Monetary

Executive Summary A Good Time For A Pause In The Bond Bear Market The global government bond selloff looks stretched from a technical perspective, and a consolidation phase is likely over the next few months as global growth and inflation momentum both roll over. Central banks are starting to turn more aggressive on the pace of rate hikes in the face of elevated inflation expectations, as evidenced by the 50bp rate hikes in Canada and New Zealand last week (and the likely similar move the Fed next month). However, forward pricing of policy rates over the next 12-18 months is already at or above policymaker estimates of neutral in most developed countries. Global bond yields will be capped until central banks and markets revise higher their estimates of neutral policy rates. This is more a 2023/24 story than a 2022 story. Interest rate expectations are too high in Canada. High household debt will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Bottom Line: Maintain a neutral stance on overall global duration exposure. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. How To Interpret Rising Real Bond Yields Chart 1Bonds Under Pressure From Both Inflation & Real Yields The sharp rise in global government bond yields seen so far in 2022 has been driven by both rising inflation expectations and higher real yields (Chart 1). The former is a function of the war-fueled surge in oil prices at a time of high realized inflation, while the latter is a consequence of expectations for tighter monetary policy to fight that inflation. The magnitude of the yield increases seen year-to-date is surprising given the downgrades to global growth expectations. Just this week, the IMF downgraded its growth forecasts for the second time this year. It now expects global growth to reach 3.6% in both 2022 and 2023, shaving 0.8 and 0.2 percentage points, respectively, from the last set of yearly forecasts made back in January. The World Bank similarly chopped its growth forecast for 2022 to 3.2% from 4.1%. Spillovers from the Russia/Ukraine war were the main factor behind the downgrades, including more aggressive monetary tightening by global central banks in response to commodity-fueled inflation. We’re already seeing a faster pace of rate hikes from developed market central banks. The Bank of Canada (BoC) and Reserve Bank of New Zealand (RBNZ) lifted policy rates by 50bps last week and the Fed is signaling a similar move in May. Not all policymakers are sending hawkish signals, however. The ECB last week opted to not commit to the timing and pace of any future moves on rates, while the Bank of Japan has pledged to maintain monetary stimulus measures even in the face of a collapsing yen. Related Report  Global Fixed Income StrategyPolicymakers Face The No-Win Scenario While government bond yields have risen across the developed world so far in 2022, the drivers of the yield increase have not been the same in all countries when looking at moves in benchmark 10-year nominal and inflation-linked bonds (Chart 2). About three-quarters of the nominal yield moves seen year-to-date in the US (+134bps), Canada (+136bps) and Australia (+130bps) have come from higher real yields, while the increase in the Gilt yield (+92bps) was more of an equal split between real yields and inflation breakevens. In Germany (+102bps) and Japan (+17bps), the upward move in 10-year yields this year has all been from higher breakevens, as real yields have fallen in both countries. Chart 2Real Yields (ex-Europe/Japan) Driving Nominal Yields Higher In 2022 In the US, Canada and UK – three countries where central banks have delivered rate hikes this year and are promising to do more – real yields have been highly correlated to rising interest rate expectations for the next two years taken from overnight index swap (OIS) curves (Chart 3). Meanwhile, in Germany, Japan and Australia - where central banks have kept rates steady and not sending strong messages on when that will change – the correlation between real yields and OIS-derived interest rate expectations has not been as strong (Chart 4). Chart 3Rising Real Yields Where Central Banks Have Been Hiking​​​​​ Chart 4More Stable Real Yields Where CBs Are More Dovish​​​​​ Chart 5Real Rate Expectations Have Risen Much Faster In The US The link between interest rate expectations and real yields is intuitive after factoring in inflation expectations. In Chart 5, we show actual real interest rates (policy rates minus headline CPI inflation) in the US, euro area and UK, as well as a “market-based” measure of real interest rate expectations derived as the difference between forward rates from the nominal OIS and CPI swap curves (the dotted lines). The current path for real rates is the black dotted line, while the path as of the start of 2022 is the green dotted line. In all three countries, the market-derived path for real rates over the next decade has shifted upward since the start of the year, which is consistent with a rising path for real bond yields. Yet the largest move has been in the US where real rates are expected to average around zero over the next ten years. This lines up logically with the more hawkish messaging on rates from the Fed, leading to a repricing of the 10-year TIPS yield from -1% at the start of the year to a mere -0.04% today. By contrast, real rate expectations and real yields remain negative in the euro area and UK, as both the ECB and Bank of England have been much less hawkish compared to the Fed in terms of signaling the timing and magnitude of future rate hikes. We have long flagged deeply negative real bond yields, especially in the US, as the greatest source of vulnerability for global bond markets. Such yield levels can only be sustained in a rising inflation environment if central banks deliberately keep policy rates below inflation for a long time. The Fed was not going to allow that to happen with inflation reaching levels not seen since the early 1980s, leaving US Treasuries vulnerable to a sharp repricing of fed funds rate expectations that would drive real bond yields higher. Looking ahead, we do not expect to see much additional bearish repricing of global rate expectations and real yields over the rest of 2022, for the following reasons: Global growth momentum is slowing The combined shock of geopolitical uncertainty from the Ukraine war, high oil prices and tightening global monetary policy – in addition to the expected slump in Chinese growth due to the latest wave of COVID lockdowns – has damaged economic confidence. The April reading from global ZEW survey of professional forecasters and investors showed another modest decline in US and euro area growth expectations after the huge drop in March (Chart 6). Interestingly, the ZEW survey also showed a big decline in the net number of respondents expecting higher inflation and a small dip in the number of respondents expecting higher bond yields – both potential signals that the increase in global bond yields is ready to pause. Medium-term US inflation expectations have remained relatively contained The sharp run-up in US inflation has boosted survey-based measures of inflation expectations, although the increase has been much higher for shorter-term expectations (Chart 7). One-year-ahead inflation expectations from the University of Michigan and New York Fed consumer surveys have doubled over the past year and now sit at 6.6% and 5.4%, respectively. Yet the 5-10 year ahead inflation expectation from the Michigan survey has seen a much smaller increase and is holding stable around 3%. The 5-year/5-year forward TIPS breakeven is at even less worrisome levels and now sits at a trendline resistance level of 2.4% (bottom panel). Chart 6ZEW Survey Shows Weaker Growth & Inflation Expectations​​​​​ Chart 7Medium-Term US Inflation Expectations Have Not Broken Out​​​​​ US inflation is showing early signs of peaking Year-over-year headline US CPI inflation reached another cyclical high of 8.6% in March. However, core CPI inflation rose by a less-than-expected +0.3% on the month and the year-over-year rate of 6.5% was essentially unchanged versus the February level (Chart 8). Used car prices, a huge driver of the surge in US goods inflation in 2021, fell by a sizeable -3.8% in March, the second consecutive monthly decrease. Chart 8A Peak In US Core Inflation?​​​​​ Chart 9Housing Cost Inflation Is A Global Problem We expect US consumer spending to shift more towards services from goods over the next 6-12 months, which should lead to overall US inflation rates converging more towards lower services inflation. Services inflation is still well above the Fed’s inflation target, however, particularly with shelter inflation – one-third of the overall US CPI index – now at 5.0% and showing no signs of slowing. Chart 10A Good Time For A Pause In The Bond Bear Market Rising housing costs are not only a problem in the US, and house prices and valuations have soared across the developed world (Chart 9). This suggests that housing and rental costs will remain an important driver of underlying inflation in many countries, not just the US. Summing it all up, we continue to see conditions conducive to a period of relative global bond market stability, with government bond yields remaining rangebound over the next several months. The stimulus for higher yields – from even more hawkish repricing of central bank expectations, even higher real bond yields or additional increases in inflation expectations – is not evident. Bond yields look stretched from a technical perspective, and our Global Duration Indicator continues to signal that global yield momentum should soon peak (Chart 10). Bottom Line: Maintain a neutral stance on overall global bond portfolio duration. Upgrade Canadian Government Bonds To Neutral The Bank of Canada (BoC) hiked its policy interest rate by 50bps last week to 1%, the first rate increase of that size since 2000. The BoC also announced that it will begin quantitative tightening of its balance sheet at the end of April when it stops buying Canadian government bonds to replace maturing debt it currently owns. In the press conference explaining the move, BoC Governor Tiff Macklem noted that the central bank now saw the Canadian economy in a state of “excess demand” with inflation that was “expected to be elevated for longer than we previously thought” and that “the economy could handle higher interest rates, and they are needed.” Chart 11Canadian Growth Momentum Peaking? This is a very clear hawkish message from Macklem, who hinted that the BoC may have to lift rates above neutral for a period to bring Canadian inflation back down to the central bank’s target. We have our doubts that the BoC will be able to raise rates that far, and keep them there for long, before inflation pressures ease. The BoC Business Outlook Survey plays an important role in the central bank’s policy decisions. The survey for Q1/2022 showed dips in the overall survey, and the individual components related to sales growth expectations, investment intentions and hiring plans (Chart 11). There were even small drops in the net number of survey respondents seeing intense labor shortages and expecting faster wage growth (bottom panel). The moves in these survey components were modest, but they are important coming after the relentless upward rise since the trough in mid-2020. Importantly, this survey was conducted before the Russian invasion of Ukraine, which likely provided an additional drag on business confidence. The components of the Business Outlook Survey related to prices and costs continued to show that Canadian firms are facing lingering capacity constraints and intense cost pressures from both labor and supply chain disruption. A net 80% of respondents – a survey record – report they would have some or significant difficulty meeting an unexpected increase in demand. A net 35% of respondents in the Q1/2022 survey cited “labor cost pass through” as a source of upward pressure on their output prices, a huge jump from the Q4/2022 reading of 19% (Chart 12). Also, a net 33% of respondents noted “non labor cost pass through”, i.e. higher prices due to supply chain disruption, as a source of pressure on output prices. Only a net 12% of respondents cited strong demand as a source of pressure on prices, and the net balance of respondents noting that the competitive environment was inflationary was effectively zero. Chart 12Canadian Businesses See More Cost-Push Inflation Pressures The two main messages from the Business Outlook Survey are: a) Canadian growth momentum likely cooled in Q1, and b) Canadian inflation pressures remain significant, but are more supply driven than demand driven. Overall Canadian inflation is still accelerating rapidly, with headline CPI hitting an 31-year high of 5.7% in February. Underlying measures of inflation are more subdued, but still elevated: the BoC’s CPI-trim and CPI-median measures are at 4.3% and 3.5%, respectively, both above the BoC’s 1-3% target band (Chart 13). Chart 13Mixed Messages On Canadian Inflation Expectations There are more mixed messages coming out of Canadian inflation surveys. The 1-year-ahead inflation expectation from the BoC’s Survey of Consumer Expectations climbed to 5.1% in Q1/2022 from 4.9% in Q4, while the 5-year-ahead expectation dropped to 3.2% from 3.5%. The 10-year breakeven inflation rate on Canadian inflation linked bonds is even lower, now sitting near at 2.2%. There are also very mixed signals on wage expectations, even with the Canadian unemployment rate dropping to a record low of 5.3% in March. Canadian consumers expect wage growth to reach 2.2% over the next year, below the latest reading on actual wage growth of 2.5% and far below the 5.2% growth expected by Canadian businesses (bottom panel). If medium-term consumer inflation expectations are not rising in the current high inflation environment, and consumer wage expectations are not increasing with a record-low unemployment rate, then the BoC can potentially move slower than markets expect on rate hikes over the next year if realized inflation peaks. On that front there are tentative signs of optimism. When breaking down Canadian inflation into goods and services components, both are still accelerating rapidly (Chart 14). Goods inflation reached 7.6% in February, while services inflation hit 3.8%. However, the pace of year-over-year inflation for some key durable goods components like new cars, household appliances and furniture – items that saw demand and prices increase during the worst of the pandemic – appears to have peaked (middle panel). This may be a sign that overall goods inflation is set to roll over, similarly to what we expect in the US in the coming months. Also like the US, services inflation is less likely to decelerate, as rent inflation is accelerating and the housing cost component of Canadian inflation (home replacement costs) is still expanding at a 13.2% annual rate. On that note, housing remains the key component to watch to determine the BoC’s next move, given highly levered household balance sheets exposed to house prices and higher mortgage rates. The robust strength of the Canadian housing market has driven house prices to some of the most overvalued levels among the developed economies. There is a speculative aspect to the housing boom, with Canadian households expecting house prices to appreciate by 7.1% over the next year according to the BoC consumer survey (Chart 15). Canadian housing demand has also become more sensitive to rate increases by the choice of mortgages. 30% of outstanding mortgages are now variable rate, up from 18% at the start of the pandemic in 2020 after the BoC cut rates to near-0%. Chart 14The Goods-Driven Canadian Inflation Surge May Be Peaking​​​​​​ Chart 15BoC Rate Hikes Will Cool Off Canadian Housing​​​​​​ During the BoC’s last rate hiking cycle in 2017-19, national house price inflation slowed from 15% to 0%. Policy rates had to only reach 1.75% to engineer that outcome. With household balance sheets even more levered today, and with greater exposure to variable rate mortgages, it is unlikely that a policy rate higher than the previous cycle peak will be needed to cool off house price growth – an outcome that should also dampen Canadian services inflation with its large housing related component. In addition to the rate hike at last week’s policy meeting, the BoC also announced the results of its annual revision to its estimated range for the neutral policy rate. The range is now 2-3%, up slightly from 1.75%-2.75%. The current pricing of interest rate expectations from the Canadian OIS curve has the BoC lifting rates to the high-end of that new neutral range by the first quarter of 2023, then keeping rates near those levels over at least the next five years (Chart 16). Chart 16Markets Expect The BoC To Keep Rates Elevated For Longer Chart 17Upgrade Canadian Government Bonds To Neutral We doubt the BoC will be able to raise rates all the way to 3% without inducing instability in the housing market. More importantly, the current surge in inflation is not becoming embedded in medium-term inflation and wage expectations – outcomes that would require the BoC to keep policy rates at the high end of its neutral range or even move them into restrictive territory. Turning to bond strategy, we have had Canada on “upgrade watch” in recent weeks, with rate hike expectations looking a bit too aggressive. We now see it as a good time to pull the trigger on that upgrade. Thus, this week, we are moving our recommended exposure to Canadian government bonds to neutral (3 out of 5) from underweight (Chart 17). We are “funding” that move in our model bond portfolio by reducing exposure to US Treasuries (see the tables on pages 15-16), as we see the Fed as being more likely than the BoC to deliver on the rate hike expectations discounted in OIS curves. A move to an outright overweight stance, versus all countries and not just the US, will be appropriate once Canadian inflation clearly peaks and interest rate expectations begin to decline. It is too soon to make that move now, but we will revisit that call later this year. Bottom Line: Interest rate expectations are too high in Canada with medium-term inflation expectations relatively subdued. High household debt in Canada will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Executive Summary Above Fair Value March’s CPI report will mark peak inflation for 2022. We recommend several ideas to profit from peak inflation. First, investors should keep portfolio duration close to benchmark. The bond market is fairly priced for the likely near-term pace of rate hikes, and long-dated forward yields are now above fair value. Second, investors should underweight TIPS versus nominal Treasuries. They should also favor inflation curve steepeners, real yield curve flatteners and outright short positions in 2-year TIPS. Third, investors should favor the 5-year nominal Treasury note relative to a duration-matched barbell consisting of the 2-year and 10-year notes. The Fed published its plan for shrinking its balance in the minutes from the last FOMC meeting. We estimate that the Fed will be able to shrink its balance sheet at its intended pace for at least the next two years before it is forced to stop. Bottom Line: Investors should position for peak inflation by keeping portfolio duration close to benchmark, by underweighting TIPS versus nominal Treasuries and by favoring the 5-year nominal Treasury note versus the 2-year and 10-year. Feature Chart 1Base Effects Kick In Next Month Last week’s March CPI report showed that 12-month core consumer price inflation came in at 6.44%, a level that will almost certainly mark the peak for the year. Several reasons justify our peak inflation call. First, base effects will send year-over-year core CPI sharply lower during the next three months (Chart 1). Monthly core CPI growth rates were 0.86%, 0.75% and 0.80% in April, May and June 2021 (Chart 1, bottom panel). These exceptionally high prints will roll out of the 12-month average during the next three months. Second, monthly core CPI grew 0.32% in March, a significant step down from the 0.5%-0.6% range that had been the norm since October. If monthly core CPI growth rates remain between 0.3% and 0.4% from now until the end of the year, then 12-month core CPI will fall to a range of 4.19% to 5.13%. We think that trends in the major components of core inflation make this outcome likely, and we could even see inflation falling to below that range. Chart 2 shows the contributions of shelter, goods and services (ex. shelter) to overall core CPI. Chart 2Monthly Core Inflation By Major Component Starting with core goods, we see that prices fell in March for the first time since February 2021. This represents an important inflection point. Core goods, particularly autos, have been the principal driver of current extremely high inflation rates (Chart 3), and these prices will continue to fall in the coming months as supply chain issues are resolved and as goods spending reverts to its pre-pandemic trend (Chart 3, bottom panel). Few dispute that core goods inflation will be weaker going forward. However, one critical question is whether the impact from falling goods prices will simply be offset by the rising cost of services. There was indeed some evidence for this in March. Core services (ex. shelter) prices rose 0.71% in March, up from 0.55% in February. While this is a strong print, it was not sufficient to prevent a drop in overall core inflation from 0.51% to 0.32%. What’s more, March’s core services print was heavily influenced by a surge in airfares that represents a rebound from steep declines seen near the end of last year. With airfares excluded, core services inflation would have only come in at 0.50% in March (Chart 4). Chart 3Goods Inflation Chart 4Services & Shelter Inflation Finally, we turn to the outlook for shelter inflation. Monthly shelter inflation has rebounded to above its pre-COVID levels, but its acceleration has abated during the past few months (Chart 4, bottom panel). Trends in home prices and some indicators of market rents suggest that shelter inflation has some further near-term upside.1 However, shelter inflation is also very sensitive to the economic cycle and the unemployment rate. With that in mind, rapid shelter inflation during the past 12 months is mostly explained by the fact that the unemployment rate fell by almost 2.5%! With the labor market already close to full employment, this sort of cyclical economic improvement will not be repeated during the next 12 months. All in all, we think monthly shelter inflation will average close to its current level during the next nine months. Bottom Line: March’s CPI report marked an inflection point for inflation. Year-over-year inflation will fall sharply during the next few months and will settle close to 4% by the end of the year. Profiting From Peak Inflation Portfolio Duration We have been recommending an “at benchmark” portfolio duration stance in US bond portfolios since mid-February, yet Treasury yields have continued their upward march during the past two months. Our sense is that bond yields now look somewhat too high, and some pullback is likely as inflation moves lower during the next few months. First, let’s consider that the bond market is priced for 262 bps of tightening during the next 12 months (Chart 5), the equivalent of more than ten 25 basis point rate hikes at the next eight FOMC meetings. Our view is that this pricing is close to fair. Chart 5Rate Expectations A 50 basis point rate hike at the May FOMC meeting is now a near certainty. The minutes from the last meeting revealed that “many” participants would have preferred a 50 bps increase in March, but uncertainty surrounding the war in Ukraine prevented that view from becoming consensus. The Treasury curve has also re-steepened significantly during the past few weeks, a development that will ease any concerns about near-term over-tightening. It’s also worth noting that the precedent for a 50 bps hike has now been set by the Reserve Bank of New Zealand and the Bank of Canada. Both central banks lifted their policy rates by 50 bps at their most recent meetings. Chart 6Above Fair Value Beyond May, we expect to see more 25 basis point rate hikes than 50 basis point hikes. Falling inflation will ease some of the Fed’s urgency and the Fed will continue to tighten policy with the goal of getting the fed funds rate close to estimates of the long-run neutral rate by the end of the year. A 25 basis point rate increase at every meeting after May would bring the fed funds rate to a range of 2.0% - 2.25% by the end of the year, just below the Fed’s median estimate of the long-run neutral rate (2.4%). One additional 50 bps hike would bring the funds rate right up to neutral, and such a path would still be consistent with what is currently priced in the curve. Meanwhile, bond pricing at the long end of the yield curve now looks a touch cheap. The 5-year/5-year forward Treasury yield – a market proxy for the long-run neutral rate – has moved up to 2.87%, significantly above survey estimates of the long-run neutral rate (Chart 6). Some pullback closer to survey levels is likely as inflation trends lower. Bottom Line: Keep portfolio duration close to benchmark. Front-end pricing looks fair and long-dated forward yields are somewhat too high. TIPS Perhaps the most obvious way to profit from peak inflation in 2022 is by shorting TIPS versus nominal Treasuries. The 10-year TIPS breakeven inflation rate has risen to 2.91%, well above the Fed’s target range of 2.3%-2.5% (Chart 7). The combination of Fed tightening and falling inflation will send this rate back toward the Fed’s target between now and the end of the year. However, the potential downside in the 10-year TIPS breakeven inflation rate is nothing compared to the 2-year rate. The 2-year TIPS breakeven inflation rate is 4.4% (Chart 7, panel 2) and this short-maturity rate is much more sensitive to the incoming inflation data. Finally, long-maturity TIPS breakeven inflation rates look elevated compared to survey estimates of long run inflation. The 5-year/5-year forward TIPS breakeven inflation rate is currently 2.46%, above the range of estimates from the New York Fed’s Survey of Primary Dealers (Chart 7, bottom panel). In addition to underweight positions in TIPS versus nominal Treasuries, we continue to see the opportunity for an outright short position in 2-year TIPS. The 2-year TIPS yield has risen significantly since the end of last year, but this has been driven by a rising 2-year nominal yield (Chart 8). Going forward, the 2-year TIPS yield still has room to rise but it’s increase will be driven less by a rising nominal yield and more by a falling 2-year TIPS breakeven inflation rate. Chart 7Inflation Expectations Chart 8Sell 2-Year TIPS Consistent with our view that the cost of short-maturity inflation compensation has more downside than the cost of long-maturity inflation compensation, we view positions in 2-year/10-year inflation curve steepeners and 2-year/10-year TIPS curve flatteners as likely to profit during the next nine months (Chart 8, bottom panel). Bottom Line: Investors should underweight TIPS versus nominal Treasuries. They should also position in inflation curve steepeners and real yield curve flatteners and hold outright short positions in 2-year TIPS. Nominal Treasury Curve Chart 9Go Long 5yr Versus 2/10 One final idea is for investors to take a long position in the 5-year Treasury note versus a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. This 5 over 2/10 trade currently offers an attractive 18 bps of yield pick-up, which is much higher than we normally see when the 2-year/10-year Treasury slope is this flat (Chart 9). In fact, a simple model of the 2/5/10 butterfly spread versus the 2-year/10-year slope shows the 5-year bullet to be very cheap relative to history (Chart 9, panel 2). This position will profit from continued 2-year/10-year curve steepening, or more likely, it will profit if the 2-year/10-year slope remains near its current level but the 2-year/5-year slope flattens as the Fed tightening cycle progresses (Chart 9, panel 3). Bottom Line: The recent steepening trend in the 2-year/10-year Treasury slope is likely exhausted, but the 5-year Treasury yield is too high relative to the current 2-year/10-year slope. Investors should go long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The Fed’s Balance Sheet Plan The minutes from the March FOMC meeting revealed the Fed’s plan for shrinking its balance sheet. This plan will likely be put into action at either the May or June FOMC meeting. Specifically, the Fed intends to allow a maximum of $60 billion of Treasuries and $35 billion of MBS to passively run off its portfolio each month. The Fed also hinted that it may decide to start with lower caps and raise them up to the $60 billion and $35 billion targets over a period of three months. However, with the market already well positioned for Quantitative Tightening (QT), this phase-in period will probably not be deemed necessary. For its Treasury securities, the Fed intends to allow a maximum of $60 billion of coupon securities to run off its portfolio each month. If fewer than $60 billion of coupon securities are maturing that month, then the Fed will redeem T-bills to reach the $60 billion target. For MBS, the Fed’s $35 billion per month cap will probably not be binding. Given the slow pace of mortgage refinancings, which will only slow further as interest rates rise, it is unlikely that there will be many months with more than $35 billion of maturing MBS. In fact, some recent Fed research estimated that average MBS runoff will be closer to $25 billion per month going forward.2 Assuming the Fed’s plan starts in June and that MBS runoff averages $25 billion per month, we calculate that the Fed’s Treasury holdings and total assets will still be above pre-COVID levels in 2026 (Chart 10). More important than the Fed’s total assets, however, are the total reserves supplied to the banking system. It is the amount of reserves, after all, that determine whether the Fed can maintain adequate control over interest rates. If too few reserves are supplied, then the fed funds rate will threaten to break above the upper end of the Fed’s target band and the Fed will be forced to increase reserves by either re-starting purchases or engaging in repo transactions. This is exactly what happened when the Fed was forced to abandon its last QT effort in September 2019 (Chart 11). Chart 10Fed Asset Projections Chart 11Reserve Projections Making a few additional assumptions about the growth rate of currency-in-circulation and the size of the Treasury’s General Account, we are able to forecast the path for reserves going forward (Chart 11, top panel). We estimate that reserves will fall to roughly $2 trillion by the end of 2025, still slightly above the levels that caused problems in fall 2019. Ultimately, neither us nor the Fed knows exactly what level of reserves will be adequate to maintain control of interest rates going forward. The Fed will track usage of its new Standing Repo Facility as it shrinks its balance sheet. If usage of the repo facility increases, that will be the sign that the Fed has done enough QT and it is time to start slowly increasing the balance sheet once again. Given the recently published pace of runoff, we think this won’t be story for at least another two years.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 https://www.newyorkfed.org/newsevents/speeches/2022/log220302 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.     Executive Summary The Currency And Interest Rates: On A Collision Course? The dip in the Swedish krona has priced in a recession in the domestic economy. If a contraction does indeed occur, the impact on the currency is already a fait accompli. If it does not, the currency is poised for a coiled spring rebound. Fundamentally, the krona is cheap, and there is a dearth of SEK bulls, which is positive from a contrarian perspective. The Riksbank’s mandate is price stability. Given inflationary pressures and a weak currency, the Riksbank will have no choice but to turn more hawkish or lose credibility (Feature chart). There is potential for a brewing demand boom in Sweden – via refugees from Ukraine and Russia – that would increase government outlays and strengthen the need for higher rates. Admittedly, catalysts for SEK weakness remain in place – geopolitical tensions, rising energy costs and a stampede into safe-haven assets, including the dollar. Our strategy therefore is to buy on dips. We could be on the precipice of a capitulation phase that will present investors with an opportunity to accumulate the SEK at a fire-sale price. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/sek 10.15 2022-04-14 0.27 Bottom Line: Sweden is a small, open economy, very sensitive to global economic conditions. A recession is already priced by weakness in the SEK. Investors willing to tolerate volatility should buy the SEK on any further weakness. Feature Chart 1The SEK Tracks The DXY The Riksbank has been one of the more dovish central banks, both within the G10 and globally. Policy rates in Sweden are still at the zero bound, while they are rising in many other countries. In the Riksbank’s latest monetary policy report, domestic inflationary pressures were characterized as transitory. As such, the repo rate would not be raised until the second half of 2024.  The consequence of the Riksbank’s dovishness has been weakness in the Swedish krona, and a steep rise in inflation expectations. Most central banks are admitting that emergency policy settings are no longer appropriate in the current environment, especially after unprecedented monetary and fiscal stimulus. Yet, Sweden remains in the dovish camp. In this report, we argue that the Riksbank will have to raise rates sooner rather than later to maintain credibility and fend off inflationary pressures. The result of the Riksbank’s easy monetary policy has been the proliferation of massive carry trades, as investors sell the SEK and buy the dollar and/or other higher yielding currencies (Chart 1). As a small open economy, this could potentially unanchor longer-term inflation expectations, via a weak currency. Why Should The Riksbank Hike Rates? Chart 2The SEK Has Priced A Swedish Recession Sweden is likely to experience a technical recession in the coming quarters. The new orders-to-inventories ratio has contracted sharply, underscoring that the manufacturing sector will deflate (Chart 2). As a small, open economy, the manufacturing sector holds the key to the business cycle. Despite this, our bias is that the Riksbank will overlook the temporary dip in economic activity for the following reasons: The currency has already acted as a relief valve, which should cushion further downside in manufacturing activity (Chart 3). This is especially beneficial in a world where purchasing managers’ indices are declining everywhere. By the same token, the incentive for a central bank to raise rates when inflation is rising and the currency is more compelling, compared to a regime where a stronger currency tightens monetary conditions. Chart 4 shows that is weak is krona has been a fluid conduit for higher inflation in Sweden. A stronger krona will cap rising inflation expectations. Chart 3SEK Weakness Has Been A Welcome Relief Valve Chart 4SEK Weakness = High Imported Inflation It is remarkable that the traditional relationship between the SEK and oil prices (which is positive) has broken down (Chart 5). This is because rising oil prices usually reflect strong global demand, which benefits Sweden. This time around, a weak SEK is a tax on the economy as energy prices soar. Chart 5The Energy Shock To Sweden Has Been Unusual The Chinese credit impulse has bottomed, which is historically a good sign that Swedish central bankers can tolerate a stronger currency (Chart 6). Sweden’s biggest trade surplus is with the US, which in turn has the biggest trade deficit with China (Chart 7). As such, the relationship between the Swedish krona and the Chinese credit impulse is tightly knit. China’s zero COVID-19 policy is generating huge supply bottlenecks that are affecting inter-oceanic supply chains, but the pent-up demand once that ends could be tectonic. Chart 6The SEK Tracks The Chinese Credit Impulse Chart 7Sweden Needs The US And China The Riksbank’s mandate is to manage inflation expectations. Inflation is at 6%. The Riksbank’s own measure of resource utilization is at a level that has typically been associated with a much higher repo rate. The output gap is closing, raising the risk of a wage inflation spiral (Chart 8). Simply put, the Riksbank would have to raise interest rates or engender a crisis of confidence in monetary policy. Chart 8A Taylor Rule Approach Suggests Interest Rates Are Too Low Finally, house prices are surging to record highs, on the back of very low mortgage rates and extremely accommodative monetary policy (Chart 9). Chart 9Low Rates Have Led To A Debt Binge And Housing Boom A Potential Demand Boom The unemployment rate in Sweden remains above pre-pandemic levels. More importantly, it might rise in the coming quarters, but that would not be particularly worrisome. The reason is a potential increase in the labor dividend in Sweden, as new entrants increase the size of the labor force. First, the employment component of the manufacturing PMI index suggests employment growth should remain around 2% or so. There has been a tight correlation between employment growth in Sweden and the purchasing managers’ survey of the employment outlook (Chart 10). In our view, there is good reason to expect employment growth to remain resilient and in turn, stimulate demand. Related Report  Foreign Exchange StrategyThe Unsung Case For The Euro Sweden has a long history of openness towards immigration compared to many other European countries. If we go back to the Syrian crisis several years ago, the number of asylum seekers skyrocketed to over 160,000 or circa 1.5% of the total population (Chart 11). This was a huge labor dividend. This time around, migrants from both Ukraine and Russia will add to the skilled pool of domestic workers. Some estimates suggest there could be as many as 200,000 immigrants, just from the current crisis. This said, it will also increase frictional unemployment, as new migrants integrate into the labor force and adopt a new language. Chart 10Employment Is Holding Up In Sweden Chart 11There Is Potential For A Huge Labor Dividend Foreign-born workers have been rising as a share of the Swedish labor force and now constitute about 20% of the total population (Chart 12). This growth dividend will be reaped for years to come. With the Social Democrats in power, upside surprises to immigration numbers are within a reasonable confidence interval of outcomes. In a nutshell, Sweden enjoys a relatively positive demographic outlook (Chart 13). Chart 12Foreign Workers Are Important Chart 13Sweden Has A Demographic Dividend The inflow of migrants has a mixed impact on inflation. While there is downward pressure on wages, due to an increase of lower-paying jobs, there is still upward pressure on housing and consumption, notwithstanding a fiscal boost as the government spends more on social services. Meanwhile, the unemployment rate among foreign-born people is around 16.2%. This means that the Phillips curve is flat for the first few years, before it starts to steepen. The Riksbank clearly understands these dynamics, which is why over the prior years, its stance has been dovish even when the Swedish economy has been holding up well. The difference this time is that inflation is surging, and the potential for cost-push pressures to translate into demand-pull inflation (via higher wages) is rising in Sweden. In our view, Governor Stefan Ingves will renormalize policy as quickly as possible, given that he is managing a small open economy with one of the cheapest currencies in the G10 universe, with a large footprint of imported inflation. Trading Strategy Chart 14The Riksbank Will Have To Raise Rates Our currency strategy is to buy the SEK on weakness. The recent dovish path by the ECB will mean that the Riksbank will tread very carefully in sounding too hawkish. However, every real-time indicator of its mandate suggests emergency policy settings are no longer necessary. Real rates are falling in Sweden relative to both the US and the euro area. As such, the SEK has not yet priced a shift in the Riksbank's policy setting. (Chart 14). This suggests that while the carry cost is high from being long the SEK at current levels, a capitulation phase will present investors with an opportunity to accumulate the SEK at a fire-sale price. As for Long EUR/SEK, the cross could overshoot, but will head lower on a 12–18-month horizon. Long SEK/CHF positions are also attractive.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The unemployment rate in the US stands at 3.6%, 0.4 percentage points below the FOMC’s estimate of full employment. Historically, the Fed’s efforts to nudge up the unemployment rate have failed: The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Despite this somber fact, there are reasons to think it will take longer for a recession to arrive than widely believed. Unlike in the lead-up to many past recessions, the US private sector is currently running a financial surplus. If anything, there are indications that both households and businesses are set to expand – rather than retrench – spending over the coming quarters. Investors should pay close attention to the housing market. As the most interest-rate sensitive sector of the economy, it will dictate the degree to which the Fed can raise rates. The US housing market has cooled, but remains in reasonably good shape, supported by rising incomes and low home inventories. Stocks will likely rise modestly over the next 12 months as inflation temporarily dips and the pandemic recedes from view. However, equities will falter towards the end of 2023. Stocks Tend To Fare Well When There Is No Recession On The Horizon Bottom Line: The US may not be able to avoid a recession, but an economic downturn is unlikely until 2024. Stay modestly overweight stocks over a 12-month horizon.  Jobs Aplenty The US unemployment rate fell from 3.8% in February to 3.6% in March, bringing it close to its pre-pandemic low of 3.5%. Adding job openings to employment and comparing the resulting sum with the size of the labor force, the excess of labor demand over labor supply is now the highest since July 1969 (Chart 1). Chart 1Labor Demand Is Outstripping Labor Supply By The Largest Margin Since 1969 Granted, the labor force participation rate is still one full percentage point below where it was prior to the pandemic. If the participation rate were to rise, the gap between labor demand and supply would shrink. Some of the decline in the participation rate is permanent in nature, reflecting ongoing population aging, which has been compounded by an increase in early retirements during the pandemic (Chart 2). Some workers who dropped out will probably re-enter the workforce. Chart 3 shows that employment among low-wage workers has been slower to recover than for other groups. With expanded unemployment benefits no longer available, the motivation to find gainful employment will escalate. Chart 2Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Chart 3Low-Wage Workers Have Not Returned In Full Force Nevertheless, it is doubtful that the entry of low-wage workers into the labor force will do much to reduce the gap between labor demand and supply. Low-wage workers tend to spend all of their incomes (Chart 4). Thus, while an increase in the number of low-wage workers will allow the supply of goods and services to rise, this will be counterbalanced by an increase in the demand for goods and services. Chart 4Richer Households Tend To Save More Than Poorer Ones To cool the labor market, the Fed will need to curb spending, and that can only be achieved by raising interest rates. Trying to achieve a soft landing in this manner is always easier said than done. The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Rising unemployment tends to produce a negative feedback loop: A weaker labor market depresses spending. This, in turn, leads to less hiring and more firing, resulting in even higher unemployment. Where is the Choke Point? How high will interest rates need to rise to trigger such a feedback loop? Markets currently expect the Fed to raise rates to 3% by mid-2023 but then cut rates by at least 25 basis points over the subsequent months (Chart 5). So, the market thinks the neutral rate of interest – the interest rate consistent with a stable unemployment rate – is around 2.5%. The Fed broadly shares the market’s view. The median dot for the terminal Fed funds rate stood at 2.4% in the March Summary of Economic Projections (Chart 6). When the Fed first started publishing its dot plot in 2012, it thought the terminal rate was 4.25%. Chart 5The Markets See The Fed Funds Rate Reaching 3% Next Year Chart 6The Fed's Estimate Of The Terminal Rate Has Fallen Over The Years Low Imbalances Imply a Higher Neutral Rate We have discussed the concept of the neutral rate extensively in the past, so we will not regurgitate the issues here (interested readers should consult the Feature Section of our latest Strategy Outlook). Instead, it would be worthwhile to dwell on the relationship between the neutral rate and economic imbalances. Simply put, when an economy is suffering from major imbalances, it does not take much monetary tightening to push it over the edge. The private-sector financial balance measures the difference between what households and firms earn and spend. A recession is more likely to occur when the private-sector financial balance is negative — that is, when spending exceeds income — since households and firms are more prone to cut spending when they are living beyond their means. In the lead-up to the Great Recession, the private-sector financial balance hit a deficit of 3.9% of GDP in the US. Leading up to the 2001 recession, it reached a deficit of 5.4% of GDP. Today, the US private-sector financial balance, while down from its peak during the pandemic, still stands at a comfortable surplus of 3% of GDP. Rather than looking to retrench, households and businesses are poised to increase spending over the coming quarters (Chart 7). Private-sector financial balances are also positive in Japan, China, and most of Europe (Chart 8). Chart 7Consumers And Businesses Are Set To Spend More Chart 8Private-Sector Financial Balances Are Positive In Most Major Economies Watch Housing Chart 9Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment At the 2007 Jackson Hole conference, Ed Leamer presented what turned out to be a very prescient paper. Titled “Housing is the Business Cycle,” Leamer concluded that “Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession.” Housing is a long-lived asset, and one that is usually financed with debt. To a much greater extent than nonresidential investment, the housing sector is very sensitive to changes in interest rates. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 9). The jump in mortgage yields has started to weigh on housing (Chart 10). Mortgage applications for home purchases have fallen by 25% from their highs. Pending home sales have dropped. Homebuilder confidence has dipped. Homebuilder stocks are down 29% year-to-date. Housing is likely to slow further in the months ahead, even if mortgage yields stabilize. Chart 11 shows that changes in mortgage yields lead home sales and housing starts by about six months. Chart 10The Jump In Mortgage Rates Has Weighed On The Housing Market Chart 11Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity The key question for investors is whether the housing market will enter a deep freeze or merely cool down. We think the latter is more likely. The 30-year fixed mortgage rate has increased nearly two percentage points since last August, but at around 5%, it is still below the average of 6% that prevailed during the 2000-2006 housing boom (Chart 12). Moreover, unlike during the housing boom, when homebuilders flooded the market with houses, the supply of new homes remains contained. The nationwide homeowner vacancy rate stands at record lows. Building permits are near cycle highs (Chart 13). Granted, real home prices are close to record highs. However, relative to incomes, US home prices have not broken out of their historic range (Chart 14). Chart 13The Homeowner Vacancy Rate Is Near Record Lows Chart 14Homes In The US Are Relatively Cheap Home affordability is much more stretched outside of the United States. The Bank of Canada, for example, has less scope to raise rates than the Fed. Chart 15Some Signs Of Easing In Supply-Side Pressures Investment Conclusions As investors, we need to be forward looking. The widespread availability of Paxlovid later this year — which, in contrast to the vaccines, is effective against all Covid strains — will help boost global growth while relieving supply-chain bottlenecks. Shipping costs, used car prices, and ISM supplier delivery times have already come down from their highs (Chart 15). Central banks have either started to raise rates or are gearing up to do so. However, monetary policy is unlikely to turn restrictive in any major economy over the next 12 months. Stocks usually go up outside of recessionary environments (Chart 16). Global equities are trading at 17-times forward earnings. The corresponding earnings yield is about 630 basis points higher than the real global bond yield – a very wide gap by historic standards (Chart 17). Chart 16Stocks Tend To Fare Well When There Is No Recession On The Horizon Chart 17AThe Equity Risk Premium Remains Elevated (I) Chart 17BThe Equity Risk Premium Remains Elevated (II) Investors should remain modestly overweight equities over a 12-month horizon and look to increase exposure to non-US stock markets, small caps, and value stocks over the coming months. Government bond yields are unlikely to rise much over the next 12 months but will increase further over the long haul. The dollar should peak during this summer, and then weaken over the subsequent 12 months. A complete discussion of our market views is contained in our recently published Second Quarter Strategy Outlook.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary The structural downtrend in Chinese bond yields has a lot further to go, because it is helping to let the air out gently of stratospheric valuations in the real estate sector, and thereby preventing a hard landing for the Chinese economy. In the US, flagging mortgage and housing market activity is weighing on an already slowing economy. Buy US T-bonds. The long T-bond yield is close to a peak. Switch equity exposure into long-duration sectors such as healthcare and biotech. Go overweight US homebuilders versus US insurers. The peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate. Fractal trading watchlist: Basic resources; Switzerland versus Germany; and USD/EUR. The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Bottom Line: The global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy. Feature Quietly and largely unnoticed, Chinese long-dated bond yields have been drifting lower (Chart I-1 and Chart I-2). At a time that surging bond yields elsewhere in the world have grabbed all the attention, the largely unnoticed contrarian move in Chinese bond yields through the past year is significant because of something else that has gone largely unnoticed: Chinese real estate has become by far the largest asset-class in the world, worth $100 trillion.1 Chart I-1The Contrarian Downdrift In The Chinese 30-Year Bond Yield Chart I-2The Contrarian Downdrift In The Chinese 10-Year Bond Yield Chinese Real Estate Is Trading On A Stratospheric Valuation The $100 trillion valuation of Chinese real estate market is greater than the $90 trillion global economy, is more than twice the size of the $45 trillion US real estate market and the $45 trillion US stock market, and dwarfs the $18 trillion Chinese economy. Suffice to say, Chinese real estate’s pre-eminence as the world’s largest asset-class is mostly due to its stratospheric valuation. Prime residential rental yields in Guangzhou, Shanghai, Hangzhou, Shenzhen and Beijing have collapsed to 1.5 percent, the lowest rental yields in the world and less than half the global average of 3 percent. Versus rents therefore, Chinese real estate is now twice as expensive as in the rest of the world (Chart I-3). Chart I-3Versus Rents, Chinese Real Estate Is The Most Expensive In The World To corroborate this point, while the US real asset market is worth around two times US annual GDP, the Chinese real estate market is worth more than five times China’s annual GDP! The structural downtrend in Chinese bond yields has a lot further to go. Crucially, the downward drift in Chinese bond yields is alleviating some of the pressure on the extremely highly valued Chinese real estate market – as it helps to let the air out gently of the stratospheric valuations, and thereby avoid a hard landing for the Chinese economy. Hence, the structural downtrend in Chinese bond yields has a lot further to go. The Surge In US Mortgage Rates Is Taking Its Toll Meanwhile, in the rest of the world, the surge in bond yields poses a major threat to the decade long housing boom. Versus rents, US house prices are the most expensive ever – more expensive even than during the early 2000s so-called ‘housing bubble’. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield. Until recently, the historically low rental yield on US real estate was justified by an extremely low bond yield. But the recent surge in the bond yield has changed all that. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield2 (Chart I-4). Chart I-4The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The surge in US mortgage rates is taking its toll. Since the end of January, US mortgage applications for home purchase have fallen by almost a fifth (Chart I-5), and the lower demand for home purchase mortgages is starting to weigh on home construction (Chart I-6). Building permits for new private housing units were already falling in February, but a more up-to-date sign of the pain is the 35 percent collapse in US homebuilder shares. Chart I-5US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth Chart I-6The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields Mortgage rates drive real estate rental yields because of the arbitrage between buying versus renting a similar home. Given a fixed annual budget for housing, I must choose between how much home I can buy – which depends on the mortgage rate, versus how much home I can rent – which depends on the rental yield. The arbitrage should make me indifferent between the two options. As a simple example of this arbitrage, let’s assume my annual budget for housing is $10k, and both the mortgage rate and rental yield are 4 percent. I will be indifferent between spending the $10k on interest on a $250k mortgage loan to buy the home, or spending the $10k to rent a similar $250k home. If the mortgage rate rises to 5 percent, then the maximum loan that my $10k of interest payment will afford me falls to $200k, reducing my maximum bid to buy the home. If I am the marginal bidder, then the home price will fall to $200k, so that the $10k rent on the similar valued home will also equate to a higher rental yield of 5 percent. In practice, the simple arbitrage described above is complicated by several factors: the maximum loan-to-value that a lender will offer on the home; the different transaction costs of buying versus renting; and the fact that people prefer to buy than to rent because buying a home is an investment which also provides a consumption service – shelter, whereas renting a home only provides the consumption service. Nevertheless, these complications do not diminish the overarching connection between mortgage rates and rental yields. The lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields. All of which brings us to the decade long global real estate boom that has doubled the value of global real estate market to an eye-watering $350 trillion, four times the size of the $90 trillion global economy. During this unprecedented boom, global rents have risen by 40 percent, tracking world nominal GDP, as they should. This means that the lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields (Chart I-7).    Chart I-7The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations Since the global financial crisis, there has been an excellent empirical relationship between the global long-dated bond yield (US/China average) and the global rental yield. The important takeaway is that the global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy (Chart I-8). Chart I-8The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market Some Investment Conclusions The good news is that the recent rise in the global bond yield has been limited by the downdrift in Chinese bond yields. Given the massive overvaluation of Chinese real estate, the structural downtrend in Chinese bond yields has a lot further to go. Meanwhile in the US, unless bond yields back down quickly, flagging mortgage and housing market activity will weigh on an already slowing economy. If US bond yields don’t back down quickly, the feedback from consequent slowdown in the economy will ultimately bring yields down anyway. As I explained last week in Fat-Tailed Inflation Signals A Peak In Bond Yields I do expect the long T-bond yield to back down relatively quickly. The sharp drop in US core inflation to just 0.3 percent month-on-month in March signals that inflation is peaking. Hence, medium to long term investors should be buying US T-bonds, and switching equity exposure into long-duration sectors such as healthcare and biotech. Finally, a peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate (Chart I-9). Hence, go overweight US homebuilders versus US insurers. Chart I-9The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Fractal Trading Watchlist Given that inflation hedging investment demand has driven at least part of the strong rally in basic resources, a peak in inflation and bond yields threatens to unwind the recent outperformance of basic resources shares. This is corroborated by the extremely fragile 130-day fractal structure (Chart I-10). Accordingly, the recommended trade is to short basic resources (GNR) versus the broad market, setting the profit target and symmetrical stop-loss at 11.5 percent. This week we are also adding to our watchlist: Switzerland versus Germany; and USD/EUR. The full list of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com  Chart I-10The Outperformance Of Basic Resources Is Vulnerable To Reversal Switzerland's Outperformance Vs. Germany Could End The Rally In USD/EUR Could End Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Chart 20Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 We estimate the value of Chinese real estate at the end of 2021 to be $97 trillion, comprising residential $85 trillion, commercial $6 trillion, and agricultural $6 trillion. The source is: the Savills September 2021 report ‘The total value of global real estate’, which valued the global real estate market to the end of 2020; and the February 2022 report ‘Savills Prime Residential Index: World Cities’ which allowed us to update the valuations to the end of 2021. 2 The US prime residential rental yield is the simple average of the prime residential rental yields in New York, Miami, Los Angeles and San Francisco. Source: Savills. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-5Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Fed officials maintained the drumbeat of hawkish commentary last week, reiterating their commitment to use the full might of their tools to bring inflation to heel. Stock and bond markets reacted adversely when dovish Governor Brainard joined the chorus, but no one should have been surprised. The FOMC is unanimous in its resolve to combat inflation before long-run expectations become unmoored. Markets may also have been discomfited by the coming shrinking of the Fed’s balance sheet. Though balance sheet runoff should exert some modest upward pressure on bond yields, we do not expect markets to dwell on it for long. Housing activity is squarely in the crosshairs of tighter monetary policy. Mortgage rates are extremely low relative to history, however, and homes remain quite affordable. We expect the housing market will weather the backup in rates. A plucky band of first-time organizers spurred workers in a New York City Amazon warehouse to vote to form a union. Labor advocates rejoiced, but it is premature to mark the event as a turning point for organized labor. What Goes Up Must Come Down Bottom Line: Last week’s Fed “news” was not particularly newsworthy. The FOMC will prioritize its inflation mandate over its full employment mandate until further notice, but the economy is well suited to withstand higher rates and even the housing market won’t buckle in the face of them. Feature Just when you thought it was safe to go back in the water, Fed speakers roiled rates markets again last week, pushing the 10-year Treasury yield over 2.6% for the first time in three years. Although Fed Governor Brainard was simply lining up behind every other governor and district president who’s been in range of a microphone over the last several weeks, her tough talk on inflation in a Tuesday morning speech jolted the 10-year yield 10 basis points (bps) higher, from 2.45% to 2.55%, and it tacked on another 10 bps overnight, hitting 2.65% as New York-based fixed income traders switched on their terminals Wednesday morning. Stocks tumbled after Brainard’s remarks, as well, with the S&P 500 shedding 1% in back-to-back sessions. Both markets got a respite after the March FOMC meeting minutes contained no further revelations but the 10-year yield marched to 2.70% on Friday. The market action demonstrated that investors remain on edge, despite the S&P 500’s 10% bounce. From our perspective, there was nothing too notable in Brainard’s comments. She may be seen as one of the more reliably dovish members of the FOMC, but Chair Powell has been at pains to stress that the entire committee is “determin[ed],” as the minutes put it, “to take the measures necessary to restore price stability.” With inflation readings persisting well above the FOMC’s target level, one participant after another has hammered home the message in speeches and interviews that the committee is unanimously resolved to wield its tools to bring it to heel. Related Report  US Investment StrategyIt All Depends On Whom You Ask Hiking the fed funds rate is the committee’s foremost weapon in the fight against inflation, and it has guided investors to discount a more rapid pace of 2022 increases and a modestly higher end point for this tightening cycle. We think the fixed income market is underestimating the terminal, or peak, rate but expect that it will require hard evidence before it reassesses its conviction that the economy cannot withstand a fed funds rate above 2.5%. It will take time to gather that evidence, as it won’t be available until the funds rate is at least 2%, so we expect that the 10-year yield will soon peak in tandem with inflation, but investors are especially uncertain and volatile financial markets reflect it. The FOMC can also adjust the size of its balance sheet to regulate the stimulus it’s providing to the economy. This tool pales in importance relative to the funds rate and despite Ben Bernanke’s smug remark at BCA’s 2015 conference that “quantitative easing works in practice but not in theory,” definitive evidence of its effects remains elusive. We therefore do not expect that curtailing reinvestment of principal repayments from the Fed’s stockpile of securities holdings will have a meaningful direct effect on the economy. Last week’s guidance that the runoff will be faster than it was in 2018-19 makes sense, given that the Fed’s securities holdings are twice as large (Chart 1), and that flush households and businesses are in markedly better shape than they were in the aftermath of the crisis. Chart 1The Funds Rate Matters More Than The Size Of The Balance Sheet There is no settled consensus on what the Fed’s balance sheet reduction will mean for the economy and markets. The US Investment Strategy view is that asset purchases are mainly a signaling device; they let economic participants and investors know that zero interest rate policy will remain in place until some period after they end. Balance sheet runoff doesn’t provide any similar information about the future; it simply indicates that the FOMC will be pursuing a supplemental stimulus reduction measure alongside its far more influential increases in short rates. Removing a price-insensitive buyer from the marketplace should put modest upward pressure on interest rates because they should have to rise, all else equal, to induce other buyers to step in to replace it. We expect, therefore, that the runoff will tighten financial conditions at the margin and exert a modest drag on economic activity. Some of that marginal tightening must have already occurred, as the Fed has taken pains to telegraph the balance sheet runoff, but it will likely contribute to volatility as markets try to settle on the proper outcome to discount. What About Housing? Interest rates affect the entire economy, but housing is the most rate-sensitive industry. Houses are the ultimate big-ticket items – they are the most expensive purchase most households will make and nearly all of them are financed via mortgages. Demand for single-family housing, away from the post-GFC phenomenon of investment buyers paying cash, is acutely sensitive to interest rates. The tide of available buyers ebbs and flows as monthly mortgage payments rise and fall. The housing market therefore finds itself in the crosshairs of the Fed’s tough talk about inflation and the homebuilder stocks have been demolished so far this year, losing a third of their value to lag every other subindustry group in the S&P 500 except closely related home furnishings (Chart 2). The stock rout contrasts with the upbeat housing market outlook we offered two months ago. Though we acknowledge that housing’s prospects have dimmed somewhat since mid-to-late February, we remain more optimistic than the consensus and are confident that a pronounced slowdown is not in store. Chart 2A Brutal Selloff ... The subsequent 75-bps surge in Freddie Mac’s national 30-year fixed-rate mortgage proxy (Chart 3, middle panel) has made homes less affordable for the median buyer (Chart 3, top panel). The drop in affordability has been modest, however, as it has been cushioned by a narrowing of the gap between median income and median home prices (Chart 3, bottom panel). Despite the last two months’ dip, homes remain quite affordable relative to history. Chart 3... Despite Solid Affordability​​​​​ Since its predecessor index began in 1971, affordability had only ever surpassed the 140 level that has marked the bottom of the post-crisis range for a brief period in the early seventies (Chart 4, top panel). While mortgage rates are clearly moving in the wrong direction, they remain extremely low. One must squint to register their current advance in the context of the series’ entire history (Chart 4, third panel). Despite rising rates, median income gains have kept the mortgage servicing burden steady – and historically light – for several months (Chart 4, second panel). Though we expect that mortgage rates will stop vaulting upward and possibly even retrace some of their advance as inflation peaks, their recent move has been unfriendly to the housing market. Viewed from the perspective of the National Association of Realtors’ affordability index, however, their level remains quite favorable, and we do not worry that great swaths of would-be buyers are going to be shut out of the market. The respondents to the NAHB’s homebuilder sentiment survey agree. While the forward sales component swooned by ten points from January to February (Chart 5, bottom panel), current sales largely kept pace (Chart 5, second panel) and potential buyer traffic rose (Chart 5, third panel). The overall index slipped a bit since January but – stop us if you’ve heard this before – remains very strong relative to history (Chart 5, top panel). Chart 4The American Dream Is Not Out Of Reach​​​​​​ Chart 5Homebuilders See Clear Skies Ahead ...​​​​​ Though demand has surely waned, as rising rates sideline some marginal buyers, we expect it will remain robust, especially as the sizzling rental market offers little relief. Supplies of new and existing homes remain constrained. Restrictive zoning laws, sporadically soaring input costs, supply chain issues and difficulty finding skilled workers have hampered new home construction. Inventories of existing homes remain historically depleted (Chart 6, middle panel) and the share of homes that are vacant remains at all-time lows (Chart 6, bottom panel). Chart 6... As Their Product Is In Short Supply​​​​​​ Chart 7Real Mortgage Rates Are Not A Problem​​​​​​ The bottom line is that the housing picture has worsened somewhat but we still believe conditions are better than the gloomy consensus perception. Construction and sales activity will surprise to the upside over the rest of the year and residential investment will augment economic activity, not detract from it. Although the ITB homebuilder ETF has been a drag on performance since we added it to our cyclical ETF portfolio last month, we will continue to hold it as a pure play on the resilience of domestic demand. It is hard to see demand evaporating in the fashion implied by the homebuilders’ skid when real mortgage rates are at such extreme lows, no matter how they are adjusted for inflation (Chart 7). David Wins A Round Against Goliath Workers at a fulfillment center in Staten Island voted two weeks ago to become the first domestic Amazon employees to form a union. The vote, along with a concurrent re-vote at a Bessemer, Alabama warehouse that union organizers lost, was closely watched by labor relations experts. Amazon is the second-largest private employer in the US, with more than a million employees, and its size and reputedly trying working conditions make it an especially appealing target for unions. Labor advocates were quick to characterize the vote as a watershed moment, but it is far too early to call an inflection point. The outcome of the Amazon vote was front-page news because it was so improbable. Despite a cyclically favorable labor market, wage earners trying to unionize confront a gaping structural resource disparity with multinational companies. The fledgling Amazon Labor Union’s (ALU) victory in Staten Island was startling but it still faces an arduous climb to bring Amazon to the negotiating table and work out a contract agreement. Amazon will be able to introduce delays at every step of the process, eroding ALU’s meager resources while pursuing a strategy of running out the clock on the current labor-friendly administration. One of the key takeaways from our January-February 2020 Special Reports on US labor relations history was that employees are only to achieve gains when the government – courts, legislatures and the executive branch – does not favor employers. The series of reports were meant to alert investors to the possibility that Democratic wins in the 2020 election could send the pendulum swinging back in employees’ favor after 40 years of tilting toward employers, carrying important implications for corporate profit margins and inflation. Chart 8The Tortoise And The Hare The election did mark a change in the White House’s attitude toward labor, installing the self-declared “most pro-union president leading the most pro-union administration in American history.1” Since President Biden took office, the National Labor Relations Board has forcefully asserted itself in its role as the official referee of union elections to the point that Amazon has accused it of taking the unions’ side instead of serving as a neutral arbiter. The president himself would seem to have been taking sides last week when he took the rare step of calling out Amazon by name during remarks to a group of unionized workers. “The choice to join a union belongs to workers alone,” he said. “By the way, Amazon, here we come. Watch.” The White House press secretary quickly walked back the comments, placing them in the context of the president’s established support for unionization and collective bargaining. “What he was not doing is sending a message that he or the U.S. government would be directly involved in any of these efforts or take any direct action.2” Regardless of whether President Biden was attempting to send a message or had ventured off-topic as is his wont, it is unclear how much his administration can do to tilt the scales in workers’ favor. New Deal-era laws endowed workers with the right to organize and employers are not allowed to obstruct their efforts to do so. There are multiple gray areas in union election campaigns, however, and employers regularly deploy a wide range of actions that are not explicitly prohibited to keep unions out of their workplace. Most importantly, this administration may only be in charge until January 2025. It can use the NLRB, OSHA, the Department of Labor and the Department of Justice to try to advance workers’ cause for four years but labor has been on the back foot for four decades. It is likely to lose its legislative majorities in November’s midterms, the federal bench is populated by a majority of judges disposed to see things from employers’ point of view and many state legislatures are markedly anti-union. Without another term, the jury is out on the administration’s ability to effect durable change. The takeaway for investors is that a wage-price spiral has not yet taken hold and our bet is that it won’t. The tight labor market has endowed workers with more leverage than they’ve had in many cycles, but structurally the labor relations landscape bears more characteristics of the Reagan Era (1980-2020) than the New Deal Era (1933-1980). Real average hourly earnings have risen since the pandemic arrived in the US (Chart 8, top panel), but we find it telling that all of the real wage growth occurred in the first year of the pandemic. Across Year 2, nominal wages have failed to keep up with consumer price inflation (Chart 8, bottom panel), despite White House support in the midst of a labor market so tight that it squeaks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Remarks by President Biden in Honor of Labor Unions | The White House Accessed April 7, 2022. 2     Biden Appears to Show Support for Amazon Workers Who Voted to Unionize - The New York Times (nytimes.com) Accessed April 7, 2022.

Executive Summary The Dollar Has Broken Above Overhead Resistance Most central banks continue to dial up their hawkish rhetoric, led by the Fed. This is putting upward pressure on the dollar (Feature Chart). The big surprise has been resilient inflationary pressures across many economies. In our view, the market has already priced in an aggressive path for interest rates in the US, putting the onus on the Fed to deliver on these expectations. Meanwhile, other central banks that are also facing domestic inflationary pressures will play catch up. Our short USD/JPY position was triggered at 124. While there are no immediate catalysts for yen bulls, the currency is very cheap, and speculators are very short. Look to sell the DXY soon. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 102 2022-04-07 - SHORT USD/JPY 124 2022-04-05 0.02 Bottom Line: Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs at 103. However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Feature The dollar performed well in the first quarter of this year. Year-to-date, the DXY index is up 3.9%.  Remarkably, this has coincided with strength in many commodity currencies such as the BRL, ZAR, COP, CLP, and AUD, that tend to be high beta plays on a falling dollar (Chart 1). Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs of 103 (Chart 2). However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Chart 1The Dollar And Commodity Currencies Have Been Strong This Year Chart 2The Dollar Has Broken Above Overhead ##br##Resistance As we have highlighted in past reports, the dollar continues to face a tug of war. If rates rise substantially in the US, and that undermines the US equity market leadership (Chart 3), the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. Chart 3Dollar Tailwinds Remain Intact This week’s Month-In Review report goes over our take on the latest G10 data releases, and the implication for currency strategy both in the near term and longer term. US Dollar: The Fed Stays Hawkish Chart 4The Case For More Tightening The dollar DXY index is up 3.9% year-to-date. The key data releases the Federal Reserve watches continue to suggest a hawkish path for interest rates going forward. Inflation remains strong in the US. Headline CPI came in at 7.9% year-on-year in February and is expected to accelerate in next week’s release. Nonfarm payrolls are still robust. The US added 431K jobs in March, nudging the unemployment rate to a cycle low of 3.6%. Wages are inflecting higher, which is pulling up unit labor costs. The Atlanta Fed Wage Growth Tracker currently sits at 6%. These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.25% by December 2022. Speculators are also very long the dollar. The mispricing in the dollar comes from the fact that markets are expecting the Fed to be more aggressive than other central banks in curtailing monetary accommodation this year (as proxied by two-year yield spreads). However, the reality is that other central banks are also ratcheting up their hawkish rhetoric. As such, we expect policy convergence to be a theme that will play out in 2022, putting downward pressure on the dollar. In conclusion, our 3-month view on the dollar is neutral, based on the risk of further escalation in the Ukrainian crisis and robust inflation prints, but our 9-month assessment will be to sell the dollar on any strength. We are revising our year-end target on the DXY to 95. The Euro: Stagflation Chart 5Euro Area Real Yields Are Too Low The euro continues to weaken, down 4.2% this year, after hitting an intraday low of 1.08 last month. Economic data in the eurozone has been soft, especially on the back of a surge in the number of new Covid-19 cases, rising energy costs driven by the military conflict between Ukraine and Russia, and a weak euro adding to upward pressure on inflation. This is pinning the euro area in a stagflationary quagmire.  More specifically: The headline HICP (harmonized index of consumer prices) index for the euro area was 7.5% for March. The hawks in the ECB are very uncomfortable with last week’s HICP release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. House prices in the euro area are accelerating on the back of very low real rates. This is increasing the unaffordability of homes across the eurozone. One of our favorite measures of economic activity, the Sentix Economic Index, tumbled in April. At -18, this is the lowest since July 2020, a negative surprise vis-à-vis the expected -9.4. Faced with a deteriorating economic backdrop, but strong inflationary pressures, the ECB has chosen a hawkish path to maintain credibility. Asset purchases will be tapered this year, and rate hikes are on the table. Forward markets are now pricing 53 bps of interest rate increases this year. In our view, while the ECB will not deliver the pace of rate hikes anticipated by markets in the near term, pricing of interest rate differentials between the eurozone and the US will narrow, as the ECB plays catch up. We are neutral on the euro over a 3-month horizon but are buyers over 9 months and beyond. Stay long EUR/GBP as a play on policy convergence between the ECB and BoE. Our year-end target for EUR/USD is 1.18.  The Japanese Yen: A Contrarian View Chart 6Too Many Yen Bears The Japanese Yen: A Contrarian View The Japanese yen is down 7% year-to-date. This pins it as the worst performing G10 currency this year. The story for Japan (and the yen) has been a very slow emergence from the latest Covid-19 wave. This has kept domestic inflation very subdued, allowing the BoJ to stay dovish, even as the external environment has done better. This has pushed interest rate differentials against the Japanese yen. The latest trigger for the selloff in the yen was the BoJ’s commitment to maintain yield curve control as global interest rates have been surging. This pushed USD/JPY above 125, the highest since 2015. On the back of this move, incoming economic data justified the BoJ’s stance. Headline inflation has picked up (still at 0.9%), but core “core” inflation remains at -1%. At 1.21, the job-to-applicant ratio is well below its pre-pandemic level of around 1.6. Ergo, the labor market is not as tight as a 2.7% unemployment rate suggests. Wage growth is improving, currently at 1.2% for February. That said, is it hard to argue that Japanese workers have bargaining power and can trigger a wage/inflation spiral that will allow the BoJ to pivot. Related Report  Foreign Exchange StrategyThe Yen In 2022 Despite these negatives, we are constructive on the yen because the downside is well priced in, while upside surprises are not. Real rates remain higher in Japan than for other G10 countries. Speculators are also very short the yen. As we highlighted last week, the yen is also extremely cheap. We went short USD/JPY at 124. Our view is that interest rate expectations for the US are overdone in the near term. As such a stabilization/retracement in global yields could be a bullish development for yen bulls. Our target is 110 with a stop at 128.  British Pound: A Hawkish BoE Chart 7The Case For A Hawkish BoE The pound is down 3.4% year-to-date. The Bank of England has been one of the more aggressive central banks, raising interest rates to 0.75% last month. Inflation continues to soar in the UK - headline CPI was at 6.2% in February while core inflation clocked in at 5.2%. This prompted the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. According to the BoE’s projections, inflation will rise above 8% this year before peaking. At the same time, taxes are slated to rise in the UK this month. While the labor market continues to heal, the combination will be a hit to consumer sentiment in the near term. The SONIA curve in the UK is pricing 130 bps of price hikes this year. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen. Tight monetary and fiscal policy in the UK could stomp out any budding economic green shoots. The pound is also very sensitive to global financial conditions, and an equity market correction, especially on the back of heightened tensions in Ukraine, will put pressure on cable. We are short sterling, via a long EUR position. In our view, the EUR/GBP cross is heavily underpricing the risks to the UK economy in the near term.    Australian Dollar: A Commodity Story Chart 8The RBA Will Stay Patient The Australian dollar is up 3% year-to-date, making it the best performing G10 currency. The Reserve Bank of Australia kept rates on hold at its April 5th meeting, but it ratcheted up its hawkish tone. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. As a result, the shift in the RBA stance was justified. Since its March meeting, home prices have continued to accelerate, rising 23.7% year-on-year in Q4. Meanwhile, the unemployment rate has fallen to a cycle low of 4% in Q4. This is below many measures of NAIRU. The RBA expects inflationary pressures to remain persistent in 2022, but ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 2%-3% target range. Admittedly, wages are still low by historical standards, but as Governor Philip Lowe has highlighted, the behavior of the Phillip’s Curve at these low levels of unemployment is unpredictable. The external environment is also AUD bullish. The RBA Index of Commodity prices soared by 40.9% year-on-year in March, widening the gap with a rather muted AUD (up 3.4% this year). In our view, the market is concerned about the zero-Covid policy in China (Australia’s biggest export partner), which could dim Australia’s economic outlook in the near term. On the flip side, many speculators are now short the Aussie which is bullish from a contrarian perspective. A healthy trade balance is also putting upward pressure on the currency. We are lifting our limit buy on AUD/USD to 72 cents, after being stopped out for a modest profit earlier this year.  New Zealand Dollar: Positive Catalysts, But Overvalued Chart 9Home Price Inflation In New Zealand Is Rolling Over The New Zealand dollar is up 1% year-to-date. The Reserve Bank of New Zealand is among the most hawkish within the G10.  The cash rate is at 1%, the highest among major developed economies on the back of economic data which remains robust. Home prices, a metric the RBNZ monitors to calibrate monetary policy, are rising 23.4% year-on-year as of March. While we are modestly positive on the Kiwi, it has become very expensive according to most of our models. The result is that the trade balance continues to print a deficit, with the latest data point in February deteriorating to NZ$ -8.4 billion. Kiwi bonds also offer the highest yield in the G10, meaning the market has already priced a hawkish path of interest rates by the RBNZ. Given the crosscurrents mentioned above, we are neutral the kiwi versus the dollar over both a 3-month and 9-month horizon.          Canadian Dollar: The BoC Will Stay Hawkish Chart 10The BoC Will Hike Next Week The CAD is up 0.4% year-to-date. The Bank of Canada is expected to raise interest rates by 50bps to 1% at next week’s meeting. This is not a surprise, since all the measures the BoC looks at to calibrate monetary policy are robust. Both headline and core inflation are well above the midpoint of the 1%-3% target range. The common, trim, and median inflation prints are either at or above the upper bound of the central bank’s target at 2.6%, 4.3%, and 3.5%, respectively. This suggests inflationary pressures in Canada are broad based. Employment in Canada is back above pre-pandemic levels, with the unemployment rate slated to come in at 5.4% with today’s release, close to estimates of NAIRU. House price inflation is raging across many cities in Canada, which argues that monetary policy is too easy and mortgage rates are too low. We have always highlighted that the key driver of the CAD remains the outlook for monetary policy and the path of energy prices. In the near term, oil prices will stay volatile as the situation in Ukraine continues to be very fluid, but the CAD has not priced in the fact that the BoC is leading the interest rate cycle vis-à-vis the US this time around.  Speculators are only neutral the CAD, an appropriate stance over the next three months. That said, we are buyers of CAD over a 9-to-12-month horizon, with a target of 0.84.   Swiss Franc: A Safe Haven Chart 11The SNB Will Lean Against Franc Strength The Swiss economy continued to fare well in the first quarter. The manufacturing PMI jumped to 64 in March. Retail sales were up 12.8% year-on-year in February. The labor market remains strong with unemployment near pre-pandemic levels. Switzerland’s direct exposure to the war appears relatively limited with little inflationary spillovers. CPI stood at 2.4% year-on-year in March, with about 1% of the increase coming from energy prices. The Swiss economy is still generating a record trade surplus, coming in at CHF 5.7bn in February. Safe-haven inflows into the franc have dampened inflationary dynamics. This leaves room for the SNB to continue easing monetary policy for longer relative to other central banks in the developed world.  In terms of monetary policy, the SNB kept interest rates unchanged at -0.75% at its Q1 meeting. The SNB has also described the franc as “highly valued” and said that it is willing to intervene in FX markets as necessary to counter the upward pressure in the currency. Sight deposits have been rising in March. We are neutral CHF on both a 3-month and 9-month horizon but will be buyers of EUR/CHF at current levels.   Norwegian Krone: Bullish On A 12-18 Month Horizon Chart 12NOK Has A Policy Tailwind The NOK is flat this year. In March, the Norges Bank raised the policy rate by 25 bps to 0.75%, in line with policymakers’ previous statements. Citing rising import prices and a tight labor market, the committee now expects to increase rates to 2.5% by the end of 2023, up from an assessment of 1.75% in December.  Inflation accelerated again in February, with headline and core CPI at 3.7% and 2.1% year-on-year respectively. Despite the removal of all Covid-19 restrictions in mid-February, consumer demand data remained soft with retail sales, household consumption, and loan growth all down in February. Still, the overall economy remains strong, and the Bank expects a rebound in demand going forward. The manufacturing PMI jumped to 59.6 in March after a three-month decline. Industrial production rose 1.6% year-on-year in February, after lackluster performance in January. The trade surplus remains robust. Registered unemployment fell to 2% in March and with rising wage expectations, the case for tighter monetary policy remains intact. The uncertainty over energy-related sanctions can keep oil prices volatile in the near time, as well as the NOK. That said, our commodity team expects oil to average $93/bbl next year, which is higher than what the forward markets are pricing. That will be bullish for the NOK.   Swedish Krona: Lower Now, Strong Later Chart 13The SEK Is Not Pricing Rate Hikes By The Riksbank SEK is down 4% year-to-date. The Riksbank remains one of the most dovish central banks in the G10, keeping the repo rate at 0% at its February meeting, with no hikes projected until 2024. Since then, inflation data has come in well above expectations and several board members have spoken out on the need to reevaluate monetary policy. The OIS curve is now pricing about two hikes by the end of the year. CPIF was 4.5% year-on-year in February and the measure excluding energy jumped to 3.4%, up from 2.5% in January. With fears that the conflict in Ukraine will exacerbate this trend, a survey of 12-month inflation expectations stood at a record 10.2% in March. While inflation is surprising to the upside, underlying economic data has been on the weaker side. The Swedish new orders-to-inventory ratio has fallen sharply. Consumer confidence also dipped in March, to the lowest point since the Global Financial Crisis. Sweden remains highly sensitive to eurozone economic conditions. As such, it is also in the direct firing range of any economic turbulence in the euro area, though it will also benefit from growth stabilization later this year, should macroeconomic risks abate. SEK is the second most undervalued currency based on our Purchasing Power Parity models and is likely positioned for a coiled spring rebound when the Riksbank eventually turns more hawkish. We are neutral SEK over a 3-month horizon but are bullish longer term.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary To understand the economy and the market we must think of them as non-linear systems which experience sudden phase-shifts. The pandemic introduced phase-shifts in our lives, which led to phase-shifts in our goods demand, which led to phase-shifts in monthly core inflation. As our lives phase-shift back to normality, goods demand will phase-shift back to low growth, and monthly core inflation prints will phase-shift from ‘high phase’ to ‘low phase’. With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, justifying a cyclical overweight position in T-bonds. Go overweight healthcare and biotech versus resources and financials. The leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Fractal trading watchlist additions: JPY/CHF, non-life insurance versus homebuilders, US homebuilders (XHB), cotton versus platinum, healthcare versus resources, and biotech versus resources. Bottom Line: With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, and the leadership of the equity market will flip back to long-duration sectors such as healthcare and biotech. Feature Inflation is a non-linear system, meaning that you cannot just dial it up or down gradually like the volume on your music system. Instead of gradual changes, non-linear systems suddenly phase-shift from quiet to loud, from cold to hot, from solid to liquid, or from stability to instability (Box I-1). Box 1: A Classic Non-Linear System – A Brick On An Elastic Band To experience the sudden phase-shift in a non-linear system, attach an elastic band to a brick and try pulling it across a table. As you start to pull, the brick doesn’t move because of the friction with the table. But as you increase your pull there comes a tipping point, at which the brick does move and the friction simultaneously decreases, self-reinforcing the brick’s acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability – the brick doesn’t move – to instability – the brick hits you in the face! Try as hard as you might, it is impossible to pull the brick across the table smoothly. In this non-linear system, the choice is either stability or instability. Back in 2017, in Mission Impossible: 2% Inflation – An Update, I posed a crucial question: “Given that price stability could phase-shift to instability, when should we worry about it?” I answered that “the risk remains low until the next severe downturn – when policymakers may be forced into desperate measures for a desperate situation.” The words proved prescient. Three years later, the desperate situation was a global pandemic, and the desperate measures were economic shutdowns combined with fiscal stimuluses of unprecedented scope and size.   A Phase-Shift In Our Lives Produced A Phase-Shift In Inflation Developed economy inflation has just experienced a stark non-linearity. Since 2007, the US core month-on-month inflation rate remained consistently below 3.5 percent.1 Then came the pandemic’s shutdowns combined with policymakers’ massive response, and month-on-month inflation didn’t just rise to above 3.5 percent, it phase-shifted to well over 6 percent. Developed economy inflation has just experienced a stark non-linearity. The remarkable fact is that since 2007, there have been over a hundred monthly core inflation prints below 4 percent, and nine prints above 6 percent, but just one solitary print between 4 and 6 percent! In other words, monthly core inflation shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-1).       Chart I-1Monthly Core Inflation Shows The Classic Hallmark Of A Non-Linear System So, what caused the phase-shift in core inflation? The simple answer is a phase-shift in durable goods spending, which itself was caused by the pandemic’s shutdown of services combined with massive fiscal stimulus. Again, this is supported by a remarkable fact. Since 2007, the monthly increase in US (real) spending on durables remained consistently below 3.5 percent. Then came the pandemic’s shutdowns and stimulus checks, and the growth in durables demand didn’t just rise to above 3.5 percent, it phase-shifted to well over 8 percent.  In other words, the growth in durable goods demand also shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-2). Chart I-2Goods Demand Shows The Classic Hallmark Of A Non-Linear System The connection between the phase-shifts in goods demand and the phase-shifts in core inflation is staring us in the face – because the three separate phase-shifts in inflation have each been associated with a preceding or contemporaneous phase-shift in goods demand, which themselves have been associated with the separate waves of the pandemic (Chart I-3). Chart I-3Phase-Shifts In Core Inflation Have Been Associated With Phase-Shifts In Goods Demand Pulling all of this together, the pandemic introduced phase-shifts in our lives – lockdown or freedom. Which led to phase-shifts in our goods demand – above 8 percent or below 3.5 percent. Which led to phase-shifts in monthly core inflation – above 6 percent or below 4 percent. The key question is, what happens next? Bond Yields Are Close To A Peak As we learn to live with the pandemic, and assuming no imminent ‘super variant’ of the virus, our lives are phase-shifting back to a semblance of normality. Which means that our spending on goods is phase-shifting back to low growth. If anything, the recent overspend on goods implies an imminent corrective underspend. At the same time, it will be difficult to compensate a phase-shift down on goods spending with a phase-shift up on services spending. This is because the consumption of services is constrained by time and biology. There is a limit to how often you can eat out, go to the theatre, or even go on vacation. The upshot is that monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’ – even if the monthly headline inflation prints are kept up longer by the commodity price spikes that result from the Ukraine crisis. Monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’. Meanwhile central banks and markets focus on the 12-month core inflation rate – which, as an arithmetic identity, is the sum of the last twelve month-on-month inflation rates.2  To establish the 12-month core inflation rate, the crucial question is: how many of the last twelve month-on-month inflation prints will be high phase versus low phase? As just discussed, the new month-on-month core inflation prints are likely to phase-shift to low phase. At the same time, the historic high phase prints will disappear from the last twelve month window. Specifically, by June 2022, the three high phase prints of April, May, and June 2021 – 10 percent, 9 percent, and 10 percent respectively – will no longer be included in the 12-month core inflation rate, with the arithmetic impact of pulling it down sharply (Chart I-4). Chart I-4The High Phase Monthly Inflation Prints Of April, May, And June 2021 Will Disappear From The 12-Month Core US Inflation Rate, Thereby Pulling It Down. Clearly, the bond market anticipates some of this ‘base effect’ on 12-month inflation. This explains why turning points in the bond yield have led by 2-3 months the turning points in the 12-month core inflation rate (Chart I-5). With the 12-month core inflation rate likely to peak by June at the latest, this suggests that – absent some new shock – the long bond yield is likely to peak at some point in April/May. Reinforcing our cyclical overweight position in T-bonds. Chart I-5The Bond Yield Turns About 2-3 Months Before Core Inflation This also carries important implications for equity investors. Rising bond yields favour short-duration equity sectors such as resources and financials versus long-duration equity sectors such as healthcare and biotech. And vice-versa. Indeed, the recent performance of resources versus healthcare and financials versus healthcare is indistinguishable from the bond yield (Chart I-6 and Chart I-7). Chart I-6The Performance of Resources Versus Healthcare Is Indistinguishable From The Bond Yield Chart I-7The Performance of Financials Versus Healthcare Is Indistinguishable From The Bond Yield With bond yields likely to peak soon, the leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Go overweight healthcare and biotech versus resources and financials. Fractal Trading Watchlist Reinforcing the fundamental analysis in the previous section, the 130-day outperformance of resources versus healthcare and biotech has reached the point of fractal fragility that has marked previous trend exhaustions, suggesting that the recent outperformance of resources is nearing an end. Also new on our watchlist is a commodity pair, cotton versus platinum, whose strong outperformance is vulnerable to reversal. And US homebuilders (XHB), whose recent underperformance is at a potential turning point. There are two new trade recommendations. First, the massive outperformance of world non-life insurance versus homebuilders is at the point of fractal fragility that has consistently marked previous turning points (Chart I-8). Hence, go short non-life insurance versus homebuilders, setting a profit target and symmetrical stop-loss at 14 percent. Second, the strong underperformance of the Japanese yen is also at the point of fractal fragility that has marked several previous turning points (Chart I-9). Accordingly, go long JPY/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Please note that our full watchlist of 19 investments that are experiencing or approaching turning points is now available on our website: cpt.bcaresearch.com Chart I-8The Massive Outperformance Of Non-Life Insurance Is Vulnerable To Reversal Chart I-9Go Long JPY/CHF The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Cotton’s Outperformance Is Vulnerable To Reversal US Homebuilders’ Underperformance Is At A Potential Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Annualized month-on-month inflation rate. 2 Strictly speaking, the 12-month inflation rate is the geometric product of the last 12 month-on-month inflation rates. Chart I-1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-2The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-3AUD/KRW Is Vulnerable To Reversal Chart I-4Canada Versus Japan Is Vulnerable To Reversal Chart I-5Canada's TSX-60's Outperformance Might Be Over Chart I-6US Healthcare Providers Vs. Software Approaching A Reversal Chart I-7The Euro's Underperformance Could Be Approaching a Resistance Level Chart I-8A Potential Switching Point From Tobacco Into Cannabis Chart I-9Bitcoin's 65-Day Fractal Support Is Holding For Now Chart I-10Biotech Approaching A Major Buy Chart I-11CAD/SEK Reversal Has Started Chart I-12Financials Versus Industrials Is Reversing Chart I-13Norway's Outperformance Could End Chart I-14Greece's Brief Outperformance Has Ended Chart I-15BRL/NZD At A Resistance Point Chart I-16The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart I-17The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart I-18Cotton's Outperformance Is Vulnerable To Reversal Chart I-19US Homebuilders' Underperformance Is At A Potential Turning Point   Fractal Trading System   Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Our recommended model bond portfolio outperformed its custom index by a robust +48bps in Q1/2022 – an impressive performance given the significant uncertainties stemming from the Ukraine war, surging commodity prices and hawkish central banks. This outperformance came entirely from the rates side of the portfolio (+52bps) as global government bond yields surged, driven by a large underweight to US Treasuries. The credit side of the portfolio was largely unchanged versus the benchmark (-4bps). Looking ahead, we see global bond yields as being more rangebound over the next six months. A lot of rate hikes in 2022 are already discounted (most notably in the US) and global inflation is likely to decelerate in Q2 & Q3. As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Bottom Line: In our model bond portfolio, we are downgrading US investment grade corporates to underweight, and reducing high-yield exposure in the US and Europe to neutral. We are also reducing inflation-linked bond allocations in the US and euro area to underweight versus nominals. Feature The first three months were horrific for global bond markets. The Bloomberg Global Aggregate index delivered a total return of -6.2%, the second worst quarter since 1990. No sector, from government bonds to corporate debt to emerging market spread product, was immune to the pressures from soaring energy prices, war-driven uncertainty and hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyOur Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely That toxic cocktail for bond returns may lose some potency in the coming months if a de-escalation of the Ukraine tensions can be reached. However, the bigger drivers of bond market volatility – high global inflation and the monetary tightening necessary to combat it – are more likely to linger for longer than expected. Government bond yields are unlikely to fall much in this environment. Increasingly, global credit spreads, especially for corporate debt in the US, will face intensifying widening pressure as central banks rapidly dial back pandemic-era monetary accommodation, led by the US Federal Reserve. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the first quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2022 Model Bond Portfolio Performance: Regional Allocation Drives Outperformance Chart 1Q1/2022 Performance: Big Gains From Rising Bond Yields The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was -4.6%, outperforming the custom benchmark index by +48bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +52bps of outperformance versus our custom benchmark index while the latter underperformed by -4bps. In an extremely negative quarter for fixed income both in terms of the breadth and depth of losses, our regional allocation choices helped us continue generating outperformance after we transitioned to a neutral overall portfolio duration stance in mid-February. Throughout the quarter, we maintained a significant underweight on US Treasuries in the portfolio, even after we tactically upgraded our duration tilt. We expected US government debt to still underperform that of other developed markets, even in an environment where the rise in global bond yields was due for a breather. Our rationale worked – admittedly helped by the inflationary shock of the Russian invasion of Ukraine - with the US Treasury part of our portfolio generating a whopping +63bps of outperformance (Table 1). Table 1GFIS Model Bond Portfolio Q1/2022 Overall Return Attribution Meanwhile, our biggest government bond overweights were in Europe, a market we expected to perform defensively in a portfolio context. We were obviously caught offside on this call as energy prices and inflation expectations in Europe surged in response to the Ukraine conflict. In total, our portfolio lost -30bps in active return terms in euro area government bonds, with the losses spread evenly between the core and periphery. We did staunch the bleeding somewhat by reducing our allocation to the periphery in the last two weeks of the quarter and using the proceeds to fund an increased allocation to European investment grade corporates. The European corporate index spread has tightened -23bps since that switch. Turning to the credit side of the portfolio, the most successful position was our underweight tilt on emerging market (EM) USD-denominated corporates (+10bps) and sovereigns (+9bps) during a catastrophic quarter for EM risky assets driven by the conflict as well as weakness in the Chinese economy. We sustained losses from our overweight on US CMBS (-11bps) which was broadly offset by gains from our underweight on US MBS (+10bps). Lastly, while we were hurt by the sell-off in euro area high-yield (-13bps), where we were overweight to start 2022, we did scale back some of that exposure towards the end of the quarter when markets started to discount the risk of a “worst case” scenario of direct NATO intervention in Ukraine. The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2022 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2022 Spread Product Performance Attribution By Sector Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+23bps) Underweight UK Gilts with a maturity greater than 10 years (+14bps) Underweight US treasuries with a maturity between 3 and 5 years (+12bps) Biggest Underperformers: Overweight euro area high-yield corporates (-13bps) Overweight US CMBS (-11bps) Overweight Spanish Bonos (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2022 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q1/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers. Notably, we were underweight UK Gilts (-1280bps) and EM Sovereigns (-1103bps) on the extreme right side of the chart. We were also underweight US Treasuries (-531bps) which, despite being in the middle of Chart 4, contributed hugely to our portfolio outperformance due to their large market cap weighting in the benchmark index. Broadly, this means that, except for Europe and Australia, our highest conviction calls worked in our favor during the quarter. Bottom Line: Our model bond portfolio outperformed its benchmark index in the third quarter of the year by +48bps – a positive result coming largely from underweight positions in US Treasuries, UK Gilts, and EM credit. Changes To Our Model Bond Portfolio Allocations The uncertainty stemming from the Russia/Ukraine conflict led us to temporarily neutralize many of the recommended exposures in the model bond portfolio. We not only moved to neutral on overall portfolio duration, we also neutralized individual country yield curve tilts and inflation-linked bond allocations. While the situation remains fluid, the worst-case scenarios of the conflict expanding beyond the borders of Ukraine appear to have been avoided. This leads us to reconsider where to once again take active risks on the rates side of the portfolio. Chart 5Our Duration Indicator Calling For Slowing Global Yield Momentum Duration On overall portfolio duration, we are maintaining a neutral (“at benchmark”) stance in the portfolio. Our Global Duration Indicator is currently signaling that the strong upward momentum of global bond yields should fade over the next few months (Chart 5). Slowing global growth expectations – a trend that was already in place prior to the Ukraine conflict - are the major reason why our Duration Indicator has turned lower. The war-fueled surge in energy prices has helped push global bond yields higher through rising inflation breakevens, which also prompted central banks – most notably the Fed and the Bank of England (BoE)- to signal a need for a faster pace of interest rate hikes in 2022 despite softening growth momentum. Looking ahead, that strong link between oil prices and bond yields will not be broken until there is some sort of de-escalation of the Ukraine conflict, which does not appear imminent. This supports a near-term neutral overall duration stance. Yield Curve Allocations In terms of yield curve exposure, we see some opportunities to adjust allocations (Chart 6). US curves have inverted and UK curves are flirting with inversion as markets are pricing in more Fed/BoE tightening, while curves in Germany and France have bear-steepened with longer-term inflation expectations going up faster than shorter-term interest rate expectations. In the US and UK, the yield curve flattening also reflects the “front loading” of Fed/BoE rate hike expectations. Overnight index swap (OIS) curves are pricing in 190bps of rate hikes in the US, and 134bps in the UK, by the end of 2022. This is followed quickly by rate cuts discounted in H2/2023 and 2024 in both countries. We see it as more likely that both central banks will deliver fewer hikes than discounted in 2022 and but will push rates to higher levels than priced by the end of 2024. That leads us to add a mild steepening bias into our US and UK government bond allocations in the model bond portfolio. We offset that by inserting a flattening bias in the German and French yield curve allocations to keep the overall portfolio duration at 7.5 years, matching that of the custom benchmark index (Chart 7). Chart 6Curve Flattening In The US & UK Is Overdone​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral​​​​​ Chart 8No Change To Our Country Allocations To Begin Q2/22 Country Allocations Turning to our country allocations, we see no need to make major changes right now (Chart 8). We still prefer to maintain an underweight stance on countries that are more likely to see multiple central bank rate hikes in 2022 (the US, UK, Canada) versus those that are less likely (Germany, France, Japan, Australia). We are also staying neutral on Italian and Spanish government bonds with the ECB set to taper the pace of its asset purchases in Q2. Less ECB buying raises the risk that higher yields will be required to entice private sector buyers to buy Italian and Spanish debt with a smaller central bank backstop. Inflation-Linked Bonds Our Comprehensive Breakeven Inflation (CBI) indicators assess the potential for a significant move in 10-year breakeven inflation rates, based on deviations from variables that typically correlate with breakevens like oil prices or survey-based measures of inflation expectations. At the moment, none of the CBIs for the eight countries in our model bond portfolio are below zero (Chart 9), which would be a signal that breakevens are too low and can move higher. Chart 9Inflation-Linked Bond Exposure: Reduce Europe & The US, Increase Canada Canada has the lowest CBI, and last week, we added a tactical trade to go long 10-year Canadian inflation breakevens. We will add that position to our model bond portfolio this week, moving the Canadian “linkers” allocation to overweight versus nominal Canadian government bonds (within an overall underweight allocation to Canada in the model bond portfolio). On the other side of our CBI rankings are countries where the CBIs are well above zero and breakevens are more stretched: Germany, Italy, France and the US. We are currently neutral inflation-linked bonds in those four countries, but strictly as a hedge against the war-fueled risks of further increases in oil prices. Now, however, 10-year breakevens have widened to levels that already factor in more expensive oil, even with oil prices struggling to break out to new highs. As a result, we are downgrading the allocation to linkers in Germany, Italy, France and the US to underweight within the model bond portfolio (Chart 10). Corporate Bonds The most meaningful changes we are making to our model bond portfolio, and in our strategic investment recommendations, are to our corporate bond allocations: We are downgrading US investment grade corporate bond exposure from neutral to underweight (2 out of 5) We are downgrading US high-yield corporate bond exposure from overweight to neutral (3 out of 5) We are also downgrading euro area high-yield exposure from overweight to neutral (3 out of 5) Credit spreads across the developed market and EM space have fully unwound the surge seen after Russia invaded Ukraine on February 24 (Chart 11). We had turned more cautious on global spread product exposure in early March because of the war-fueled shock to energy prices and investor sentiment. We viewed this as a bigger issue for European and EM credit, with Europe heavily reliant on Russian energy supplies and EM market liquidity impacted by bans on trading of Russian assets. We therefore reduced exposures to European high-yield and EM hard currency debt in the model bond portfolio. Chart 10Our Inflation-Linked Bond Country Allocations Now, while markets have become more sanguine about the prospects of a long war that can more directly draw in Western forces, a bigger threat to financial market stability has emerged – more aggressive tightening of global monetary policy led by the Fed. Chart 11Global Credit Spreads Have Returned To Pre-Invasion Levels​​​​​​ Chart 12Global Monetary Backdrop Turning More Negative For Credit Already, the move away from quantitative easing by the Fed, ECB and BoE has led to a negative impulse for global credit returns (Chart 12). Excess returns for the Bloomberg Global Corporate and High-Yield indices are now essentially flat on a year-over-year basis, and the riskiest credit tiers of both indices are seeing the greater spread widening (bottom panel). Another indicator of tightening monetary policy, the flat US Treasury curve, is also signaling a poor environment for US credit market returns. Our colleagues at our sister service, BCA Research US Bond Strategy, have noted that when the 2-year/10-year US Treasury curve flattens below +25bps, the odds of US investment grade credit outperforming duration-matched Treasuries decline sharply. Dating back to 1973, the average excess return (over Treasuries) for the Bloomberg US investment grade index over the twelve months after the 2/10 curve flattens below +25bps is -0.56%. The 2/10 US Treasury curve is now inverted at -3bps, even with the Fed having only delivered a single +25bp rate hike so far in the current cycle. This is a highly unusual occurrence, as the Treasury curve typically inverts after the Fed has delivered multiple rate hikes in a tightening cycle. Bond investors are clearly “front-running” the Fed in discounting aggressive rate hikes in 2022 in response to US inflation near 8%. We think the Fed will deliver fewer hikes than markets are discounting this year, but will do more in 2023 and 2024. Yet the message from the now-inverted yield curve, and what it means for corporate bond performance, is too powerful to ignore. This underpins our decision to downgrade our recommended allocation to US investment grade to underweight. We do not, however, see a need to move the allocations for other corporate bond markets as aggressively. The credit spread widening seen so far in 2022 in the US and Europe – a trend that was already in place before the start of the Ukraine war – has restored more value to European corporate spreads compared to US equivalents. That can be seen when looking at our preferred measure of spread valuations, 12-month breakeven spreads.2 The historical percentile ranking of the 12-month breakeven spread is 63% for euro area investment grade and a much lower 23% for US investment grade (Chart 13). The absolute level of the euro area ranking justifies maintaining an overweight stance on euro area investment grade, both in absolute terms and relative to US investment grade. A smaller gap exists for high-yield, where the euro area 12-month breakeven spread percentile ranking is 50% versus 33% in the US. Those lower percentile rankings justify no higher than a neutral allocation to high-yield on either side of the Atlantic. On the surface, maintaining a higher allocation to US high-yield over US investment grade does appear counter-intuitive in an environment where the US Treasury curve is inverted and investors are growing increasingly worried that the Fed will need to engineer a major growth slowdown to cool inflation. However, that same high inflation helps to maintain a fast enough pace of nominal economic growth to limit the default risk for riskier borrowers. Moody’s estimates that the default rate for high-yield corporates will reach 3.1% in the US and 2.6% in Europe by year-end. Using those estimates, we can calculate a default-adjusted spread, or the current high-yield spread minus one-year-ahead expected default losses. That spread is currently 134bps in the US and 206bps in Europe, both well above the low end of the long-run range and closer to the long-run average (Chart 14). Those are levels that are consistent with a neutral allocation to high-yield in both regions, as current spreads offer a decent cushion in an environment of relatively low default risk. Chart 13More Attractive Spread Levels In Europe Vs. US​​​​​​ Chart 14Low Default Risk Helps Support High-Yield Valuations​​​​​​ Chart 15Persistent Headwinds To EM Credit Performance Emerging Markets Finally, we continue to see more reasons to be cautious on EM USD-denominated credit, given the lack of support from typical fundamental drivers (Chart 15). Weak Chinese growth, slowing commodity price momentum (on a year-over-year basis), and a firm US dollar are all factors that weigh on EM economic growth and the ability to service hard-currency debt. We are maintaining an underweight allocation to EM USD-denominated sovereign and corporate debt in our model bond portfolio. Indications that China is ready to introduce more fiscal and monetary stimulus, and/or if the Fed’s messaging turned less hawkish – and less US dollar bullish – would be the signals necessary for us to consider an EM upgrade. Summing It All Up The full list of our recommended portfolio allocations after making all of the above changes can be seen in Table 2. The changes leave the portfolio with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Chart 16Overall Portfolio Allocation: Underweight Spread Product Vs Governments the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has now flipped to an underweight stance on the exposure of spread product to government bonds, equal to four percentage points of the portfolio (Chart 16) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 80bps – a level similar to that before the changes were made and still well below our self-imposed 100bps tracking error limit (Chart 17) the portfolio now has a yield below that of the custom benchmark index, equal to 2.51% (Chart 18). Chart 17Overall Portfolio Risk: Moderate​​​​​​ Chart 18Overall Portfolio Yield: Below-Benchmark​​​​​​ The changes leave the portfolio much more exposed to a widening of global credit spreads than a rise in government bond yields – a desired outcome with bond yields already discounting a lot of tightening but credit spreads still at historically tight levels. Bottom Line: As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. We are expressing that by cutting the exposure to corporate bonds in our model bond portfolio. Portfolio Scenario Analysis For The Next Six Months After making all the specific changes to our model portfolio weightings, which can be seen in the tables on pages 23-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes Table 3BEstimated Government Bond Yield Betas To US Treasuries For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around developments in the Ukraine/Russia conflict and the impacts on uncertainty and commodity-fueled inflation. Base Case There is no further escalation of the Ukraine/Russia conflict, possibly resulting in a temporary ceasefire. Oil prices pull back on a lower war risk premium, helping lower inflation expectations. Global realized inflation peaks during Q2/2022, alongside some moderation of global growth in lagged response to high energy prices. Within that slower pace of global growth, the US outperforms Europe while Chinese growth remains weak because of COVID lockdowns (although that will eventually lead to more stimulus from Chinese policymakers). The Fed delivers 100bps of rate hikes by July, starting with a 50bp increase at the May meeting, before pausing at the September meeting in response to slowing US inflation and growth. There is a mild bear flattening of the US Treasury curve, but yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 20 and the fed funds rate reaches 1.5%. Escalation Scenario The is no reduction in Ukraine war tensions, with increased Russian aggression resulting in greater NATO military involvement. The risk premium in oil prices increases, delaying the expected peak in global inflation until the second half of 2022. Inflation expectations remain elevated. Global growth weakens more than in the base case scenario because of higher energy prices, but with US growth still outperforming Europe. China’s economy remains weighed down by COVID lockdowns and an inadequate fiscal/monetary/credit policy response. The Fed is forced to be more aggressive because of high inflation expectations, delivering 150bps of hikes by September. The US Treasury curve bear-flattens, but with Treasury yields rising across the curve through wider TIPS breakevens and greater-than-expected rate hikes keeping real yields stable. The Brent oil price rises +25%, the VIX index climbs to 30, the US dollar appreciates by +5% thanks to slowing global growth and a more aggressive move by the Fed to push the funds rate to 2%. De-Escalation Scenario There is a full and lasting ceasefire between Russia and Ukraine. The war risk premium in oil prices collapses, allowing global inflation to peak in Q2 and then decline rapidly. Global growth sentiment improves because of lower energy prices and diminished worries about a wider world war. European growth outperforms US growth (relative to expectations) as European natural gas prices decline. China responds faster than expected to the latest COVID wave with more aggressive policy stimulus. Lower inflation allows the Fed to be more patient on rate hikes, delivering only 75bps of hikes by July before pausing. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is fairly small as lower TIPS breakevens are partially offset by higher real yields (as growth sentiment improves). The Brent oil price falls -20%, the VIX index drifts down to 18, and the US dollar depreciates by -3% as global growth improves and the Fed pushes the funds rate to a less-than-expected 1.25% by July. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 19 and Chart 20, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 19Risk Factor Assumptions For The Scenario Analysis​​​​​​ Chart 20US Treasury Yield Assumptions For The Scenario Analysis​​​​​​ Given our neutral overall portfolio duration stance, and the mild changes in nominal bond yields implied by our forecasts, it should not be surprising that the rates side of the portfolio is expected to not contribute any excess return in Q2 and Q3. However, Fed rate hikes – which push up yields on spread product in the forecasting regressions – result in negative credit returns in all scenarios (especially in the cases where the VIX is expected to rise). Thus, the return on the credit side of the model portfolio, where we are now underweight credit risk, will be the main driver of performance, delivering a range of excess return outcomes between +29bps and +53bps. Bottom Line: The next six months will be about locking in the significant gains in our model bond portfolio performance from rising bond yields, and transitioning to outperforming via wider credit spreads in US investment grade and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     12-month breakeven spreads compare the option-adjusted spread (OAS) of a credit market or sector to its duration, using Bloomberg bond index data. The breakeven spread is the amount of spread widening that must occur over a one-year horizon to make the total return of a credit instrument equal to that of duration-matched risk-free government debt. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months)  

Executive Summary Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia Chart 4Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth Chart 7Futures Curves For Most Commodities Are Backwardated     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US...​​​​​​ Chart 12... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Chart 33An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued Chart 50Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well Chart 63Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix Special Trade Recommendations   Current MacroQuant Model Scores