Japan

Highlights Structural headwinds are still too strong to hold a long-term bullish view on Eurozone equities relative to the US. However, the coming two years should be kind to euro area stocks. The relative performance of European stocks compared to that of the US is predominantly a function of yields. BCA foresees higher yields over a 24-month period. Moreover, European equities are exceptionally cheap, which accentuates their appeal as a yield play. Tactical considerations indicate that a modest overweight in European stocks, not an aggressive one, is most appropriate for cyclical investors. European investment grade bonds are appealing in a European fixed-income portfolio. Feature Chart 1Europe's Underperformance Explained Europe's Underperformance Explained Europe's Underperformance Explained Over the past decade, Eurozone equities have massively underperformed US ones. The poor outcome generated by European bourses mimicked the fall in European profits against the US (Chart 1). Considering that the relative performance of euro area stocks stands at an all-time low, should investors begin to bet on Europe? The outlook for yields favors European stocks on a cyclical basis. However, the structural picture suggests that both Europe and the US must experience fundamental changes before European stocks can surpass their US counterparts on a long-term basis.  Structural Challenges Remain The case for overweighting European equities on a structural investment horizon (5 to 10 years) remains weak. Only some major changes in the European and US economies can alter the long-term headwinds facing Eurozone stocks. Table 1US Possesses The Favored Sectors Time And Attraction Time And Attraction Sectoral biases partly explain Europe’s inability to match the US’s profit potential. The US market over-represents high-margin and high return-on-equity businesses, such as technology and healthcare, while most Eurozone bourses have significant weightings in the structurally challenged financial, materials, and energy sectors (Table 1). This difference in sector representation also explains the larger buybacks witnessed in US markets compared to euro area ones, which further boosted the US’s relative EPS. Chart 2Japan Never Recovered Japan Never Recovered Japan Never Recovered The performance of Japanese equities over the past three decades provides another cautionary tale for European stocks. Despite a substantial underperformance in the 1990s, Japanese equities never meaningfully recovered in the 2000s and ended up falling further behind the US over the past 12 years (Chart 2). A powerful liquidity trap and a 23% decline in the Japanese population compared to that of the US seriously hampered the ability of Japanese firms to generate stronger relative cash flows. This challenging profit picture meant that no matter how low JGB rates fell in comparison to the US, Japanese multiples never benefited from a significant re-rerating.  The Eurozone suffers from similar ills to that of Japan, which warns that the latter constitutes a valid template for European assets. Europe’s population is expected to decline by 16% relative to that of the US over the coming three decades, which will hurt sales and capex in Europe. Moreover, despite low interest rates, private credit demand is weak, which limits the region’s economic vigor. Most concerning, Europe’s capital stock as a share of GDP is substantial, especially in the periphery (Chart 3). Such an observation indicates that there is a high probability that previously misallocated capital is burdening the euro area. This misallocation will continue to hurt economic activity, because it encumbers demand via weak capex and also harms productivity. A DuPont decomposition of RoE reveals how Europe’s economic malaise affects corporate profitability (Chart 4). The Eurozone’s excessively large capital stocks means that its asset turnover is inferior to that of the US, which corroborates the notion that capital is misallocated. Moreover, the euro area’s low profit margins reflect more than its sectoral composition. Greater economic rigidities as well as lower market power and concentration in Europe hurt profitability (even if it limits inequalities compared to the US). Finally, the corporate sector is deleveraging, which is a consequence of a liquidity trap and poor trend growth, causing the ratio of RoE to RoA to decline relative to the US. Chart 3Too Much Capital Too Much Capital Too Much Capital Chart 4DuPont De No Good DuPont De No Good DuPont De No Good To reverse the structural outperformance of US equities relative to the Eurozone, Europe’s secular profitability underperformance must end. We will look for the following factors to stop this decline, which we will explore in further detail over time: European reforms. Europe will remain disadvantaged until its excess capital stock is written off. This process is complex and it will require greater fiscal integration as well as greater reforms to promote competition and to decrease labor market as well as service sector rigidities. More Innovation. Despite a strong patent record in economies such as Germany, Europe lags behind the US in the creation of leading innovative companies. Europe’s industrial and consumer discretionary sectors could prove beneficiaries of the green revolution taking place around the world, but it is still too early to tell. Chart 5Market Power Helps The US Market Power Helps The US Market Power Helps The US An ossification of the US economy. Europe could also begin to outperform, because the US might lose its edge. Economic populism is rife in the US, fueled by growing discontent with economic inequalities. As a result, government involvement in the economy as well as regulatory efforts could increase significantly. While a push to redistribute income toward the middle class would alleviate inequalities, it would hurt profitability and cause US RoE to decline toward European levels (Chart 5). Bottom Line: The secular underperformance of Eurozone equities reflects their inability to generate as much profits as US ones. Beyond sector biases, Europe’s demographic hurdles and its deeper problem with secular stagnation remain its key handicaps. For now, there is no solid case to bet on a major change in these trends, which only European reforms or problems in the US can undo. But A Cyclical Opportunity Exists Despite the challenging structural environment for European equities, the cyclical outlook (24 months) is attractive. Even in Japan, multi-year episodes of outperformance punctuated a decades-long underperformance relative to the US or the MSCI all-country world index. In the case of the Eurozone, this upbeat view rests on BCA Research expectations of higher global yields. The performance of Europe’s equities relative to the US correlates closely with the level of US yields (Chart 6). The sectoral footprint of both bourses is an important driver of this correlation. The US overweighs growth and defensive stocks, which account for 49% and 23% of its capitalization, respectively. Meanwhile, the euro area over-represents value stocks and deep cyclicals, which account for 55% and 26% of its market, respectively. Historically, global value stocks beat growth equities when yields are rising (Chart 7).  Chart 6A Yield Story A Yield Story A Yield Story Chart 7What Value Likes What Value Likes What Value Likes The outperformance of value stocks when yields rise is multifaceted. Deep cyclicals, such as industrials, materials, financials and energy, constitute a larger share of value benchmark than growth ones. Consequently, when yields increase because the global business cycle experiences an upswing, the earnings of value stocks accelerate compared to those of growth stocks (Chart 7, bottom panel). The positive impact of yields on the value versus growth split is also more direct. Higher yields, especially if they accompany a steeper yield curve, boost the profitability of financials. Meanwhile, mounting yields increase the discount factor applied to the long-term deferred cash flows that contribute a large proportion of the intrinsic value of growth stocks. Higher yields also support the relative performance of Eurozone stocks via the evolution of the expected growth rates of their long-term earnings. As Chart 8 illustrates, upgrades to sell-side estimates of the long-term growth rate of European EPS relative to the US coincide with a steeper US yield curve slope and rising 5-year/5-year forward Treasury yields. These relationships exist because European economic activity and sectoral representation are more cyclical than that of the US.  Eurozone equities look like a particularly cheap bet on higher yields over the coming 18 to 24 months. Sentiment toward European assets remains depressed compared to the US. Even on an equal-weighted basis, the discount of the expected long-term growth rate of euro area EPS relative to the US is exceptionally wide (Chart 9, top panel). True, the sustainable growth rate (SGR) of earnings is a function of the return on equity and the dividend payout ratio. Nonetheless, despite the fact that the euro area low RoE forces the European SGR down, Eurozone stocks embed a long-term growth rate that is 47% too low vis-à-vis the US. Other metrics underscore the cheapness of European equities relative to the US. Our Mechanical Valuation Indicator, which is sector neutral, stands at a 1-sigma discount in favor of the Eurozone (Chart 9, bottom panel). Chart 8EPS Growth and The Yield Structure EPS Growth and The Yield Structure EPS Growth and The Yield Structure Chart 9Europe Is Cheap Europe Is Cheap Europe Is Cheap Ultimately, Europe’s relative expected growth and valuations are particularly depressed, because domestic activity lags behind that of the US by a significant margin. As the vaccination campaign advances and the economy reopens later in the quarter, the Eurozone’s service sector will catch up and the earnings growth discount will dissipate (Chart 10). Moreover, regardless of its recent dynamism, even the European industrial sector has room to catch up to the US. Our Swedish Economic Diffusion Index captures the general strength in Swedish economic activity, which foretells a further increase in both the euro area Manufacturing PMI and equities relative to the US (Chart 11). Chart 10Stronger Services Will Help Stronger Services Will Help Stronger Services Will Help Chart 11Listen To Sweden Listen To Sweden Listen To Sweden Bottom Line: BCA’s expectations that global yields will rise over the coming 24 months are consistent with Eurozone equities outperforming US ones over this period, even if the long-term outlook remains challenging for Europe. European equities are much more pro-cyclical than US ones, which is reified by their sector and value biases. Moreover, euro area equities currently embed a particularly large discount to their US counterpart, which increases their attractiveness as a play on rising bond yields. The Right Entry Point? Strategy and forecasts are two different things. BCA strongly believes that yields will rise over the coming two years; however, a large overweight in Eurozone equities is a risky bet at the current juncture. Instead, we recommend investors opt for a modest overweight. Short-term traders should stay clear of this market for now. The reason for this cautiousness is that yields are very vulnerable to a temporary near-term pullback because: Chart 12A Countertrend Bond Rally? A Countertrend Bond Rally? A Countertrend Bond Rally? Technicals point to a counter-trend bounce in bond prices. Our BCA Composite Technical Indicator is massively oversold, our Composite Sentiment Indicator is extremely depressed, and speculators are aggressively shorting T-Bonds (Chart 12). The recent bond market behavior is puzzling. Despite March’s blockbuster non-farm payroll data and Manufacturing, as well as Services ISM surveys, yields are softening. Not even the announcement of the Biden administration’s $2.3 trillion American Jobs Plan could increase yields in recent weeks. This price action confirms that bonds are oversold and that, until the recent price decline is digested, the threshold to push yields higher has risen meaningfully. Equities are at risk of a pullback. Euphoria is prevalent, which increases the odds of corrective action in equities. Our BCA Equity Capitulation Index stands at a 45-year high (Chart 13) and our US Equity Strategy team’s Risk Appetite Index is at its highest levels since 2007, both of which suggest that complacency is rife. Moreover, the put/call ratio has collapsed to 0.45, which shows the carefree attitude of traders. Yields will decline if stock prices correct. EM equities are underperforming US stocks. EM benchmarks are more sensitive to marginal changes in the global growth outlook. For now, the risk is that growth disappoints lofty expectations. Since 2014, periods of relative weakness in EM bourses precede declines in Treasury yields (Chart 14). Authorities are trying to limit credit growth in China. As we argued two weeks ago, Beijing is aiming to slow credit growth to prevent systemic vulnerabilities from developing. This process is fraught with risks and is likely to result in a deceleration in China’s economy. While Europe and most emerging markets remained mired in a health crisis, China will be a source of temporary downside for global economic activity. The recent announcement that the PBoC asked Chinese banks to limit new loans confirms this assessment. Chart 13Euphoria! Euphoria! Euphoria! Chart 14EM Stocks Are Telling Us Something EM Stocks Are Telling Us Something EM Stocks Are Telling Us Something Bottom Line: For now, investors with a cyclical horizon (two years) should only keep a modest overweight position in Eurozone equities because the near-term outlook for yields points to some temporary downside. Not allocating the full allowable capital budget to Europe will allow investors to upgrade their overweight after the near-term downside in yields has passed. Investors may also consider implementing some hedges. Our foreign exchange strategist recommends a short EUR/JPY position as a form of portfolio protection. Keeping some cash in yen to deploy later in Europe mimics this advice. Short-term traders should stay clear of Europe as long as bond markets have not digested their oversold condition. Market Focus: Investment Grade Corporates and the ECB The ECB’s minutes highlight that investment grade corporate bonds are attractive within European fixed-income portfolios. The recently released ECB minutes revealed that higher real rates do not overly concern the Governing Council, because they reflect an improving global economic outlook and not an eventual policy tightening. Moreover, the GC does not want to give the impression it will engage in yield control, yet the pace of purchases under the Pandemic Emergency Purchase Programme (PEPP) will remain accelerated and flexible until June, at a minimum. The ECB will not derail the supportive environment for economic activity anytime soon. Meanwhile, as we have argued in past reports, fiscal policy in Europe will also stay relaxed for the time being. Thus, the Eurozone’s policy environment remains supportive for credit spreads, especially since the default cycle has been muted. However, do corporate bonds already fully price in this positive backdrop? According to the 12-month breakeven spread, European credit spreads can compress further. The breakeven spread is the amount of spread widening required for corporate bond returns to break even with a duration-matched position in government bond securities over a 12-month horizon. It is approximated by dividing the OAS of a bond (or an index) by its duration. The breakeven spread is then compared to its own history, by observing the percentage of time that it has been lower in the past.1  Chart 15Some Value Left Some Value Left Some Value Left European credit spreads have tightened 160 bps since March last year and are already below their pre-Covid level (Chart 15). However, the 12-month breakeven spread has been tighter 18% of the time since 1999. In other words, higher quality corporate bonds in Europe have room to see further spread compression, since policy will remain relaxed for a long time. This is especially true in the Aa-rated credit tier, where the breakeven spread has been more expensive 35% of the time (not shown). Meanwhile, US breakeven spreads for IG corporate bonds are in their 2nd percentile and policy will tighten sooner than in Europe. Therefore, bond investors with a European-only mandate are not forced to step down the quality ladder as aggressively as those in the US do. Table 2Norway, France And Italy Stand Out Time And Attraction Time And Attraction Table 2 provides the same analysis at the country level. Taking into consideration the average credit rating of each countries’ investment grade bonds, we find that Norwegian, French, and Italian spreads have the most value left. Interestingly, the ECB’s purchases of Italian and French paper is currently deviating widely from its capital keys, which should place downward pressure on credit spreads in these jurisdictions. Bottom Line: There is still value left in European investment grade corporate bonds, unlike in the US, where valuations are extremely expensive and a decrease in quality is warranted. For now, such a move is uncalled for in Europe, especially since the value in its high-yield index is concentrated in its riskiest credit tiers. At the country level, investors should favor Norwegian, French, and Italian investment grade corporate bonds.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Jeremie Peloso, Senior Analyst JeremieP@bcaresearch.com   Footnotes 1We find this valuation tool superior to others for two main reasons: (i) using the breakeven spread rather than the average index OAS allows us to control for the changing average duration of the benchmark bond indices; and (ii) the percentile rank is often a better representation of credit spreads than the spread itself.   Cyclical Recommendations Structural Recommendations Trades Currency Performance Time And Attraction Time And Attraction Fixed Income Performance Government Bonds Time And Attraction Time And Attraction Corporate Bonds Time And Attraction Time And Attraction Equity Performance Major Stock Indices Time And Attraction Time And Attraction Geographic Performance Time And Attraction Time And Attraction Sector Performance Time And Attraction Time And Attraction Closed Trades

Highlights Continued upgrades to global economic growth – most recently by the IMF this week –will support higher natgas prices.  In our estimation, gas for delivery at Henry Hub, LA, in the coming withdrawal season (November – March) is undervalued at current levels at ~ $2.90/MMBtu. Inventory demand will remain strong during the current April-October injection season, following the blast of colder-than-normal weather in 1Q21 that pulled inventories lower in the US, Europe and Northeast Asia. The odds the US will succeed in halting completion of the final leg of the Russian Nord Stream 2 natural gas pipeline into Germany are higher than the consensus expectation.  Our odds the pipeline will not be completed this year stand at 50%, which translates into higher upside risk for natural gas prices.  We are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close.  The probability of Nord Stream 2 cancellation is underpriced, which means European TTF and Asian JKM prices will have to move higher to attract LNG cargoes next winter from the US, if the pipeline is cancelled (Chart of the Week). Feature As major forecasting agencies continue to upgrade global growth prospects, expectations for industrial-commodity demand – energy, bulks, and base metals – also are moving higher. This week, the IMF raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021.1 This upgrade follows a similar move by the OECD last month.2 In the US, the EIA is expecting industrial demand for natural gas to rise 1.35 Bcf/d this year to 23.9 Bcf/d; versus 2019 levels, industrial demand will be 0.84 Bcf/d higher in 2021. For 2022, industrial demand is expected to be 24.2 Bcf/d. US industrial demand likely will recover faster than the EU's, given the expectation of a stronger recovery on the back of massive fiscal and monetary stimulus. Overall natgas demand in the US likely will move lower this year, given higher natgas prices expected this year and next will incentivize electricity generators to switch to coal at the margin, according to the EIA. Total demand is expected to be 82.9 Bcf/d in the US this year vs. 83.3 Bcf/d last year, owing to lower generator demand. Pipeline-quality gas output in the US – known as dry gas, since its liquids have been removed for other uses – is expected to average 91.4 Bcf/d this year, essentially unchanged. Lower consumption by the generators and flat production will allow US gas inventories to return to their five-year average levels of 3.7 Tcf by the end of October, in the EIA's estimation (Chart 2). Chart of the WeekUS-Russia Geopolitical Risk Underpriced US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 2US Natgas Inventories Return To Five-Year Average US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher US Liquified Natural Gas (LNG) exports are likely to expand, as Asian and European demand grows (Chart 3). Prior to the boost in US LNG demand from colder weather, exports set monthly records of 9.4 Bcf/d and 9.8 Bcf/d in November and December of last year, respectively, with Asia accounting for the largest share of exports (Chart 4). This also marked the first time LNG exports exceeded US pipeline exports to Mexico and Canada. The EIA is forecasting US LNG exports will be 8.5 bcf/d and 9.2 Bcf/d this year and next, versus pipeline exports of 8.8 Bcf/d and 8.9 Bcf/d in 2021 and 2022, respectively. Chart 3US LNG Exports Continue Growing US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 4US LNG Exports Set Records In November And December 2020 US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher US LNG exports – and export potential given the size of the resource base at just over 500 Tcf – now are of a sufficient magnitude to be a formidable force in global markets, particularly in Europe. This puts it in direct conflict with Russia, which has targeted Europe as a key market for its pipeline natural gas exports. US-Russia Standoff Looming Over Nord Stream 2 Given the size and distribution of global oil and gas production and consumption, it comes as no surprise national interests can, at times, become as important to pricing these commodities as supply-demand fundamentals. This is particularly true in oil, and increasingly is becoming the case in natural gas. That the same dramatis personae – the US and Russia – should feature in geopolitical contests in oil and gas markets also should not come as a surprise. In an attempt to circumvent transporting its natural gas through Ukraine, Russia is building a 1,230 km underwater pipeline from Narva Bay in the Kingisepp district of the Leningrad region of Russia to Lubmin, near Greifswald, in Germany (Map 1). The Biden administration, like the Trump administration and US Congress, is officially attempting to halt the final leg of the pipeline from being built, although Biden has not yet put America’s full weight into stopping it. Biden claims it will be up to the Europeans to decide what to do. At the same time, any major Russian or Russian-backed military operation in Ukraine could trigger an American action to halt the pipeline in retaliation. Map 1Nord Stream 2 Route US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher In our estimation, there is a 50% chance that the Nord Stream 2 natural gas pipeline will not be completed this year or go into operation as planned given substantial geopolitical risks. The $11 billion pipeline would connect Russia directly to Germany with a capacity of about 55 billion cubic meters, which, combined with the existing Nord Stream One pipeline, would equal 110 BCM in offshore capacity, or 55% of Russia's natural gas exports to Europe in 2019. The pipeline’s construction is 94% complete, with the Russian ship Akademik Cherskiy entering Danish waters in late March to begin laying pipes to finish the final 138-kilometer stretch, according to Reuters. The pipeline could be finished in early August at the pace of 1 kilometer per day.3 The Russian and German governments are speeding up the project to finish it before US-Russia tensions, or the German elections in September, interrupt the construction process again. It is not too late for the US to try to halt the pipeline through sanctions. But for the Americans to succeed, the Biden administration would have to make an aggressive effort. Notably the Biden administration took office with a desire to sharpen US policy toward Russia.4 While Biden seeks Russian engagement on arms reduction treaties and the Iranian nuclear negotiations, he mainly aims to counter Russia, expand sanctions, provide weapons to Ukraine, and promote democracy in Russia’s sphere of influence. The result will almost inevitably be a new US-Russia confrontation, which is already taking shape over Russia’s buildup of troops on the border with Ukraine, where US and Russian meddling could cause civil war to reignite (Map 2). Map 2Russia’s Military Tensions With The West Escalate In Wake Of Biden’s Election And Ukraine’s Renewed Bid To Join NATO US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Tensions in Ukraine are directly tied to US military cooperation with Ukraine and any possibility that Ukraine will join the NATO military alliance, a red line for Putin. Nord Stream 2 is Russia’s way of bypassing Ukraine but a new US-Russia conflict, especially a Russian attack on Ukraine, would halt the pipeline. The pipeline’s completion would improve Russo-German strategic relations, undercut US liquefied natural gas exports to Germany and the EU, and reduce the US’s and eastern Europe’s leverage over Russia (and Germany). Biden says his administration is planning to impose new sanctions on firms that oversee, construct, or insure the pipeline, and such sanctions are required under American law.5 Yet Biden also wants a strong alliance with Germany, which favors the pipeline and does not want to escalate the conflict with Russia. The American laws against Nord Stream have big loopholes and give the president discretion regarding the use of sanctions, which means Biden would have to make a deliberate decision to override Germany and impose maximum sanctions if he truly wanted to halt construction.6 This would most likely occur if Russia committed a major new act of aggression in Ukraine or against other European democracies. The German policy, under the current ruling coalition led by Chancellor Angela Merkel’s Christian Democratic Union, is to finish the pipeline despite Russia’s conflicts with the West and political repression at home. Russia provides more than a third of Germany’s natural gas imports and this pipeline would bypass eastern Europe’s pipeline network and thus secure Germany’s (and Austria’s and the EU’s) natural gas supply whenever Russia cuts off the flow to Ukraine (through which roughly 40% of Russian natural gas still must pass to reach Europe). Germany's Election And Natgas Politics Germany wants to use natural gas as a bridge while it phases out nuclear energy and coal. Natural gas has grown 2.2 percentage points as a share of Germany’s total energy mix since the Fukushima disaster of 2011, and renewable energy has grown 7.7ppt, while coal has fallen 7.3ppt and nuclear has fallen 2.5ppt (Chart 5). The German federal election on September 26 complicates matters because Merkel and the Christian Democrats are likely to underperform their opinion polls and could even fall from power. They do not want to suffer a major foreign policy humiliation at the hands of the Americans or a strategic crisis with Russia right before the election. They will insist that Biden leave the pipeline alone and will offer other forms of cooperation against Russia in compensation. Therefore, the current German government could push through the pipeline and complete the project even in the face of US objections. But this outcome is not guaranteed. The German Greens are likely to gain influence in the Bundestag after the elections and could even lead the German government for the first time – and they are opposed to a new fossil fuel pipeline that increases Russia’s influence. Chart 5Germany Sees Nord Stream 2 Gas As Bridge To Low-Carbon Economy US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Hence there is a fair chance that the pipeline does not become operational: either Americans halt it out of strategic interest, or the German Greens halt it out of environmental and strategic interest, or both. True, there is a roughly equal chance that Merkel’s policy status quo survives in Germany, which would result in an operational pipeline. The best case for Germany might be that the current government completes the pipeline physically but the next government has optionality on whether to make it operational. But 50/50 odds of cancellation is a much higher risk than the consensus holds. The Russian policy is to finish Nord Stream 2 while also making an aggressive military stance against the West’s and NATO’s influence in Ukraine. This would expand Russian commodity and energy exports and undercut Ukraine’s natgas transit income. It would also increase Russian leverage over Germany – and it would divide Germany from the eastern Europeans and Americans. A preemptive American intervention would elicit Russian retaliation. The Russians could respond in the strategic sphere or the economic sphere. Economically they could react by cutting off natural gas to Europe, but that would undermine their diplomatic goals, so they would more likely respond by increasing production of natural gas or crude oil to steal American market share. In any scenario Russian retaliation would likely cause global price volatility in one or more energy markets, in addition to whatever volatility is induced by the cancellation of Nord Stream 2 itself. US-Russia tensions are likely to escalate but only Ukraine and Nord Stream 2, or the separate Iranian negotiations, have a direct impact on global energy supply. If Germany goes forward with the pipeline, then Russia would need to be countered by other means. The Americans, not the Germans, would provide these “other means,” such as military support to ensure the integrity of Ukraine and other nations’ borders. The Russians may gain a victory for their energy export strategy but they will never compromise on Ukraine and they will still need to focus on the broader global shift to renewable energy, which threatens their economic model and hence ultimately their regime stability. So, the risk of a market-moving US-Russia conflict can be delayed but probably not prevented (Chart 6). Chart 6US-Russia Conflit Likely US-Russia Conflit Likely US-Russia Conflit Likely Bottom Line: The Nord Stream 2 pipeline is not guaranteed to be completed this year as planned. The US is more likely to force a halt to the Nord Stream 2 pipeline than the consensus holds, especially if Russia attacks Ukraine. If the US fails to do so, then the German election will become the next signpost for whether the pipeline will become operational. If the Americans halt the pipeline, then US-Russian conflict either already erupted or will occur sooner rather than later and will likely impact global oil or natural gas prices. Investment Implications Our subjective assessment of 50% odds the US will succeed in halting completion of the final leg of Nord Stream 2 are higher than the consensus expectation. This translates directly into higher upside risk for natural gas prices in the US and Europe later this year and next. Given our view, we are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close. The probability of Nord Stream 2 cancellation is underpriced, which means the odds of higher prices in the LNG market are underpriced (Chart 7). The immediate implication of our view is European TTF prices will have to move higher to attract LNG cargoes next winter from the US, if the Nord Stream 2 pipeline's final leg is cancelled. This also would tighten the Asian markets, causing the JKM to move higher as well (Chart 8). Any indication of colder-than-normal weather in the US, Europe or Asian markets would mean a sharper move higher. Chart 7Natgas Tails Are Too Narrow For Next Winter US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 8Nord Stream 2 Cancellation Would Boost JKM Prices Nord Stream 2 Cancellation Would Boost JKM Prices Nord Stream 2 Cancellation Would Boost JKM Prices   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Commodities Round-Up Energy: Bullish The US and Iran began indirect talks earlier this week in Vienna aimed at restoring the Joint Comprehensive Plan of Action (JCPOA), otherwise known as the "Iran nuclear deal." All of the other parties of the deal – Britain, China, France, Germany and Russia – are in favor of restoring the deal. BCA Research believes this is most likely to occur prior to the inauguration of a new president who is expected to be a hardliner willing to escalate Iran’s demands. US President Biden can unilaterally ease sanctions and bring the US into compliance with the deal, and Iran could then reciprocate. If a deal is not reached by August it could take years to resolve US-Iran tensions. China could offer to cooperate on sanctions and help to broker negotiations following the signing of its 25-year trade deal with Iran last week. Russia likely would demand the US not pressure its allies to cancel the Nord Stream 2 deal, in return for its assistance in brokering a deal. Base Metals: Bullish Iron ore prices continue to be supported by record steel prices in China, trading at more than $173/MT earlier this week. Even though steel production reportedly is falling in the top steel-producer in China, Tangshan, as a result of anti-pollution measures, for iron ore remains stout. As we have previously noted, we use steel prices as a leading indicator for copper prices. We remain long Dec21 copper and will be looking for a sell-off to get long Sep21 copper vs. short Sep21 copper if the market trades below $4/lb on the CME/COMEX futures market (Chart 9). Precious Metals: Bullish Gold held support ~ $1,680/oz at the end of March, following an earlier test in the month. We remain long the yellow metal, despite coming close to being stopped out last week (Chart 10). The earlier sell-off appeared to be caused by a need to raise liquidity to us. We continue to expect the Fed to hold firm to its stated intent to wait for actual inflation to become manifest before raising rates, and, therefore, continue to expect real rates to weaken. This will be supportive of gold and commodities generally (Chart 10). Ags/Softs: Neutral Corn continues to be well supported above $5.50/bu, following last week's USDA report showing farmers intend to increase acreage planted to just over 91mm acres, which is less than 1% above last year's level. Chart 9 Copper Prices Surge As Global Storage Draws Copper Prices Surge As Global Storage Draws Chart 10 Gold Disconnected From US Dollar And Rates Gold Disconnected From US Dollar And Rates       Footnotes 1     Please see the Fund's April 2021 forecast Managing Divergent Recoveries. 2     We noted last week these higher growth expectations generally are bullish for industrial commodities – energy, metals, and bulks.  Please see Fundamentals Support Oil, Bulks, And Metals, which we published 1 April 2021.  It is available at ces.bcaresearch.com. 3    For the rate of construction see Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Eurasia Daily Monitor 18: 17 (February 1, 2021), Jamestown Foundation, jamestown.org. For the current status, see Robin Emmott, “At NATO, Blinken warns Germany over Nord Stream 2 pipeline,” Reuters, March 23, 2021, reuters.com. 4    The Democratic Party blames Russia for what it sees as a campaign to undermine the democratic West and recreate the Soviet sphere of influence. See for example the 2008 invasion of Georgia, the failure of the Obama administration’s 2009-11 diplomatic “reset,” the Edward Snowden affair, the seizure of Crimea and civil war in Ukraine, the survival of Syria’s dictator, and Russian interference in US elections in 2016 and 2020. 5    The Countering Russian Influence in Europe and Eurasia Act of 2017, and the Protecting Europe’s Energy Security Act of 2019/2020, contain provisions requiring sanctions on firms that have contributed in any way a minimum of $1 million to the project, or provide pipe-laying services or insurance. There are exceptions for services provided by the governments of the EU member states, Norway, Switzerland, or the UK. The president has discretion over the implementation of sanctions as usual. 6    The German state of Mecklenburg-Vorpommern is creating a shell foundation to enable the completion of the pipeline. It can shield companies from American sanctions aimed at private companies, not sovereigns.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Dear client, In addition to this abbreviated weekly report, we are also sending you an in-depth report on the euro, written by my colleague Mathieu Savary. Mathieu argues that the euro could continue to face some downside in the near-term, creating perfect conditions for a buying opportunity below 1.15. We agree with Mathieu’s assessment and are shorting EUR/JPY this week as a tactical trade. Finally, last week, we held a webcast during which I discussed the key themes that will shape the dollar landscape in the coming months. In case you missed it, you can listen to the replay here. Kind regards, Chester Highlights Being long the dollar is now a consensus trade. A new US infrastructure bill will be positive for US growth. However, the new package also increases the probability that inflation will be higher in the US, which will depress relative real rates. Go short EUR/JPY as a tactical trade. Feature Chart I-1Dollar Sentiment Has Been Reset Dollar Sentiment Has Been Reset Dollar Sentiment Has Been Reset The DXY index is fast approaching our 94-95 target and it is an open question whether the rally will stall at these levels, or punch through for new highs this year. Historically, the dollar has tended to move in long cycles, with the latest bull and bear markets lasting about a decade or so. If, as we believe, a dollar bear market did indeed commence in 2020, then the historical evidence is that any bounce will be capped around 4-6%. This was the experience of the 2000s. The defining landscape during the latter stages of the dollar bull market in 2018 and 2019 was deteriorating global growth, with financial conditions which remained relatively too tight. The situation today is extremely easy financial conditions and improving global growth. As such, our bias remains that the landscape is more characteristic of a dollar bear market.  Speculators are now long the dollar and our capitulation index is approaching overbought levels (Chart I-1). So while there is scope for the dollar to continue to rise in the near term, the big gains are behind us. US Infrastructure Spending And Bond Yields President Joe Biden’s American Jobs Plan did little to lift US long bond yields. This suggests that most of the improvement to aggregate demand may have already been priced in. The big driver of the US dollar this year has been the improvement in yields, particularly at the long end of the curve. Short yields have remained anchored near zero (Chart I-2). If this improvement in long rates is torpedoed by lack of bi-partisan support for a larger fiscal package, then this will provide less scope for the US dollar to rise. Economically, a large infrastructure package makes sense. The neutral rate of interest in the US is well above the Fed funds target rate. A widening gap suggests underlying financing conditions (short rates) are low relative to the potential growth rate of the economy (long rates). Not surprisingly, this also tends to track the yield curve pretty closely (Chart I-3). This incentivizes banks to lend, and fund these projects. Chart I-2The Move In Rates Has Been On The Long End The Move In Rates Has Been On The Long End The Move In Rates Has Been On The Long End Chart I-3A Steeping Curve Usually Encourages Lending A Steeping Curve Usually Encourages Lending A Steeping Curve Usually Encourages Lending The feedback loop with the dollar could however be negative. First, while the boost to aggregate demand supports US growth in the short term, there will be spillovers to other countries. The net beneficiaries might also be the countries that have the raw materials needed to realize this infrastructure plan. The proposal has a largely “buy American” tilt, but this will also create sharp domestic shortages as the US is not a manufacturing-based economy. An increase in imports will widen the US trade deficit. Second, the returns on infrastructure investments tend to be large in lower-productivity countries. Meanwhile, the increase in US taxes to fund these deficits will lower the return on capital for US assets. This might limit foreign inflows into US capital markets. Third, the US output gap is slated to close faster than in other economies, meaning the increase in aggregate demand will soon become inflationary. This could further depress real rates in the US. There is a longstanding correlation between US relative real rates and the dollar (Chart I-4). Chart I-4The Dollar Moves With Relative Real Rates The Dollar Moves With Relative Real Rates The Dollar Moves With Relative Real Rates Chart I-5The Dollar Is Overvalued The Dollar Is Overvalued The Dollar Is Overvalued Finally, it is important to remember that the starting point for the US dollar is as an expensive currency. According to our PPP models, the dollar is overvalued by over 10% (Chart I-5). This is already manifesting itself in a deteriorating trade balance. It also suggests that should the dollar continue to rise significantly, it will negatively impact US growth. Trading Strategy Amidst Market Uncertainty The near term outlook for the dollar remains bullish. Vaccinations are progressing at the fastest pace in the US and in the UK while the euro area, Canada and Japan are seeing a third wave of infections underway (Chart I-6). New lockdown measures have been implemented in these latter countries, which will further dent their Q2 outlook. While our bias is that these economies eventually benefit as their vaccination program progresses, the dollar remains in a sweet spot for now. Chart I-6AA Third Wave Is Underway A Third Wave Is Underway A Third Wave Is Underway Chart I-6BA Third Wave Is Underway A Third Wave Is Underway A Third Wave Is Underway Chart I-6CA Third Wave Is Underway A Third Wave Is Underway A Third Wave Is Underway One hedge to this scenario is to go short the EUR/JPY cross. First, our Chief European Investment Strategist Mathieu Savary argues that the euro could undershoot to 1.12 in the near term. This suggests that EUR/JPY which faces critical resistance a nudge above 130, will stage a countertrend reversal (Chart I-7). Both EUR/USD and EUR/JPY tend to be positively correlated. Second, European bourses are underperforming those in Japan in common-currency terms. The relative performance of the equity markets have usually moved in lockstep with the currency, but a divergence has opened up (Chart I-8). In fact, given very similar sector compositions across both bourses, this divergence might be down to competitiveness, given the rally in EUR/JPY. Should profits in Europe suffer relative to those in Japan, this will cap EUR/JPY gains (Chart I-9) Chart I-7EUR/JPY Faces Strong Resistance At 130 EUR/JPY Faces Strong Resistance At 130 EUR/JPY Faces Strong Resistance At 130 Chart I-8EUR/JPY Moves With Relative Share Prices EUR/JPY Moves With Relative Share Prices EUR/JPY Moves With Relative Share Prices   Chart I-9EUR/JPY And Relative Profits EUR/JPY And Relative Profits EUR/JPY And Relative Profits Finally, monetary policy is more accommodative in Europe than in Japan. Interest rates are lower, and the ECB’s balance sheet is rising more aggressively. This has historically been accompanied by a lower EUR/JPY exchange rate (Chart I-10). Chart I-10EUR/JPY And Relative Monetary Policy EUR/JPY And Relative Monetary Policy EUR/JPY And Relative Monetary Policy We eventually expect EUR/JPY to break higher, but for now, we are opening a short position in this cross as a portfolio hedge. In line with this view, we are tightening stops on all of our trades this week. The dollar could be set for violent moves in the coming weeks. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The Biden Administration's $2.25 trillion infrastructure plan rolled out yesterday will, at the margin, boost global demand for energy and base metals more than expected later this year and next.  Global GDP growth estimates – and the boost supplied by US stimulus – once again will have to be adjusted higher (Chart of the Week). Energy and metals fundamentals continue to tighten. OPEC 2.0's so-far-successful production management strategy will keep the level of supply just below demand, which will keep Brent crude oil on either side of $60/bbl. Base-metals output will struggle to meet higher demand from the ongoing buildout of renewables infrastructure and growing electric-vehicle sales. Of late, concerns that speculative positioning suggests prices will head lower – or, at other times, higher – are entirely misplaced: Spec positioning conveys no information on price levels or direction.  Energy and metals prices, on the other hand, do convey useful information on spec positioning, demonstrating specs do not lead the news or prices, they follow them. Short-term headwinds caused by halting recoveries and renewed lockdowns – particularly in the EU – will fade in 2H21 as vaccines roll out, if the experience of the UK and US are any guide.  Continued USD strength, however, would remain a headwind. Feature If the Biden administration is successful in getting its $2.25 trillion infrastructure-spending bill through Congress, the US will join the rest of the world in the race to re-build – in some cases, build anew – its long-neglected bridges, roads, schools, communications and high-speed transportation networks, and, critically, its electric-power grid.  There's a lot of game left to play on this, but our Geopolitical Strategy group is giving this bill an 80% of passage later this year, after all the wrangling and log-rolling in Congress is done. In and of itself, the infrastructure-directed spending coming out of Biden's plan will be a catalyst for higher US industrial commodity demand – energy, metals and bulks.  In addition, it will support the lift in the demand boost coming out of higher GDP growth globally, which will be pushed higher by US fiscal spending, as the Chart of the Week shows.  Of note is the extremely robust growth expected in India, China and the US, which are among the largest consumers of industrial commodities globally.  Overall growth in the G20 and globally will be expansive in 2022 as well. Chart of the WeekBiden's $2.25 Trillion Infrastructure Bill Will Boost Global Commodity Demand Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals Higher GDP growth translates directly into higher demand for commodities, all else equal, as can be seen in the relationship between EM and DM GDP, supply and inventories and Brent crude oil prices in Chart 2.  While we have reduced our Brent forecast for this year to $60/bbl on the back of renewed demand-side weakness in the EU due to problems in acquiring and distributing COVID-19 vaccines, we expect this to be reversed next year and into 2025, with prices trading between $60-$80/bbl (Chart 3).  OPEC 2.0, the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, has done an excellent job of keeping the level of oil supply below demand over the course of the pandemic, which we expect to continue to the end of 2025.1 Chart 2Higher GDP Growth Presages Higher Commodity Demand Higher GDP Growth Presages Higher Commodity Demand Higher GDP Growth Presages Higher Commodity Demand Chart 3Brent Crude Oil Prices Will Average - / bbl to 2025 Brent Crude Oil Prices Will Average $60 - $80 / bbl to 2025 Brent Crude Oil Prices Will Average $60 - $80 / bbl to 2025 As the Biden plan makes its way through Congress, markets will get a better idea of how much diesel fuel, copper, steel, iron ore, etc., will be required in the US alone.  What is important to note here that the US is just moving to the starting line, whereas other economies like China and the EU already have begun their investment cycles in renewables and EVs.  At present, key markets already are tight, particularly copper (Chart 4) and aluminum (Chart 5).  In both markets, we expect physical deficits this year and next, which inclines us to believe the metals leg of this renewables buildout is just beginning – higher prices will be required to incentivize the development of new supply.2  Chart 4Copper Will Post Physical Deficit... Copper Will Post Physical Deficit... Copper Will Post Physical Deficit... Chart 5...As Will Aluminum ...As Will Aluminum ...As Will Aluminum This is particularly important in copper, where growth in mining output of ore has been flat for the past two years.  Copper is the one metal that spans all renewables technologies, and is a bellwether commodity for global growth.  We expect copper to trade to $4.50/lb (up ~ $0.50/lb vs spot) on the COMEX in 4Q21 on the back of increasing demand and tight supplies – i.e., falling mining supply and refined copper output growth (Chart 6). Worth noting also is steel rebar and hot-rolled coil prices traded at record highs this week on Chinese futures markets.  Stronger steel markets continue to support iron ore prices, although the latter is trading off its recent highs and likely will move lower toward the end of the year as Brazilian supply returns to the market.3  We use steel prices as a leading indicator for copper prices – steel leads copper prices by ~ 9 months.  This makes sense when one considers steel is consumed early in infrastructure and construction projects, while copper consumption occurs later as airports and houses are fitted with copper for electric, plumbing and communications applications. Chart 6Copper Ore Output Flat Copper Ore Output Flat Copper Ore Output Flat   Does Speculative Positioning Matter? Of late, media pundits and analysts have cited an unwinding of speculative positions in oil and metals markets following sharp run-ups in net long positions as a harbinger of weaker prices in the near future (Chart 7).4  At other times, speculation has been invoked as a reason for price surges – e.g., when oil rocketed  toward $150/bbl in mid-2008, which was followed by a price collapse at the start of the Global Financial Crisis (GFC).5 Brunetti et al note, "The role of speculators in financial markets has been the source of considerable interest and controversy in recent years. Concern about speculative trading also finds support in theory where noise traders, speculative bubbles, and herding can drive prices away from fundamental values and destabilize markets." (p. 1545) Chart 7Speculative Positioning Lower In Brent Than WTI Speculatives Positioning Lower in Brent Than WTI Speculatives Positioning Lower in Brent Than WTI We recently re-tested earlier findings in our research, which found that knowledge of how specs are positioned – either on the long or the short side of the market – conveys no information on the level of prices or the change that should be expected given that knowledge.  However, knowledge of the price level does convey useful information on how speculators are positioned in futures markets.6 In cointegrating regressions of speculative positions in crude oil, natural gas and copper futures on price levels for these commodities, we find the level of prices to be a statistically significant determinant of spec positions. We find no such relationship using spec positions as an explanatory variable for prices.7 On the other hand, Chart 2 above is an example of statistically significant relationships for Brent and WTI price as a function of supply-demand fundamentals displaying coefficients of determination (r-squares) of close to 90% in the post-GFC period (2010 to now).  This supports our earlier findings regarding spec behavior: They follow prices, they don't lead them.8 We are not dismissive of speculation.  It plays a critical role in markets, by providing the liquidity that enables commodity producers and consumers to hedge their price exposures, and to investors seeking to diversify their portfolios with commodity exposures that are uncorrelated to their equity and bond holdings.  Short-Term Headwinds Likely Dissipate COVID-19 remains the largest risk to markets generally, commodities in particular.  The mishandling of vaccine rollouts in the EU has pushed back our assumption for demand recovery deeper into 2H21, but it has not derailed it.  We expect COVID-related deaths and hospitalizations to fall in the EU as they have in the UK and the US following the widespread distribution of vaccines, which should occur in the near future as Brussels organizes its pandemic response (Chart 8).  Making vaccines available for other states in dire straits will follow, which will allow the global re-opening to progress as lockdowns are lifted (Chart 9). Chart 8EU Vaccination Rollouts Will Boost Global Economic Recovery Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals Chart 9Global Re-Opening Has Slowed, But Will Resume In 2H21 Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals The other big risk we see to commodities is persistent USD strength (Chart 10).  The dollar has rallied for the better part of 2021, largely on the back of improving US economic prospects relative to other states, and success in its vaccination efforts.  The resumption of the USD's bear market may have to wait until the rest of the world catches up with America's public-health response to the pandemic, and the global economy ex-US and -China enters a stronger expansionary mode. Bottom Line: We remain bullish industrial commodities expecting demand to improve as the EU rolls out vaccines and begins to make progress in arresting the pandemic and removing lockdowns.  Global fiscal and monetary policy, which likely will be bolstered by a massive round of US infrastructure spending beginning in 4Q21 will catalyze demand growth for oil and base metals.  This will prompt another round of GDP revisions to the upside.  The dollar remains a headwind for now, but we expect it to return to a bear market in 2H21. Chart 10The USD's Evolution Remains Important The USD's Evolution Remains Important The USD's Evolution Remains Important   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Going into the April 1 meeting of OPEC 2.0 today, we are not expecting any increase in production.  OPEC earlier this week noted demand had softened, mostly due to the slow recovery from the COVID-19 pandemic in the EU, which, based on their previous policy decisions, suggests the producer coalition will not be increasing production.  The coalition led by KSA and Russia will have to address Iran's return as a major exporter to China this year, which appears to have been importing ~ 1mm b/d of Iranian crude this month (Chart 11).  This puts Iran in direct competition with KSA as a major exporter to China, in defiance of the US re-imposition of sanctions against Iranian exports.  China and Iran over the weekend signed a 25-year trade pact that also could include military provisions, which could, over time, alter the balance of power in the Persian Gulf if Chinese military assets – naval and land warfare – deploy to Iran under their agreement.  Details of the deal are sparse, as The Guardian noted in its recent coverage.  Among other things, government officials in Tehran have come under withering criticism for entering the deal, which they contend was signed with a "politically bankrupt regime."  The Guardian also noted US President Joe Biden " is prepared to make a new offer to Iran this week whereby he will lift some sanctions in return for Iran taking specific limited steps to come back into compliance with the nuclear agreement, including reducing the level to which it enriches uranium," in the wake of the signing of this deal. Base Metals: Bullish Copper fell this week, initially on an inventory build, and has now settled right under the $4/lb mark, as investors await details on the US infrastructure bill unveiled in Pittsburgh, PA, on Wednesday.  According to mining.com, a major chunk of the proposed bill will be devoted to investments in infrastructure, which will be metals-intensive.  Precious Metals: Bullish Gold fell further this week, as US treasury yields rose, buoyed by the increased US vaccine efforts and President Biden’s proposed spending plans (Chart 12). USD strength also worked against the yellow metal, which has been steadily declining since the beginning of this year.  COMEX gold fell below the $1,700/oz mark for the third time this month and settled at $1,683.90/oz on Tuesday. Chart 11 Sporadic Producers Will Be Accomodated Sporadic Producers Will Be Accomodated Chart 12 Gold Trading Lower On The Back of A Strong Dollar Gold Trading Lower On The Back of A Strong Dollar     Footnotes 1     Please see Five-Year Brent Forecast Update: Expect Price Range of $60 - $80/bbl, which we published 25 March 2021.  It is available at ces.bcaresearch.com. 2     Please see Industrial Commodities Super-Cycle Or Bull Market?, which we published 4 March 2021 for additional discussion, particularly regarding the need for additional capex in energy and metals markets. 3    Please see UPDATE 1-Strong industrial activity, profit lift China steel futures, published by reuters.com 29 March 2021. 4    See, e.g., Column: Frothy oil market deflates as virus fears return published 23 March 2021. 5    Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), " Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74, for further discussion. 6    Please see Specs Back Up The Truck For Oil, which we published 26 April 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility published 10 May 2018.  Both are available at ces.bcaresearch.com. 7     We group money managers (registered commodity trading advisors, commodity pool operators and unregistered funds) and swap dealers (banks and trading companies providing liquidity to hedgers and speculators) together to test these relationships. 8    In our earlier research, we also noted our results generally were supported in the academic literature.  See, e.g., Fattouh, Bassam, Lutz Kilian and Lavan Mahadeva (2012), "The Role of Speculation in Oil Markets: What Have We Learned So Far?" published by The Oxford Institute For Energy Studies.   Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Central Bank Expectations: Market expectations of short-term interest rate moves over the next few years are inching higher. The potential for markets to offer a greater bond-bearish challenge to the current highly dovish forward guidance of the major central banks should not be dismissed given the growth-positive mix of expanding global vaccinations and US fiscal stimulus. Global Golden Rule: The gap between market expectations of global central bank policy rates and realized interest rate outcomes is a reliable predictor of government bond returns – a dynamic we have dubbed the “Global Golden Rule of Bond Investing”. Given our expectation that no major developed market central bank will hike rates within the next twelve months, the Global Golden Rule is calling for the recent government bond market laggards to outperform over the next year. Tapering & The Golden Rule: Government bonds in countries where central banks are most likely to begin tapering in 2022 well before considering rate hikes – most notably, the US and Canada – are likely to suffer returns worse than implied by the Global Golden Rule. It is too soon to raise allocations to those higher-beta bond markets. Feature As the first quarter of 2021 draws to a close, fixed income investors are licking their wounds from a rough start to the year. Government bonds across the developed world have absorbed heavy losses as yields have climbed higher, led by US Treasuries which are down -4.0% year-to-date in total return terms. Other markets have also been hit hard, like Canada (-3.9%), Australia (-3.5%) and the UK (-6.3%). The trend in rising yields has been concentrated at longer maturities, with shorter ends of yield curves seeing much smaller moves (Chart 1). Two-year government bond yields are still being pinned down by the dovish forward guidance of the major central banks. The Fed is signaling no rate hikes through at least the end of 2023, while other central banks are sending similar messages on the timing of any potential future rate moves. However, global growth expectations continue to gain upward momentum, fueled by the optimistic combination of expanding COVID-19 vaccinations and aggressive US fiscal stimulus. Real GDP growth is expected to soar to a mid-single digit pace in the US, UK, Canada and even the euro zone - moves heralded by the steady climb of the OECD leading economic indicators and composite purchasing manager indices (Chart 2). Chart 1Rising Yields Reflect Reflation Rising Yields Reflect Reflation Rising Yields Reflect Reflation Chart 2A Bond-Bearish Surge In Global Growth Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Markets will continue to pull forward the timing and pace of the next monetary tightening cycle if those faster above-trend growth forecasts are realized. This will represent a change of “leadership” in the global bond bear market from faster inflation breakevens to increased policy rate expectations helping drive real yields higher. That shift may already be underway according to the ZEW survey of global investor expectations which now shows that the net number of respondents expecting higher short-term interest rates in the US and UK has turned positive (Chart 3). Already, our Central Bank Monitors for the US, Canada and Australia (Chart 4) have climbed back to neutral levels suggesting that easier monetary policy is no longer required. Similar trends can be seen to a lesser extent in the UK, euro area and even Japan (Chart 5). These moves are already coinciding with increased cyclical upward pressure on global bond yields, even without any change in dovish central bank guidance alongside ongoing buying of government bonds via quantitative easing programs. Chart 3Shifting Expectations For Policy Rates? Shifting Expectations For Policy Rates? Shifting Expectations For Policy Rates? Chart 4Diminishing Need For Easy Monetary Policy Here Diminishing Need For Easy Monetary Policy Here Diminishing Need For Easy Monetary Policy Here   Chart 5Easy Policy Still Required Here Easy Policy Still Required Here Easy Policy Still Required Here How will a trend of rising short-term interest rate expectations translate into future expected returns on government bonds? For that, we revisit a framework temporarily set aside during the pandemic era of crisis monetary policies – the Global Golden Rule (GGR) of bond investing. An Update Of The Global Golden Rule, By Country In September 2018, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.” This was an extension of a framework introduced by our sister service, US Bond Strategy, that links US Treasury returns (versus cash) to changes in the fed funds rate that were not already discounted in the US Overnight Index Swap (OIS) curve.1 The historical results convincingly showed that investors who "get the Fed right" by making correct bets on changes in the funds rate versus expectations were very likely to make the right call on the direction of Treasury yields. We discovered that relationship also held in other developed market countries. Thus, we now had a framework to help project expected bond returns simply based on a view for future central bank interest rate moves versus market expectations.2 Specific details on the calculation of the Global Golden Rule can be found in those original 2018 papers. In the following pages, we present the latest results of the Global Golden Rule for the US, Canada, Australia, the UK, the euro area and Japan. The set-up for the chart shown for each country is the same. We show the 12-month policy rate “surprise”, defined as the actual change in the central bank policy rate over the preceding 12-months versus the expected 12-month change in the policy rate from a year earlier extracted from OIS curves (aka our 12-month discounters). We then compare the 12-month policy rate surprise to the annual excess return over cash (treasury bills) of the Bloomberg Barclays government bond index for each country. We also show the 12-month policy rate surprise versus the 12-month change in the government bond index yield. The very strong historical correlation between those latter two series is the backbone of the Global Golden Rule framework. After that, we present tables showing expected yield changes and excess returns for various maturity points, as well as the overall government bond index, derived from the Global Golden Rule regressions. The expected change in yield is derived from regressions on the policy rate surprises, with different estimations done for each maturity point. In the tables, we show the results for different scenarios for changes in policy rates. For example, the row in the return tables called “1 rate hike” would show the expected yield changes and excess returns if the central bank for that particular country lifts the policy interest rate by +25bps over the next 12 months. This allows us to pick the scenario(s) that most closely correlate to our own expectation for central bank actions, translating that into government bond return expectations. Global Golden Rule: US Chart 6UST Selloff Akin To A Hawkish Surprise UST Selloff Akin To A Hawkish Surprise UST Selloff Akin To A Hawkish Surprise The Golden Rule would have underestimated the losses realized by US Treasuries over the past year (-4.5%), as negative excess returns over cash typically occur when the Fed is more hawkish than expectations – an outcome that did not occur (Chart 6). The trailing 12-month policy rate surprise for the US is currently zero, as last year’s massively dovish rate cuts have rolled off. The US OIS curve now discounts only 5bps of interest rate increases over the next 12 months, a period that runs to the end of first quarter of 2022. This is in line with the Fed’s guidance that no rate hikes will take place before the end of 2023. Our base case is the “Flat” scenario shown in Table 1 and Table 2, with the Fed keeping the funds rate unchanged near 0% for the next twelve months – a very modest “dovish” surprise. This produces a Golden Rule forecast of the overall US Treasury index yield falling -2bps that generates a total return of +1.1%. This is essentially a coupon-clipping return equivalent to the current index yield. Table 1US: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 2US: Expected Changes In Treasury Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: Canada Chart 7Canadian Bond Selloff Worse Than Implied By Golden Rule Canadian Bond Selloff Worse Than Implied By Golden Rule Canadian Bond Selloff Worse Than Implied By Golden Rule Canadian government bonds have sold off smartly over the past 12 months, delivering an excess return over cash of -2.8%. That is a smaller loss, however, compared to other developed economy government bond markets. The Canadian OIS curve did not move as aggressively to price in rate cuts last year, so the rapid pace of Bank of Canada (BoC) easing that was actually delivered constituted a modest “dovish surprise” that helped mute Canadian bond losses to some degree (Chart 7). The trailing 12-month policy rate surprise for Canada is +37bps (a dovish surprise), but rate expectations are more aggressive on forward basis. The Canadian OIS curve now discounts +28bps of interest rate increases over the next 12-months, a period that runs to the end of first quarter of 2022. This stands out as the highest such figure among the countries discussed in this report. This is likely due to the relatively less dovish messaging from BoC officials who have hinted that QE could be tapered sooner than expected if the economy outperforms the BoC’s forecasts for 2021. Our base case is the “Flat” scenario shown in Table 3 and Table 4, with the BoC keeping the policy interest rate at 0.25% for the next twelve months. This produces a Golden Rule forecast of a decline in the overall Canadian government bond index yield of -12bps, delivering a projected total return of +1.69%. That return may turn out to be overly optimistic if the BoC does indeed begin tapering QE later this year. Table 3Canada: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 4Canada: Expected Changes In Government Bond Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: Australia Chart 8Australian Bonds Acting Like The RBA Was Hawkish Australian Bonds Acting Like The RBA Was Hawkish Australian Bonds Acting Like The RBA Was Hawkish Australian government bonds have delivered a negative excess return over cash of -3.6% over the past year (Chart 8). This underperformed the projection from the Golden Rule, as the Reserve Bank of Australia (RBA) was not more hawkish than market expectations. The central bank actually delivered a dovish surprise in 2020, not only cutting policy rates dramatically but starting up a bond-buying QE program and instituting yield curve control to cap 3-year bond yields. The trailing 12-month policy rate surprise for Australia is zero, as last year’s massively dovish surprise rate cuts have rolled off. The Australia OIS curve now discounts only 7bps of interest rate increases over the next 12-months, a period that runs to the end of first quarter of 2022. This is in line with the RBA’s highly dovish guidance suggesting that there will be no change to current policy settings until Australian wage growth picks up to the 3% level consistent with the RBA’s 2-3% CPI inflation target. The central bank does not expect that to occur before 2023. We agree with dovish guidance from the RBA, thus our base case is the “Flat” scenario shown in Table 5 and Table 6, with the RBA keeping the Cash Rate unchanged at 0.1% for the next twelve months. This generates a Golden Rule forecast of an -5bps decline in the overall Australian government bond index yield, producing a total return projection of +1.4%. Table 5Australia: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 6Australia: Expected Changes In Government Bond Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: UK Chart 9A UK Gilt Selloff Without A Hawkish BoE A UK Gilt Selloff Without A Hawkish BoE A UK Gilt Selloff Without A Hawkish BoE UK Gilts underperformed the Golden Rule forecast over the past 12 months, delivering a negative excess return over cash of –5.1% even with the Bank of England (BoE) not delivering any hawkish surprise versus market expectations (Chart 9). The trailing 12-month policy rate surprise for the UK is currently zero. The UK OIS curve now discounts only 5bps of interest rate increases over the next 12-months, a period that runs to the end of first quarter of 2022. This is in line with the BoE’s guidance that no monetary tightening will take place until there is clear evidence that the excess capacity created by the pandemic shock is clearly being absorbed. Yet while the BoE has still left the door open to moving to a negative policy rate if needed, markets are not discounting any such move. Our base case is the “Flat” scenario shown in Table 7 and Table 8, with the BoE keeping the Bank Rate unchanged at 0.1% for the next twelve months. This produces a Golden Rule forecast of the overall UK Gilt index yield falling -2bps that generates a total return of +1.0%. This is a return only slightly above the current index yield. Table 7UK: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 8UK: Expected Changes In Gilt Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: Germany Chart 10Even Bunds Acting Like ECB Is "Hawkish" Even Bunds Acting Like ECB Is "Hawkish" Even Bunds Acting Like ECB Is "Hawkish" German government bonds have produced an excess return over cash of -1.6% over the past year. There was no surprise from the European Central Bank (ECB) during that time relative to market expectations (Chart 10), so that negative return reflected the modest rise in German bond yields on the back of improving global growth. The trailing 12-month policy rate surprise for Germany (and the overall euro area) remains stuck near zero, as has been the case since the ECB cut its deposit rate below zero and instituted QE back in 2016. The euro area OIS curve now discounts only -4bps of interest rate cuts over the next 12 months, a period that runs to the end of first quarter of 2022. This is in line with the ECB’s guidance that rates will be kept unchanged until at least 2023, as the central bank’s projections call for euro area inflation to not climb above 1.5% - below the ECB’s 2% target – through 2023. The OIS curve is discounting a small probability that the ECB could be forced to deliver a small rate cut given the degree of the euro area inflation undershoot. Our base case, however, is that the ECB will keep rates steady over the next 12 months (and likely for a few more years after that). Thus, the “Flat” scenarios shown in Table 9 and Table 10 are most relevant, with the German government bond index yield rising +2bps according to the Golden Rule. This produces a total return projection of -0.6%. Table 9Germany: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 10Germany: Expected Changes In Bund Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: Japan Chart 11JGBs Bucking The Global "Hawkish" Selloff JGBs Bucking The Global "Hawkish" Selloff JGBs Bucking The Global "Hawkish" Selloff Japanese government bonds (JGBs) have delivered an excess return versus cash of -0.8% over the past twelve months (Chart 11). Although it may sound unusual for Japan, there was actually a tiny “hawkish” surprise as the Bank of Japan (BoJ) kept policy rates steady over the past year even as markets had priced in a possibility of a small rate cut in response to the COVID-19 growth shock. Admittedly, the Golden Rule framework is poorly suited to project Japanese bond returns. The Bank of Japan (BoJ) has been unable to lift policy rates for many years, while they have instituted yield curve control on 10-year JGBs since 2016, anchoring yields near zero. With no variability on policy rates or bond yields, a methodology that links bond returns to unexpected policy interest rate changes will have poor predictive power. The Japan OIS curve now discounts -5bps of interest rate cuts over the next 12 months, a period that runs to the end of first quarter of 2022. The BoJ has not ruled out the possibility of a small rate cut sometime in the next few months, as Japanese inflation remains far below the 2% BoJ target. Our base case is the “Flat” scenarios shown in Table 11 and Table 12, with the BoJ keeping policy rates unchanged near 0% for the next twelve months. That generates a Golden Rule forecast of a +5bp increase in the Japanese government bond index yield, with a total return projection of -0.4%. This would be consistent with the BoJ producing a small hawkish “surprise” by not cutting rates deeper into negative territory. Table 11Japan: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 12Japan: Expected Changes In JGB Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Investment Implications Of The Global Golden Rule Projections Among all the scenarios laid out above, our base case has been that no change in policy rates should be expected over the next 12 months in any of the countries. This fits with our view that central banks will be reluctant to consider any changes to the current dovish forward guidance on future rate hikes until there is clear evidence that the global economy has moved beyond the pandemic. That means taking some near-term inflation risks given the very robust pace of growth expected over the rest of 2021. In Table 13, we rank all the return projections generated by the Global Golden Rule for the “Flat” scenarios on policy rates over the next year. Returns are shown both in local currency terms and in USD-hedged terms. Table 13Government Bond Index Total Return Forecasts Over The Next 12 Months Assuming Policy Rates Remain Unchanged Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing The return rankings are a mirror image of the performance seen year-to-date, with the “higher beta” bond markets (Canada, Australia and the US) outperforming the more defensive low-yielding markets (the UK, Germany and Japan). Returns are projected to be moderate, however, with Canada leading the way both unhedged (+1.69%) and currency hedged (+1.73%). The return rankings excluding the +10-year maturity buckets of the government bond indices are shown in Table 14. We present these to allow a more “apples to apples” comparison of the six regions shown, as the UK index has a huge weighting in the +10-year bucket while there is no +10-year benchmark for Australia. On this basis, Australia stands out as having the best Global Golden Rule generated return projections, both unhedged (+1.44%) and USD-hedged (+1.66%).3 Table 14 Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing These return rankings run counter to our current recommended country allocation: underweight the US, overweight Germany and Japan and neutral the UK, Canada and Australia. We still believe there is more near-term upside for global bond yields, led by US Treasuries, thus it is too soon to begin to position for the results projected by the Global Golden Rule. There is one other factor that leads us to interpret the results cautiously – the likelihood that some central banks will begin tapering their bond purchases within the next 12 months. Our expectation is that the Fed will begin to signal a need to slow the pace of its QE bond buying in the fourth quarter of this year, with actual tapering beginning in Q1 of 2022. The BoC is likely to follow suit shortly thereafter. Thus, the Fed and BoC will begin tapering within the 12-month forecasting window of the Global Golden Rule. The RBA and BoE will debate a need to taper later in 2022 – beyond that 12-month window – while the ECB and BoJ will maintain their current pace of bond buying until at least the end of 2022. From the point of view of bond markets, tapering by the Fed and BoC will likely feel as if those central banks were actually delivering rate hikes. Bond yields will likely rise by more than projected by the Global Golden Rule in the “Flat” scenarios highlighted earlier. Quantitative models that attempt to translate QE into interest rate changes, so-called “shadow rates”, show that the Fed’s QE bond buying over the past year has been equivalent to nearly 250bp of additional Fed rate cuts after the funds rate was slashed to 0% (Chart 12). Thus, when the Fed begins to taper QE, it will conceptually be as if the Fed started a rate hike cycle with the starting point of a fed funds rate at minus -2.5%. When looking at the historical correlation of changes in the US shadow rate and US Treasury yields, the +40bps rise in the Treasury index yield over the past 12 months is equivalent to roughly a 100bp increase in the shadow fed funds rate (Chart 13, top panel). That would line up with a fairly aggressive pace of Fed tapering when looking at the correlation of changes in the shadow rate to changes in the size of the Fed balance sheet (middle panel). Chart 12"Shadow Policy Rates" Are Below 0% "Shadow Policy Rates" Are Below 0% "Shadow Policy Rates" Are Below 0% Chart 13UST Yields Discount A Lot Of Fed Tapering UST Yields Discount A Lot Of Fed Tapering UST Yields Discount A Lot Of Fed Tapering US Treasury yields have been rising for more fundamental reasons like improving growth expectations alongside rising inflation expectations. If the Fed is forced to signal a tapering of QE later this year because that robust growth outlook comes to fruition, it is a stretch to think that Treasury yields will not see additional upward pressure. Thus, we are sticking with our current country allocations, despite the message from our Global Golden Rule. US Treasury returns may look more like the “1 rate hike” or “2 rate hikes” scenarios shown in Table 1 when the Fed begins tapering early in 2022. The same goes for Canadian bond yields once the BoC moves to taper soon after the Fed, as we expect, which is why we are keeping Canada on “downgrade watch.” Bottom Line: The Global Golden Rule is calling for the recent government bond market laggards to outperform over the next year if central banks keep rates on hold. Government bonds in countries where central banks are most likely to begin tapering in 2022 well before considering rate hikes – most notably, the US and Canada – are likely to suffer returns worse than implied by the Global Golden Rule. It is too soon to raise allocations to those higher-beta bond markets.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcarearch.com. 2 Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25, 2018, available at gfis.bcaresearch.com. 3 Note that in Table 14, we rescale the other maturity buckets after removing the +10-year bucket. The index returns are presented as a market-capitalization weighted combination of the expected returns of the remaining maturity buckets. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Global Duration: Markets are correctly interpreting the $1.9 trillion US fiscal stimulus package as a factor justifying higher global growth expectations and bond yields. Maintain a below-benchmark stance on overall global duration. Yield Betas & Country Allocation: Within government bond portfolios, overweighting the “lower-beta” countries that have bond yields less sensitive to changes in US yields (Germany, France, Japan) versus the higher-beta markets (Canada, Australia, UK) remains the appropriate strategy during the current bond bear market. Underweights should remain concentrated in the US, though, as it is highly unlikely that any central bank will begin to tighten policy before the Fed. UK Follow-Up: The conclusions from our UK Special Report published last week do not change after adjusting for the difference in the inflation indices used to calculate UK inflation-linked bond yields compared to those of other countries. UK real interest rates are the lowest in the developed economies, while inflation breakevens are the highest. NOTE: There will be no Global Fixed Income Strategy report published next week. Instead, BCA Chief Global Fixed Income Strategist Rob Robis will do a webcast discussing his latest thoughts on global bond markets. Yields Rising Around The World Chart of the WeekPolicy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish The path of least resistance for global bond yields remains biased upward. Optimism on future economic growth remains ebullient with consumer and business confidence indices surging in much of the developed world. The epicenter of the global bond bear market remains the US, where pandemic related economic restrictions are being unwound with 21.4% of the US population now having received at least one dose of a vaccine. Fiscal policy in the US is also supporting the positive vibes on future growth after the $1.9 trillion stimulus package was signed into law by President Biden last week. The 10-year US Treasury yield climbed back to the 2021 high of 1.63% on the back of that announcement. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget (Chart of the Week). This, combined with ongoing quantitative easing from global central banks eager to keep bond yields as low as possible until inflation expectations sustainably return to policymaker targets, is providing a bond-bearish lift to both inflation expectations and real yields – most notably in the US. Central bankers can try to fight back against the speed of the increase in bond yields by maintaining their commitment to current policy settings, as the European Central Bank (ECB) and Bank of Canada (BoC) did last week. The Fed, Bank of England (BoE) and Bank of Japan (BoJ) will all get the chance to do the same this at this week’s policy meetings. The likely message from all will be one of staying the course and not reflexively responding to higher bond yields, which have not triggered a broad-based selloff in global risk assets that would pre-emptively tighten financial conditions. The S&P 500 index hit an all-time high last week, while equity markets in Europe and Japan have returned to pre-pandemic levels (Chart 2). Global corporate credit spreads have remained calm, consistent with a positive growth backdrop that diminishes the potential for credit downgrades and defaults. The US dollar has gotten a lift from improving US growth expectations and relatively higher US Treasury yields, which has had some negative spillover effect into emerging market equities and currencies. The dollar rebound has been relatively modest to date, however, with the DXY index up only 3% from the early 2021 lows. A major reason why global equity and credit markets have absorbed higher bond yields so well is because the sheer scope of the new US fiscal stimulus will have a major impact on growth momentum both in the US and outside the US. This comes on top of the boost to optimism from the speed of the US and UK vaccine rollouts. In an update to its December 2020 economic outlook published last week, the OECD estimated that the $1.9 trillion US stimulus will boost US real GDP growth by 3.8 percentage points versus its original forecast over the next year (Chart 3). Other countries will also benefit from the implied surge in US demand spilling over from that stimulus package, with the OECD projecting a 1.1 percentage point increase to world real GDP growth. Chart 2Risk Assets Ignoring Rising Global Bond Yields Risk Assets Ignoring Rising Global Bond Yields Risk Assets Ignoring Rising Global Bond Yields Chart 3Big Growth Spillovers From US Fiscal Stimulus Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger Countries that have the greater exposure to US demand, like Canada and Mexico, are expected to benefit a bit more than the rest of the world, but the expected boost to growth is consistent (around one half of a percentage point) from China to Europe to Japan to major emerging market countries like Brazil. That US-fueled pickup in global economic activity will help absorb some of the spare capacity that opened up during the COVID-19 pandemic. In Chart 4 and Chart 5, we show the estimates taken from the December 2020 OECD Economic Outlook for the output gaps in the US, euro area, UK, Japan, Canada and Australia for 2021 and 2022. We adjust those projections by the OECD’s estimate of the impact of the US fiscal stimulus in 2021, as well as by the additional upward revisions to the OECD growth projections in 2021 and 2022 that were published last week. Chart 4The $1.9 Trillion Stimulus Will Close The US Output Gap … Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger Chart 5… And Help Narrow Output Gaps Elsewhere Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger Chart 6Maintain Below-Benchmark Duration Maintain Below-Benchmark Duration Maintain Below-Benchmark Duration The conclusion is that the US output gap will be eliminated in 2022, while output gaps will still be negative, but diminished, in the other countries after factoring in the impact of the latest US fiscal package. This suggests that the maximum upward pressure on global bond yields should still be centered in the US, where inflation pressures will be more evident and the Fed will likely begin signaling a shift to a less dovish stance sooner than other central banks (although not likely until much later in 2021). Our Global Duration Indicator continues to flag pressure for higher bond yields ahead for the major developed economies (Chart 6). The improving growth momentum means that rising real yields should increasingly become the more important driver of higher nominal bond yields. Persistent central bank dovishness in the face of that growth surge, however, means that it is still too soon to position for narrowing global inflation expectations or any bearish flattening of government bond yield curves - even in the US. Bottom Line: Markets are correctly interpreting the $1.9 trillion US fiscal stimulus package as a factor justifying higher global growth expectations and bond yields. Maintain a below-benchmark stance on overall global duration. Using Yield Betas For Bond Country Allocation, One More Time Over the past two months, we have published Special Reports that delved into the outlook for bond yields and currencies in Australia, Canada and the UK. We selected those three countries as they represented the most likely downgrade candidates within our recommended government bond country allocation given their status as “higher beta” bond markets that are more correlated to US Treasury yields. We estimate US Treasury yield betas from a rolling regression (over a three-year window) of changes in 10-year non-US government bond yields to changes in 10-year US Treasury yields (Chart 7). This allows us to assess which markets are more or less sensitive to the ups and downs of US bond yields. We have used this framework to help guide our country allocation strategy during the pandemic and, for the most part, it has been successful. Chart 7Government Bond Yield Sensitivities To USTs Are Shifting Fast Government Bond Yield Sensitivities To USTs Are Shifting Fast Government Bond Yield Sensitivities To USTs Are Shifting Fast So far in 2021, the markets with higher US Treasury yield betas (Canada, Australia and New Zealand) have underperformed the lower beta markets (Germany, France and Japan). We show that in the top panel of Chart 8, which plots the yield betas at the start of the year versus the year-to-date relative return of each country’s government bond market to that of the overall Bloomberg Barclays Global Treasury index. The returns are adjusted to reflect any differences in the durations of each country versus that of the overall index, and are shown in USD-hedged terms to allow for a common currency comparison. The bottom panel of Chart 8 shows the same relationship for the all of 2020. This is a mirror image of what has occurred so far in 2021, with the countries with higher yield betas outperforming the lower beta markets. The obvious difference between the two years is the direction of Treasury yields, which fell in 2020 and have been rising this year. So far in 2020, the differences between the returns of the higher beta markets have been quite similar. New Zealand has had the biggest negative performance (-2.8% versus the global benchmark), but this has only been moderately worse than Australia (-2.6%) and Canada (-2.4%). These are all just slightly worse than the return of US Treasuries relative to the Global Treasury index (-2.3%). Our estimated yield betas have changed rapidly over the past few months. For example, the rolling three-year yield beta of Australia has shot up from 0.61 at the beginning of the year to 0.78, while Canada has seen a similar move (0.81 to 0.88). This reflects the rapid repricing of interest rate expectations in both countries as current growth momentum and growth expectations improve. While not a perfect relationship, yield betas do show some correlation to our Central Bank Monitors – designed to measure the pressure on central banks to tighten of ease monetary policy (Chart 9). The latest increases in the yield betas of Australia, New Zealand and Canada have occurred alongside a rising trend in our Central Bank Monitors for each nation. The implication is that the relative underperformance of government bonds in those countries is related to the cyclical pressure for the RBA, RBNZ and BoC to tighten monetary policy. Chart 8An Intuitive Link Between Yield Betas & Bond Market Performance Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger Chart 9Cyclical Pressures & Yield Betas Are Linked Cyclical Pressures & Yield Betas Are Linked Cyclical Pressures & Yield Betas Are Linked At the same time, the yield betas of government bonds in Germany and the UK have remained low despite the cyclical upturn in our ECB and BoE Monitors. The lingering impact of COVID-19 lockdowns on economic growth and inflation in the euro area and UK is likely weighing on bond yields in both regions. This limits any challenge to the dovish forward guidance of the ECB and BoE, in contrast to the repricing of interest rate expectations seen in other countries. The market-implied path of policy interest rates extracted from OIS forward curves does show a much more aggressive expected path of policy rates in the higher beta markets versus the lower beta markets (Chart 10). Chart 10More Rate Hikes Expected In The Higher Yield Beta Countries Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger ​​​​​​​ The “liftoff” date for each central bank shown, representing when the first full interest rate hike is priced into the OIS forwards, is shown in Table 1. We rank the countries in the table by the amount of time until the discounted liftoff date, from shortest to longest. The first rate hike is expected in New Zealand in June 2022, with the BoC expected to lift rates in Canada two months later. The market is not pricing a full rate hike by the Fed until January 2023, while liftoff in the UK and Australia are expected during the summer of 2023. Table 1The "Pecking Order" Of Global Liftoff Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger We treat the countries with perpetually low interest rates, the euro area and Japan, differently in Table 1, as both the ECB and BoJ would most likely move slowly if and when they ever decided to raise rates again. Thus, we define liftoff as only a 10bp increase in policy interest rates for those two regions, while for all the other central banks we assume the size of the first rate hike will be 25bps. On that reduced basis, the market is priced for “liftoff” by the ECB and BoJ in September 2023 and February 2025, respectively. In terms of that “order of liftoff” shown in Table 1, we generally agree with current market pricing except for New Zealand and Canada. We fully expect the Fed to be the first central bank to begin signaling the path towards monetary policy normalization, largely due to the impact of the fiscal stimulus, starting with a move to begin tapering the Fed’s asset purchases at the start of 2022. The Fed will also be the first to begin rate hikes after tapering. We do not anticipate the BoC or Reserve Bank of New Zealand (RBNZ) to make any hawkish moves (reduced asset purchases or rate hikes) before the Fed does the same, as this would put unwanted appreciation pressures on the New Zealand and Canadian dollars. We expect the BoC and RBNZ to move soon after the Fed begins to shift, followed by the BoE and RBA a bit later after that in line with the current liftoff ordering. The pace of rate hikes after liftoff also appears to be a bit too aggressively priced in the countries with higher yield betas. The cumulative amount of interest rate increases to the end of 2024 currently priced in OIS curves is larger in Canada (175bps) and Australia (156bps) than the US (139bps) and New Zealand (140bps). The relative differences are not huge, however, but we think the odds favor the Fed delivering the greater amount of rate hikes over the next three years. More generally, when looking at what is more important for each central bank in determining the timing of liftoff, we can boil it down to a couple of the most important measures for the higher beta countries (Chart 11): US: The Fed will continue to focus on both inflation expectations and broad measures of labor market utilization before signaling any policy shift. On that basis, there is still some way to go before TIPS breakevens return to the 2.3-2.5% level we believe to be consistent with the Fed sustainably hitting its 2% inflation goal on the PCE deflator. Also, there is still a lot of ground to cover before the US labor market fully returns to pre-pandemic health, as the employment/population ratio is four percentage points below the pre-COVID peak. New Zealand: The RBNZ is now under a lot more pressure to tighten policy after the New Zealand government changed the central bank’s remit to include stabilizing house prices, which have soured to unaffordable levels that have exacerbated income inequality. With house prices now rising at a 19% annual rate, the highest since 2004, the RBNZ will be under pressure to hike sooner, although any associated rise in the New Zealand dollar will likely be of equal concern. Canada: The BoC has been very candid that its current policy mix of aggressive asset purchases and 0% policy rates will be altered if the Canadian economy improves. We believe that the current trends of booming house price inflation, recovering business investment prospects and a rapidly recovering labor market will all make the BoC more willing to signal tighter monetary policy fairly soon after the Fed does the same. Australia: The RBA is likely to continue surprising bond markets with its dovishness in the face of a rapidly recovering economy, given underwhelming inflation. In a recent speech, RBA Governor Philip Lowe noted that Australian inflation will not return to the RBA’s 2-3% target band without wage growth rising from the current 1.4% pace up to 3%. The RBA does not expect the labor market to tighten enough to generate that kind of wage growth until at least 2024, suggesting no eagerness to begin normalizing monetary policy. Among the lower-beta markets, the most important things that will dictate future policy moves are the following (Chart 12): Chart 11What To Watch In The Higher Yield Beta Countries What To Watch In The Higher Yield Beta Countries What To Watch In The Higher Yield Beta Countries Chart 12What To Watch In The Lower Yield Beta Countries What To Watch In The Lower Yield Beta Countries What To Watch In The Lower Yield Beta Countries UK: The BoE’s current focus is on how fast the UK economy recovers from the pandemic shock, with inflation expectations remaining elevated (see the next section of this report). The degree of strength in business investment and consumer spending will thus dictate the timing of any BoE shift to a less accommodative policy stance. Euro Area: The latest set of ECB projections call for inflation to only reach 1.4% by 2023. As long as inflation (both realized and expected) stays well below the 2% ECB target, the central bank will focus more on supporting easy financial conditions (lower corporate bond yields, tighter Italy-Germany yield spreads and resisting euro currency strength). Japan: Inflation continues to underwhelm in Japan, and the BoJ is a long way from contemplating any tightening measures. Summing it all up, we still see value in using yield betas to dictate our recommended fixed income country allocations. Although these should be complemented with assessments of the relative likelihood of central banks moving before others to further refine country allocations. Bottom Line: Within government bond portfolios, overweighting the “lower-beta” countries that have bond yields less sensitive to changes in US yields (Germany, France, Japan) versus the higher-beta markets (Canada, Australia, UK) remains the appropriate strategy during the current bond bear market. Underweights should remain concentrated in the US, though, as it is highly unlikely that any central bank will begin to tighten policy before the Fed. A Brief Follow-Up To Our UK Special Report In our Special Report on the UK published last week, we noted that the UK had the lowest real bond yields and highest inflation expectations among the developed market countries with inflation-linked bonds.1 Some astute clients pointed out that we neglected to discuss how the UK inflation-linked bonds are priced off the UK Retail Price Index (RPI) which typically runs with a faster inflation rate than the UK Consumer Price Index (CPI). This creates a downward bias to UK real yields in comparison to other countries that use domestic CPI indices in inflation-linked bond pricing. We did not ignore the RPI-CPI differential in our report, we just did not think it to be relevant to the conclusions of our report. The UK still has the lowest real rates and highest inflation expectations even after adjusting both by the RPI-CPI gap (Chart 13). Furthermore, survey-based measures of UK inflation expectations are broadly in line with the RPI-based inflation breakevens, confirming the message from the RPI-based real yields and inflation expectations. Chart 13UK Real Yields Are Too Low, Using RPI Or CPI UK Real Yields Are Too Low, Using RPI Or CPI UK Real Yields Are Too Low, Using RPI Or CPI Looking ahead, the RPI-CPI gap is likely to stay in a much narrower range compared to its longer run history. Chart 14A Less Active BoE Has Narrowed The RPI-CPI Gap A Less Active BoE Has Narrowed The RPI-CPI Gap A Less Active BoE Has Narrowed The RPI-CPI Gap For example, between 2000 and 2007, the RPI-CPI gap averaged a full percentage point but with very large fluctuations (Chart 14). This is because mortgage interest costs are included in the RPI but are not part of the CPI. Thus, RPI inflation tends to be more volatile when the BoE is more active in adjusting interest rates. After the 2008 financial crisis, the BoE has kept policy rates at very low levels with very few changes. The RPI-CPI gap has narrowed as a result, averaging only one-half of a percentage point between 2009 to today. Thus, our conclusion on UK bond yields remains the same – Gilt yields are too low and are likely to rise further over the next 6-12 months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Why Are UK Interest Rates Still So Low?",dated March 10, 2021, available at gfis.bcaresearch.com and fes.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns