structural reforms started in 2017, albeit without single-party rule in the National Assembly. Reforms aimed at reducing the size of the state, and its cost, would go a long way to improve France’s economic competitiveness over the long run. Therefore, the prospect of Macron’s reelection is bullish for France, even though the reality of his second term would be more complex. 2017 All Over Again? Yes And No At first glance, the 2022 election seems to be a repeat of 2017. Le Pen and Macron are likely to face off in the second round and the latter, the Europhile centrist candidate, is likely to win once more. However, everything surrounding this election has changed. The Incumbency Effect One of the major changes is favorable for Macron: he is the incumbent running for re-election. Macron had been part of President Francois Hollande’s government since 2014, so he was still viewed in 2017 as a political neophyte and dark horse candidate. His rapid rise to power, along with that of his upstart party, La République En Marche (LREM), was astounding. Chart 1Pro-Incumbency Effect Favors Macron France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu There is a strong pro-incumbency effect in French presidential elections, especially in the first round (Chart 1). Since 1965, five incumbents have run for re-election, and all have made it to the second round. Importantly, four won first place in the first round, with a six percentage-point margin on average. The chief exception is Nicolas Sarkozy in 2012. The reason for Sarkozy’s loss, however, is well known: he attempted to pass an unpopular pension reform in the teeth of the Euro debt crisis, 12 months before facing re-election. The only other incumbent who failed at re-election was Valerie Giscard d’Estaing, who lost to Francois Mitterrand in 1981, when the whole world was in stagflation and upheaval. The incumbency effect is not as pronounced in the second round (Chart 1, bottom panel). However, when facing a far-right candidate, incumbents win by a wide margin. This was the case in 2002 and 2017. Today, Macron still has a 12-point lead on Le Pen. Macron compares well to his predecessors. Chart 2 shows the approval rating for all presidents sitting in office over the past 40 years. The number of people who intend to vote for Macron has increased, the first time this has happened for an incumbent president since 1988. Only three presidents had a higher approval rating at this stage of their term, albeit from a higher starting point. Macron’s approval rating has increased by 10% since February 2020, when the COVID-19 pandemic hit Europe. Chart 2Macron Compares Well To His Predecessors France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Table 1Incumbency And Recessions Under The Fifth Republic France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu The shock of the pandemic and recession is the greatest change since 2017, and the biggest challenge facing Macron. Four incumbents have made a bid for re-election that was preceded by a recession within 12-24 months (Table 1). The results are mixed, and it is hard to establish a clear anti-incumbency effect. If anything, the timing and nature of this crisis are likely to help Macron rather than hurt him, since the vaccination campaign and easing of lockdown measures will enable the economy to normalize and improve ahead of April 10-24, 2022, when voters cast their first ballots. Nonetheless, another major shock (of any kind) could undermine the incumbent advantage. Economic Recovery Is The Top Priority While the Macron administration’s handling of the pandemic was questioned, public opinion was never aggressively hostile toward his handling of the economy. Macron was instrumental in securing a major European fiscal stimulus package (and joint debt issuance) with the German Chancellor, Angela Merkel. He enthusiastically adopted the crisis mentality of “whatever it takes” to wage war against COVID-19, enabling the oversized French state to deploy the most generous furlough scheme in Europe, shielding millions of workers and preventing businesses from going under. This will be one of his winning cards. Chart 3The Handling Of The Pandemic Dictates Macron's Popularity The Handling Of The Pandemic Dictates Macron's Popularity The Handling Of The Pandemic Dictates Macron's Popularity His approval rating began to rebound following the end of lockdowns (Chart 3). This trend should strengthen as the French economy reopens, supported by a government that will play an accommodative and reflationary economic role until the election. Public opinion wants him to focus on the labor market and the economic recovery in the months to come, and he will be happy to oblige. Public opinion also views Macron as the most qualified candidate when it comes to economic matters (Table 2). 42% of respondents think that Le Pen is not qualified “at all” on economic matters, her Achilles’ heel, a perception that was already entrenched when Macron crushed her in a televised debate before the second round of the 2017 election. Table 2Macron Is Perceived As The Most Qualified To Oversee The Economic Recovery France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Europhile Versus Eurosceptic? The central issue of the 2017 election was Europe and France’s role in it. Following the UK’s disruptive Brexit referendum in 2016, and a long tradition of Euroscepticism within her party, Le Pen campaigned on “Frexit” and the abandonment of the euro. Conversely, Macron embraced the EU and the monetary union as he ran for president and committed to having France play a more important role within the bloc if he won. Chart 4Le Pen And The EU: Not The Divorce We Expected Le Pen And The EU: Not The Divorce We Expected Le Pen And The EU: Not The Divorce We Expected Since then, Le Pen has drastically shifted her stance on the EU. She now claims that the benefits of the common currency and single market outweigh the costs. After all, 70% of the French public support the euro and EU membership (Chart 4). Like clockwork, her personal approval ratings have steadily gone up. This strategic shift aligns her with the median voter, and combined with the Covid crisis, it is the only reason to take her candidacy remotely seriously in 2022, despite Macron’s clear advantages. Nevertheless, Le Pen has not yet risen above her 2012 peak in popular support. She failed to do so between 2014 and 2015, when the lingering European debt crisis, the Syrian refugee crisis, multiple terrorist attacks in France, and sluggish economic growth should have boosted her popularity. Her shifting perspective on the euro was therefore necessary and might be just what she needs to break through her 37% ceiling of popular support. Le Pen’s policy agenda is now focusing on protectionism, immigration, and national security. It is a Trumpian mix. However, while her new stance is more mainstream, it also differentiates her less from the other center-right politicians in France, namely Xavier Bertrand, who recently made local electoral gains in Le Pen’s northern industrial base. Macron is as strong an advocate for Europe as ever. He convinced Germany to break the taboo on joint fiscal policy during the pandemic. Now, he is also mounting a bid to become the natural leader of Europe, given that Merkel is stepping down, and her party is likely to lose standing in the German election in September.  France is set to take over the rotating EU Council Presidency in the first half of 2022, under the theme “Recovery, power, belonging,” which provides Macron with a golden opportunity to pitch himself as Europe’s premier statesman and economic steward in the final months of the election campaign. One Thing Hasn’t Changed: The Outcome Of A Macron/Le Pen Duel Most opinion polls give Macron a 10-12 point lead on Le Pen in the second round of the election. This gap is wide enough to reassure investors that it is not a polling error. However, in 2017, Macron’s average lead over Le Pen was 22%, and he won the election with 66% of votes. It is the narrowing of that gap that raises eyebrows among investors. Table 3Ideological Blocs Also Favor Macron France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Still, Le Pen’s chances at closing the gap are overrated. She is not a political “unknown” anymore and has very little ability to “surprise” voters into rallying around her next year. She will have trouble persuading those who know all about her. Grouping French voters according to ideological blocs, that is, presidential preference by party affiliation, suggests that the biggest threat to Macron is a strong center-right candidate who can beat Le Pen, especially if this should coincide with a revival of the center-left (Table 3). Otherwise, as in 2017, Macron will be able to count on voters from other parties in the second round of the election (Table 4). While both candidates appeal to right-wing constituents and would have to share their ballots, Macron can count on the green EELV party, as well as left-wing voters, to join center-right voters to elect him. Macron has made environmental issues a part of his mandate, which should help him confront a green neophyte such as Le Pen. Table 4Voting Against Le Pen Implies Voting For Macron France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu The results of the regional elections held last month confirm this analysis. The motivation to keep Le Pen and her Rassemblement National (National Rally) party out of power is still strong (see Box 1). The poor showing of the National Rally means she won’t be able to maintain her current momentum in her personal approval ratings.   Box 1 2021 Regional Elections: Bad Omen For Marine Le Pen In Revival Of The Center-Right? The regional elections took place on June 20 and 27. While limited in relevance for the 2022 presidential race, the result of extremely low voter turnout, regional elections offer a gauge of how constituents feel about the political offerings from anti-establishment parties. Le Pen’s party suffered a heavy blow. It had hoped to consolidate power and build momentum ahead of the presidential election, but it failed even to win in its stronghold of Southern France. Meanwhile, Macron’s party (La République En Marche!) also disappointed. This outcome is not surprising; the local elections last year yielded similar results, highlighting the lack of presence at the local and regional levels for the four-year-old party. The surprise came from the center-right. It managed to win seven of the thirteen regions, beating far-right candidates by wide margins. Importantly, Xavier Bertand, Valérie Pécresse, and Laurent Wauquiez, all predicted to run for president next year, held onto their seats.   Chart 5Strong Demographic Base In The Second Round France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Both candidates’ demographic bases have remained the same. Macron is still popular among Millennials, white collar workers, and the elderly (Chart 5). He also has a strong base in Paris (and the suburbs) as opposed to Le Pen, and he still outperforms Le Pen among rural voters in today’s polls. Macron also scores high among the employees of the public sector—even though he is in favor of a smaller public sector. Furthermore, the unemployed mostly favor him, which reinforces the perception that he is the best candidate to improve the French economy and cut the unemployment rate. What if Le Pen fails to make it into the second round of the election? We discuss this possibility in the next section. Risks To The Base Case Scenario The greatest risks to our view are a setback in the economic recovery, an outperformance from the center-right, and the emergence of a dark horse. The latest developments in the UK and Israel, where a large share of the population is fully vaccinated, suggest that the “Delta” variant of COVID-19 remains a threat, with the potential to send economies back into lockdowns. The consequences would be dire for Macron. His chances at re-election would likely evaporate if his government imposed new lockdown measures. What about presidential candidates other than Le Pen? Our base case scenario that Macron will win is based on two assumptions: (1) the center-left Socialist Party will remain in shambles, and (2) the center-right remains scattered under different banners and will therefore lack unity. There is very little chance that the center-left will make a comeback in time, but the results from the regional elections suggest that the center-right could surprise to the upside (see Box 1), especially if it decides to rally behind a single candidate ahead of the first round. Could this candidate be a dark horse? Former Prime Minister Edouard Philippe or outsider candidate Xavier Bertrand could make formidable opponents to both Macron and Le Pen. Philippe’s personal approval rating currently stands at 50%, the highest among French politicians. He also appeals to constituents of all political leanings (Chart 6). This scenario could reshuffle the likely outcomes of both the first and second round of the election. Both Bertand and Philippe could win over voters who decided to side with Le Pen in 2017, while Philippe can compete with Macron over LREM voters. Additionally, Xavier Bertrand cuts into Le Pen’s support since he has made blue collar workers and the middle-class a priority. However, Macron and Le Pen each enjoy a strong voters’ base. It is necessary to monitor whether Valérie Pécresse (Soyons libres) and Laurent Wauquiez (Les Républicains) can be brought to endorse Xavier Bertrand ahead of the first round in 2022. Chart 6Edouard Philippe: From Ally To Outcast To Challenger? France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Beyond The Election Aside from the presidency, the outstanding question is the makeup of the National Assembly in 2022. Macron is not likely to enjoy the strong single-party legislative majority of his first term or to gain control of the Senate. Consequently, he will be more constrained in the legislature in a second term. Nonetheless, the demand for a better economy and a healthier job market requires pro-productivity reforms, which the public knows, and Macron has made reform his banner. Other conventional parties will come under pressure to support Macron’s reform agenda, even though that agenda will be less ambitious than it was in his first term. Chart 7Strong Presence Of Right-Leaning Forces Strong Presence Of Right-Leaning Forces Strong Presence Of Right-Leaning Forces Efforts at cutting back the size of the state are still likely, even though the pandemic has helped rather than hurt statism. This is because the French median voter, who never witnessed the degree of neoliberal reform that took place in the Anglo-Saxon world, has grown weary of the economy’s inefficiencies, just as the Anglo-Saxons have grown weary of laissez-faire neoliberalism. Before the pandemic, the French people understood the need to reduce the size of the state. After all, a larger state implies a larger cost burden borne by both households and corporations. When faced with the choice between paying the bill for the government’s fiscal response to COVID-19 (through higher taxes), or undertaking reforms aiming at reducing the size of the state, the French people will pick the former. Moreover, centrist forces will hold sway in the legislature (Chart 7); hence, some kind of budget normalization is expected in 2023 or thereafter. Other structural reforms If Macron wins would include pension reforms. We should also expect measures to push French companies to bring activities back to France, as well as a greater focus on leading France on the green path. Bottom Line: Barring major surprises, President Macron will be re-elected in 2022. There is a risk to our view if a center-right candidate defeats Le Pen to make it to the second round of the election. Either Macron or a center-right presidency would see a continuation of the structural reforms started in 2017, but with a longer process for coalition-building in the National Assembly. Investment Implications The French economy is currently experiencing an economic upswing. Three factors explain this pick-up: ultra-accommodative monetary conditions in Europe, fiscal largesse, and considerable pent-up demand. In 2021, GDP is projected to expand by 5.75% in annual average terms, higher than the Euro Area average of 4.6%. It should then grow by 4% in 2022 and by 2% in 2023. We remain bullish on French equities on a secular basis, as long as the elections result in further incremental structural reforms over time. As the election draws nearer, investors should treat any French OAT/German Bund spread widening as a buying opportunity and purchase the euro on any election-related dip. French Equities The CAC40 and French equities have had a good run since the beginning of the year. In absolute terms, the CAC40 is one of the best performers year-to-date, up +17%, driven by the outperformance of French consumer discretionary and financials equities, both in absolute and relative terms. However, a period of turbulence is appearing on the horizon; the shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries are creating headwinds for the cyclicals-to-defensives ratio this summer. As such, we recently recommended investors downgrade cyclical equities tactically in Europe from overweight to neutral. With 66% in cyclicals, the French MSCI equity index will underperform in this environment, especially relative to the more defensive Spanish market (Table 5). Table 5Cyclicals Versus Defensives In European Markets France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Chart 8Three Trade Ideas Three Trade Ideas Three Trade Ideas In fact, our Combined Mechanical Valuation Indicator (CMVI) shows that French consumer discretionary equities are expensive relative to both their European and global peers (Chart 8). Regarding the reform theme, we stick with our long French industrial equities / short German industrial equities on a long-term horizon (Chart 8, second and third panel). The idea is that French reforms should suppress unit labor costs and make French exports more competitive vis-à-vis their main competitor, Germany. The latter faces a leftward shift in policy in elections this September. Finally, we recommend investors go long French tech stocks relative to their European counterparts. This sector is cheap (Chart 8, bottom panel), and the French tech sector will be supported by additional government spending of EUR7 billion on digital investments over the next two years. Bond Markets & FX A dovish ECB is consistent with a continued overweight in European peripheral bonds and an underweight stance on French government bonds. Chart 9Just Buy The Dip Just Buy The Dip Just Buy The Dip What is more relevant with respect to the French election is the OAT/Bund spread. In the past, unusually wide spreads between the two represented a euro breakup premium. In early 2017, spreads widened when the approval rating of Le Pen increased (Chart 9). However, since “Frexit” and the abandonment of the euro are no longer part of Le Pen’s agenda, investors should view spread widening as a buying opportunity. Similarly, investors should buy the euro on any election-related dip, particularly following the first round. “Frexit” has been removed from the equation, hence the euro should not weaken on breakup risk this time around. Bottom Line: We remain bullish on French equities within a European portfolio on a secular basis. If our views on the cyclicals-to-defensives ratio materialize in the near-term, highly cyclical French equities will temporarily underperform, unlike the more defensive Spanish market. On a 3- to 12-month horizon, investors should short French consumer discretionary equities relative to both their European and global counterparts. Current valuations suggest that betting on the booming French tech sector at the expense of its European neighbors will be profitable. Once the election draws nearer, investors should treat any French OAT/German Bund spread widening as a buying opportunity and purchase the euro on any election-related dip.   Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, July 8 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic Outlook: Global growth is peaking but will remain solidly above trend. While the proliferation of the Delta strain is likely to trigger another wave of Covid cases this summer, the economic impact will be far smaller than during past waves. Global Asset Allocation: The risk-reward profile for stocks has deteriorated since the start of the year. Nevertheless, with few signs that the global economy is heading towards another major downturn, investors should maintain a modest equity overweight on a 12-month horizon. Equities: Favor cyclicals, value-oriented, and non-US equities. Emerging markets should spring back to life in the autumn once vaccine supplies increase and Chinese fiscal policy turns more stimulative. Fixed Income: Maintain below average interest-rate duration exposure. The 10-year US Treasury yield will finish the year at 1.9%. Spread product will continue to outperform high quality government bonds. Currencies: The US dollar will resume its weakening trend as growth momentum rotates from the US to the rest of the world. EUR/USD will finish the year at 1.25. Commodities: Brent will rise to $79/bbl by end-2021, 9% above current market expectations. While the lagged effects from the slowdown in Chinese credit growth earlier this year will weigh on base metals during the summer months, the long-term outlook for metals is positive. Favor gold over cryptos as an inflation hedge. I. Macroeconomic Outlook Global Vaccination Campaign Kicks Into High Gear Nearly 18 months after the pandemic began, the global economy is on the mend. In its latest round of forecasts released on May 31st, the OECD projects that the global economy will expand by 5.8% this year, up from its March projection of 5.6%. The OECD also bumped up its growth forecast for 2022 from 4% to 4.4%. After a rough start, the vaccination campaign is progressing well in most advanced economies (Chart 1). The US and the UK were the first major developed economies to roll out the vaccines, followed by Canada and the EU. While Japan has lagged behind, the pace of vaccinations has picked up lately. Twenty percent of the Japanese population has now received at least one dose. Developing economies are still struggling to secure enough vaccines. Fortunately, this problem should abate over the next six months. The Global Health Innovation Center at Duke University estimates that pharmaceutical companies are on track to produce more than 10 billion vaccine doses this year (Chart 2). While perhaps not enough to inoculate everyone who wants a jab, it will suffice in providing protection to the most vulnerable members of society – the elderly and those with pre-existing medical conditions. Chart 1The Vaccination Campaign Is Progressing Well In Most Developed Economies The Vaccination Campaign Is Progressing Well In Most Developed Economies The Vaccination Campaign Is Progressing Well In Most Developed Economies Chart 2Vaccine Makers Are On Track To Produce Over 10 Billion Doses In 2021 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal New Variants And Vaccine Hesitancy Are Risks Novel strains of the virus remain a concern. First identified in India, the so-called “Delta variant” is spreading around the world. The number of new cases in the UK, where the Delta variant accounts for over 90% of all new infections, is rising again (Chart 3). The latest outbreak has forced the government to postpone “Freedom Day” from June 21st to July 19th (Chart 4). Chart 3The Number Of New Cases In The UK Is Rising Anew 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 4Dismantling Of Lockdown Measures Occurring At Varying Pace 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal     It is highly likely that the Delta variant will produce another wave of cases in the US this summer. Despite ample availability, one-third of Americans over the age of 18 have yet to receive a single dose of a vaccine. As is the case with most everything in the United States, the question of whether to be inoculated has become politicized. In many Republican-leaning states, more than half the population remains unvaccinated (Chart 5). Chart 5The US Politicization Of Vaccines Raises The Risk From COVID-19 Variants 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Vaccine hesitancy will likely diminish as the evidence of their effectiveness continues to mount. According to analysis by the Associated Press using CDC data, fully vaccinated people accounted for less than 1% of the 18,000 COVID-19 deaths in the US in May. A study out of the UK showed that two doses of the Pfizer-BioNTech vaccine was 96% effective against hospitalization from the Delta variant, while the Oxford-AstraZeneca vaccine was 92% effective. While another wave of the pandemic will curb growth this summer, the economic impact will be far smaller than in the past. At this point, the initial terror of the pandemic has faded. Politically, it will be more difficult to justify lockdowns in countries such as the US where almost everyone who wants a vaccine has already been able to get one. Macro Policy Outlook: Tighter But Not Tight After cranking the fire hose to full blast during the pandemic, policymakers are looking to scale back support. On the fiscal side, governments are slowly starting to rein in budget deficits. The IMF expects the fiscal impulse in advanced economies to average -4% of GDP in 2022, implying an incrementally tighter fiscal stance (Chart 6). Chart 6Budget Deficits Set To Decline, But Remain High By Historic Standards 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Tighter does not necessarily mean tight, however. The IMF sees advanced economies running an average cyclically-adjusted primary budget deficit of 2.6% of GDP between 2022 and 2026, compared to an average deficit of 1.1% of GDP between 2014 and 2019. In the US, Congress is debating an infrastructure bill, a key element of President Biden’s “Build Back Better” agenda. If the bill fails to move out of the Senate, our geopolitical strategists expect Congress to use the reconciliation process to pass most of Biden’s legislative program. This should result in an additional 1.3% of GDP in federal spending per year over the next 8 years, offset only partly by higher taxes. Chart 7EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 8Japanese PMIs Stuck In The Mud Japanese PMIs Stuck In The Mud Japanese PMIs Stuck In The Mud In the euro area, the IMF expects fiscal policy to remain structurally looser by nearly 2% of GDP in the post-pandemic period. After six months of parliamentary debates, all 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 7). Most of the money will be spent on public investment projects with high fiscal multipliers. Japan has a habit of tightening fiscal policy at exactly the wrong moment, with the October 2019 hike in the sales tax from 8% to 10% being no exception. Unlike in other developed economies, both the Japanese manufacturing and services PMI remain stuck in the mud (Chart 8). The odds are rising that Prime Minister Yoshihide Suga will announce a major stimulus package after the Olympic Games and ahead of the general election due by October 22nd. China: Normalization Not Deleveraging Chart 9China: Weak Infrastructure Spending Should Pick Up China: Weak Infrastructure Spending Should Pick Up China: Weak Infrastructure Spending Should Pick Up In China, strong export growth, propelled by the shift in global spending towards manufactured goods during the pandemic, allowed the government to tighten fiscal policy modestly in the first half of the year. Looking out, fiscal policy should turn more stimulative. Local governments used only 16% of their bond issuance allocation between January and May, compared with 59% over the same period last year and 40% in 2019. Proceeds should benefit infrastructure spending, which has been on the weak side in recent years (Chart 9). After a sharp decline, Chinese credit growth should stabilize in the second half of the year. The current pace of credit growth of 11% is near its 2018 lows and is broadly in line with nominal GDP growth (Chart 10). Given that the authorities have stated their desire to stabilize the ratio of credit-to-GDP, they are unlikely to proactively suppress credit growth further. The recent decline in the 3-month SHIBOR, which usually moves in the opposite direction of credit growth, is evidence to this effect (Chart 11). Chart 10Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chart 11China: Easing Off The Brakes? China: Easing Off The Brakes? China: Easing Off The Brakes? Nevertheless, changes in fiscal and credit policy tend to affect the Chinese economy with a lag (Chart 12). Thus, the tightening in fiscal policy and the deceleration in credit growth that occurred early this year could still weigh on economic activity during the summer months. Chart 12China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag Don’t Sweat The Dot Plot Markets interpreted the June FOMC meeting in a hawkish light. Both the 2-year and 5-year yield jumped 10 basis points following the meeting (Table 1). The US dollar, which is quite sensitive to changes in short-term rate expectations, strengthened by nearly 2%. In contrast, long-term bond yields declined following the meeting, with the 10-year and 30-year bond yield falling by 6 and 19 basis points, respectively. Table 1Change In Yields Following June FOMC Meeting 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal As long duration assets, stocks take their cues more from long-term yields than short-term rates. Hence, it was not surprising that equities held their ground, and that growth stocks reversed some of their underperformance against value stocks this year. Chart 13Markets Interpreted The June FOMC Meeting In A Hawkish Light Markets Interpreted The June FOMC Meeting In A Hawkish Light Markets Interpreted The June FOMC Meeting In A Hawkish Light This publication agrees with BCA’s bond strategists that the market overreacted to the changes in the Fed’s projections (aka “the dots”). As Chair Powell himself noted during the press conference, the dot plot is “not a great forecaster of future rate moves,” before adding that “Lift-off is well into the future.” The market is currently pricing in 105 basis points of tightening by the end of 2023. Prior to the meeting, investors were expecting 85 basis points in rate hikes (Chart 13). The regional Fed presidents tend to be more hawkish than the Board of Governors. Our guess is that Jay Powell himself only penciled in one hike for 2023. Lael Brainard, who may be replacing Powell next year, likely projects no hikes for 2023. The Path To Full Employment Chart 14The Divergence Of Goods And Services Spending The Divergence Of Goods And Services Spending The Divergence Of Goods And Services Spending Rather than obsessing over the dots, investors should focus on the questions that will actually drive Fed policy, namely how long it takes the US economy to return to full employment and what happens to inflation in the interim and beyond. There is a lot of uncertainty over these questions – both on the demand side (how fast will spending recover?) and the supply side (how much labor market slack is there and how quickly can firms ramp up hiring?). On the demand side, the pandemic led to unprecedented changes in household spending and saving behavior. As Chart 14 shows, goods spending surged while services spending collapsed. Overall spending declined, and together with increased transfer payments, savings ballooned. As of May, US households were sitting on $2.5 trillion in excess savings. Looking at disaggregated bank deposit data as a proxy for the distribution of household savings, the wealthiest 10% of households accounted for about 70% of the increase in savings between Q1 of 2020 and Q1 of 2021 (Chart 15). Given that richer households have relatively low marginal propensities to spend, this suggests that a large fraction of these excess savings will remain unspent. Nevertheless, $2.5 trillion is a lot of money – it’s equal to almost 17% of annual consumption. Hence, even if a third of this cash hoard were to make its way into the economy, it could buoy aggregate demand significantly. Chart 15Excess Savings Have Mostly Flowed To The Rich 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal A Labor Market Puzzle Turning to the supply side, there were over 4% fewer people employed in the US in May than in January 2020 (Chart 16). On the face of it, this would suggest the presence of a significant amount of labor market slack. Chart 16US Employment Still More Than 4% Below Pre-Pandemic Levels 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Yet, the NFIB small business survey tells a different story. It revealed that 48% of firms reported difficulty in filling vacant positions in May, the highest percentage of respondents in the 46-year history of the survey (Chart 17). Chart 17US Labor Market Shortages (I) US Labor Market Shortages (I) US Labor Market Shortages (I) Chart 18US Labor Market Shortages (II) US Labor Market Shortages (II) US Labor Market Shortages (II)   Along the same lines, the nationwide job openings rate reached a record high of 6% in April, up from 4.5% in January 2020. The quits rate, a good proxy for worker confidence, is also at a record high (Chart 18). How does one reconcile the low level of employment with other data pointing to a tight labor market? As we discussed in a report two weeks ago, four explanations stand out: Generous unemployment benefits, which have depressed labor force participation among low-wage workers (Chart 19). Chart 19Labor Scarcity Prevalent In Low-Wage Sectors 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 20School Closures Have Curbed Labor Supply 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Pandemic-related school closures. As Chart 20 shows, they have had a noticeable impact on labor force participation among women with young children. Reduced immigration. At one point during the pandemic, visa issuance was down 99% from pre-pandemic levels (Chart 21). An increase in early retirements. We estimate that about 1.5 million more workers retired during the pandemic than would have been expected based solely on demographic trends (Chart 22). Chart 21US Migrant Worker Supply Is Depressed 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 22The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement All but the last effect is likely to be fleeting. Enhanced unemployment benefits expire in September; President Biden has reversed President Trump’s ban on most worker visas; and schools should fully reopen by the fall. And even for the retirement effect, most recent retirees were approaching retirement age anyway. Thus, there will likely be fewer incremental retirements over the next few years. A Speed Limit To Hiring? Assuming that a large fraction of sidelined workers return to the labor market in the fall, how fast will firms be able to hire them? In general, we are skeptical of arguments claiming that there is much of a speed limit to the pace of hiring. Chart 23There Is A Lot Of Churn In The Labor Market There Is A Lot Of Churn In The Labor Market There Is A Lot Of Churn In The Labor Market There is a lot of churn in the labor market. Gross job flows are much larger than net flows. Between 2015 and 2019, 66.1 million people were hired on average per year compared with 59.6 million who quit or were discharged. Churn is especially strong in the retail and hospitality sectors, the two segments that account for the bulk of today’s shortfall in jobs. In April of this year, retailers hired nearly 800,000 workers. An additional 1.42 million workers found jobs in the leisure and hospitality sectors. This is equivalent to 5.3% and 10.1% of total employment in those sectors, respectively (Chart 23). And remember, we are talking about only one month’s worth of hiring. During past V-shaped recoveries, employment growth often surpassed 5% on a year-over-year basis (Chart 24). Such a growth rate would produce net 670K new jobs per month, enough to restore full employment by mid-2022. Chart 24V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries The Fed’s Three Criteria For Lift-Off In August of 2020, the Fed formally adopted a “flexible average inflation targeting” framework. It seeks to offset periods of below-target inflation with periods of above-target inflation. The goal is to better anchor long-term inflation expectations, while giving households and firms more clarity over where the price level will be many years out. In the spirit of this new framework, the Fed has made it clear that it needs to see three things before it considers raising rates: The labor market must be at “maximum employment” 12-month PCE inflation must be above 2% The FOMC must expect inflation to remain above 2% for some time If the US economy achieves full employment by the middle of next year, the first criterion will be satisfied. PCE inflation clocked in at 3.9% in May, so at least for now, the second criterion is satisfied as well. The big question concerns the third criterion. How Transitory Is US Inflation Likely To Be? As Chart 25 shows, more than half of the increase in the CPI in April and May can be explained by higher vehicle prices, along with a rebound in pandemic-affected service prices (airfares, hotels, and event admissions). Outside those sectors, the level of the CPI still remains below its pre-pandemic trend, while the level of the PCE deflator is barely above it (Chart 26). Aside from a few low-wage sectors such as retail and hospitality, overall wage growth remains contained. Neither the Atlanta Fed Wage Growth Tracker nor the Employment Cost Index – the two cleanest measures of US wage inflation – is signaling a brewing wage-price spiral (Chart 27). Chart 25Rebounding Pandemic-Affected Services Prices Are Pushing Up Overall CPI 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 26AUnwinding Of "Base Effects" (I) Unwinding Of "Base Effects" (I) Unwinding Of "Base Effects" (I) Chart 26BUnwinding Of "Base Effects" (II) Unwinding Of "Base Effects" (II) Unwinding Of "Base Effects" (II) Chart 27No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now Chart 28Rising Oil Prices Have Fueled The Jump In Inflation Expectations 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal   Chart 29Inflation Expectations Back Below The Fed's Target Zone Inflation Expectations Back Below The Fed's Target Zone Inflation Expectations Back Below The Fed's Target Zone Chart 30A Top In Inflation Expectations? A Top In Inflation Expectations? A Top In Inflation Expectations? While inflation expectations have risen, they should fall in the second half of the year as gasoline prices descend from their seasonal highs (Chart 28). Market expectations of inflation have already dipped back below the Fed’s comfort zone (Chart 29). Inflation expectations 5-to-10 years out in the University of Michigan’s Survey of Consumers also dropped from 3% in May to 2.8% in June (Chart 30). Overall producer price inflation should decline. Chart 31 shows that lumber prices, steel prices, agriculture prices, and memory chip prices have all peaked. Taken together, all this suggests that the recent surge in inflation is indeed likely to be “transitory.” Chart 31Input Prices Have Rolled Over Input Prices Have Rolled Over Input Prices Have Rolled Over Risk-Management Considerations Favor A “Go Slow” Approach Chart 32Market Participants See An Even Lower Terminal Rate Than The Fed Market Participants See An Even Lower Terminal Rate Than The Fed Market Participants See An Even Lower Terminal Rate Than The Fed The financial press often characterizes the Fed’s monetary policy as ultra-accommodative. With policy rates near zero, one would be forgiven for agreeing. However, the reality is that neither the Fed nor, for that matter, most market participants think that monetary policy is all that easy. Using expectations for the terminal Fed funds rate as a proxy for the neutral rate of interest, the Fed’s estimate of the terminal rate has fallen from 4.3% in 2012 to 2.5% at present (Chart 32). Surveys of primary dealers and other market participants suggest that investors think the terminal rate is even lower than what the Fed believes it to be. It is an open question as to whether the neutral rate really is as low as widely believed. But if it is, raising rates prematurely would be a grave mistake. Given the zero lower bound constraint on nominal policy rates, the Fed would be hard-pressed to ease monetary policy by enough to respond to any future deflationary shock. In contrast, if inflation proves to be more persistent, raising rates to cool the economy would be relatively straightforward. All this suggests that the Fed is likely to maintain its “go slow” approach. This publication expects tapering of QE to begin early next year, with no rate hike until December 2022 or early 2023. Other Central Banks Constrained By The Fed Chart 33Long-Term Inflation Expectations Remain Subdued Long-Term Inflation Expectations Remain Subdued Long-Term Inflation Expectations Remain Subdued The Fed’s dovish bias limits the ability of other developed economy central banks to tighten monetary policy. For some central banks, such as the ECB and BoJ, raising rates is the last thing they want to do. In both the euro area and Japan, long-term inflation expectations remain well below target (Chart 33). The Bank of England is in a better position to tighten monetary policy than the ECB. Inflation expectations are relatively high in the UK and a frothy housing market poses a long-term threat to economic stability. Nevertheless, the need to maintain a competitive currency to facilitate post-Brexit economic adjustments will limit the BoE’s ability to raise rates. Moreover, the departure of BoE Chief Economist, Andy Haldane, from the MPC will silence the sole voice sounding the alarm over rising inflation. Among the G7 economies, the Bank of Canada is the closest to raising rates. After a slow start, the vaccination campaign is now progressing well there. Property prices have gone through the roof. The Western Canada Select oil price has reached the highest level since 2014. The discount to WTI has shrunk from a peak over 50% in November 2018 to about 20% in recent weeks. The Bank of Canada has already begun tapering asset purchases. While concerns about a stronger loonie will tie the BoC’s hands to some extent, the first rate hike is still likely in mid-2022. II. Financial Markets A. Portfolio Strategy The Golden Rule embraced by this publication is “remain bullish on stocks as long as growth is likely to remain strong for the foreseeable future.” Historically, bear markets rarely occur outside of recessions (Chart 34). With both fiscal and monetary policy still supportive, and households in many countries sitting on plenty of dry powder, the odds that the global economy will experience a major downturn in the next 12 months are low. Chart 34Recessions And Bear Markets Tend To Overlap 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal That said, we do acknowledge that the risk-reward profile for equities has deteriorated since the start of the year. Global stocks have risen 12% year-to-date, implying that investors have priced in an increasingly optimistic economic outlook. Our equity valuation indicator points to very poor long-term future returns, particularly in the US (Chart 35). Chart 35ALong-Term Expected Returns Are Nothing To Write Home About (I) Long-Term Expected Returns Are Nothing To Write Home About (I) Long-Term Expected Returns Are Nothing To Write Home About (I) Chart 35BLong-Term Expected Returns Are Nothing To Write Home About (II) Long-Term Expected Returns Are Nothing To Write Home About (II) Long-Term Expected Returns Are Nothing To Write Home About (II) Democrats in Congress will likely use the reconciliation process to raise corporate taxes. While this is unlikely to cause major problems for the economy, it could weigh on stocks. As we discussed in a past report, neither analyst earnings estimates nor market expectations are baking in much impact from higher tax rates. Meanwhile, economic growth has peaked in the US and China, and will peak in the other major economies over the balance of 2021. Slower growth is usually associated with lower overall equity returns (Table 2). Stocks are also likely to face headwinds as spending shifts back from goods to services. Goods producers are overrepresented in stock market indices compared to the broader economy. Table 2The Economic Cycle And Financial Assets 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal The fact that global growth is peaking at exceptionally high levels will soften the blow for stocks. Likewise, the need to rebuild inventories and satisfy pent-up demand for some manufactured goods that have been in short supply will keep goods production from falling too drastically. Nevertheless, investors who have been maximally overweight stocks should consider paring exposure by raising cash. Only a modest equity overweight is appropriate going into the second half of this year. B. Equity Sectors, Regions, And Styles While we continue to favor cyclical equity sectors over defensives, non-US over the US, and value over growth, our conviction is lower than it was at the start of the year. In the near term, the lagged effects from the slowdown in Chinese credit growth could weigh on global cyclicals. Cyclicals could also stumble as the Delta variant rolls through the US and other countries. In addition, the US dollar could sustain recent gains as investors continue to fret that the Fed is turning hawkish. A stronger dollar is usually bad for cyclicals and non-US stocks (Chart 36). Chart 36Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Chart 37Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment   Ultimately, as discussed earlier in this report, the Fed is likely to push back against the market’s hawkish interpretation of its dot plot. The resulting reflationary impulse should cause the dollar to weaken over a 12-month horizon while allowing for a re-steepening of the yield curve. Higher long-term bond yields tend to benefit banks, which are overrepresented in value indices (Chart 37). A stabilization in credit growth and more stimulative Chinese policy later this year should temper concerns about EM growth. Greater access to vaccines will also allow more EM economies to partake in reopening euphoria, thus benefiting local EM stock markets and global cyclicals. C. Fixed Income If stocks are pricey, government bonds are even more dear. Real yields are negative in most G10 economies. And while persistently higher inflation is not an imminent threat, it is a longer-term risk that bond valuations are not discounting. We expect the 10-year US Treasury yield to rise to 1.9% by the end of the year, above current market expectations of 1.61%. As of today, we are expressing this view by going short the 10-year Treasury note in our trade table. US Treasuries have a higher beta than most other government bond markets (Chart 38). Treasury yields tend to rise more when global bond yields are moving higher and vice versa. Given our expectation that global growth will remain solidly above trend over the next 12 months, fixed-income investors should underweight high-beta bond markets such as the US and Canada, while overweighting the euro area and Japan. Chart 38US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets BCA’s bond strategists see more upside from high-yield bonds than for investment grade. While high-yield spreads are quite tight, they are still pricing in a default rate of 2.9%. This is more than their fair-value default estimate of 2.3%-to-2.8% (Chart 39). It is also above the year-to-date realized default rate of 1.8%. Chart 39Spread-Implied Default Rate Spread-Implied Default Rate Spread-Implied Default Rate Our bond team sees USD-denominated EM corporate bonds as being attractively priced relative to domestic investment-grade corporate bonds with the same duration and credit rating. They prefer EM corporates to EM sovereigns in the A and Baa credit tiers, while preferring EM sovereigns over EM corporates in the Aa credit tier. Investors willing to take on foreign-exchange risk should consider EM local-currency bonds. As we discuss next, a weaker US dollar over the next 12 months should translate into stronger EM currencies. D. Currencies Four forces tend to drive the US dollar over cyclical horizons of about 12 months: Growth: As a countercyclical currency, the dollar typically does poorly when global growth is strong. This is especially the case when growth is rotating away from the US to other countries (Chart 40). Bloomberg consensus estimates imply that the US economy will transition from leader to laggard over the coming months, which is dollar bearish (Table 3). Chart 40The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Table 3Growth Is Peaking, But At A Very High Level 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Interest Rate Differentials: The trade-weighted dollar tends to track the real 2-year spread between the US and its trading partners (Chart 41). It is unlikely that US real rates will fall much from current levels. However, the current level of spreads is already consistent with a meaningfully weaker dollar. Chart 41Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Balance Of Payments: The US trade deficit has increased significantly over the past year (Chart 42). Equity inflows have been helping to finance the trade deficit (Chart 43). However, if stronger growth abroad causes equity flows to move out of the US, the dollar will suffer. Chart 42The US Trade Deficit Has Increased Significantly The US Trade Deficit Has Increased Significantly The US Trade Deficit Has Increased Significantly Chart 43Equity Inflows Have Helped Finance The Trade Deficit Equity Inflows Have Helped Finance The Trade Deficit Equity Inflows Have Helped Finance The Trade Deficit Momentum: Being a contrarian is a losing strategy when it comes to trading the dollar. This is because the US dollar is a high momentum currency (Chart 44). The dollar usually continues to weaken when it is trading below its various moving averages and sentiment is bearish (Chart 45). At present, while the dollar is near its short-term moving averages, it is still below its long-term moving averages. Sentiment is bearish, but has come off its lows. On balance, the technical picture for the dollar is slightly negative.   Chart 44The Dollar Is A High Momentum Currency 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 45ABeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Chart 45BBeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Adding it all up, we expect the dollar to weaken over a 12-month horizon. The dollar’s downdraft will likely begin in earnest during the fall when Chinese policy turns more stimulative and fears that the Fed has turned hawkish subside. We expect EUR/USD to finish the year at 1.25. GBP/USD should hit 1.50. Both EM and commodity currencies should also do better. The lone laggard among “fiat currencies” will be the yen. As a highly defensive currency, the yen usually struggles when global growth is firm. Chart 46To This Day, Most Crypto Payments Are Made To Criminals 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal What about cryptocurrencies? I debated the topic with my colleague, Dhaval Joshi, in early June. To make a long story short, I think it is highly unlikely that cryptos will ever thrive. More than 13 years since Bitcoin was created, cryptos continue to be mainly used to facilitate illicit transactions. According to Chainalysis, there were fewer cryptocurrency payments processed by merchants in 2020 than in 2017 (Chart 46). Meanwhile, Bitcoin mining continues to produce significant environmental damage (Chart 47). And if there is any place where there is hyperinflation, it is in the creation of new cryptocurrencies. There are over 5000 cryptocurrencies at last count, double the number at this time last year (Chart 48). We are currently short Bitcoin in our trade table.   Chart 47Bitcoin And Ethereum: How Dare You! 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 48Hyperinflation In New Cryptocurrency Creation 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal E. Commodities Structurally, oil faces a bleak future. Transport accounts for about 60% of global oil consumption. The shift to electric vehicles will undermine this key source of oil demand. Cyclically, however, crude prices could still rise as the global economic recovery unfolds. Supply remains quite tight, reflecting both OPEC vigilance and the steep drop in oil and gas capex of recent years (Chart 49). Bob Ryan, BCA’s chief commodity strategist, expects Brent to rise to $79/bbl by the end of the year, which is 9% above current market expectations (Chart 50). Chart 49Oil And Gas Companies Curtailed Capex In Recent Years 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 50Oil Prices Still Have Room To Run Oil Prices Still Have Room To Run Oil Prices Still Have Room To Run Chart 51Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom In contrast to oil, the long-term outlook for base metals is favorable. A typical electric vehicle requires four times as much copper as a typical gasoline-propelled vehicle. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, representing about 15% of current annual copper production. Strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then (Chart 51). In the near term, however, base metals have to grapple with the lagged effects of slower Chinese credit growth (Chart 52). We downgraded base metals to neutral on May 28 and are currently long global energy stocks via the IXC ETF versus global copper miners via the COPX ETF. We expect to reverse this trade by the fall. We are generally positive on gold. Since peaking last August, the price of gold has fallen more than one might have expected based on movements in real bond yields (Chart 53). Gold will also benefit from a weaker dollar later this year. Lastly, and importantly, gold should retain its standing as a good inflation hedge. Chart 52Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Chart 53Gold Prices Tend To Track Real Rates Gold Prices Tend To Track Real Rates Gold Prices Tend To Track Real Rates Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Special Trade Recommendations 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Current MacroQuant Model Scores 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal

Dear Client, China Investment Strategy will take a summer break next week. We will resume our publication on July 14th. Best regards and we wish you a happy and healthy summer. Jing Sima, China Strategist   Highlights A USD rebound and higher domestic bond yields pose near-term challenges to Chinese risk assets. A sharp deceleration in credit growth in the past seven months will lead to weaker-than-expected data from China’s old-economy sectors in the second half of the year.  Robust global trade has propelled Chinese exports, allowing the country to pursue financial deleverage and structural reforms. However, next year policymakers will face increased pressure to support the domestic economy as the global economic recovery peaks and demand slows. Investors should maintain an underweight stance towards Chinese stocks in 2H21, but remain alert to any improvements in China’s policy tone.  An easing monetary policy may signal a potential upgrade catalyst in 1H22. Feature Most recent macro figures confirm that China’s impressive economic upcycle has peaked. We expect that the official manufacturing and non-manufacturing PMIs, which will be released as this report is published, will come in modestly down. We maintain the view that a major relapse in economic activity is unlikely, but the strong tailwinds that have propelled China's recovery since Q2 last year have since abated and will lead to softer growth. Meanwhile, the rate of economic and export expansions has given Chinese policymakers confidence to scale back leverage and continue with market reforms. In the second half of the year, investors' sentiment towards Chinese stocks will be tested based on three risks: A rebound in the US dollar index. A tighter liquidity environment and higher interest rates. A weakening in macro indicators beyond market expectations. As the global economic recovery peaks into 2022, pressures to support the domestic economy will become more urgent if policymakers want to maintain an average rate of 5% real GDP growth in 2020 - 2022. The current policy settings are not yet favorable to overweight Chinese risk assets. Major equity indexes remain richly valued and the market could easily correct if domestic rates move higher. However, signs of policy easing may emerge by yearend, which would prompt us to shift our view to overweight Chinese stocks in both absolute and relative terms. The Case For A Dollar Rebound On a tactical basis (next three months), a rebound in the US dollar index may curb investors’ enthusiasm for Chinese stocks. A stronger dollar will give the RMB’s appreciation some breathing room and will be reflationary for China’s economy. However, in the short term a stronger USD will also lead to weaker foreign inflows to China’s equity markets. Chinese stock prices have become more closely and negatively correlated with the dollar index since early 2020 (Chart 1). A weaker dollar is usually accompanied by a global economic upturn and a higher risk appetite from investors, propelling more foreign portfolio flows to emerging markets (which includes Chinese risk assets). Although foreign inflows account for a small portion of the Chinese A-share market cap, global institutional investors’ sentiment has become more influential and has led fluctuations in Chinese onshore stock prices (Chart 2). Chart 1Closer Correlations Between Chinese Stocks And The Dollar Index Closer Correlations Between Chinese Stocks And The Dollar Index Closer Correlations Between Chinese Stocks And The Dollar Index Chart 2Foreign Investors Matter To Chinese Onshore Stock Prices Foreign Investors Matter To Chinese Onshore Stock Prices Foreign Investors Matter To Chinese Onshore Stock Prices Chart 3Rising Market Expectations For The Fed's Rate Liftoff Rising Market Expectations For The Fed's Rate Liftoff Rising Market Expectations For The Fed's Rate Liftoff The US Federal Reserve delivered a slightly more hawkish surprise at its June FOMC meeting with the message that it will move the projected timing of its first fed fund rate liftoff from 2024 to 2023. Since then, market expectations have shifted from growth and inflation to focusing on the next monetary policy tightening phase, with the short end of the US yield curve rising sharply (Chart 3). Given that currency markets trade off the short end of the yield curve, higher US interest rate expectations will at least temporarily lift the US dollar. The timing and pace of the Fed’s tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the US central bank’s definition of “maximum employment.” BCA’s US Bond Investment strategist anticipates that sizeable and positive non-farm payroll surprises will start in late summer/early fall, which will catalyze a move higher in bond yields. As such, we expect additional upside risks in the dollar index in the coming months, which will discourage foreign investors’ appetite for Chinese equities. Bottom Line: A rebound in the dollar index will be a near-term downside risk to Chinese stocks. Risk Of Higher Chinese Interest Rates Another near-term risk to Chinese stock prices is a tightening in domestic liquidity conditions and a rebound in interest rates, particularly in Q3. Chart 4The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus So far this year the PBoC has kept liquidity conditions accommodative to avoid massive debt defaults, while allowing a faster deceleration in the pace of credit expansion and a sharp contraction in shadow banking (Chart 4). In the coming months, however, the trend may reverse. Even though we do not think China’s current inflation and growth dynamics warrant meaningful and sustainable monetary policy tightening, there is still room for rates to normalize to their pre-pandemic levels in the next few months. Our view is based on the following:  First, there was a major delay in local government bond issuance in the first five months of the year. The supply of government bonds will pick up meaningfully in Q3 to meet the annual quota for 2021. An increase in government bond issuance will remove some liquidity from the banking system because the majority of these local government bonds are purchased by commercial banks. Adding to the liquidity gap is a large number of one-year, medium-term lending facility (MLF) loans that will be due in 2H21. Secondly, the PBoC may shift its policy tightening from reducing the volume of total credit creation (measured by total social financing) to raising the price of money. Credit growth (on year-over-year basis) in the first five months of 2021 dropped by three percentage points from its peak in Q4 last year, much faster than the 13-month peak-to-trough deceleration during the 2017/18 policy tightening cycle. As the rate of credit creation approaches the government’s target for the year, which we expect around 11%, the pressure to further compress credit expansion has eased into 2H21. China’s policy agenda is still focused on de-risking in the financial and real estate sectors, therefore, we expect policymakers to keep overall monetary conditions restrictive by raising the price of money. Furthermore, we do not rule out the possibility of a hike in mortgage rates. Chart 5Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Lastly, as the Fed prepares market expectations for its rate liftoff and China’s domestic economy is still relatively solid, the PBoC may seize the opportunity to guide market-based interest rates towards their pre-pandemic levels. Thus, the market will likely price in tighter liquidity conditions while lowering expectations for the economy and inflation. The short end of the yield curve will rise faster than the longer end, resulting in a flattening of the curve (Chart 5). There is a nontrivial risk that the market will react negatively to tighter liquidity conditions and rising bonds yields, particularly when the economy is slowing. We mentioned in previous reports that rising policy rates and bond yields do not necessarily lead to lower stock prices, if rates are rising while credit keeps expanding and corporate profit growth accelerates. However, currently credit impulse has decelerated sharply, and corporate profit growth has most likely peaked in Q2. Therefore, even a small increase in bond yields or market expectations of higher rates will likely trigger risk asset selloffs. Bottom Line: Bond yields will move higher in Q3, risking market selloffs. Chinese Economy Standing On One Leg China’s economic fundamentals also pose downside risks to Chinese stock prices. Macro indicators on a year-over-year comparison will soften further in 2H21 when low base effects wane, although they will weaken from very high levels. This year’s sharp credit growth deceleration will start to drag down domestic demand, with the risk of corporate profits disappointing the market. A positive tailwind from global trade prevented China's old economy from decelerating more in the first half of the year. It is reflected in the nominal imports and manufacturing orders components in the BCA Activity Index (Chart 6). However, while rising commodity prices boosted the value of Chinese imports, the volume of imports has been moving sideways of late (Chart 7). Chart 6Our BCA Activity Index Is Still Rising... Our BCA Activity Index Is Still Rising... Our BCA Activity Index Is Still Rising... Chart 7...But The Volume Of The Import Component Has Rolled Over ...But The Volume Of The Import Component Has Rolled Over ...But The Volume Of The Import Component Has Rolled Over Chart 8Export Growth Is Moderating From Current Level Export Growth Is Moderating From Current Level Export Growth Is Moderating From Current Level Moreover, China’s export volume is peaking as the reopening in other countries shifts consumer demand from goods to services. Strong export growth would likely decelerate and converge to global industrial production growth in the coming 12 months, even though a regression-based approach suggests that export growth will stay above trend-growth if global economic activity remains robust (Chart 8). All three components of the official Li Keqiang Index, which measures China’s industrial sector activity and incorporates electricity consumption, railway transportation and bank lending, have rolled over (Chart 9). Among the three components in BCA’s Li Keqiang Leading Indicator, only the monetary conditions index improved on the back of lower real rates. Contributions from the money supply and credit expansion components to the overall indicator have been negative (Chart 10). Chart 9The Official Li Keqiang Index Is Weakening... The Official Li Keqiang Index Is Weakening... The Official Li Keqiang Index Is Weakening... Chart 10...So Is Our BCA Li Keqiang Leading Indicator ...So Is Our BCA Li Keqiang Leading Indicator ...So Is Our BCA Li Keqiang Leading Indicator Chart 11Household Consumption Recovery Remains A Laggard Household Consumption Recovery Remains A Laggard Household Consumption Recovery Remains A Laggard The recovery in household consumption remains well behind the industrial sector in the current cycle (Chart 11). We expect consumption and services to continue recovering very gradually. Apart from China’s long-standing structural issues, such as sliding household income growth and a high propensity to save, the cyclical recovery in consumption is dependent on China’s domestic COVID-19 situation. The country is on track to fully vaccinate 40% of its population by the end of June and 80% by year-end (Chart 12). However, hiccups in the service sector recovery are expected through 2H21, given China’s “zero tolerance” policy on confirmed COVID cases, which could trigger sporadic local lockdowns (Chart 13). Chart 12China Is Racing To Reach “Full Inoculation Rate” By Yearend China Outlook: A Mid-Year Recap China Outlook: A Mid-Year Recap Chart 13Expect Some Hiccups In Service Sector Recovery In 2H21 Expect Some Hiccups In Service Sector Recovery In 2H21 Expect Some Hiccups In Service Sector Recovery In 2H21 Bottom Line: Any moderation in exports in the rest of 2021 may add to the slowdown in China’s economic activity. Don’t Count On Fiscal Support Chart 14Fiscal Spending Has Been Disappointing In 1H21 Fiscal Spending Has Been Disappointing In 1H21 Fiscal Spending Has Been Disappointing In 1H21 During the first five months of the year, fiscal spending has downshifted (Chart 14). The amount of local government special-purpose bonds (SPBs) issued was far less than in the same period of the past two years, and below this year’s approved annual quota. Although we expect fiscal support to increase into 2H21, backloading SPBs would qualify, at best, as a remedial measure rather than a meaningful boost to economic activity. The RMB3 trillion SPBs to be issued in 2H21 represent only about 10% of this year’s total credit expansion. To substantially boost credit impulse and economic activity, the pickup in SPB issuance will need to be accompanied by looser monetary policy and an acceleration in bank loans (Chart 15). We do not expect that liquidity conditions will remain as lax as in 1H21. Additionally, given that the central government’s focus is to rein in the leverage of local governments and their affiliated financial vehicles (LGFV), provincial officers have little incentive to take on more bank loans against a restrictive policy backdrop. Historically, a stronger fiscal impulse linked to hefty increases in local government bond issuance has not necessarily led to meaningful improvements in infrastructure investment, which has been on a structural downshift since 2017 (Chart 16). Following a V-shaped recovery in 2H20, the growth in infrastructure investment will likely continue to slide in 2H21 due to sluggish government spending. Chart 15Bank Loans Still Hold The Key To Stimulus Impulse Bank Loans Still Hold The Key To Stimulus Impulse Bank Loans Still Hold The Key To Stimulus Impulse Chart 16Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Bottom Line: There are no signs that the overall policy stance is easing to facilitate a higher fiscal multiplier from an upturn in local government bond issuance. As such, fiscal support for infrastructure spending and economic activity will disappoint in 2H21 despite more SPB issuance. Investment Conclusions Monetary conditions may tighten in Q3 although credit growth will decelerate at a slower pace. Pressures to support domestic demand will be more pronounced next year as tailwinds abate from the global recovery and domestic massive stimulus. Our view is that Chinese authorities will likely ease on the policy tightening brake towards the end of this year and perhaps even signal some reflationary measures in early 2022.  Therefore, while we maintain an underweight stance on Chinese stocks for the time being, investors should remain alert to any improvements in China's policy direction. In particular, any monetary policy easing by end this year/early 2022 may signal a potential catalyst to upgrade Chinese stocks to overweight in absolute terms. Although both Chinese onshore and investable equities are currently traded at a discount relative to global stocks, they are richly valuated compared with their 2017/18 highs (Chart 17). China's economy is slowing and the corporate sector has substantially increased its leverage in the past decade. We believe that the current discount in Chinese equities relative to global stocks is warranted. Chart 18 presents a forecast for A-share earnings growth in US dollars, based on earnings’ relationship with the official Li Keqiang index. The chart shows that while an earnings contraction is not probable, without more stimulus the growth rate may fall sharply in the next 12 months from its current elevated level. This aspect, combined with only a minor valuation discount relative to global stocks, paints an uninspiring outlook for Chinese onshore stocks. Chart 17Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chart 18An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook Our baseline view is that Chinese authorities will be more willing to step up policy supports into 2022. Fiscal impulse will likely turn negative for most major economies next year and global economic recovery will have peaked. In this scenario, both China’s economy and stocks will have the potential to outperform their global peers next year.   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Fed: The Fed’s interest rate projections moved up sharply in June but its verbal forward guidance on interest rates and asset purchases didn’t change in any meaningful way. Investors should ignore the Fed’s dot plot and assess the timing of rate hikes based on when they expect the Fed’s “maximum employment” goal to be met. We expect it will be met in time for Fed liftoff in 2022. Duration: The drop in long-dated yields following last week’s FOMC meeting is overdone. Maintain below-benchmark portfolio duration. TIPS: Long-maturity TIPS breakeven inflation rates have fallen below the Fed’s 2.3% to 2.5% target band. We expect they will quickly move back into that range but doubt they will move above 2.5%. Maintain a neutral allocation to TIPS versus nominal Treasuries. Yield Curve: We are now close enough to Fed liftoff that investors should shift out of curve steepeners and into curve flatteners. Specifically, we recommend shorting the 5-year bullet and buying a duration-matched 2/10 barbell. Feature Chart 1Markets React To The Fed's Hawkish Surprise Markets React To The Fed's Hawkish Surprise Markets React To The Fed's Hawkish Surprise The Fed caused quite a stir in bond markets last week. The 10-year US Treasury yield did a roundtrip from 1.50% before Wednesday’s FOMC meeting up to a peak of 1.58% and then back down to 1.44% by Friday’s close. This, however, wasn’t the most significant bond market move. Shorter-dated Treasury yields increased sharply after the FOMC statement was released and have remained high, resulting in a huge flattening of the curve (Chart 1). Real yields, at both the long and short ends of the curve, also jumped on Wednesday and have not fallen back down. This led to a significant drop in TIPS breakeven inflation rates. In fact, both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are now below the Fed’s 2.3% - 2.5% target range (Chart 1, bottom panel). What’s really interesting is that this massive re-shaping of both the real and nominal yield curves was prompted by an FOMC meeting where the Fed didn’t make any significant policy announcements and, at least from our perspective, didn’t alter its forward guidance on interest rates or asset purchases in any meaningful way. In this report we will try to disentangle the seeming contradiction between the Fed’s actions and the market’s reaction. The first section looks at what the Fed actually announced at last week’s meeting and considers what that means for the future course of monetary policy. The second section looks at the market’s reaction in more detail to see if it presents any investment opportunities. What The Fed Said Considering the sum total of last week’s Fed communications – the FOMC Statement, the Summary of Economic Projections and Jay Powell’s press conference – we arrive at four takeaways: 1. The Dots Moved In The Fed’s interest rate forecasts shifted noticeably higher compared to where they were in March, a change that likely catalyzed the dramatic move in bond markets. Thirteen out of 18 FOMC participants now expect to lift rates before the end of 2023 (Chart 2A). At the March FOMC meeting only seven participants forecasted rate hikes in 2023 (Chart 2B). On top of that, seven FOMC participants now expect to lift rates before the end of 2022, this is up from four in March. Finally, the median participant’s interest rate forecast went from calling for no rate hikes through the end of 2023 to two. Cahrt 2AMarket And Fed Rate Expectations After The June FOMC Meeting Market And Fed Rate Expectations After The June FOMC Meeting Market And Fed Rate Expectations After The June FOMC Meeting Chart 2BMarket And Fed Rate Expectations Before The June FOMC Meeting Market And Fed Rate Expectations Before The June FOMC Meeting Market And Fed Rate Expectations Before The June FOMC Meeting Rate expectations embedded in the overnight index swap (OIS) market also moved up last week. The OIS curve is now priced for Fed liftoff in December 2022 and for a total of 87 bps of rate hikes by the end of 2023 (Chart 2A). Prior to the FOMC meeting, the OIS curve was priced for Fed liftoff in April 2023 and for a total of 78 bps of rate hikes by the end of 2023 (Chart 2B). It’s important to note that this change in the Fed’s interest rate forecasts occurred without the Fed changing its forward guidance about when it will be appropriate to lift rates. The Fed continues to communicate that it has a three-pronged test for liftoff: 12-month PCE inflation must be above 2% The labor market must be at “maximum employment” The committee must expect that inflation will remain above 2% for some time We asserted back in March that investors should focus on this verbal forward guidance from the Fed and not the dot plot, noting that the Fed’s interest rate forecasts were inconsistent with its own verbal forward guidance.1 The reason for the inconsistency is that Fed participants were trying to err on the side of signaling dovishness to the market. In his March press conference Chair Powell said that the Fed wants to see “actual progress” towards its economic objectives not “forecast[ed] progress”. This bias likely led FOMC participants to place their dots too low, ignoring the strong likelihood that the economy would make rapid progress toward its employment and inflation goals in the coming months. After last week, the Fed’s dots are now more consistent with a reasonable timeline for achieving its policy goals, but our advice remains the same. Investors should ignore the dot plot and focus instead on what the Fed is telling us about when it will lift rates. On that note, we have repeatedly made the case that the three items on the Fed’s liftoff checklist will be met in time for rate hikes to begin next year.2 2. Upside Risks To Inflation Chart 3Upside Risks To Inflation Upside Risks To Inflation Upside Risks To Inflation The second change the Fed made last week was in how it characterized the risks surrounding inflation. The official FOMC Statement continues to describe the recent increase in inflation as “transitory”, but the Summary of Economic Projections revealed a huge increase in the number of participants who view the risks surrounding their inflation forecasts as tilted to the upside (Chart 3). This shouldn’t be too surprising. Inflation has been incredibly strong in recent months with 12-month core CPI and 12-month core PCE rising to 3.80% and 3.06%, respectively. Importantly, however, a change in risk assessment doesn’t portend a change in policy. The Fed’s median forecast sees core PCE inflation falling from 3.4% this year to 2.1% in 2022, and we also agree that inflation has peaked.3 That said, it is interesting to consider how the Fed might respond if consumer prices continue to accelerate. On that question, Chair Powell said last week that the Fed would “be prepared to adjust the stance of monetary policy” if it “saw signs that the path of inflation or longer-term inflation expectations were moving materially and persistently beyond levels consistent with [its] goal.” Our sense is that the Fed would be prepared to bring forward the tapering of its asset purchases in response to stronger-than-expected inflation, but it is extremely unlikely that it would lift rates before its three liftoff criteria are met. In fact, given the Phillips Curve lens through which the Fed views inflation, it is much more likely that any increase in inflation that isn’t matched by a tight labor market will continue to be written off as “transitory”. 3. Tapering Discussions Have Begun Third, Jay Powell revealed in his post-meeting press conference that the Fed has begun discussions about when to start tapering its asset purchases. The Fed’s test for when to start tapering is “substantial further progress” toward its policy goals. This test is much vaguer than the criteria for liftoff, and this gives the Fed more flexibility on when it could announce tapering. For what it’s worth, Powell also said that “the standard of ‘substantial further progress’ is still a ways off.” We don’t view this revelation about tapering discussions as that significant for markets. For one thing, there is already a strong consensus among market participants that tapering will begin in Q1 2022 (Tables 1A & 1B). Given that the Fed has promised to “provide advance notice before announcing any decision to make changes to our purchases”, starting discussions this summer seems consistent with market expectations, as well as our own.4 Table 1ASurvey Of Market Participants Expected Fed Timeline How To Re-Shape The Yield Curve Without Really Trying How To Re-Shape The Yield Curve Without Really Trying Table 1BSurvey Of Primary Dealers Expected Fed Timeline How To Re-Shape The Yield Curve Without Really Trying How To Re-Shape The Yield Curve Without Really Trying It’s also important to note that any announcement of asset purchase tapering wouldn’t tell us much about when the Fed’s three liftoff criteria are likely to be met. In other words, a tapering announcement doesn’t tell us anything about when rate hikes are likely to occur. This means that any tapering announcement will have much less of an impact on financial markets than the 2013 taper tantrum, for example. In 2013, markets interpreted the tapering announcement as a signal that rate hikes were coming sooner than expected. The Fed’s explicit interest rate guidance will prevent that outcome this time around. 4. Operational Tweaks Finally, the Fed raised the interest rate it pays on excess reserves (IOER) from 0.10% to 0.15% and the interest rate on its overnight reverse repo facility (ON RRP) from 0% to 0.05% (Chart 4). We discussed the possibility that the Fed might make these changes in last week’s report.5 In recent months, a surplus of cash in overnight markets caused benchmark interest rates to fall toward the lower-end of the Fed’s 0% - 0.25% target range. Critically for the Fed, the ON RRP facility functioned properly as a firm floor on interest rates. It saw its usage surge (Chart 4, bottom panel) but it prevented interest rates from falling below 0%. The IOER and ON RRP rate increases are probably not necessary if the Fed’s goal is to simply keep overnight interest rates within its target band, but the increases will help push rates up toward the middle of the target range. They may also lead to some decline in ON RRP usage, though that has not occurred just yet. In any event, the surplus of cash in money markets that is applying downward pressure to overnight interest rates will evaporate within the next few months. The Treasury Department expects to hit a cash balance of $450 billion by the end of July and, as long as Congress passes legislation to increase the debt limit this summer, the Treasury’s cash balance will probably not get much below $450 billion (Chart 5). A tapering of the Fed’s asset purchases starting late this year or early next year would also remove surplus cash from money markets.     Chart 4IOER And ON RRP Rate Hikes IOER And ON RRP Rate Hikes IOER And ON RRP Rate Hikes Chart 5The Cash Surplus In Money Markets The Cash Surplus In Money Markets The Cash Surplus In Money Markets Bottom Line: The Fed’s interest rate projections moved up sharply in June but its verbal forward guidance on interest rates and asset purchases didn’t change in any meaningful way. Investors should ignore the Fed’s dot plot and assess the timing of rate hikes based on when they expect the Fed’s “maximum employment” goal to be met. We expect it will be met in time for Fed liftoff in 2022. How The Market Reacted As noted at the outset of this report, the bond market didn’t have the same sanguine reaction to the Fed’s communications as we did. It reacted as though the Fed had delivered a massive hawkish surprise. The major bond market moves were as follows: Short-maturity nominal Treasury yields jumped following the FOMC meeting on Wednesday, and those short-dated yields remained at their new higher levels through Thursday and Friday (Table 2A). Table 2AChange In Nominal Yields Following June FOMC Meeting How To Re-Shape The Yield Curve Without Really Trying How To Re-Shape The Yield Curve Without Really Trying Table 2BChange In Real Yields Following June FOMC Meeting How To Re-Shape The Yield Curve Without Really Trying How To Re-Shape The Yield Curve Without Really Trying Table 2CChange In TIPS Breakeven Inflation Rates Following June FOMC Meeting How To Re-Shape The Yield Curve Without Really Trying How To Re-Shape The Yield Curve Without Really Trying The 10-year nominal Treasury yield also increased following the Fed meeting, but then gave back all of that increase and then some on Thursday and Friday (Table 2A). The result is a significant flattening of the nominal Treasury curve, consistent with the market discounting a more hawkish path for monetary policy. Looking at real yields, we see significant increases following Wednesday’s Fed meeting for all maturities (Table 2B). Then, with the exception of the 30-year yield, real yields did not fall back down later in the week. Finally, we see large declines in the cost of inflation compensation at both the short and long ends of the curve (Table 2C). Once again, this is consistent with the market pricing-in a more hawkish Fed that will be less tolerant of an inflation overshoot. In light of these significant yield moves, we consider the investment implications for the level of bond yields, the performance of TIPS versus nominal Treasuries and the slope of the nominal Treasury curve. The Level Of Yields Chart 65y5y Yield Has Upside 5y5y Yield Has Upside 5y5y Yield Has Upside There were two major developments last week that influence our view on the level of Treasury yields. First, the market is now priced for a more reasonable December 2022 liftoff date and 87 bps of rate hikes by the end of 2023. Second, the 5-year/5-year forward Treasury yield fell sharply. It currently sits at 2.06%, just 6 bps above the median estimate of the long-run neutral fed funds rate from the New York Fed’s Survey of Market Participants and 25 bps below the same measure from the Survey of Primary Dealers (Chart 6). On the one hand, the market-implied path for overnight interest rates looks more in line with reality, though we still see scope for it to move higher. On the other hand, the 5-year/5-year forward Treasury yield now looks too low compared to consensus estimates of the long-run neutral interest rate. We are inclined to think that the market-implied path for rates will either stay where it is or move higher and that the drop in the 5-year/5-year forward yield is overdone. We maintain our recommended below-benchmark portfolio duration stance. TIPS Versus Nominal Treasuries As shown in Chart 1, long-maturity TIPS breakeven inflation rates have fallen back to levels below the Fed’s desired target range. We don’t think TIPS breakeven inflation rates will stay below target for long. The principal goal of the Fed’s new Average Inflation Targeting strategy is to ensure that long-term inflation expectations are well-anchored near target levels. Recent market action seems to imply that the Fed will overtighten and miss its inflation objective from below, but that is highly unlikely. We recently downgraded our recommended TIPS allocation from overweight to neutral because breakevens were threatening to break above the top-end of the Fed’s target band.6 We maintain our neutral 6-12 month allocation, but we do see long-maturity TIPS breakevens moving back into the 2.3% to 2.5% target band relatively quickly. Nimble investors may wish to buy TIPS versus nominal Treasuries as a short-term trade. Nominal Treasury Curve Slope Chart 7A Transition To Curve Flattening A Transition To Curve Flattening A Transition To Curve Flattening We see the potential for some of last week’s dramatic curve flattening to reverse in the near-term. It was, after all, a drop in long-maturity TIPS breakeven inflation rates that was responsible for the curve flattening on Thursday and Friday and, as was already discussed, this drop in the cost of inflation compensation will likely prove fleeting. However, if we look out on a longer 6-12 month time horizon, it is much more likely that the curve will continue to flatten rather than steepen. If we assume that the first rate hike occurs in December 2022, it means that we are roughly 18 months away from the start of a rate hike cycle. In past cycles, 18 months prior to liftoff was pretty close to the inflection point between curve steepening and flattening, whether we look at the 2/10, 5/30 or even 2/5 slope (Chart 7). For this reason, we think it makes more sense to enter curve flatteners at this stage of the cycle than steepeners, even though flatteners tend to have negative carry. We therefore exit our prior curve position – long 5-year bullet / short duration-matched 2/30 barbell – a trade that was designed to be a positive carry hedge against our below-benchmark portfolio duration allocation.7 In its place, we recommend that investors enter a 2/10 curve flattener. Specifically, we recommend shorting the 5-year note and going long a duration-matched 2/10 barbell. This trade offers a negative yield pick-up of 16 bps, but the 2/10 barbell does look somewhat cheap relative to the 5-year on our model (Chart 8). Chart 8Buy 2/10 Barbell, Sell 5-Year Bullet Buy 2/10 Barbell, Sell 5-Year Bullet Buy 2/10 Barbell, Sell 5-Year Bullet We expect to hold this trade for some time, profiting from a bear-flattening of the 2/10 yield curve as we move closer and closer to eventual Fed liftoff.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021. 2 Please see US Bond Strategy Weekly Report, “Watch Employment, Not Inflation”, dated June 15, 2021. 3 Please see US Bond Strategy Weekly Report, “Entering A New Yield Curve Regime”, dated May 11, 2021. 4 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021. 5 Please see US Bond Strategy Weekly Report, “Watch Employment, Not Inflation”, dated June 15, 2021. 6 Please see US Bond Strategy Portfolio Allocation Summary, “Fed Won’t Catch Inflation Fever”, dated May 4, 2021. 7 Please see US Bond Strategy Weekly Report, “Entering A New Yield Curve Regime”, dated May 11, 2021. Fixed Income Sector Performance Recommended Portfolio Specification

Feature This week, we present the BCA Central Bank Monitor Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions in developed market countries. The surging Monitors are all sending a similar message: tighter global monetary policy is necessary because of above-trend economic growth, intensifying inflation pressur­­es and booming financial markets (Charts 1A & 1B). Chart 1ATightening Pressures … Tightening Pressures... Tightening Pressures... Chart 1B… Everywhere ...Everywhere ...Everywhere The Monitors are pointing to a continuation of the cyclical rise in global bond yields seen since mid-2020, justifying our recommended below-benchmark stance on overall duration exposure in global bond portfolios. The driver of the next leg upward in yields, however, is shifting from growth and inflation expectations to monetary policy expectations. The Fed is starting to slowly prepare markets for the next US tightening cycle, which is already putting flattening pressure on the US Treasury curve and creating more two-way risk for the US dollar over the next 6-12 months. The timing and pace of rate hikes discounted by markets varies across countries, however, creating interesting opportunities for currency pairs, via changing interest rate differentials, away from the US dollar crosses. An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data which have historically been correlated to changes in monetary policy. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure similar things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors. We have constructed Monitors for ten developed market countries: the US, the euro area, the UK, Japan, Canada, Australia, New Zealand, Sweden, Switzerland and Norway. A rising trend for each Monitor indicates growing pressures for central banks to tighten policy, and vice versa. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators (equity prices, corporate credit spreads, etc). The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates. Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar. We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Chart 2AThe Surging CB Monitors …. The Surging CB Monitors... The Surging CB Monitors... Chart 2B… Suggest More Upside For Bond Yields ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher In each edition of the Central Bank Monitor Chartbook, we include a “non-standard” chart that shows an interesting correlation between the Monitors and a financial market variable. In this latest report, we show how the relationship between the Monitors and our 24-Month Discounters, which measure that amount of rate hikes/cuts discounted in overnight index swap (OIS) forward curves over the next two years. We have also added a new Appendix Table that shows the so-called “liftoff dates” (the date when a first full rate hike is discounted in OIS curves), the cumulative amount of rate hikes expected to the end of 2024, and the valuation of each country’s currency on a purchasing power parity (PPP) basis. We’ve ranked the countries in the table by liftoff dates, thus providing a handy reference to see how markets are judging the order with which central banks will begin the next monetary policy tightening cycle. Fed Monitor: A Clear Signal Our Fed Monitor has been climbing steadily, uninterrupted, for 13 consecutive months, driven by the combination of strong US growth, sharply higher inflation and booming financial markets (Chart 3A). The message from the highly elevated level of the indicator is clear – the Fed should begin the process of unwinding the massive monetary policy accomodation put in place because of the COVID-19 pandemic. At this week’s FOMC meeting, the Fed delivered a mildly hawkish surprise by pulling forward the projected timing of “liftoff” (the first fed funds rate hike) from 2024 to 2023. The timing and pace of future Fed tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the Fed’s definition of “maximum employment”. We see that happening by the end of 2022, which is a bit ahead of the Fed’s own projections for the unemployment rate. The US OIS curve now discounts liftoff near the end of 2022 (see Appendix Table 1), which is now more in line with our own view that the Fed will begin tapering next January and begin rate hikes in December 20221. US economic growth momentum has likely peaked in Q2, but will remain solid in the latter half of 2021. Most of the nation has lifted the remaining pandemic restrictions on activity after a succesful vaccination program, and fiscal policy is still providing a boost to growth. The Fed’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. The Fed’s assumption is trend GDP growth is still only 1.8%, thus the central bank now expects three consecutive years of above-trend growth. Unsurprisingly, the Fed is forecasting headline PCE inflation to stay above the Fed’s 2% target for all three years (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BIs This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? The recovery in the Fed Monitor has been led primarily by the growth component, although the inflation and financial components have also risen significantly (Chart 3C). The Fed Monitor has typically been negatively correlated to the momentum of the US dollar, which has always been more of a counter-cyclical currency that weakens in good economic times. A more hawkish path for US interest rates could eventually give a sustainable lift to the greenback, but for now, the currency will be caught in a tug of war between shifting Fed expectations and robust global growth over the next 6-12 months. Chart 3CBooming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness We continue to recommend an underweight strategic allocation to US Treasuries within global government bond portfolios, with markets still pricing in a pace of Fed tightening that appears too conservative (Chart 3D). Chart 3DNot Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced The Fed’s mildly hawkish surprise this week generated a signficant flattening of the US Treasury curve, with the spread between 5-year and 30-year US yields narrowing by a whopping 20bps. We are closing our two recommeded yield curve trades in the BCA Research Global Fixed Income Strategy tactical trade portfolio, which were positioned more to earn near-term carry in a stable curve environment that has now changed with the Fed injecting volatility back into the bond market. BoE Monitor: More Hawkish Surprises Coming Our Bank of England (BoE) Monitor has spiked higher, fueled by a rapid recovery of UK growth alongside a pickup in inflation pressures (Chart 4A). The BoE has already responded by slowing the pace of its asset purchases in May, and we expect more tapering announcements over the next 6-12 months. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 4B). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUpside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? The recent decision by the UK government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant represents a potential near-term setback to UK growth momentum. The bigger picture, however, still points to an economy benefitting far more from the earlier success of the vaccination program. Consumer confidence remains resilient, while business confidence – and investment intentions – has taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. The backdrop still remains one of above-potential UK growth over the next 12-24 months. Within the BoE Monitor sub-components, the economic and financial elements stand out as having the biggest moves over the past year (Chart 4C). Momentum in the British pound is positively correlated to our BoE Monitor. As the central bank moves incrementally moves towards more tapering and eventual rate hikes, the currency, which remains moderately undervalued on a PPP basis (see Appendix Table 1), should be well supported. Chart 4CAll BoE Monitor Components Are Rising All BoE Monitor Components Are Rising All BoE Monitor Components Are Rising The UK OIS curve currently discounts BoE liftoff in May 2023, with 57bps of cumulative rate hikes expected by the end of 2024. We see risks of the central bank moving sooner than the market on liftoff, with a rate hike in the 3rd or 4th quarter of 2022 more likely. The Gilt market is vulnerable to any hawkish shift by the BoE with so few rate hikes discounted (Chart 4D). For now, we are maintaining a neutral stance on UK Gilts, given the BoE’s history of talking hawkishly but failing to deliver, but we do have them on “downgrade watch.” Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Growth? Yes. Inflation? No. Our European Central Bank (ECB) Monitor has moved sharply higher as more of the euro area has emerged from pandemic restrictions (Chart 5A). Yet the central bank is not sending any of the kinds of moderately hawkish signals coming from the Fed and other central banks. The ECB is still a long way from such a move. While growth has clearly recovered strongly, the overall euro area unemployment rate remains high at 8% and wage growth remains anemic in most countries. There is the potential for upside growth surprises coming from fiscal policy, with the Next Generation EU (NGEU) funds set to be disributed by the EU later this year. Yet even with this fiscal boost, most of the euro area is likely to remain far enough away from full employment allowing the ECB to stay dovish for longer. While headine euro area inflation reached the ECB’s 2% target in May, core inflaton remained subdued at a mere 0.9% (Chart 5B). Market based measures of inflation expectations are also well below the ECB target, with the 5-year/5-year forward CPI swap rate only at 1.6%. Such “boring” inflation readings – even after a surge in commodity price fueled inflation in many other countries – proves that there remains ample spare capacity in the euro area economy and labor markets. The ECB is under no pressure to turn less dovish anytime soon. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BStill Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe The lack of an immediate inflation threat can also be seen in the sub-components of our ECB Monitor, where the inflation elements have clearly lagged the growth upturn (Chart 5C). From a currency perspective, a growth fueled surge in the ECB Monitor is usually enough to provide a boost to the euro. Yet, without an inflation trigger, the likelihood of the ECB dialing back bond purchases, let alone raising interest rates, is low. This suggests any rally in the euro from current levels will be a slow adjustment towards fair value. Chart 5CInflation Components Lagging Inflation Components Lagging Inflation Components Lagging Currently, the European OIS curve is discounting an initial ECB rate hike in October 2023, with only 27bps of rate hikes expected by the end of 2024 - one of the most dovish pricings in the G10 (see Appendix Table 1). Even though our ECB Monitor suggests that European bond markets should be pricing in more rate hikes (Chart 5D), that is unlikely to happen with the ECB messaging a dovish stance and with the central bank set to release a review of its inflation strategy later this year. We continue to recommend an overweight stance on European government bonds within global fixed income portfolios. Chart 5DMarkets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message BoJ Monitor: Deflation Is Still A Threat Our Bank of Japan (BoJ) Monitor has recovered from deeply depressed pandemic lows to just above the zero line (Chart 6A). This is welcome news for the BoJ, that kept interest rates and asset purchases unchanged at yesterday's meeting, but recognized the need for additional stimulus via "green" loans.The reading from the central bank monitor is also consistent with a Japanese economy that requires more accommodative monetary policy vis-à-vis the rest of the G10. The Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases remains at the highest level per capita in developed Asia. Meanwhile, the manufacturing PMI is the lowest in the developed world and a third wave of infections has also crippled the services sector. This pins the Japanese recovery well behind that of other G10 countries. The IMF expects the output gap in Japan to close sometime in 2023, but it is worth noting that there are few signs of inflationary pressures that would signal such an outcome. Both core and headline Japanese prices are deflating in a world where the risks are tilted towards an inflation overshoot (Chart 6B). The unemployment rate has rolled over, but still remains a ways from pre-pandemic lows. Savings in Japan are also surging, short-circuiting the sort of positive feedback loop that will generate genuine inflation. Chart 6AThe BoJ Monitor The BoJ Monitor The BoJ Monitor Chart 6BDeflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan The individual elements of the BoJ Monitor suggest that the growth component has seen steady improvement over the last few months, while the financial component has rolled over (Chart 6C). The latter reflects the underperformance of Japanese equities in recent months, after a spectacular rally late last year. However, weakness in the yen has also allowed financial conditions to remain relatively easy. The yen is a safe-haven currency, making the relationship with the central bank monitor less intuitive. When the central bank monitor is improving (both in Japan and globally), traders tend to use the yen to fund carry trades elsewhere, which weakens the currency. When risk aversion sets in, these trades are unwound, and the yen rallies. This year, the yen has weakened in sympathy with improving global growth, suggesting this playbook remains very much relevant. Chart 6CModest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components The strength of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should rise towards the upper bound of the -25bps to +25bps band. However, the BoJ will stand firm in maintaining easy monetary policy, as expected by market participants (Chart 6D). This policy-induced stability makes JGBs a defensive bond market when US Treasury yields are rising, a key reason for our overweight stance on JGBs. Chart 6DNo Change In Policy Expected No Change In Policy Expected No Change In Policy Expected BoC Monitor: Strong Growth = Early Tightening Our Bank of Canada (BoC) Monitor has shown an impressive rebound and currently displays the highest figure among our Central Bank Monitors (Chart 7A). With a growing number of central banks contemplating a less dovish turn, Canada will be in the group of developed countries that hikes policy rates first. The Canadian economy started the year gaining significant positive momentum, with Q1 GDP growing by +5.6% (annualized quarter-on-quarter rate of change). The Q2 picture is a bit more mixed because of another wave of COVID-19 lockdowns. However, thanks to the rapid improvement in the pace of vaccinations after a botched initial rollout, Canadian household consumption and confidence have notably accelerated. Business confidence and investment intentions have also picked up solidly according the BoC’s most recent Business Outlook Survey. The job market also gained significant momentum, and as the lockdown measures gradually ease, workers who have been laid off during the pandemic will return to work. Therefore, the improvement in labor market will continue. A rapidly closing output gap means that the current surge in inflation may endure after the base effect comparisons to 2020 fade (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Looking at the components of our BoC Monitor, all three factors have clearly rebounded but the growth factor has shown the most impressive move (Chart 7C). Amid the broad economic factors that have improved, booming house prices – a primary cause for the BoC’s decision to taper its asset purchases back in April - have caused the growth factor to rebound quickly. Chart 7CA Positive Story For The CAD A Positive Story For The CAD A Positive Story For The CAD The Canadian OIS curve is pricing in BoC liftoff in August 2022 (Appendix Table 1), with a sooner liftoff only expected in Norway and New Zealand. We see risks that the BoC moves much sooner than that next year. A quicker liftoff which will put additional upward pressure on the Canadian dollar, both against the US dollar and on a trade-weighted basis, particularly if Canadian export demand remains solid and oil prices continue to climb, as our commodity strategists expect. Our PPP model suggests that the Loonie is close to fair value, so valuation is not yet an impediment to additional strength in the Canadian dollar. Looking at the longer-term horizon, the OIS curve is discounting four BoC rate hikes within the next 24 months, and it is not clear that will be enough to cool off the red-hot Canadian housing market – currently the biggest threat to inflation stability in Canada (Chart 7D). Given that relatively hawkish view, the more optimistic growth outlook, and the high-beta status of Canadian government bonds, we continue to recommend an underweight position on Canadian government bonds within a global fixed income portfolio. Chart 7DCanadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced RBA Monitor: Waiting For Inflation Our Reserve Bank of Australia (RBA) Monitor has continued its strong rebound since the trough in 2020 and is now at all-time highs, suggesting heightened pressure on the RBA to tighten policy (Chart 8A). This rebound comes amid dovish messaging from an RBA that is waiting on signs of an inflation turnaround. The RBA’s patience makes sense when you consider measures of slack in the economy, such as output and unemployment gaps (Chart 8B). While the IMF does expect the output gap to tighten up significantly in 2021, it does not expect it to be closed even by 2022. Looking to capacity in the labor market, the unemployment rate has just returned to pre-COVID levels. However, the labor market will need to run “hot” for a sustained period of time to push up wage inflation, which remains deep in the doldrums according to the RBA’s wage price index. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BMuted Inflationary Pressures Down Under BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight A look at the components of our RBA Monitor explains the RBA’s dovishness in the face of the tightening pressure indicated by the “headline” figure (Chart 8C). The rebound in the Monitor can be attributed almost entirely to the growth and financial components, which are driven in turn by improving confidence and an expanding RBA balance sheet. However, the inflation component, which has barely budged off its 2020 low, best captures the metrics that the RBA is watching. Importantly, the RBA will need to see sustainable domestically-generated inflation before it can begin to tolerate a stronger AUD which would otherwise imperil tradable goods inflation. With the AUD only slightly expensive on our PPP models, the RBA does not have much of a “valuation cushion” to play with in terms of delivering a hawkish surprise (Appendix Table 1). ​​​​​​ Chart 8CGrowth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Chart 8D shows that market pricing for hikes over the next two years has remained mostly flat in 2021 in the face of persistently dovish messaging from the RBA. Our view, as expressed in a recent update of our “RBA checklist”2, is that fundamental factors will force the RBA to remain dovish, making Australian government debt an attractive overweight within global government bond portfolios. Chart 8DMarkets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia RBNZ Monitor: Heating Up Our Reserve Bank of New Zealand (RBNZ) Monitor has rebounded to levels last seen in 2017, largely on the back of improving growth (Chart 9A). Success at containing the virus has allowed the New Zealand economy to beat growth expectations for Q1/2021, effectively pulling forward future policy tightening. Measures of capacity utilization in New Zealand will likely respond accordingly to improved growth prospects, with the output gap likely to close even faster than projected by the IMF (Chart 9B). Measures of core and headline inflation remain within the RBNZ’s 1-3% target range, with the Bank expecting headline inflation to shoot up to 2.6% in Q2/2021 before settling around the midpoint of the range. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BThe New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack Looking at the individual components of our RBNZ Monitor, the rebound in the overall indicator is clearly a growth story (Chart 9C). This component of our Monitor also captures the effect of accelerating house prices, which have become a direct concern for RBNZ policy. According to the bank’s own projections, house prices will post a whopping 29% growth rate in the second quarter. With issues of housing affordability at the forefront, and political pressure mounting, the RBNZ will likely be forced to turn less dovish soon, even if it comes with unwanted strength in the NZD. However, the currency is among the most expensive on our PPP models (Appendix Table 1), which means that a reversion to fair value could counteract upward pressure from a hawkish RBNZ. Chart 9CThe RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices Historically, our RBNZ Monitor has correlated well with market pricing embedded in the OIS curve (Chart 9D). In 2021, however, market expectations have far outstripped the signal from our central bank monitor, meaning that markets believe the RBNZ is more focused on growth factors rather than the overall picture, a view that we largely agree with. Chart 9DMarkets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Even after the Fed’s hawkish surprise at this week’s meeting, we still believe that the RBNZ will be among the first to taper its balance sheet and move towards normalizing policy. Stay underweight New Zealand sovereign debt. Riksbank Monitor: Watch For An Upside Surprise Our Riksbank Monitor has posted a strong rebound, reaching all-time highs (Chart 10A). This rebound has come on the back of a robust economic recovery. Meanwhile, monetary policy has been accommodative with the Riksbank holding the repo rate at 0% while expanding the size of its balance sheet. Capacity utilization, which in Sweden did not fall nearly as much as in other developed economies, is looking set to recover in the coming years (Chart 10B). Although headline CPI shot past the 2% target, driven by fuel and food prices, underlying core inflation remains stable. The Riksbank expects inflation to fall due to less favorable year-over-year base effects, and only sustainably climb to the 2% level by mid-2024. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BThe Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... Breaking down the rise in the Riksbank Monitor, we can see that it is driven overwhelmingly by the growth component (Chart 10C). This, in turn, has been driven by surging PMIs and soaring business and consumer confidence. Our colleagues at BCA Research European Investment Strategy have pointed out that the small export-sensitive economy will be poised to benefit from an upturn in the global industrial cycle3. While Sweden did arguably botch its COVID-19 response last year, it is catching up, with 42% of Swedes having already received their first dose of the vaccine. The case for the SEK is strong, given that the currency is a high-beta play on global growth and is also quite undervalued according to our PPP models (Appendix Table 1). Market expectations are that the Riksbank will lag others in normalizing policy, putting off a hike until September 2023. The Riksbank baseline is a flat repo rate out to Q2/2024 but an earlier rate hike is well within the “uncertainty bands” of the Riksbank’s forecast. Such a scenario may manifest if growth and inflation surprise to the upside. Chart 10C...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth Given the positive economic backdrop and the financial stability risks posed by rising house prices and household indebtedness, we believe market pricing is too dovish relative to the actual pressure on the Riksbank to tighten policy (Chart 10D). This makes Swedish sovereign debt an attractive underweight candidate in global government bond portfolios. Chart 10DThe OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank Norges Bank Monitor: The First To Hike Our Norges Bank Monitor has risen sharply from the pandemic lows and now signals that emergency monetary settings are no longer appropriate for the Norwegian economy (Chart 11A). Consistent with this message, Norges Bank governor, Øystein Olsen, suggested this week that a rate hike will occur in September, with possibly another hike by December of this year. Norway has handled the pandemic successfully. Since the onset of the COVID-19 crisis, it has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was also prompt and finely tailored to the sectors most in need of emergency funds. Moreover, monetary policy was highly accommodative, with the Norges Bank cutting interest rates to zero for the first time since its founding in 1816. Fiscal stimulus will remain relatively accommodative, as Norway will register one of the smallest fiscal drags in the G10 for the remainder of 2021 and 2022. Rapid improvement in the labor market also continues. After peaking at 9.5% in March 2020, the headline unemployment rate has fallen to 3.3%. On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024. These developments have set the Norwegian economy on a sustainable recovery path. This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3% (Chart 11B). Meanwhile, while core inflation at 2% is decelerating, the slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mindset has not taken root in Norway. Chart 11AThe Norges Bank Monitor The Norges Bank Monitor The Norges Bank Monitor Chart 11BInflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway The biggest improvement in our Norges Bank Monitor comes from its growth and inflation components, the former surging to its highest level in two decades. This improvement surpasses those that followed the global financial crisis and the bursting of the dot-com bubble (Chart 11C). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. The Monitor shows a very tight correlation with the trade-weighted currency, suggesting the exchange rate is an important valve for adjusting financial conditions. As an oil-producing economy, the drop in the NOK cushioned the crash in oil prices last year. This year, a recovery has benefitted the krone. The Norwegian krone also remains undervalued according to our PPP models. Chart 11CThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates A positive correlation also exists between the Monitor and expected rate hikes by the Norges bank (Chart 11D). This suggest yields in Norway should either coincide or lead the improvement in global bond yields. From a portfolio perspective, our default stance is neutral, as the market is thinly traded. Chart 11DThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates SNB Monitor: Green Shoots Our Swiss National Bank (SNB) Monitor has recovered smartly, and is at the highest level in over a decade (Chart 12A). This is a marked turnaround for a country that has had negative interest rates since 2015. It also raises the prospect that Switzerland may be finally able to escape its liquidity trap, allowing the SNB to modestly adjust monetary policy upward. The Swiss economy has recovered swiftly. As of May, the manufacturing PMI was at 69.9, the highest reading since the start of the series. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades. This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. Inflation dynamics in Switzerland will be particularly beholden to improvements in private sector demand. The unemployment rate in Switzerland has rolled over, which should begin to provide an anchor to wage growth. Both core and headline inflation are also recovering, albeit at a slow pace (Chart 12B). Import prices in Switzerland will also rise, driven by the relative weakness of the currency. This is important because for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Chart 12AThe SNB Monitor The SNB Monitor The SNB Monitor Chart 12BSwiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Looking at the components of our SNB Monitor, the growth component has been in the driver’s seat (Chart 12C). But encouragingly, both the inflation and financial component have also been grinding higher. This improvement suggests that the weakness in the franc, especially amidst global dollar weakness, has been a welcome jolt to the economy. Like the yen, the CHF is a safe-haven currency, making the relationship with the central bank monitor less intuitive. Most of the time, the relationship with the monitor is inverse, corresponding to investors using the Swiss franc for carry trades when global conditions improve. Similar to the yen this year, the CHF has also weakened in sympathy with improving global growth. Should global growth see a setback in the near term, the franc will benefit. Chart 12CGrowth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland The SNB Monitor is more accurate at capturing expected policy changes by the SNB. This means that yields in Switzerland could see more meaningful upside (Chart 12D). That said, our default stance on Swiss bonds is neutral in a global portfolio, given low liquidity. Chart 12DCould The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Appendix Table 1 Table 1Appendix Table 1 BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight Footnotes 1 See BCA Research US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021, available at gfis.bcaresearch.com 2 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research European Investment Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Feature This week, we present the BCA Central Bank Monitor Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions in developed market countries. The surging Monitors are all sending a similar message: tighter global monetary policy is necessary because of above-trend economic growth, intensifying inflation pressur­­es and booming financial markets (Charts 1A & 1B). Chart 1ATightening Pressures … Tightening Pressures... Tightening Pressures... Chart 1B… Everywhere ...Everywhere ...Everywhere The Monitors are pointing to a continuation of the cyclical rise in global bond yields seen since mid-2020, justifying our recommended below-benchmark stance on overall duration exposure in global bond portfolios. The driver of the next leg upward in yields, however, is shifting from growth and inflation expectations to monetary policy expectations. The Fed is starting to slowly prepare markets for the next US tightening cycle, which is already putting flattening pressure on the US Treasury curve and creating more two-way risk for the US dollar over the next 6-12 months. The timing and pace of rate hikes discounted by markets varies across countries, however, creating interesting opportunities for currency pairs, via changing interest rate differentials, away from the US dollar crosses. An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data which have historically been correlated to changes in monetary policy. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure similar things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors. We have constructed Monitors for ten developed market countries: the US, the euro area, the UK, Japan, Canada, Australia, New Zealand, Sweden, Switzerland and Norway. A rising trend for each Monitor indicates growing pressures for central banks to tighten policy, and vice versa. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators (equity prices, corporate credit spreads, etc). The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates. Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar. We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Chart 2AThe Surging CB Monitors …. The Surging CB Monitors... The Surging CB Monitors... Chart 2B… Suggest More Upside For Bond Yields ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher In each edition of the Central Bank Monitor Chartbook, we include a “non-standard” chart that shows an interesting correlation between the Monitors and a financial market variable. In this latest report, we show how the relationship between the Monitors and our 24-Month Discounters, which measure that amount of rate hikes/cuts discounted in overnight index swap (OIS) forward curves over the next two years. We have also added a new Appendix Table that shows the so-called “liftoff dates” (the date when a first full rate hike is discounted in OIS curves), the cumulative amount of rate hikes expected to the end of 2024, and the valuation of each country’s currency on a purchasing power parity (PPP) basis. We’ve ranked the countries in the table by liftoff dates, thus providing a handy reference to see how markets are judging the order with which central banks will begin the next monetary policy tightening cycle. Fed Monitor: A Clear Signal Our Fed Monitor has been climbing steadily, uninterrupted, for 13 consecutive months, driven by the combination of strong US growth, sharply higher inflation and booming financial markets (Chart 3A). The message from the highly elevated level of the indicator is clear – the Fed should begin the process of unwinding the massive monetary policy accomodation put in place because of the COVID-19 pandemic. At this week’s FOMC meeting, the Fed delivered a mildly hawkish surprise by pulling forward the projected timing of “liftoff” (the first fed funds rate hike) from 2024 to 2023. The timing and pace of future Fed tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the Fed’s definition of “maximum employment”. We see that happening by the end of 2022, which is a bit ahead of the Fed’s own projections for the unemployment rate. The US OIS curve now discounts liftoff near the end of 2022 (see Appendix Table 1), which is now more in line with our own view that the Fed will begin tapering next January and begin rate hikes in December 20221. US economic growth momentum has likely peaked in Q2, but will remain solid in the latter half of 2021. Most of the nation has lifted the remaining pandemic restrictions on activity after a succesful vaccination program, and fiscal policy is still providing a boost to growth. The Fed’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. The Fed’s assumption is trend GDP growth is still only 1.8%, thus the central bank now expects three consecutive years of above-trend growth. Unsurprisingly, the Fed is forecasting headline PCE inflation to stay above the Fed’s 2% target for all three years (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BIs This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? The recovery in the Fed Monitor has been led primarily by the growth component, although the inflation and financial components have also risen significantly (Chart 3C). The Fed Monitor has typically been negatively correlated to the momentum of the US dollar, which has always been more of a counter-cyclical currency that weakens in good economic times. A more hawkish path for US interest rates could eventually give a sustainable lift to the greenback, but for now, the currency will be caught in a tug of war between shifting Fed expectations and robust global growth over the next 6-12 months. Chart 3CBooming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness We continue to recommend an underweight strategic allocation to US Treasuries within global government bond portfolios, with markets still pricing in a pace of Fed tightening that appears too conservative (Chart 3D). Chart 3DNot Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced The Fed’s mildly hawkish surprise this week generated a signficant flattening of the US Treasury curve, with the spread between 5-year and 30-year US yields narrowing by a whopping 20bps. We are closing our two recommeded yield curve trades in the BCA Research Global Fixed Income Strategy tactical trade portfolio, which were positioned more to earn near-term carry in a stable curve environment that has now changed with the Fed injecting volatility back into the bond market. BoE Monitor: More Hawkish Surprises Coming Our Bank of England (BoE) Monitor has spiked higher, fueled by a rapid recovery of UK growth alongside a pickup in inflation pressures (Chart 4A). The BoE has already responded by slowing the pace of its asset purchases in May, and we expect more tapering announcements over the next 6-12 months. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 4B). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUpside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? The recent decision by the UK government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant represents a potential near-term setback to UK growth momentum. The bigger picture, however, still points to an economy benefitting far more from the earlier success of the vaccination program. Consumer confidence remains resilient, while business confidence – and investment intentions – has taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. The backdrop still remains one of above-potential UK growth over the next 12-24 months. Within the BoE Monitor sub-components, the economic and financial elements stand out as having the biggest moves over the past year (Chart 4C). Momentum in the British pound is positively correlated to our BoE Monitor. As the central bank moves incrementally moves towards more tapering and eventual rate hikes, the currency, which remains moderately undervalued on a PPP basis (see Appendix Table 1), should be well supported. Chart 4CAll BoE Monitor Components Are Rising All BoE Monitor Components Are Rising All BoE Monitor Components Are Rising The UK OIS curve currently discounts BoE liftoff in May 2023, with 57bps of cumulative rate hikes expected by the end of 2024. We see risks of the central bank moving sooner than the market on liftoff, with a rate hike in the 3rd or 4th quarter of 2022 more likely. The Gilt market is vulnerable to any hawkish shift by the BoE with so few rate hikes discounted (Chart 4D). For now, we are maintaining a neutral stance on UK Gilts, given the BoE’s history of talking hawkishly but failing to deliver, but we do have them on “downgrade watch.” Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Growth? Yes. Inflation? No. Our European Central Bank (ECB) Monitor has moved sharply higher as more of the euro area has emerged from pandemic restrictions (Chart 5A). Yet the central bank is not sending any of the kinds of moderately hawkish signals coming from the Fed and other central banks. The ECB is still a long way from such a move. While growth has clearly recovered strongly, the overall euro area unemployment rate remains high at 8% and wage growth remains anemic in most countries. There is the potential for upside growth surprises coming from fiscal policy, with the Next Generation EU (NGEU) funds set to be disributed by the EU later this year. Yet even with this fiscal boost, most of the euro area is likely to remain far enough away from full employment allowing the ECB to stay dovish for longer. While headine euro area inflation reached the ECB’s 2% target in May, core inflaton remained subdued at a mere 0.9% (Chart 5B). Market based measures of inflation expectations are also well below the ECB target, with the 5-year/5-year forward CPI swap rate only at 1.6%. Such “boring” inflation readings – even after a surge in commodity price fueled inflation in many other countries – proves that there remains ample spare capacity in the euro area economy and labor markets. The ECB is under no pressure to turn less dovish anytime soon. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BStill Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe The lack of an immediate inflation threat can also be seen in the sub-components of our ECB Monitor, where the inflation elements have clearly lagged the growth upturn (Chart 5C). From a currency perspective, a growth fueled surge in the ECB Monitor is usually enough to provide a boost to the euro. Yet, without an inflation trigger, the likelihood of the ECB dialing back bond purchases, let alone raising interest rates, is low. This suggests any rally in the euro from current levels will be a slow adjustment towards fair value. Chart 5CInflation Components Lagging Inflation Components Lagging Inflation Components Lagging Currently, the European OIS curve is discounting an initial ECB rate hike in October 2023, with only 27bps of rate hikes expected by the end of 2024 - one of the most dovish pricings in the G10 (see Appendix Table 1). Even though our ECB Monitor suggests that European bond markets should be pricing in more rate hikes (Chart 5D), that is unlikely to happen with the ECB messaging a dovish stance and with the central bank set to release a review of its inflation strategy later this year. We continue to recommend an overweight stance on European government bonds within global fixed income portfolios. Chart 5DMarkets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message   BoJ Monitor: Deflation Is Still A Threat Our Bank of Japan (BoJ) Monitor has recovered from deeply depressed pandemic lows to just above the zero line (Chart 6A). This is welcome news for the BoJ, that kept interest rates and asset purchases unchanged at yesterday's meeting, but recognized the need for additional stimulus via "green" loans.The reading from the central bank monitor is also consistent with a Japanese economy that requires more accommodative monetary policy vis-à-vis the rest of the G10. The Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases remains at the highest level per capita in developed Asia. Meanwhile, the manufacturing PMI is the lowest in the developed world and a third wave of infections has also crippled the services sector. This pins the Japanese recovery well behind that of other G10 countries. The IMF expects the output gap in Japan to close sometime in 2023, but it is worth noting that there are few signs of inflationary pressures that would signal such an outcome. Both core and headline Japanese prices are deflating in a world where the risks are tilted towards an inflation overshoot (Chart 6B). The unemployment rate has rolled over, but still remains a ways from pre-pandemic lows. Savings in Japan are also surging, short-circuiting the sort of positive feedback loop that will generate genuine inflation. Chart 6AThe BoJ Monitor The BoJ Monitor The BoJ Monitor Chart 6BDeflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan The individual elements of the BoJ Monitor suggest that the growth component has seen steady improvement over the last few months, while the financial component has rolled over (Chart 6C). The latter reflects the underperformance of Japanese equities in recent months, after a spectacular rally late last year. However, weakness in the yen has also allowed financial conditions to remain relatively easy. The yen is a safe-haven currency, making the relationship with the central bank monitor less intuitive. When the central bank monitor is improving (both in Japan and globally), traders tend to use the yen to fund carry trades elsewhere, which weakens the currency. When risk aversion sets in, these trades are unwound, and the yen rallies. This year, the yen has weakened in sympathy with improving global growth, suggesting this playbook remains very much relevant. Chart 6CModest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components The strength of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should rise towards the upper bound of the -25bps to +25bps band. However, the BoJ will stand firm in maintaining easy monetary policy, as expected by market participants (Chart 6D). This policy-induced stability makes JGBs a defensive bond market when US Treasury yields are rising, a key reason for our overweight stance on JGBs. Chart 6DNo Change In Policy Expected No Change In Policy Expected No Change In Policy Expected BoC Monitor: Strong Growth = Early Tightening Our Bank of Canada (BoC) Monitor has shown an impressive rebound and currently displays the highest figure among our Central Bank Monitors (Chart 7A). With a growing number of central banks contemplating a less dovish turn, Canada will be in the group of developed countries that hikes policy rates first. The Canadian economy started the year gaining significant positive momentum, with Q1 GDP growing by +5.6% (annualized quarter-on-quarter rate of change). The Q2 picture is a bit more mixed because of another wave of COVID-19 lockdowns. However, thanks to the rapid improvement in the pace of vaccinations after a botched initial rollout, Canadian household consumption and confidence have notably accelerated. Business confidence and investment intentions have also picked up solidly according the BoC’s most recent Business Outlook Survey. The job market also gained significant momentum, and as the lockdown measures gradually ease, workers who have been laid off during the pandemic will return to work. Therefore, the improvement in labor market will continue. A rapidly closing output gap means that the current surge in inflation may endure after the base effect comparisons to 2020 fade (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Looking at the components of our BoC Monitor, all three factors have clearly rebounded but the growth factor has shown the most impressive move (Chart 7C). Amid the broad economic factors that have improved, booming house prices – a primary cause for the BoC’s decision to taper its asset purchases back in April - have caused the growth factor to rebound quickly. Chart 7CA Positive Story For The CAD A Positive Story For The CAD A Positive Story For The CAD The Canadian OIS curve is pricing in BoC liftoff in August 2022 (Appendix Table 1), with a sooner liftoff only expected in Norway and New Zealand. We see risks that the BoC moves much sooner than that next year. A quicker liftoff which will put additional upward pressure on the Canadian dollar, both against the US dollar and on a trade-weighted basis, particularly if Canadian export demand remains solid and oil prices continue to climb, as our commodity strategists expect. Our PPP model suggests that the Loonie is close to fair value, so valuation is not yet an impediment to additional strength in the Canadian dollar. Looking at the longer-term horizon, the OIS curve is discounting four BoC rate hikes within the next 24 months, and it is not clear that will be enough to cool off the red-hot Canadian housing market – currently the biggest threat to inflation stability in Canada (Chart 7D). Given that relatively hawkish view, the more optimistic growth outlook, and the high-beta status of Canadian government bonds, we continue to recommend an underweight position on Canadian government bonds within a global fixed income portfolio. Chart 7DCanadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced RBA Monitor: Waiting For Inflation Our Reserve Bank of Australia (RBA) Monitor has continued its strong rebound since the trough in 2020 and is now at all-time highs, suggesting heightened pressure on the RBA to tighten policy (Chart 8A). This rebound comes amid dovish messaging from an RBA that is waiting on signs of an inflation turnaround. The RBA’s patience makes sense when you consider measures of slack in the economy, such as output and unemployment gaps (Chart 8B). While the IMF does expect the output gap to tighten up significantly in 2021, it does not expect it to be closed even by 2022. Looking to capacity in the labor market, the unemployment rate has just returned to pre-COVID levels. However, the labor market will need to run “hot” for a sustained period of time to push up wage inflation, which remains deep in the doldrums according to the RBA’s wage price index. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BMuted Inflationary Pressures Down Under BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight A look at the components of our RBA Monitor explains the RBA’s dovishness in the face of the tightening pressure indicated by the “headline” figure (Chart 8C). The rebound in the Monitor can be attributed almost entirely to the growth and financial components, which are driven in turn by improving confidence and an expanding RBA balance sheet. However, the inflation component, which has barely budged off its 2020 low, best captures the metrics that the RBA is watching. Importantly, the RBA will need to see sustainable domestically-generated inflation before it can begin to tolerate a stronger AUD which would otherwise imperil tradable goods inflation. With the AUD only slightly expensive on our PPP models, the RBA does not have much of a “valuation cushion” to play with in terms of delivering a hawkish surprise (Appendix Table 1). ​​​​​​ Chart 8CGrowth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Chart 8D shows that market pricing for hikes over the next two years has remained mostly flat in 2021 in the face of persistently dovish messaging from the RBA. Our view, as expressed in a recent update of our “RBA checklist”2, is that fundamental factors will force the RBA to remain dovish, making Australian government debt an attractive overweight within global government bond portfolios. Chart 8DMarkets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia RBNZ Monitor: Heating Up Our Reserve Bank of New Zealand (RBNZ) Monitor has rebounded to levels last seen in 2017, largely on the back of improving growth (Chart 9A). Success at containing the virus has allowed the New Zealand economy to beat growth expectations for Q1/2021, effectively pulling forward future policy tightening. Measures of capacity utilization in New Zealand will likely respond accordingly to improved growth prospects, with the output gap likely to close even faster than projected by the IMF (Chart 9B). Measures of core and headline inflation remain within the RBNZ’s 1-3% target range, with the Bank expecting headline inflation to shoot up to 2.6% in Q2/2021 before settling around the midpoint of the range. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BThe New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack Looking at the individual components of our RBNZ Monitor, the rebound in the overall indicator is clearly a growth story (Chart 9C). This component of our Monitor also captures the effect of accelerating house prices, which have become a direct concern for RBNZ policy. According to the bank’s own projections, house prices will post a whopping 29% growth rate in the second quarter. With issues of housing affordability at the forefront, and political pressure mounting, the RBNZ will likely be forced to turn less dovish soon, even if it comes with unwanted strength in the NZD. However, the currency is among the most expensive on our PPP models (Appendix Table 1), which means that a reversion to fair value could counteract upward pressure from a hawkish RBNZ. Chart 9CThe RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices Historically, our RBNZ Monitor has correlated well with market pricing embedded in the OIS curve (Chart 9D). In 2021, however, market expectations have far outstripped the signal from our central bank monitor, meaning that markets believe the RBNZ is more focused on growth factors rather than the overall picture, a view that we largely agree with. Chart 9DMarkets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Even after the Fed’s hawkish surprise at this week’s meeting, we still believe that the RBNZ will be among the first to taper its balance sheet and move towards normalizing policy. Stay underweight New Zealand sovereign debt. Riksbank Monitor: Watch For An Upside Surprise Our Riksbank Monitor has posted a strong rebound, reaching all-time highs (Chart 10A). This rebound has come on the back of a robust economic recovery. Meanwhile, monetary policy has been accommodative with the Riksbank holding the repo rate at 0% while expanding the size of its balance sheet. Capacity utilization, which in Sweden did not fall nearly as much as in other developed economies, is looking set to recover in the coming years (Chart 10B). Although headline CPI shot past the 2% target, driven by fuel and food prices, underlying core inflation remains stable. The Riksbank expects inflation to fall due to less favorable year-over-year base effects, and only sustainably climb to the 2% level by mid-2024. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BThe Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... Breaking down the rise in the Riksbank Monitor, we can see that it is driven overwhelmingly by the growth component (Chart 10C). This, in turn, has been driven by surging PMIs and soaring business and consumer confidence. Our colleagues at BCA Research European Investment Strategy have pointed out that the small export-sensitive economy will be poised to benefit from an upturn in the global industrial cycle3. While Sweden did arguably botch its COVID-19 response last year, it is catching up, with 42% of Swedes having already received their first dose of the vaccine. The case for the SEK is strong, given that the currency is a high-beta play on global growth and is also quite undervalued according to our PPP models (Appendix Table 1). Market expectations are that the Riksbank will lag others in normalizing policy, putting off a hike until September 2023. The Riksbank baseline is a flat repo rate out to Q2/2024 but an earlier rate hike is well within the “uncertainty bands” of the Riksbank’s forecast. Such a scenario may manifest if growth and inflation surprise to the upside. Chart 10C...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth Given the positive economic backdrop and the financial stability risks posed by rising house prices and household indebtedness, we believe market pricing is too dovish relative to the actual pressure on the Riksbank to tighten policy (Chart 10D). This makes Swedish sovereign debt an attractive underweight candidate in global government bond portfolios. Chart 10DThe OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank Norges Bank Monitor: The First To Hike Our Norges Bank Monitor has risen sharply from the pandemic lows and now signals that emergency monetary settings are no longer appropriate for the Norwegian economy (Chart 11A). Consistent with this message, Norges Bank governor, Øystein Olsen, suggested this week that a rate hike will occur in September, with possibly another hike by December of this year. Norway has handled the pandemic successfully. Since the onset of the COVID-19 crisis, it has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was also prompt and finely tailored to the sectors most in need of emergency funds. Moreover, monetary policy was highly accommodative, with the Norges Bank cutting interest rates to zero for the first time since its founding in 1816. Fiscal stimulus will remain relatively accommodative, as Norway will register one of the smallest fiscal drags in the G10 for the remainder of 2021 and 2022. Rapid improvement in the labor market also continues. After peaking at 9.5% in March 2020, the headline unemployment rate has fallen to 3.3%. On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024. These developments have set the Norwegian economy on a sustainable recovery path. This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3% (Chart 11B). Meanwhile, while core inflation at 2% is decelerating, the slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mindset has not taken root in Norway. Chart 11AThe Norges Bank Monitor The Norges Bank Monitor The Norges Bank Monitor Chart 11BInflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway The biggest improvement in our Norges Bank Monitor comes from its growth and inflation components, the former surging to its highest level in two decades. This improvement surpasses those that followed the global financial crisis and the bursting of the dot-com bubble (Chart 11C). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. The Monitor shows a very tight correlation with the trade-weighted currency, suggesting the exchange rate is an important valve for adjusting financial conditions. As an oil-producing economy, the drop in the NOK cushioned the crash in oil prices last year. This year, a recovery has benefitted the krone. The Norwegian krone also remains undervalued according to our PPP models. Chart 11CThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates A positive correlation also exists between the Monitor and expected rate hikes by the Norges bank (Chart 11D). This suggest yields in Norway should either coincide or lead the improvement in global bond yields. From a portfolio perspective, our default stance is neutral, as the market is thinly traded. Chart 11DThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates SNB Monitor: Green Shoots Our Swiss National Bank (SNB) Monitor has recovered smartly, and is at the highest level in over a decade (Chart 12A). This is a marked turnaround for a country that has had negative interest rates since 2015. It also raises the prospect that Switzerland may be finally able to escape its liquidity trap, allowing the SNB to modestly adjust monetary policy upward. The Swiss economy has recovered swiftly. As of May, the manufacturing PMI was at 69.9, the highest reading since the start of the series. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades. This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. Inflation dynamics in Switzerland will be particularly beholden to improvements in private sector demand. The unemployment rate in Switzerland has rolled over, which should begin to provide an anchor to wage growth. Both core and headline inflation are also recovering, albeit at a slow pace (Chart 12B). Import prices in Switzerland will also rise, driven by the relative weakness of the currency. This is important because for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Chart 12AThe SNB Monitor The SNB Monitor The SNB Monitor Chart 12BSwiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Looking at the components of our SNB Monitor, the growth component has been in the driver’s seat (Chart 12C). But encouragingly, both the inflation and financial component have also been grinding higher. This improvement suggests that the weakness in the franc, especially amidst global dollar weakness, has been a welcome jolt to the economy. Like the yen, the CHF is a safe-haven currency, making the relationship with the central bank monitor less intuitive. Most of the time, the relationship with the monitor is inverse, corresponding to investors using the Swiss franc for carry trades when global conditions improve. Similar to the yen this year, the CHF has also weakened in sympathy with improving global growth. Should global growth see a setback in the near term, the franc will benefit. Chart 12CGrowth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland The SNB Monitor is more accurate at capturing expected policy changes by the SNB. This means that yields in Switzerland could see more meaningful upside (Chart 12D). That said, our default stance on Swiss bonds is neutral in a global portfolio, given low liquidity. Chart 12DCould The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Appendix Table 1 Table 1Appendix Table 1 BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight Footnotes 1 See BCA Research US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021, available at gfis.bcaresearch.com 2 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research European Investment Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcaresearch.com.

Highlights Duration: The Fed will ignore inflation for the time being and focus on its “maximum employment” target to decide when to lift rates off the zero bound. As a result, bond investors should also ignore inflation and focus on the employment data. We anticipate that significant positive nonfarm payroll surprises will start in late-summer/early-fall and that they will catalyze a move higher in bond yields. Keep portfolio duration below benchmark. Fed Operations: We see no implications for the Fed’s balance sheet or interest rate policies stemming from the recent uptick in ON RRP usage. It is possible that the Fed will decide to slightly increase the IOER or ON RRP rates at this month’s FOMC meeting in an effort to move the funds rate closer to the middle of its target range, but we don’t view this as a pressing need. Inflation: Inflation will moderate in the coming months, but 12-month core inflation will remain close to or above the Fed’s target at least through the end of 2022. Baffling Bond Market Strength We’ve received more questions than usual in recent days, mostly from readers seeking to understand why long-dated bond yields fell during a week that saw one of the strongest CPI prints of the past 40 years and the Treasury dump $38 billion of new 10-year supply on the market. We believe we can explain the conundrum. First, consensus expectations are finally starting to catch up with the pace of economic recovery. Economic surprise indexes measure the strength of economic data relative to consensus expectations and they have fallen a lot compared to the elevated levels seen last year (Chart 1). In fact, if it weren’t for incredibly strong inflation data these indexes would be much closer to “negative surprise” territory. The Industrial Sector and Labor Market components of the Bloomberg Economic Surprise Index have already dipped well below the zero line (Chart 1, bottom panel). Encouragingly, the fall in surprise indexes has more to do with investor expectations ratcheting higher than it does with a slowdown in the pace of economic growth, or at least that is the message you get from the CRB/Gold ratio, an excellent coincident indicator for bond yields (Chart 2). The CRB Raw Industrials commodity price index serves as a proxy for global economic growth and it remains in a solid uptrend. What has changed in the past few weeks is that gold is also staging a rally (Chart 2, bottom panel). This tells us that bond yields are not falling because of a slowdown in economic growth. Rather, they are falling because investors see the Federal Reserve turning increasingly dovish. Chart 1Surprise Indexes Surprise Indexes Surprise Indexes Chart 2CRB/Gold Ratio CRB/Gold Ratio CRB/Gold Ratio Why might investors have this impression of Fed Policy? During the past few months the Fed has successfully convinced markets that it will not lift rates until its “maximum employment” target is achieved, irrespective of what happens with inflation or inflation expectations (more on this in the section titled “A Checklist For Liftoff” below). This explains why bond investors are ignoring positive inflation surprises and focusing instead on the employment data, which have been disappointing. Nonfarm payroll growth came in significantly below consensus expectations in both May and April (Table 1). In light of those disappointing numbers, investors have pushed out expectations for the timing of Fed liftoff and bond yields have fallen as a result. Table 1Monthly Nonfarm Payroll Results Versus Consensus Watch Employment, Not Inflation Watch Employment, Not Inflation In For A Jolt Chart 3Labor Demand Is Not The Problem Labor Demand Is Not The Problem Labor Demand Is Not The Problem We view the recent drop in yields as a bond market over-reaction to weak employment data. Investors are focusing on the weaker-than-expected nonfarm payroll numbers but ignoring skyrocketing indicators of labor demand such as the JOLTS Job Openings Rate, the NFIB Jobs Hard To Fill survey and the Consumer Confidence Jobs Plentiful less Hard To Get survey (Chart 3). As we have noted in past reports, the demand for labor has already fully recovered from the pandemic and it is the lack of labor supply that is holding back the employment recovery.1 That is, people are not making themselves available to work. When we think about possible reasons why people are not making themselves available for job opportunities, the most obvious candidates relate to the pandemic and the fiscal response to the pandemic. Table 2 shows the net number of jobs lost since February 2020 broken down by major industry group. It shows that the Leisure & Hospitality sector (mostly restaurants and bars) accounts for about one third of the net job loss. Together, the Education & Health Services and Government sectors account for another third. A lot of these missing jobs are close-proximity service industry jobs that pay a relatively low average hourly wage. It therefore shouldn’t be too surprising that people are reluctant to take these jobs due to fears of contracting COVID and the fact that they have received large income supplements from the federal government in the form of stimulus checks and expanded unemployment benefits. Table 2Employment By Industry Watch Employment, Not Inflation Watch Employment, Not Inflation It seems unlikely that these constraints to labor supply will persist beyond the next few months. Virus fears will ebb over time, as long as the case count remains low, and government income support will also go away. There will be no more stimulus checks and expanded unemployment benefits are scheduled to expire in September. Chart 4S&L Government Hiring Will Increase S&L Government Hiring Will Increase S&L Government Hiring Will Increase With this in mind, we expect that labor supply constraints will ease by end-summer/early-fall and the result will be significant upside surprises to nonfarm payroll growth. Bond yields will likely stay rangebound in the near-term, but the next significant move will be an increase in yields driven by strong employment data. As a final point on the labor market, we noted above that the Government sector accounts for about 15% of the net job loss since February 2020. In fact, all those missing government jobs are from state & local governments.2 State & local governments cut expenditures drastically last year, but thanks to a faster-than-expected recovery in tax revenues and generous transfers from the federal government, they actually saw overall revenues exceed expenditures in 2020 and again in the first quarter of 2021 (Chart 4). The upshot is that state & local governments are now in a position to ramp up spending, and their pace of hiring should accelerate in the coming months. Bottom Line: The Fed will ignore inflation for the time being and focus on its “maximum employment” target to decide when to lift rates off the zero bound. As a result, bond investors should also ignore inflation and focus on the employment data. We anticipate that significant positive nonfarm payroll surprises will start in late-summer/early-fall and that they will catalyze a move higher in bond yields. Keep portfolio duration below benchmark. A Note On Reverse Repos And Fed Operations Chart 5An Over-Supply Of Reserves An Over-Supply Of Reserves An Over-Supply Of Reserves Many investors have noticed that usage of the Fed’s Overnight Reverse Repo Facility (ON RRP) has surged during the past few weeks, and many are also wondering if this will force the Fed to alter its interest rate or balance sheet policies. The short answer is no. In fact, the increased take-up of the ON RRP is a sign that the Fed’s operational strategy is working as intended. Let’s explain. The Fed’s main task is to set a target range for the federal funds rate and then ensure that the funds rate stays within that range. Today, that target range is between 0% and 0.25%. The fed funds market is where banks trade reserves amongst each other. If the Fed has over-supplied the market with reserves, then they will be very cheap to acquire and the fed funds rate will fall. Conversely, if the Fed has under-supplied the market with reserves, they will be more expensive to acquire and the fed funds rate will rise. At present, the market is awash with reserves. This is the result of the Fed’s asset purchases and the Treasury department’s ongoing policy of reducing its cash holdings.3 This over-supply of reserves is forcing the fed funds rate down, toward the lower-end of the Fed’s target band (Chart 5). This is where the ON RRP comes to the rescue. Through the ON RRP, the Fed pledges to borrow reserves from any eligible counterparty at a rate of 0% using a security off its balance sheet as collateral. This effectively gives any eligible counterparty the option of depositing excess reserves at the Fed in return for a rate of 0%. The result is that the ON RRP establishes a firm floor of 0% under the fed funds rate. Chart 6An Under-Supply Of Reserves An Under-Supply Of Reserves An Under-Supply Of Reserves This is why we say that the ON RRP is working as intended. The market is currently over-supplied with bank reserves and the ON RRP is absorbing that excess while keeping the funds rate anchored within the Fed’s target range. We should note that, in addition to the ON RRP rate, the Fed also pays a rate of interest on excess reserves (IOER). This IOER rate is currently 0.10%. Much like the ON RRP, the IOER should function as a floor on interest rates since it promises banks a rate of 0.10% for excess reserves deposited at the Fed. The problem is that the IOER is only available to primary dealer banks that have accounts at the Federal Reserve. There are other major players in overnight money markets, such as the GSEs and large money market funds, and these institutions do not have access to the IOER, only to the ON RRP. It is this broader counterparty access that makes the ON RRP the true floor on interest rates. It’s also interesting to look back at a time when the Fed was grappling with the opposite issue. In September 2019 the Fed was supplying the market with too few reserves and the fed funds rate was rising as a result (Chart 6). During this period, the fed funds rate actually did briefly break above the top-end of the Fed’s target range. This is because the Fed does not have a standing facility to put a ceiling above rates the way that the ON RRP provides a floor. In September 2019, the Fed had to conduct ad-hoc repo operations – lending reserves in exchange for securities – in order to bring the funds rate back down. Fortunately, the Fed has plans to rectify this problem. The minutes from the last FOMC meeting reveal that a “substantial majority of participants” supported the establishment of a standing repo facility to serve as a ceiling on interest rates in the same way that the ON RRP serves as a floor. The establishment of such a facility will make it easier for the Fed to shrink the size of its balance sheet when the time comes. All in all, we see no implications for the Fed’s balance sheet or interest rate policies stemming from the recent uptick in ON RRP usage. It is possible that the Fed will decide to slightly increase the IOER or ON RRP rates at this month’s FOMC meeting in an effort to move the funds rate closer to the middle of its target band (the fed funds rate is currently 0.06%), but we don’t view this as a pressing need. It is more likely that the Fed will stay the course, knowing that the over-supply of reserves will abate once the Treasury’s cash balance re-normalizes and that the ON RRP will keep the funds rate well-anchored in the meantime. A Checklist For Liftoff Table 3The Fed’s Liftoff Checklist Watch Employment, Not Inflation Watch Employment, Not Inflation At the beginning of this report we claimed that, in determining when to lift rates off the zero bound, the Fed will ignore inflation and inflation expectations and will be guided only by the labor market. This claim stems from the three criteria that the Fed has said will determine the timing of liftoff (Table 3). Yes, above-target inflation is one of the items on the checklist. However, the checklist places no upper limit on inflation that would cause the Fed to ignore the checklist’s “maximum employment” criteria. Further, it’s highly likely that inflation will remain close to or above the Fed’s target at least through the end of 2022. In essence, this means that the inflation portion of the Fed’s liftoff checklist has been achieved and it is only employment that will determine the timing of liftoff. Inflation To see why inflation is likely to remain close to or above target levels we look at 12-month core CPI (Chart 7A) and 12-month core PCE (Chart 7B) and run some scenarios based on future monthly growth rates of 0.1%, 0.2%, 0.3% and 0.4%. For context, core CPI grew 0.9% in April and 0.7% in May. Core PCE grew 0.7% in April and May data have not yet been released. Chart 7A12-Month Core CPI Scenarios 12-Month Core CPI Scenarios 12-Month Core CPI Scenarios Chart 7B12-Month Core PCE Scenarios 12-Month Core PCE Scenarios 12-Month Core PCE Scenarios Charts 7A and 7B show that an average monthly growth rate of 0.2%, a significant drop from current rates, will cause 12-month core CPI and core PCE to level-off either at or above target levels and this leveling-off won’t even occur until the middle of next year. Given that we are likely to see at least a few more elevated monthly inflation prints, it is highly likely that inflation will be at or above the Fed’s target by the end of 2022. Employment As for the Fed’s “maximum employment” criteria, we have updated our scenarios for the average monthly pace of nonfarm payroll growth required to reach “maximum employment” by specific dates in the future. As a reminder, we define “maximum employment” as an unemployment rate between 3.5% and 4.5% and a labor force participation rate of 63.3%, equal to its February 2020 level. Our results are presented in Tables 4A-4C. We calculate that average monthly nonfarm payroll growth of between +378k and +462k is required to reach “maximum employment” by the end of 2022. As noted above, we expect that nonfarm payroll growth will come in far above this range starting in late-summer/early-fall. Table 4AAverage Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Watch Employment, Not Inflation Watch Employment, Not Inflation Table 4BAverage Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Watch Employment, Not Inflation Watch Employment, Not Inflation Table 4CAverage Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Watch Employment, Not Inflation Watch Employment, Not Inflation All in all, we think that the Fed’s maximum employment and inflation criteria will both be met in time for a rate hike in 2022.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the lack of labor supply please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 2 The federal government has added a net 24 thousand jobs since Feb. 2020. State & local governments have lost a net 1.2 million. 3  For more details on how the Treasury department’s cash management policy is influencing the supply of bank reserves please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The ECB did not tighten policy, despite its upgrade to the Euro Area growth outlook. The rise in the Eurozone inflation will be transitory. The Euro Area continues to suffer from excessive slack, and current price pressures are narrow. The ECB rightfully worries about tightening financial conditions by prematurely removing monetary accommodation. The ECB does not want to move ahead of the release of its Strategy Review. Global growth is likely to experience a temporary hiccup this summer. The ECB will only taper its PEPP program in Q1 2022 with no firm announcement until Q4 2021. Stay overweight European peripheral bonds. Despite a favorable 18-month outlook, European cyclical equities face pronounced risks this summer. Investors should raise cash levels for now to keep dry powder for this fall. Feature At its policy meeting last week, the ECB refrained from adjusting policy. While the euro and bund yields barely budged on the news, Italian and Greek spreads narrowed a few basis point, welcoming the dissipating risk of decreased bond purchases. The ECB’s decision is in line with the analysis we published two weeks ago, which argued against the Governing Council hinting at a tapering of asset purchases at its June meeting.  Growing signs that the expected pick-up in the Eurozone inflation will be transitory and that China’s credit slowdown will negatively impact Europe increase our confidence that the ECB will not announce any adjustment to its asset purchases until the fourth quarter of 2021. This setup supports European peripheral bonds. However, it also points to a correction in European cyclical stocks. The ECB Announcement ECB President Christine Lagarde highlighted the need for a steady hand, with no policy change. The risks to growth are now “broadly balanced,” but enough uncertainty remains that removing accommodation too early still creates a much poorer risk/reward trade-off than maintaining the current policy. The ECB boosted its growth forecast in 2021 and 2022. As Table 1A illustrates, 2021 GDP growth was raised to 4.6% from 4% in March, and 2022 GDP growth was raised to 4.7% from 4.1%. Activity was left unchanged at 2.1% in 2023. The ECB and this publication are on the same page; Euro Area domestic activity will enjoy a welcomed fillip as a result of the re-opening of the economy, a response to the improving pace of vaccination across the continent. Moreover, the NGEU program will start disbursing funds this summer and will add another boost to growth. Despite this significant upgrade to anticipated growth, the ECB kept its accelerated pace of asset purchases in place, at least through the summer, because the inflation outlook remains below its target of “close but below 2%” durably. As Table 1B shows, the ECB expects HICP to hit 1.9% in 2021, but it will subsequently slow to 1.5% in 2022 and 1.4% in 2021. Table 1AUpgraded Growth Forecast Slow Ride Slow Ride Table 1BBelow Target Inflation Slow Ride Slow Ride Bottom Line: The ECB did not taper its PEPP purchases, because of uncertainty and below-target inflation. Too Many Deflationary Risks The policy stance of the ECB is appropriate on three levels. First, the case for Eurozone inflation to be transitory is even stronger than it is in the US. Second, financial conditions could easily deteriorate if the ECB were to tighten policy too early. Finally, the Strategy Review due this fall further paralyzes the ECB for now. Transitory Inflation Headline and core CPI in the Eurozone will increase significantly in the coming months but will slow next year. The ECB’s core CPI measure, which excludes food and energy, is set to rise above the levels of the past 15 years. As the US re-opened, core CPI spiked on both yearly and monthly bases. The presence of bottlenecks across domestic and global supply chains indicates that the Euro Area will experience a similar outcome. Assuming that monthly inflation rates will settle between 0.2% and 0.25% for the remainder of 2021, by year’s end, annual inflation will stand between 2% and 2.5% (Chart 1). The European PMI indices confirm the upside for the Euro Area’s core inflation. Service inflation has been more stable than in the US, but goods inflation is rising in line with the higher manufacturing PMI (Chart 2). Services inflation will accelerate according to the services PMI. Chart 1Higher Inflation For 2021 Higher Inflation For 2021 Higher Inflation For 2021 Chart 12Accelerating Goods And Services Inflation Accelerating Goods And Services Inflation Accelerating Goods And Services Inflation   Surveys confirm that this summer’s re-opening will jumpstart inflation. The employment components of both the European Commission’s Retail and Services Surveys are consistent with a rapid pickup in employment (Chart 3). This will support household income and consumption. Additionally, the EC’s Consumer Survey indicates that European households are ready to increase their purchase of homes and cars compared to last year (Chart 3, bottom panel). When stronger demand meets supply bottlenecks, higher prices ensue. Already, the EC’s Retail Survey points to this outcome (Chart 4). Despite these inflationary developments, most economic forces indicate that the Eurozone’s core and headline CPI will not stay elevated for long. Chart 3Stronger Employment In Pandemic-Hit Sectors Stronger Employment In Pandemic-Hit Sectors Stronger Employment In Pandemic-Hit Sectors Chart 4Re-Opening Pricing Pressures Re-Opening Pricing Pressures Re-Opening Pricing Pressures Our Trimmed Mean Inflation measure for the Euro Area (which mimics the construction of the Cleveland Fed Trimmed-Mean CPI in the US) has weakened to 0.1% (Chart 5). Hence, underlying inflation trends are still muted and the recent uptick in core CPI reflects outliers, as has been the case in the US. The outlook for the components of CPI confirms that any uptick in Euro Area inflation will be temporary. Shelter inflation, which accounts for 24% of the ECB core CPI, will rise as the unemployment rate declines. However, the strength in the euro is limiting import prices, which will cap non-energy industrial goods inflation (Chart 6). Moreover, the peak in oil price annual increases points toward a rollover in transportation inflation. Together, these two categories represent almost 60% of the core CPI components. Chart 5Inflation Is Not Broad-Based Inflation Is Not Broad-Based Inflation Is Not Broad-Based Chart 6Key CPI Components Will Slow Key CPI Components Will Slow Key CPI Components Will Slow Labor market dynamics are also consistent with a temporary inflation spurt. Total hours worked remain 6.5% below their pre-COVID-19 summit and underneath the level congruent with full employment based on the size of the Eurozone’s working-age population (Chart 7). This model understates the slack in the labor market, because the reforms implemented in peripheral economies in the wake of last decade’s Euro Area crisis have brought down structural unemployment. Moreover, the chart shows that, after total hours worked return to their equilibrium, it still takes a few years before negotiated wages firm up. Even if labor shortages materialized earlier than we anticipate, it does not guarantee a pickup in core CPI. From 2016 to 2019, a large proportion of Euro Area businesses cited labor shortages as a key factor limiting production. Yet, despite both this perceived tightness and a trendless euro, core CPI remained flat, averaging 1% per annum (Chart 8). Chart 7Still Too Much Slack Still Too Much Slack Still Too Much Slack Chart 8Labor Shortages Do Not Guarantee Inflation Labor Shortages Do Not Guarantee Inflation Labor Shortages Do Not Guarantee Inflation Outside of the labor market, the amount of stimulus injections also argues against a permanent increase in European inflation. BCA’s US Bond Strategy, Global Investment Strategy, and Bank Credit Analyst services believe that the current spurt of US Inflation is temporary, despite vast monetary and fiscal stimuli. In relation to 2019 GDP, the ECB’s liquidity injections have been larger than those of the Fed; however, the US fiscal activism greatly outdid that of the Eurozone (Chart 9). Consequently, the combined monetary and fiscal impulse in the US is larger, and its greater weight toward fiscal policy makes it more inflationary. Thus, if the US is unlikely to see durable inflation, the Eurozone is even less at risk. Chart 9More Timid European Stimulus Slow Ride Slow Ride Chart 10Lower European Inflation Expectations Lower European Inflation Expectations Lower European Inflation Expectations Euro Area inflation expectations are also muted compared to that of the US (Chart 10). This development confirms that Eurozone policy is less inflationary than that of the US. It also creates an anchor for realized inflation, which will constrain the acceleration in the Euro Area CPI. Financial Conditions The ECB is deeply concerned about the impact of the hurried removal of monetary accommodation on the Eurozone’s financial conditions. Chart 11The Euro Is Deflationary The Euro Is Deflationary The Euro Is Deflationary The ECB does not want to see a much more rapid pace of appreciation in the euro. If it begins to slow its QE program when the Fed remains reluctant to talk about tapering, EUR/USD will surge. This will feed into weaker core inflation in the region. The ECB’s broad trade-weighted euro, based on 41 currencies, has already rallied to a record high. Thus, an even more rapid euro rally would spell deeper deflationary pressures in the region (Chart 11). Peripheral spreads remain fragile. The ECB will not want to cause a rapid widening of Italian, Spanish, or Greek government bond spreads by decreasing its asset purchases prematurely. Otherwise, the health of the banking sector in the periphery will once again deteriorate, which will both harm the recovery and ignite deflationary tendencies. Strategy Review The ECB’s Strategy Review also prevents the Governing Council from adjusting policy. The ECB will release its Strategy Review in September or October. This exercise could result in a change to the inflation target. In line with the new Fed Average Inflation Target, the ECB objective may become more symmetric. Inflation has not hit the ECB’s target of nearly 2% since 2012, and the level of HICP stands 8% below what the target implies. Therefore, if the ECB adjusts its target this fall, it will become harder to justify the removal of accommodation. Bottom Line: The ECB wants to avoid a repeat of its 2011 policy mistake, when it tightened policy prematurely and catalyzed a period of profound weakness in the European economy. Eurozone inflation will increase this year; however, this bump is transitory and inflation will once again decline in 2022. Moreover, the ECB rightfully worries about tightening financial conditions, because the euro is exerting profound deflationary forces on the continent and peripheral spreads remain fragile. Finally, the ongoing Strategy Review limits what the ECB can do until its results are known. Look Out For Q4 2021 The ECB will keep the PEPP program in place until March 2022, as was originally announced. Therefore, the ECB will only telegraph its intention after the summer and will most likely announce in December its firm commitment to begin tapering. The program size does not constrain the ECB. The total envelope of the PEPP stands at EUR1850 billion, and the ECB has already purchased EUR1100 billion (Chart 12). Based on the current accelerated pace of purchases, the ECB will run out of room in February 2022. Thus, the ECB continues to enjoy great flexibility without adjusting the PEPP program meaningfully. Chart 12Plentiful PEPP Room Plentiful PEPP Room Plentiful PEPP Room Chart 13China Will Act As A Drag China Will Act As A Drag China Will Act As A Drag Chart 14The Global Growth Tax Is Biding The Global Growth Tax Is Biding The Global Growth Tax Is Biding The expanding threat of a global growth scare will likely limit the ability of the ECB to tighten policy ahead of Q4. China’s credit impulse is decelerating, which portends an imminent peak in our BCA Global Industrial Activity Nowcast (Chart 13). Moreover, the rise in global yields since August 2020 and the rapid rally in oil prices since April 2020 are consistent with a meaningful deceleration in global manufacturing activity. The collapse in our Global Leading Economic Indicator Diffusion Index also hints at a coming global soft patch (Chart 14). Hence, the heightened sensitivity of the Euro Area economy to the global manufacturing sector  points toward softer-than-anticipated growth this summer. Historically, a deceleration of the Chinese PMI New Orders components warns of a decline in the 1-year forward EONIA (Chart 15). While the ECB is unlikely to flag a rate reduction in response to the upcoming global deterioration, it could respond by delaying its tapering decision. Ultimately, the accumulation of constraints and risks suggests that, even after the PEPP taper starts in 2022, the ECB will roll it into the older PSPP program. The ECB will want to keep a lid on peripheral spreads and guarantee that the euro does not melt up. Germany is unlikely to block this initiative, because its large Target 2 surplus means that problems in the periphery will percolate to the German banking system (Chart 16). Moreover, Germany’s export sector will benefit from a euro whose appreciation is contained. Chart 15Chinese New Orders Are Inconsistent With A Tighter ECB Chinese New Orders Are Inconsistent With A Tighter ECB Chinese New Orders Are Inconsistent With A Tighter ECB Chart 16Germany Does Not Want Italian Troubles Germany Does Not Want Italian Troubles Germany Does Not Want Italian Troubles Bottom Line: The ECB will not formally announce its tapering until December 2021. The ECB still has considerable room to continue using the PEPP program, and the global economy is likely to generate a negative growth surprise this summer. Instead, once the PEPP taper begins in 2022, the program will be rolled into the PSPP rather than being completely discarded. European policy, therefore, will remain accommodative. Investment Implications A dovish ECB is consistent with a continued overweight in European peripheral bonds. Chart 17European Peripheral Bonds Remain Attractive Slow Ride Slow Ride Portuguese, Greek, Spanish, and Italian bonds offer much more attractive valuations than the global or the European averages (Chart 17). The robust pace of ECB bond purchases, along with the increased fiscal risk-sharing created by the NGEU programs, will allow this value to continue to generate excess returns for investors. The growth scare, however, threatens our positive stance on European equities and cyclical stocks. We expect a correction to take place this summer or early fall. Thus, investors should raise cash now to buy cyclicals stocks once they correct. First, a deceleration in global growth catalyzed by a Chinese credit slowdown is consistent with an underperformance of cyclical stocks and European stocks in general. Second, the ECB Central Bank Monitor currently sports an elevated 2.1 reading, which is negative for cyclicals. A high reading for the monitor materializes when the Eurozone economy is experiencing strong momentum. However, markets are forward looking, and they rapidly internalize a brightened outlook. Once the price of cyclical stocks embed enough good news, they will start to generate poorer returns. Consequently, positive readings of the monitor are followed by negative relative excess returns for cyclical stocks, such as Industrials, Financials, Tech, and Consumer discretionary on both 6- and 12-month horizons (Table 2A). Table 2AThe Higher The ECB Monitor Rises, The More Poorly Cyclicals Perform Slow Ride Slow Ride The higher the ECB Monitor reaches, the worse the cyclical sectors’ excess returns become, even if the ECB does not tighten policy. Moreover, outliers do not distort the results of the study. The batting averages confirm that, the higher the ECB Monitor, the lower the probability of a subsequent outperformance of cyclicals. The reverse is true for defensive sectors. The higher the ECB Monitor climbs, the greater the subsequent 6- and 12-month relative excess returns for Telecommunication, Consumer Staples, Utilities, and Healthcare turn out. Their probability of outperformance also increases (Table 2B). Table 2BThe Higher The ECB Monitor Rises, The More Poorly Cyclicals Perform Slow Ride Slow Ride Investors should therefore curtail their exposure to risk over the coming months, tactically tilt toward some attractive defensive names and buy some hedges or raise some cash in order to participate more fully in the rest of the rally later this year. Bottom Line: An easy ECB policy favors an overweight stance in European peripheral bonds. However, if global growth slows, the current reading of our ECB Monitor is consistent with a period of underperformance for cyclical equities. Such underperformance should correlate with a corrective episode for the broad market as well as an underperformance of European stocks relative to the US. Investors, therefore, should raise cash levels and tactically move into attractive defensive names in order to buy back cyclicals later this year.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Currency Performance Slow Ride Slow Ride Fixed Income Performance Government Bonds Slow Ride Slow Ride Corporate Bonds Slow Ride Slow Ride Equity Performance Major Stock Indices Slow Ride Slow Ride Geographic Performance Slow Ride Slow Ride   Sector Performance Slow Ride Slow Ride ​​​​​​​

Highlights Bond Market Performance: Government bonds in the developed economies are currently trapped in ranges, consolidating the sharp upward moves seen in the first quarter of 2021. This is only a pause in the broader cyclical uptrend, however, with central banks under increasing pressure to turn less dovish amid surging inflation and tightening labor markets. Oversold USTs: Technical indicators of yield/price momentum and investor sentiment/positioning suggest that US Treasuries are oversold. Working off this condition can take another 2-3 months, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation for Australian government bonds to overweight on a tactical (0-6 months) investment horizon. Feature Dear Client, Next week, in lieu of our regularly weekly report, I will be hosting a webcast on Tuesday, June 15 where I will discuss the outlook for global fixed income markets in the second half of 2021. Following that, we will be jointly publishing our bi-annual Global Central Bank Monitor Chartbook with our colleagues at BCA Research Foreign Exchange Strategy on Friday, June 18th. We will return to our regular publishing schedule on Tuesday, June 29th. Best Regards, Rob Robis Chart of the WeekA Tale Of Two Quarters A Summer Nap For Global Bond Yields A Summer Nap For Global Bond Yields The performance of government bond markets in the developed world so far in 2021 has been a tale of two quarters. In Q1, yields were rising steadily on the back of upside surprises in global growth and emerging signs of the biggest inflation upturn seen in nearly a generation. The Bloomberg Barclays Global Treasury index delivered a total return of -2.7% (hedged into US dollars) during the quarter, with no country escaping losses (Chart of the Week). The biggest declines were seen in the UK (-7.5%) the US (-4.3%), with the smallest losses occurring in Japan (-0.3%) and Italy (-0.7%). Chart 2Lower Vol Means High Yielders Outperform Low Yielders Lower Vol Means High Yielders Outperform Low Yielders Lower Vol Means High Yielders Outperform Low Yielders Q2 has been a different story, however. Yields have retreated somewhat from the year-to-date peaks seen at the end of Q1, leading to positive returns so far in Q2 in the UK (+0.8), the US (+1.2%) and Australia (+1.1%). The laggards are the low yielding euro area markets, most notably Italy (-0.7%) and France (-0.9%), that have seen yields move higher on the back of accelerating European growth. The Q2 returns look very much like a carry-driven market, with higher-yielding markets outperforming lower-yielding ones. That trend can persist if the current backdrop of low market volatility persists (Chart 2), although this calm will eventually be broken by a shift towards less dovish monetary policies. Some countries will make that shift at a faster pace than others, leading to relative value opportunities for bond investors in the latter half of 2021. This week, we discuss one such opportunity – Australia versus the US. US Treasuries: Oversold & Trendless – For Now After reaching a 2021 intraday high of 1.77% back on March 30, the benchmark 10-year US Treasury yield has traded in a narrow 15bp range between 1.55% and 1.70%. From a fundamental perspective, US yields are lacking direction because inflation expectations have already made a major upward adjustment to the more inflationary backdrop, but real yields have remained depressed by the continued dovish messaging from the Fed – for now - with regards to the timing of tapering or future rate hikes. From a technical perspective, however, the sideways pattern for US Treasury yields is also consistent for a market that trying to work off an oversold condition. Most of the technical indicators for the US Treasury market that we monitor regularly were at or close to the most bearish/oversold extremes seen since 2000 (Chart 3): Chart 3US Treasuries Are Working Off An Oversold Condition US Treasuries Are Working Off An Oversold Condition US Treasuries Are Working Off An Oversold Condition The 10-year Treasury yield is 39bps above its 200-day moving average, but that gap was as high as 84bps on March 19; The 26-week total return of the 10-year Treasury is -4.7%, after reaching a low of -8.8% on March 19; The JP Morgan client survey of bond managers and traders shows some of the largest underweight duration positioning in the 19-year history of the series; The Market Vane index of sentiment for Treasuries is in the bottom half of the range that has prevailed since 2000; The CFTC data on positioning in 10-year Treasury futures is the only one of our indicators that is not signaling an oversold market, with a small net long position of +3% (scaled by open interest). The overall message of these indicators suggests that price momentum and positioning reached such a bearish extreme by mid-March that some pullback in Treasury yields was inevitable. However, a look back at past periods when Treasuries became heavily oversold since the turn of the century shows that the duration and magnitude of such a pullback is highly variable – anywhere from two months to ten months. The main determining factors are the trends in economic growth and inflation in the US, and the Fed’s expected policy response to both. To show this, we conducted a simple study, updating work we first presented in a 2018 report.1 We looked at “oversold episodes” since 2000, which began when the 10-year Treasury yield was trading at least 50bps above its 200-day moving average. We then defined the end of the oversold episode as simply the point when the 10-year Treasury yield subsequently converged back to its 200-day moving average. We then looked at the length of the episode (in days), and the change in bond yields, for each oversold episode. There were nine such episodes since the year 2000, not counting the current one which has not yet ended. In Table 1, we rank the episodes by the number of days it took to complete each one, based on our simple moving average rule. We also show the change in both the 10-year Treasury yield and its 200-day moving average during each episode, to show how the convergence between the two unfolds. Table 1A Look At Prior Episodes Of An Oversold Treasury Market A Summer Nap For Global Bond Yields A Summer Nap For Global Bond Yields To describe the US economic backdrop during each episode, we looked at the change in the ISM manufacturing index and core PCE inflation during those oversold periods. We also show changes in two important determinants of the level of Treasury yields: inflation expectations using 10-year TIPS breakeven rates, and Fed rate hike expectations using our 12-month Fed discounter which measures the expected change in interest rates - one year ahead - priced into the US overnight index swap (OIS) curve. At the bottom of the table, we show the average for all nine oversold episodes, as well as the averages for the episodes were the ISM was rising and where core PCE inflation was rising. Chart 4US Treasury Market Oversold Episodes: 2003-2007 US Treasury Market Oversold Episodes: 2003-2007 US Treasury Market Oversold Episodes: 2003-2007 There are a few messages gleaned from the results in Table 1: The longest correction of an oversold Treasury market since 2000 took place between February 2018 and December 2018, when 305 days passed before the 10-year yield fell back to its 200-day moving average; The shortest correction was between June 2007 and August 2007, where only 52 days elapsed; Treasury yields typically decline during oversold periods, with two notable exceptions: 2018 and 2013/14, which were also the two longest episodes; During all of the oversold periods, markets reduced the amount of expected Fed tightening by an average of 26bps. However, that was entirely concentrated in four of the nine episodes - including three of the four shortest episodes – and is typically associated with a decline in inflation expectations. Growth momentum appears to be a bigger factor than inflation momentum in determining the length of an oversold episode, with longer episodes typically occurring alongside a rising ISM index, and vice versa. The notable exception was the longest episode in 2018, where the ISM declined by six points, although the bulk of that decline occurred in a single month at the end of the period (November 2018). For the more visually oriented, we present the time series for all the data in Table 1, shaded for the oversold periods, in Chart 4 (for the 2003-2007 period), Chart 5 (2008-2012), Chart 6 (2013-2017) and Chart 7 (2018 to today). We’ve added one additional variable – our Fed Monitor, designed to signal the need for tighter or looser US monetary policy – in the bottom panel of each of those charts. Chart 5US Treasury Market Oversold Episodes: 2008-2012 US Treasury Market Oversold Episodes: 2008-2012 US Treasury Market Oversold Episodes: 2008-2012 Chart 6US Treasury Market Oversold Episodes: 2013-2017 US Treasury Market Oversold Episodes: 2013-2017 US Treasury Market Oversold Episodes: 2013-2017 Chart 7US Treasury Market Oversold Episodes: 2018 To Today US Treasury Market Oversold Episodes: 2018 To Today US Treasury Market Oversold Episodes: 2018 To Today What does this look back tell us about looking ahead? The current episode, at only 105 days old, is still 62 days “younger” than the average oversold period, and 76 days “younger” than the average period where core inflation was rising. This would put the end of the current episode sometime in August. The ISM is essentially unchanged over the current episode so far, making it difficult to draw conclusions based on growth momentum – although the longest episode in 2018 shows that yields can trade sideways for a long time, even in the absence of a big slowing of growth, if the Fed is in a rate hiking cycle. However, the current episode differs dramatically from others in this analysis on two critical fronts. Core inflation has surged 1.6 percentage points since the oversold period began in February, far more than any other episode, while the gap between a rapidly increasing Fed Monitor and a flat 12-month Fed Discounter is also unique among post-2000 oversold periods. In other words, the Treasury market is still vulnerable to a repricing of Fed tightening expectations, especially with positioning and sentiment measures like the Market Vane survey and net futures positioning not yet at fully bearish extremes. Bottom Line: The current oversold condition in the US Treasury market can take another 2-3 months to unwind, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist Update: No Case For A Hawkish Turn Yet Australia has been one of the top performing government bond markets within the developed economies, as discussed earlier. This performance has occurred even with strong acceleration of both Australian economic momentum and market-based inflation expectations (Chart 8). Despite our RBA Monitor flashing pressure on the RBA to tighten, and the Australian OIS curve already discounting 48bps of rate hikes over the next two years, Australian bond yields have remained very well behaved during the “calm” second quarter for global fixed income. Chart 8RBA Policies Limiting Rise In Bond Yields RBA Policies Limiting Rise In Bond Yields RBA Policies Limiting Rise In Bond Yields Chart 9RBA Stimulus Takes Many Forms RBA Stimulus Takes Many Forms RBA Stimulus Takes Many Forms The continued dovish messaging from the Reserve Bank of Australia (RBA) is the main reason for the solid Australia bond performance. The central bank is signaling no imminent shift in its combination of 0.1% nominal policy rates, deeply negative real rates, yield curve control on 3-year bonds and quantitative easing on longer-maturity bonds (Chart 9). Other central banks are starting to inch towards reining in the massive monetary accommodation of the past year. Could the RBA be next? In a Special Report published back in January of this year, we outlined a list of variables to watch to determine when the Reserve Bank of Australia (RBA) could be expected to turn less dovish.2 This checklist would also inform our country allocation view on Australian government bonds, which has remained neutral. A quick update on the latest readings from the RBA Checklist shows little pressure on the RBA to begin preparing markets for tighter monetary policy. 1. The vaccination process goes quickly and smoothly We are NOT placing a checkmark next to this part of our RBA Checklist. Australia has weathered COVID-19 far better than most other Western countries in terms of actual cases and deaths, but the vaccine rollout Down Under has been underwhelming. Only 16% of the population has received at least one vaccine jab, while a mere 2% is fully vaccinated. These are numbers that are more comparable to pandemic-ravaged emerging market countries like India and Brazil where access to vaccines is an issue (Chart 10). Chart 10A Slow Vaccine Rollout Down Under A Summer Nap For Global Bond Yields A Summer Nap For Global Bond Yields The slow vaccine rollout is less worrisome in light of the Australian government having secured enough vaccine doses to inoculate the entire population, and with the domestic economy facing limited remaining COVID-19 restrictions. The issue has been distribution and that is now occurring at a quickening pace. Until a much greater share of the population is vaccinated, however, Australia will continue to maintain aggressive COVID-related international travel restrictions – the government just announced that borders will remain shut until mid-2022 - that will be a major drag on the economically-important tourism sector. 2. Private sector demand accelerates alongside fiscal stimulus (✔) We ARE placing a checkmark next to this part of our RBA Checklist. Australia’s fiscal stimulus in response to the pandemic was one of the largest in the developed world. The stimulus was heavily focused on wage subsidies and income support measures like the JobSeeker program, which expired back in March. As the expensive stimulus programs are unwound, it is critical that the domestic economy can stand on its own without support. On that front, the news is good. Australia’s economy grew by 1.8% during Q1/2021, lifting the level of real GDP above the pre-pandemic peak (Chart 11). Both consumer spending and business investment posted solid growth during the quarter, fueled by surging confidence with the NAB business outlook measure hitting a record high in May (bottom panel). As a sign that the domestic economy is benefitting from a return to pre-pandemic habits, Q1 saw a 15% increase in spending in hotels, cafes and restaurants. That strength looked to extend into the Q2, with retail sales rising 1.1% in April, suggesting that Australian domestic demand is enjoying strong upward momentum. Chart 11A Confidence-Led Recovery In Domestic Demand A Confidence-Led Recovery In Domestic Demand A Confidence-Led Recovery In Domestic Demand Chart 12China Is A Drag On Australian Exports China Is A Drag On Australian Exports China Is A Drag On Australian Exports 3. China reins in policy stimulus by less than expected We are NOT placing a checkmark next to this part of our RBA Checklist. China is by far Australia’s largest trading partner, so Chinese demand is always an important contributor to Australian economic growth. This is why we included a China element in our RBA Checklist. Specifically, we deemed the outcome that would potentially turn the RBA more hawkish would be Chinese policymakers pulling back monetary and fiscal stimulus by less than expected in 2021 after the big policy support in 2020. The combined fiscal and credit impulse for China has already slowed by 9% of GDP since December 2020, signaling a meaningful cooling of Chinese growth in the latter half of 2021 that should weigh on demand for imports from Australia (Chart 12). However, Chinese import demand has already been severely impacted because of worsening China-Australia political tensions, which has led Beijing to impose restrictions on Australian imports for a variety of products, include coal, wine, beef, barley and cotton. The result is that there has been no growth in Australian total exports to China over the past year – an outcome that was flattered by the surge in iron ore prices - which has weighed on overall Australian export growth. Given this weak starting point for Chinese demand for Australian goods, the sharp reduction in the China stimulus is, on the margin, a factor that will not force the RBA to turn less dovish sooner than expected. 4. Inflation, both realized and expected, returns to the RBA’s 2-3% target We are NOT placing a checkmark next to this part of our RBA Checklist. Australian inflation remains well below the RBA’s 2-3% target range, with the headline CPI and the less volatile trimmed mean CPI both expanding at only a 1.1% annual rate in Q1/2021 (Chart 13). The RBA is forecasting a brief boost to both measures in Q2, before settling back below 2% to the end of 2022. Chart 13No Bond-Bearish RBA Policy Shift Without More Inflation No Bond-Bearish RBA Policy Shift Without More Inflation No Bond-Bearish RBA Policy Shift Without More Inflation Chart 14Diminishing Financial Stability Risks From Housing Diminishing Financial Stability Risks From Housing Diminishing Financial Stability Risks From Housing The RBA’s message on the inflation outlook has been very consistent. A sustainable move of realized inflation back to the 2-3% target range – that would prompt a normalization of monetary policy – cannot occur without a significant tightening of labor markets that drives wage growth back to 3% from the Q1/2021 reading of 1.5%. The RBA currently does not expect that outcome to occur before 2024. The RBA believes that the full employment NAIRU is between 4-4.5%, well below the OECD’s latest estimate of 5.4%. Given the sharp drop in Australian unemployment already seen over the past few quarters, there is the potential for an upside surprise in the wage data that could lead the RBA to change its policy bias. The central bank would need to see a few quarters of such wage surprises, however, before altering its forward guidance on the timing of future rate hikes. 5. House price inflation begins to accelerate We are NOT placing a checkmark next to this part of our RBA Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets were overheating could prompt the RBA to consider tighten monetary policy. The annual growth of median house prices has dipped from +8% in Q1 2020 to +4% in Q4 2020, despite robust housing demand as evidenced by the 40% growth in building approvals. At the same time, housing valuations have become less stretched with the ratio of median home prices to median household incomes falling -9% from the 2017 peak according to data from the OECD (Chart 14). The RBA remains sensitive to the potential financial stability risks from overvalued housing. The latest trends in the house price data, however, suggest that the central bank does not yet to have the use the blunt tool of tighter monetary policy to cool off an overheated housing market. Chart 15Upgrade Australia To Overweight (Vs. USTs) Upgrade Australia To Overweight (Vs. USTs) Upgrade Australia To Overweight (Vs. USTs) In sum, the majority of items in our RBA Checklist are signaling no immediate pressure on the central bank to tighten policy. The first 25bp rate hike is not discounted in the Australian OIS curve until April 2023, a little ahead of RBA guidance but still consistent with a very dovish policy bias. The inflation data, in our view, will be the critical factor that could prompt the markets to pull forward expected monetary tightening, leading to a surge in Australian bond yields. With the RBA already expecting a surge in inflation in the Q2/2020 data, the central bank would likely want to see at least a couple of more quarterly inflation prints – both for the CPI and wage price index - before signaling a more hawkish policy shift. Thus, the RBA will likely stay dovish over the latter half of 2021 Therefore, we are moving to an overweight recommended stance on Australian government bonds on a tactical (0-6 months) basis. In our model bond portfolio on pages 16-17, we are “funding” that shift to an above-benchmark weighting in Australia out of US Treasury exposure. Given our view that the Fed will soon begin to signal a 2022 taper of its asset purchases, relative policy dovishness should lead Australian government bonds to outperform US Treasuries in the latter half of this year. In addition, Australian bonds have a lower yield beta to changes in US Treasury yields, relative to the high beta to changes in non-US developed market yields (Chart 15), making allocations out of the US into Australia attractive from a risk management perspective in a global bond portfolio. Bottom Line: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation to Australian government bonds to overweight on a tactical investment horizon.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 See BCA Research Global Fixed Income Strategy Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20, 2018. 2 See BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Summer Nap For Global Bond Yields A Summer Nap For Global Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Tracking Nonfarm Payrolls Tracking Nonfarm Payrolls Tracking Nonfarm Payrolls With 12-month PCE inflation already above the Fed’s 2% target, it is progress toward the Fed’s “maximum employment” goal that will determine both the timing of Fed liftoff and whether bond yields rise or fall. On that note, the bond market is currently priced for Fed liftoff in early 2023. We also calculate that average monthly nonfarm payroll growth of between 378k and 462k is required to meet the Fed’s “maximum employment” goal by the end of 2022, in time for an early-2023 rate hike. It follows from this analysis that any monthly employment print above +462k should be considered bond-bearish and any print below +378k should be considered bond-bullish (Chart 1). In that light, May’s +559k print is bond-bearish, and we anticipate further bond-bearish employment reports in the coming months as COVID fears fade and people return to a labor market that is already awash with demand. Investors should maintain below-benchmark portfolio duration in US bond portfolios and also continue to favor spread product over duration-matched Treasuries. Feature Table 1Recommended Portfolio Specification It’s All About Employment It’s All About Employment Table 2Fixed Income Sector Performance It’s All About Employment It’s All About Employment 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 47 basis points in May, bringing year-to-date excess returns up to +159 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. At 142 bps, the 2/10 Treasury slope is very steep and the 5-year/5-year forward TIPS breakeven inflation rate sits at 2.27% - almost, but not quite, within the 2.3% to 2.5% range that the Fed considers “well anchored”.1 The message from these two indicators is that the Fed is not yet ready for monetary conditions to turn restrictive. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is almost at its lowest since 1995 (Chart 2). Though we retain a positive view of spread product as a whole, tight valuations cause us to recommend only a neutral allocation to investment grade corporates. We prefer high-yield corporates, municipal bonds and USD-denominated Emerging Market Sovereigns. Last week, the Fed announced that it will wind down its corporate bond portfolio over the coming months. The corporate bond purchase facility has not been operational since December 2020, meaning that the corporate bond market has been functioning without an explicit Fed back-stop for all of 2021. The portfolio itself is also quite small compared to the size of the corporate bond market. As a result, we anticipate no material impact on spreads. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* It’s All About Employment It’s All About Employment Table 3BCorporate Sector Risk Vs. Reward* It’s All About Employment It’s All About Employment 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 8 basis points in May, bringing year-to-date excess returns up to +343 bps. In a recent report, we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.3% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth. The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s corporate debt binge will moderate in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4%, very close to what is priced into junk spreads. Given that the large amount of fiscal stimulus coming down the pike makes the Fed’s 6.5% real GDP growth forecast look conservative, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 36 basis points in May, dragging year-to-date excess returns down to -9 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 7 bps in May. The spread remains wide compared to recent history, but it is still tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) currently sits at 24 bps. This is considerably below the 51 bps offered by Aa-rated corporate bonds and the 27 bps offered by Agency CMBS. It is only slightly more than the 18 bps offered by Aaa-rated consumer ABS. All in all, value in MBS is not appealing compared to other similarly risky sectors. In a recent report, we looked at MBS performance and valuation across the coupon stack.3 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be flat-to-higher during the next 6-12 months, we recommend favoring high coupons over low coupons within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +87 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 32 bps in May, bringing year-to-date excess returns up to +53 bps. Foreign Agencies outperformed the Treasury benchmark by 2 bps on the month, bringing year-to-date excess returns up to +37 bps. Local Authority bonds outperformed by 30 bps in May, bringing year-to-date excess returns up to +360 bps. Domestic Agency bonds and Supranationals both outperformed by 8 bps, bringing year-to-date excess returns up to +27 bps and +24 bps, respectively. We recently took a detailed look at USD-denominated Emerging Market (EM) Sovereign valuation.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Indonesia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space where there is still some value left in US corporate spreads and where the EM space is dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 21 basis points in May, dragging year-to-date excess returns down to +286 bps (before adjusting for the tax advantage). We took a detailed look at municipal bond performance and valuation in a recent report and came to the following conclusions.5 First, the economic and policy back-drop is favorable for municipal bond performance. The recently enacted American Rescue Plan includes $350 billion of funding for state & local governments, a bailout that comes after state & local government revenues already exceeded expenditures in 2020 (Chart 6). President Biden has also proposed increasing income tax rates. However, there may not be time to pass these tax hikes before the 2022 midterm elections. Second, Aaa-rated municipal bonds look expensive relative to Treasuries (top panel). Muni investors should move down in quality to pick up additional yield. Third, General Obligation (GO) and Revenue munis offer better value than investment grade corporates with the same credit rating and duration, particularly at the long-end of the curve. Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporates. GO munis offer a breakeven tax rate of just 7% (panel 2). Fourth, taxable munis offer a yield advantage over investment grade corporates that investors should take advantage of (panel 3). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 22% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them prone to extension risk if bond yields gap higher. Treasury Curve: Buy 5-Year Bullet Versus 2/30 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields fell in May, with the 5-10 year part of the curve benefiting the most. The 7-year yield fell 8 bps in May while the 5-year and 10-year yields both fell 7 bps. Yield declines were smaller for shorter (< 5-year) and longer (> 10-year) maturities. The 2/10 Treasury slope flattened 5 bps to end the month at 144 bps. The 5/30 Treasury slope steepened 3 bps to end the month at 147 bps (Chart 7). We recently changed our recommended yield curve position from a 5 over 2/10 butterfly to a 5 over 2/30 butterfly.6 In making the switch we noted that the slope of the Treasury curve has behaved differently since bond yields peaked in early April. Prior to April, the rise in bond yields was concentrated at the very long-end (10-year +) of the curve. During the past two months, the belly of the curve (5-7 years) has seen more volatility. We conclude that we are now close enough to an expected Fed liftoff date that further significant increases in yields will be met with a flatter curve beyond the 5-year maturity point and that the 5-year and 7-year notes are likely to benefit the most if bond yields dip. We also observe an exceptional yield pick-up of +33 bps in the 5-year bullet over a duration-matched 2/30 barbell. Given our view that bond yields will be flat-to-higher during the next 6-12 months, we recommend buying the 5-year bullet over a duration-matched 2/30 barbell to take advantage of the strong positive carry in a flat yield environment, and as a hedge against our below-benchmark portfolio duration stance. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 86 basis points in May, bringing year-to-date excess returns up to +484 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 1 bp and 2 bps on the month, respectively. At 2.42%, the 10-year TIPS breakeven inflation rate is near the top-end of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.27%, the 5-year/5-year forward TIPS breakeven inflation rate is just below the target band (panel 3). With long-maturity breakevens already consistent (or close to consistent) with the Fed’s target, they have limited upside going forward. The Fed has so far welcomed rising TIPS breakeven inflation rates, but it will have an increasing incentive to lean against them if they continue to move up. We also think that the market has priced-in an overly aggressive inflation outlook at the front-end of the curve. The 1-year and 2-year CPI swap rates stand at 3.76% and 3.12%, respectively. There is a good chance that these lofty inflation expectations will not be confirmed by the actual data. With all that in mind, investors should maintain a neutral allocation to TIPS versus nominal Treasuries and also a neutral posture towards the inflation curve (panel 4). The inflation curve could steepen somewhat in the near-term if short-maturity inflation expectations moderate, but we expect the curve to remain inverted for a long time yet. An inverted inflation curve is more consistent with the Fed’s Average Inflation Target than a positively sloped one, and it should be considered the natural state of affairs moving forward. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in May, bringing year-to-date excess returns up to +33 bps. Aaa-rated ABS outperformed by 13 bps on the month, bringing year-to-date excess returns up to +26 bps. Non-Aaa ABS outperformed by 12 bps on the month, bringing year-to-date excess returns up to +70 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. This excess savings has still not been spent and, already, the most recent round of stimulus checks is pushing the savings rate higher again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 41 basis points in May, bringing year-to-date excess returns up to +163 bps. Aaa Non-Agency CMBS outperformed Treasuries by 27 bps in May, bringing year-to-date excess returns up to +78 bps. Non-Aaa Non-Agency CMBS outperformed by 84 bps, bringing year-to-date excess returns up to +453 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Even with the economic recovery well underway, commercial real estate loan demand continues to weaken and banks are not making lending standards more accommodative (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 37 basis points in May, bringing year-to-date excess returns up to +125 bps. The average index option-adjusted spread tightened 7 bps on the month and it currently sits at 27 bps (bottom panel). Though Agency CMBS spreads have completely recovered 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 May 28TH, 2021) It’s All About Employment It’s All About Employment 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 May 28TH, 2021) It’s All About Employment It’s All About Employment 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 57 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 57 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) It’s All About Employment It’s All About Employment Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 28TH, 2021) It’s All About Employment It’s All About Employment Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For further discussion of how we assess the state of monetary policy vis-à-vis spread product please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021. 3 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021. 5 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 6 Please see US Bond Strategy Weekly Report, “Entering A New Yield Curve Regime”, dated May 11, 2021.