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The narrative that the US can tolerate much higher interest rates, compared to the rest of the world has helped the dollar in 2022. In this report, we examine the sustainability of this thesis, from our holistic assessment of global growth indicators.

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Dear Client, Section II of this month’s Bank Credit Analyst report is a guest piece written by Martin Barnes, which we are making available to all clients. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for government debt and the possibility of an eventual crisis. I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Highlights Recent developments in the UK highlight the power of financial markets to reimpose discipline over wayward fiscal policies. However, the bond vigilantes remain notably absent in the US. The strong dollar and lack of a fiscal premium in Treasury yields indicates investor complacency about the US fiscal position. However, the long-run trajectory of US government debt and deficits is unsustainable. It will take market pressures to force an inevitable change in US fiscal policies. This is very unlikely to occur in the coming year but there are good odds of it happening within five years. The ‘solution’ to a market-induced US debt crisis will involve a mix of higher inflation, financial repression, increased taxes and spending restraint. Feature I, however, place economy among the first and most important of virtues, and public sector debt as the greatest of the dangers to be feared. Thomas Jefferson I used to think that if there was reincarnation, I wanted to come back as the president or the pope. But now I want to be the bond market: you can intimidate everybody. James Carville, adviser to former US President Bill Clinton. If something cannot go on forever, then it will stop. Herb Stein, renowned US economist A remarkable feature of the economic and financial landscape during the past two decades has been the markets’ calm acceptance of an explosion in government debt throughout the developed world. In many countries, public sector debt-to-GDP ratios have hit peacetime records as a share of GDP yet until recently, bond yields remained at historically low levels. What happened to the bond vigilantes that so impressed James Carville? With the benefit of hindsight, we can look back and explain why soaring public deficits and debt levels did not cause major disruptions. Central bank purchases of government bonds reduced the supply available for private investors at a time when the demand for ‘safe’ assets was very strong. Meanwhile, private sector savings were abundant and, again until recently, inflation was quiescent. But that is the past, what about the future? There is little prospect of a significant reduction in public-sector debt burdens in the major developed economies in the coming few years. Uninspiring economic growth implies ongoing pressures for fiscal stimulus, aging populations will underpin growth in pensions and health care spending and geopolitical tensions will support increased defense spending. The rise in inflation gives some help to revenues, but higher interest rates provide an offset. The long-standing concern about large public sector deficits is that they threaten to push up interest rates, crowd out private sector investment and lower potential growth. And along the way, there is the threat of financial volatility and crises. I could fill several pages with quotes and analyses from eminent economists during the past two decades predicting impending economic and financial doom unless government finances were brought under control. Not surprisingly, the failure of any crises to emerge has discredited such gloomy forecasts, fostering complacency about the issue. Recent developments in the UK warn of what can happen. The announcement of an aggressive program of tax cuts and increased borrowing rattled investors, leading to a sharp drop in the exchange rate and rise in bond yields. As a result, the government was quickly forced to abruptly change policy, abandoning its planned tax cuts. The economic and financial fallout also led to a change in political leadership with the new government warning that tax increases and spending curbs will be needed to restore fiscal stability. The market vigilantes clearly are alive and well in the UK, even if they are missing in action in the US. The US dollar’s status as the world’s premier reserve currency gives the country protection from the wrath of investors that is not always available to others. However, this is a mixed blessing because it gives policymakers more rope with which to hang themselves. The trend in US public debt burdens is unsustainable, and as Herb Stein noted, this means something will change. The key questions relate to how and when this will occur. The Disturbing Path Of Government Debt Chart II-1The Historical Sweep Of Debt Historically, major spikes in government deficits and debt generally occurred only in wartime (Chart II-1). However, the past 15 years have witnessed two extraordinary surges in public sector indebtedness – firstly in response to the 2007-09 economic and financial meltdown and secondly because of the Covid pandemic. In both episodes, tax revenues declined, and governments boosted spending to shore up economic activity. In the major advanced economies, net government debt as a percentage of GDP jumped by around 20% from pre-crisis levels in each of the periods (Chart II-2). And when indebtedness ratchets higher, it is difficult to reverse. Despite concerns about crowding out, it is hard to find an empirical relationship between the size of budget deficits and either interest rates or the growth in private investment. For example, deficits rise when the economy is weak and this is when interest rates tend to fall, not rise. Even if the analysis uses cyclically-adjusted budget balances (i.e. removing the impact of swings in the economy) it is hard to find a good relationship. But that does not mean rising deficits and debt do not matter. At some point they impact market confidence about how policy may be forced to change in the future. Uncontrolled fiscal finances ultimately will lead to financial turbulence. Public sector dynamics are a function of two key variables: the difference between the average interest rate on the debt and nominal GDP growth, and the primary budget balance (i.e. the budget balance before interest payments). The debt-to-GDP ratio will decline if the primary budget is at least in balance and the borrowing rate is below the GDP growth rate. Conversely, it will soar if there is a primary deficit and the borrowing rate is above the economic growth rate. Currently, most countries face primary deficits (Chart II-3) and interest rates are not likely to be far enough below growth to stop debt-to-GDP ratios from rising in the years ahead. Chart II-2Economic Crises Cause Spikes In Debt Chart II-3Lingering Primary Deficits   Chart II-4The Long-Run US Debt Outlook The picture in the US is particularly disturbing given its outsized role in global markets. According to the Congressional Budget Office (CBO), absent any policy changes, the federal budget deficit will average 5% of GDP over the next decade, with the primary deficit averaging 2.5% of GDP. As a result, the ratio of federal debt to GDP will be close to 110% of GDP in ten years’ time. Importantly, these projections do not allow for any recessions and use optimistic assumptions for interest rates (averages of 2.4% and 3.5% over the next decade for 3-month rates and 10-year Treasury yields, respectively). The uptrend in indebtedness continues over the longer run, taking the federal debt-GDP ratio to 140% by 2042 and 185% by 2052 (Chart II-4). Of course, this won’t happen because markets will force a change long before we get to that point. Signposts For A Debt Crisis It is impossible to predict what level of indebtedness will trigger a market reaction because much will depend on the circumstances at the time. Nevertheless, several signs can help to warn when a country is approaching a debt wall. Warnings signs include the following: Surging debt interest payments An increased dependance on issuing short-term or foreign currency debt A limited ability to raise taxes to reduce budget deficits Rising risk premia on government yields and/or a plunging exchange rate Surging Debt Interest Payments: Failure to service the debt means falling into default – something inconceivable for any developed country. Thus, debt interest payments must be made and if they rise sharply then they can crowd out other forms of government spending, creating political and/or economic problems. Canada faced this problem in the early 1990s with federal debt interest payments exceeding 30% of total revenues and more than 25% of total spending. This forced the government into a major fiscal retrenchment, eventually leading to several years of budget surpluses. In 2021, interest costs were a mere 6.5% of federal revenues. The past 15 years have been a period of exceptionally low interest rates, dramatically reducing borrowing costs, even as debt levels have climbed. In the US, federal interest payments represented only 8.7% of revenues in fiscal 2021. This was less than half the level of the early 1990s even though the ratio of outstanding debt to revenues doubled over the period (Chart II-5). While interest rates have risen this year, it will take time for this to feed through into a significant increase in the average cost of debt financing. The fact that the Fed holds more than 20% of outstanding Treasuries also helps because the interest payments on these securities are returned to the Treasury. In sum, there are few signs of an imminent problem in the US on this score. Increasing dependence of short-term or foreign currency debt: If investors are worried about a country’s fiscal stability then they will become increasingly reluctant to take on duration risk. This should show up in increased risk premia on longer-term debt, forcing governments to rely more on short-term financing. Once again, there are few signs of problems in the US. The spread between 30- and 10-year Treasuries has fallen sharply in the past year and there has not been any notable change in the average maturity of debt (Chart II-6). It is surprising that the Treasury did not use the opportunity of historically low yields to lock in more longer-term debt. Chart II-5Low Interest Rates Have Cut Debt Servicing Costs Chart II-6No Evidence Of A Fiscal Risk Premium   A financial revolt against economic policies typically shows up in the foreign exchange market as investors abandon the perceived risky currency. Collapsing currencies put upward pressure on inflation and interest rates and typically force a change in government policy. And countries that depend on overseas buyers of their debt may be forced to start issuing debt in foreign currencies, creating a vicious cycle as a weak currency then adds to debt servicing costs. A rise in the issuance of US dollar-denominated debt was another sign that Canada was facing problems in the 1990s. US dollar-denominated issues as a percent of foreign purchases of Canadian public sector bonds rose from 6% in 1983-88 to 45% in 1988-93. The US is in a very favorable position because the dollar’s reserve currency status means that the US can borrow freely in its own currency. Even when the dollar suffered long-run declines such as in 1985 to 1995 and 2002 to 2011, the US never needed to issue foreign-currency debt. The last time the US issued non-dollar debt was in 1978 when it issued bonds denominated in Deutschemarks and Swiss Francs in an effort to prop up the dollar (the so-called Carter bonds). Without the dollar’s reserve status, the US would be in a very different position because it is, by far, the world’s largest external debtor to the tune of $18 trillion (79% of GDP) at the end of 2021. The combination of high ratios of public debt-to-GDP and external debt-to-GDP normally would be toxic for a currency and the US is at an extreme in both measures compared with other major countries (Chart II-7). The US position compares to countries such as Germany, Canada and Switzerland that are net international creditors and have relatively low government debt-to-GDP ratios. There is a particularly interesting contrast with Japan as it has extremely high government debt but is a massive net external creditor. The fact that Japan does not rely on foreigners to buy its debt helps to explain why bond yields have stayed low in the face of huge budget deficits. And it helps that the Bank of Japan owns close to 50% of outstanding government bonds. Since 2016, the Bank of Japan has pledged to keep 10-year bond yields within 25 basis points of zero, but yields remained low even before that policy. It seems odd for the world’s largest international debtor nation to have the major reserve currency, but there has been no major competition from other countries. Given the economic problems faced by Europe, Japan and China, no change is in prospect any time soon. Room for tax hikes: A return to fiscal discipline can come from increased taxes, lower spending, or a mixture of both. Lowering the path of spending is politically challenging, especially given that in most countries, aging populations mean that non-discretionary spending (e.g. pensions and health care) accounts for a rising share of the total. Meanwhile, if tax burdens are already high, then further increases could be self-defeating via weaker economic growth and thus revenues. Not surprisingly, structural budget deficits rise more easily than they fall. Throughout much of the developed world, overall tax burdens are at historically high levels (Chart II-8). The UK experience highlights the challenges: the government used the record level of tax burdens as the case for cutting taxes, even in the face of high deficits and debt. But there was strong opposition to any attempt to finance lower taxes with real cuts to social programs. As noted earlier, bond vigilantes did not play along with the UK government’s plans. Chart II-7External And Government Debt Ratios Chart II-8The US Is A Low Tax Country   The US is in a different situation. Overall tax burdens (total general government receipts as a percent of GDP) are not at historically high levels and are by far the lowest of any industrial country, except for Ireland. While there is strong political resistance to higher taxes in the US, this is a viable route to pursue should market pressures force action. The long-term solution may be to introduce a federal sales tax.1 Options to reduce federal spending are limited given that non-discretionary spending and interest payments account for more than 70% of total outlays, a share that will continue to rise. The Changing Pattern Of Treasury Ownership Where will market pressures for US fiscal restraint come from? A long-standing concern has been that it will come from overseas – perhaps a decision by China to dump its Treasuries as a deliberate political act. This was never a very realistic possibility as it would represent an aggressive act of economic warfare, leading to serious retaliation via sanctions and curbs on Chinese exports. Nevertheless, it is reasonable to assume that, as with smaller more open economies, foreign investors will sell Treasuries and the dollar if they expect major economic and financial instability in the US. Chart II-9Ownership Of US Federal Debt The potential impact of foreign selling was greater in the past because overseas investors have accounted for a shrinking share of outstanding federal debt. The peak was in 2008-16 when the share fluctuated in the 40% to 44% range. It has since dropped below 30% (Chart II-9). Between 2002 and 2008, foreign investors absorbed two-thirds of Treasury issuance, with the two largest holders Japan and China accounting for 8.5% and 10% respectively of total outstanding debt by the end of the period. By the middle of this year, Japan’s share was down to 4.7% while China’s was 3.7%. Of course, changes occur at the margin, and it may not need much foreign selling of Treasuries to trigger panic among domestic investors. At that point, the Fed would likely step in. The launch of the Fed’s quantitative easing in 2008 represented the start of a new era of central bank intervention in the markets.2 The Fed holds more than 20% of outstanding Treasury debt and although it wants to further reduce its holdings, there is little doubt that it would resume purchases in the event of a market panic. The Bank of England recently did just that when the UK bond market went into freefall in response to the government’s reckless fiscal announcements. The Debt End Game Chart II-10Beware Of Budget Forecasts A frequently-asked question is “how will the debt ever be paid off”. The answer is that it will not get paid off because the only way to do this is to run budget surpluses, a remote possibility for the foreseeable future. The US did run federal budget surpluses for four years between fiscal 1998 and 2001 and the CBO’s January 2001 baseline projections showed the federal debt (then at $3 trillion) being almost entirely paid off within ten years. This prompted then Fed Chairman Alan Greenspan to worry about the technical challenges of conducting monetary policy in a world without government debt. Of course, things did not pan out as expected with Treasury debt reaching $11 trillion in fiscal 2011 rather than disappearing. The trend in Federal debt versus the CBOs baseline projections makes for a dismal picture and most of the divergences can be attributed to policy actions rather than economic forecasting errors (Chart II-10). Unfortunately, it is hard to imagine how the federal budget could be returned to surplus given the high and growing burden of non-discretionary spending. The solution is to make the debt easier to live with and this can be done in a few ways. Most importantly, the debt-to-GDP ratio can be reduced by boosting the growth in the denominator – nominal GDP. Ideally, this would happen via faster real growth but that seems unlikely given the demographic outlook and the lackluster trend in productivity. So it will have to occur via inflation. Reducing debt burdens by inflating nominal GDP growth will require the cooperation of the Fed. Otherwise, higher interest rates would make the fiscal situation even worse by slowing the economy and boosting debt servicing costs. The Fed’s current tightening stance should not be taken as a sign that it would never tolerate some increase in inflation. As we wrote a few months ago, inflation is set to fall over the coming year, but this will be a temporary respite.3 It will prove extremely difficult to return to sustained inflation near 2% over the medium term and a new base of 3% to 4% is likely. Another way to ease the debt problem will be via financial repression. This means keeping interest rates below ‘normal’ levels (one of the reasons to expect higher inflation) and having regulatory rules requiring financial institutions to hold high levels of government debt for supposedly prudential reasons. And finally, we will have the Fed as the ultimate backstop, stepping in if private and overseas investors cease to be buyers of Treasury debt. Finally, there will be some measures to reduce structural deficits. Taxes will increase, and actions taken to reduce the trajectory of non-discretionary spending. For example, there is scope for savings in health care spending by negotiating better prices for drugs. While it will prove near impossible to return to surpluses, it should be possible to reduce deficits from current levels. However, no politicians will impose fiscal austerity willingly and it will thus require a market crisis to force action. The bond vigilantes will have to reemerge from the shadows. Conclusions Public finance is a kind of Ponzi scheme where the proceeds of new debt issuance are used to pay existing investors. As long as new debt can be issued at reasonable yields, the show can go on. Problems emerge when investors take fright at the path of government finances and demand ever-increasing yields to compensate for perceived risks. As with all Ponzi schemes, it falls apart when new buyers fail to emerge. Proponents of Modern Monetary Theory (MMT) argued that public deficits and debt do not matter because they can be financed by central banks. However, even MMT advocates accept that this can only persist for as long as inflation stays under control. The past year’s rise in inflation has taken the wind out the sails of the MMT movement and there is very little support for the view in the economic and financial community. Chart II-11What Debt Problem? Clearly, the US is not facing an immediate problem, despite the worrying trajectory of public deficits and debt. For example, the dollar’s trade-weighted index is at a new all-time high, up 40% in the past 12 years (Chart II-11). Higher inflation and a tightening in monetary policy have pushed up bond yields, but there is no sense of a fiscal-induced investor revolt. The near-term outlook for the economy is gloomy with high odds of a recession in the coming year. That will help ease inflation pressures and bring an end to Fed rate hikes. Against that backdrop, Treasury yields will eventually reverse some of their recent rise and bond vigilantes will remain out of sight. But that will not last. Remember: what cannot go on, will stop! We should not expect politicians or voters to willingly seek fiscal austerity. For politicians, raising taxes and cutting spending is not a vote-winning proposition. And while voters may pay lip service to the idea that governments should live within their means, few people want higher taxes or the kind of cuts in spending that would make a difference. This means that financial markets have to be the ultimate disciplinarian on profligate governments. It would be nice to put a date on when markets eventually will revolt against fiscal excesses, but any attempt would be pure speculation. I am quite confident it will not be in the next 12 months but would put a 75% probability it will be within the next five years. At that point, debt-servicing costs could be at new highs. This would make it a problem for the next administration. What has happened in the UK in terms of fiscal policy and market reactions is a good indicator of what the US ultimately will face. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com   Footnotes 1    The US is the only industrial country that does not have a federal sales tax. 2    The Bank of Japan embarked on quantitative easing in 2001, but it was alone in doing so at that time. 3    Please see The Bank Credit Analyst “Inflation Whipsaw Ahead,” dated June 30, 2022, available at bca.bcaresearch.com

Is the US in a wage-price inflation spiral that could lead to more aggressive Fed rate hikes? Is it time to buy UK Gilts after a wild month of volatility? We answer "no" to both questions, as we discuss in this week’s report.

In this report, we assess that sterling likely bottomed below 1.04. We expect volatility in the currency to remain in place but are buyers below current levels. On balance, there is a tug of war between irresponsible fiscal policy and the pound as a global reserve currency. This will create a buy-in opportunity for investors who missed the latest dip.

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A message for Foreign Exchange Strategy clients, There will be no report next week, as we take a summer break. We will be joining our clients and colleagues for our annual investment conference to be held in New York, on September 7 & 8. We will resume our publication the following week, with a Special Report on the Hong Kong dollar, together with our China Investment Strategy colleagues. Looking forward to seeing many of you in person. Kind regards, Chester Ntonifor, Foreign Exchange Strategist Executive Summary No Urgency To Tighten Policy The biggest medium-term threat for Japan remains deflation, rather than inflation. This suggests that the BoJ will be loathe to abandon yield curve control anytime soon. That said, inflation is still accelerating globally, and has meaningfully picked up in Japan. Betting on a hawkish BoJ policy shift could therefore be a significant macro trade. We have identified five conditions that need to be met for the BoJ to begin removing accommodation. None are currently indicating an imminent need to alter monetary policy settings, particularly with the Japanese economy softening alongside subdued inflation expectations. The yen will soar on any hawkish BoJ policy shift. Currently, BCA Foreign Exchange Strategy is short EUR/JPY. That said, the historical evidence suggests waiting for an exhaustion in yen selling pressure, before placing fresh bets on selling USD/JPY. Longer-term bond yields in Japan, for maturities beyond the BoJ yield target, are already moving higher, while speculative interest in shorting JGBs has increased.  We recommend fading these trends for now – shorting JGBs outright will remain a “widowmaker trade”. Bottom Line: The yen has undershot and longer-term investors should buy it - our preferred way to express that view in the near-term is to be short EUR/JPY.  Bond investors should be underweight “low-beta” JGBs in fixed-income portfolios on a tactical basis, not as a hawkish BoJ bet, but because global bond yields are more likely to stay in broad trading ranges than break to new highs. Feature Chart 1The BoJ Is A Lonesome Dove Almost every G10 central bank has raised rates over the last 12 months, even the perennially dovish banks like the ECB and Swiss National Bank, in response to soaring inflation.  The one exception has been the Bank of Japan (BoJ). The BoJ has kept policy rates unchanged throughout the year (Chart 1), while also maintaining its Yield Curve Control policy of capping 10-year Japanese government bond (JGB) yields at 0.25%. There has been interest from the macro investor community on Japan in recent months, betting on the BoJ eventually succumbing to the global monetary tightening trend.  If the BoJ were to shift gears and turn less accommodative, then the yen would surely soar, while JGBs will go on a fire sale. In this report, jointly published by BCA Research Foreign Exchange Strategy and Global Fixed Income Strategy, we explore the necessary conditions that need to be in place for the BoJ to meaningfully shift policy, most likely starting with the end of Yield Curve Control before interest rate hikes. We see five such conditions, which will form a “checklist” to be monitored in the months ahead. Condition 1: Overshooting Inflation Expectations The BoJ has a policy mandate on inflation and most measures of underlying Japanese inflation are still well below its 2% target. For example, the weighted median and mode CPI inflation rates are only at 0.5%, even as headline CPI inflation has climbed to 2.6% on the back of two primarily non-domestic factors – rapidly rising prices for energy and goods (Chart 2). With such low baseline inflation, it has been hard to lift market-based Japanese inflation expectations like CPI swap rates above 1%, even as far out as ten years (Chart 3). CPI swaps have tended to provide a more realistic assessment of underlying Japanese inflation, adhering more closely to trends in realized core CPI inflation, and thus deserve the most attention from the BoJ.  This is in stark contrast to the BoJ’s own consumer survey of inflation expectations, that has consistently overestimated inflation over the years, which is currently showing both 1-year-ahead and 5-year-ahead inflation expectations at a startling, yet highly inaccurate, 5%.  Chart 2Low Underlying Inflation In Japan Chart 3No Unmooring Of Inflation Expectations In Japan The BoJ is likely to side with the more subdued read on market-based inflation expectations in determining if monetary policy needs to turn less dovish – especially with the BoJ’s own estimate of the output gap now at -1.2%, indicating spare capacity in the economy and a lack of underlying inflation pressures (Chart 4). Chart 4Japan Still Suffers From Excess Capacity Condition 2: Excessive Yen Weakness Our more comprehensive measure of determining the pressure to change monetary policy is captured in our central bank monitor for Japan, a.k.a. the BoJ Monitor.  The Monitor includes economic, inflation and financial variables. This measure suggests that the BoJ should not be tightening monetary policy today (Chart 5). One of the variables that goes into our BoJ Monitor is the yen. The yen impacts monetary conditions through two ways. First, import prices tend to rise as the yen weakens, feeding into domestic inflation. In short, it eases monetary conditions. That has been the story over the last year with the yen falling -15% on a trade-weighted basis (Chart 6). The second impact is through profit translation effects. Overseas earnings for Japanese exporters are buffeted in yen terms as the currency depreciates. Both impacts would tend to put more pressure to tighten monetary policy, on the margin. Chart 5No Urgency To Tighten Policy Chart 6Yen Weakness Only Generates Temporary Inflation However, the impact of yen weakness in boosting profit translation costs for Japanese concerns has eased over the years. As many Japanese companies have offshored production, lower wages in Japan have been offset by higher costs abroad. As a result, profit margins for multinational Japanese corporations are not rising meaningfully relative to their G10 peers, despite yen weakness (Chart 7). That puts the central bank in a quandary regarding how to interpret yen weakness vis-à-vis future policy moves. On the one hand, soaring global inflation and a weak yen should be allowing the BoJ to declare victory on rising inflation expectations in Japan. On the other hand, domestic wage growth will not reach “escape velocity” (Chart 8), and inflation will fail to overshoot on a sustainable basis, if corporate profit margins are not rising meaningfully. Chart 7No Widespread Signs Of Increased Profitability From Yen Weakness Chart 8No Escape Velocity Yet In Japanese ##br##Wages Of course, Japanese authorities care about excessive moves in the yen, but they also understand their limited ability to alter the path of the currency. The Ministry of Finance last intervened to support the currency in 1998. That helped the yen temporarily, but global factors dictated its longer-term trend. A BoJ monetary tightening designed solely to stabilize the yen, before inflation expectations stabilize at the BoJ target, is a recipe for failure on both fronts. The bottom line is that yen weakness is giving a lift to inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year just to generate a one percentage point increase in Japanese inflation. As such, the current bout of yen weakness is unlikely to alter the longer-term goals of BoJ policy, unless a wave of selling undermines financial stability. Condition 3: Continually Rising Energy Costs Chart 9Japan Is More Energy Dependent Than Many Other Countries Policy makers in the eurozone have told us that even in the face of a recession, a threat to their credibility on price stability – like the energy-fueled overshoot of European inflation - is worth defending through monetary tightening. Thus, a continued external energy shock could also cause the BoJ to shift. Our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium on oil to increase in the near term. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 9). A rise in energy costs that unanchors inflation expectations is a threat worth monitoring for the BoJ, one that could drag it into monetary tightening as has been the case in Europe. That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent is likely to soften, assuaging energy import costs (Chart 10). Japan is also ramping up nuclear power production, which can help provide alternative sources to imported energy (Chart 11). Chart 10An Unprecedented Arbitrage Chart 11Nuclear Power Could Help? The BoJ would likely not consider an early exit from accommodative monetary policy based solely on energy-fueled inflation.  After all, the current surge in global energy prices, compounded by yen weakness, has barely pushed headline inflation above the BoJ 2% target – with little follow-through into core inflation or wage growth. Condition 4: An Economic Revival In Japan A burst in Japanese growth that absorbs excess capacity and tightens labor market conditions could convince the BoJ that a policy adjustment is due. This could result in higher Japanese interest rates and bond yields.  The yen also tends to appreciate when the Japanese economy is improving (Chart 12). Unfortunately, Japanese growth momentum is going in the wrong direction for that outcome. Chart 12The Yen And the Japanese Economy Domestic demand has been under siege from the lingering effects of the pandemic, including an unprecedented collapse in tourism. As the pandemic effects have faded, however, Japan’s economy faces new threats from slowing global growth, waning export demand, and declining consumer confidence (Chart 13). It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains nearly three percentage points below the level implied by its pre-pandemic trend. While Japan’s unemployment rate is 2.6% and falling, it remains above the low reached just before the start of the pandemic. Chart 13A Broad-Based Slowing Of Japanese Growth What Japan needs now is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Stronger fiscal spending could lift animal spirits in Japan and cause the BoJ to shift. Yet even on that front, the evidence does not point to a direct link from fiscal stimulus to rising inflation expectations – a necessary catalyst for the BoJ to turn more hawkish. A recent study by the Federal Reserve Bank of San Francisco concluded that there was no boost to depressed Japanese inflation expectations from the massive Japanese government fiscal programs during the worst of the 2020 COVID-19 pandemic shock. Waning Japanese economic momentum is not putting any pressure on the BoJ to begin considering a shift to less accommodative monetary settings. Condition 5: More Hawkish Members At The BoJ There are important transitions occurring within the BoJ’s nine-member board that could change the policy bias in a less dovish direction.  In July, two new board members – Hajime Takata and Naoki Tamura – were appointed to the BoJ board. Both brought up the notion of the need for an “exit strategy” from current easy monetary policies at their introductory press conference, although both were also careful to state that they did not think the conditions were in place yet for that to occur. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? Nonetheless, the two new appointees represent a marginally hawkish shift in the policy bias of the BoJ board, especially Takata who replaced one of the more vocal advocates for maintaining aggressive monetary easing, economist Goushi Kataoka.  Of course, the big change at the top of the BoJ will come next April when Governor Haruhiko Kuroda’s current term ends. This will follow the departures of the two deputy governors, Masayoshi Amamiya and Masazumi Wakatabe in March. That means five of nine board members would be changed in less than one year, including the most senior leadership. That would be a huge change for any central bank, but especially for the BoJ where Governor Kuroda has overseen the introduction of all the current aggressive monetary policies, from negative interest rates to massive quantitative easing to Yield Curve Control. A growing constraint for the future of Yield Curve Control As outlined earlier, underlying inflation and growth trends in Japan are nowhere close to justifying an end to Yield Curve Control or even a mere upward tweak of the current 0.25% yield target on 10-year JGBs. However, there are negative spillover effects from the BoJ’s bond market manipulation that could make the current policies less sustainable over the medium term for the new incoming BoJ leadership. We addressed one of those issues earlier with the extreme yen weakness, which is largely a product of the BoJ keeping a lid on Japanese interest rates while almost the entire rest of the world is in a monetary tightening cycle. But another issue to be addressed is the impaired liquidity of the JGB market. After years of steady, aggressive bond buying, the BoJ has essentially “cornered” the JGB market.  The central bank now owns roughly 50% of all outstanding JGBs, doubling its ownership share since Yield Curve Control started in 2016 (Chart 14).  The numbers are even more extreme when focusing on the specific maturity targeted by the BoJ under Yield Curve Control, with the central bank now owning nearly 80% of all 10-year JGBs (Chart 15). Chart 14The BoJ Has Cornered The JGB Market Chart 15BoJ Now Owns 80% Of 10yr JGBs By absorbing so much supply of the main risk-free asset in the Japanese financial system, the BoJ has made life more difficult for Japanese commercial banks, insurance companies and pension funds that require JGBs for regulatory and risk management purposes. In the most recent BoJ survey of bond market participants, 68 of 69 firms surveyed described the JGB market as having poor liquidity conditions, with an equal amount stating that JGB trading conditions were as bad or worse than three months earlier. The change in BoJ leadership could also bring about a change in policymakers’ desire to continue manipulating the JGB market via Yield Curve Control.  Although the BoJ would have to be very careful in how it signals and executes any change to Yield Curve Control.  There is currently a very wide gap between a 10-year JGB yield at 0.25% and a 30-year JGB yield at 1.25% (Chart 16). If the BoJ completely ended Yield Curve Control, the 10-year yield would converge rapidly towards that 30-year yield, likely reaching 1%. That would create a major negative total return shock to the Japanese banks and institutional investors that still own nearly 40% of JGBs. Chart 1610yr JGB Yields Will Surge Without Yield Curve Control A more likely outcome would be the BoJ raising the yield target on the 10-year to something like 0.50%, or perhaps shifting to a different maturity target where the BoJ owns a smaller share of outstanding JGBs like the 5-year sector. Yet without an actual trigger for such a move coming from faster economic growth or core inflation hitting the 2% BoJ target, it is highly unlikely that the BoJ would dare tinker with its yield curve policy, and risk a JGB market blowup, solely over concerns about bond market liquidity. Investment Conclusions None of the items in our newly constructed “BoJ Checklist” are currently indicating that a shift in Japanese monetary policy is imminent.  We therefore see it as being too early to put on the legendary “widowmaker trade” of shorting JGBs, although a case can be made to go long the yen based on longer-term valuation considerations. Japanese yen The carnage in the yen is in an apocalyptic phase, but the BoJ is unlikely to rescue the yen in the near term. As such, short-term traders should be on the sidelines. For longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 17). Meanwhile, according to our PPP models (and a wide variety of others), the Japanese yen is the cheapest G10 currency, undervalued by around -41% (Chart 18). BCA Foreign Exchange Strategy is currently long the yen versus the euro and the Swiss franc. Chart 17The Yen Is On Sale Chart 18The Yen Is Very Cheap JGBs Chart 19Stay Tactically Underweight JGBs In the absence of a bearish domestic monetary policy trigger, JGBs should be treated by global bond investors as a risk management tool as much as anything else. The relative return performance of JGBs versus the Bloomberg Global Treasury Index of government bonds is highly correlated to the momentum of global bond yields (Chart 19). Thus, increasing the exposure to JGBs in a global bond portfolio is akin to reducing the interest rate duration of a bond portfolio – both positions will help a portfolio outperform its benchmark when global bond yields rise. On a tactical basis (3-6 month time horizon), an underweight allocation to JGBs in government bond portfolios seems appropriate, even with JGBs offering relatively attractive yields on a currency-hedged basis, most notably for USD-based investors.  Global bond yields are more likely to stay in broad trading ranges, capped by slowing global growth and decelerating goods inflation but floored by stickier non-goods inflation and hawkish central banks. Thus, the defensive properties of JGBs as a “duration hedge” in global bond portfolios are less necessary in the near-term. Beyond the tactical time horizon, the uncertainty over the potential makeup of new BoJ leadership in 2023, along with some easing of global inflation pressures from the commodity space, could justify lower JGB exposure on a more structural basis - if it appears that a new wave of more hawkish policymakers is set to take over in Tokyo. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Listen to a short summary of this report.       Executive Summary A Tremendous Inflow Into US Government Bonds Multiple frameworks exist for managing currencies. These include forecasting growth differentials, watching central banks, gauging terms of trade and balance of payment dynamics or even assigning a probability to the occurrence of black swans. For us, the most useful tool has been to simply track portfolio flows. In today’s paradigm, portfolio flows into US equities are rapidly dwindling, while those flowing into fixed income have picked up meaningfully. Gauging what happens next will be critical for the dollar call (Feature chart). The Fed is being viewed as the most credible central bank to curb inflation. As a result, US rates have risen more than in other markets. This has also pushed valuation and sentiment of the dollar to very elevated levels. If inflation peaks and the world economy achieves a soft landing, downside in the dollar will be substantial. On sentiment, being a contrarian can make you a victim, but when the stars are aligned where valuation, sentiment and the appropriate macro analysis point towards a single direction, our framework proves extremely useful. In a nutshell, many currencies, especially the euro, are already pricing in a nasty recession into their respective economies. If a recession does occur, they could undershoot. If one does not, they are poised for a coiled spring rebound. Bottom Line: Tactical investors should be neutral to overweight the dollar in the near term, as the probability of a recession rises. Longer-term investors should be slowly accumulating assets in countries where fundamentals make sense, and their currencies are deeply undervalued. Feature The real neutral rate of interest in the US is difficult to estimate ex ante, but Chart 1 highlights that the real Fed Funds rate is well below many estimates of neutral. In a world where inflation has become a widespread problem, and a few economies (like the US) are overheating, markets have moved to test the credibility of their respective central banks. The consensus has been that the Federal Reserve will be the most credible in taming runaway inflation by being able to raise rates faster than other central banks (Chart 2). This is especially the case as many European economies remain at firing range from the Russia-Ukraine conflict and, as such, face more supply-side driven inflation. Chart 1The Fed Has Scope To Tighten Further Chart 2Interest Rates Have Moved In Favor Of The Dollar The typical pattern for the dollar is that it tends to rise when growth is falling and inflation is also subsiding, which triggers tremendous haven flows into US Treasurys. Right now, inflation remains strong but growth is rolling over, which has historically painted a mixed picture for the dollar (Chart 3). Chart 3The Dollar Rises On Falling Growth What happens next is critical. The dollar tends to rise 10%-15% during downturns. We are already there. The DXY index is up 8.8% this year, and up 16.3% from the trough last year. European currencies like the SEK and the EUR have already priced in a recession as deep as in 2020. If this indeed proves to be the case, commodity currencies will be next, which could push the DXY to fresh highs. But as we outline below, even in a pessimistic scenario, a systematic approach to looking at currencies warns against fresh bets in favor of the dollar. Inflation And Central Banks One of the key themes we outlined in our outlook for this year is that inflation is a global problem, and not centric to the US. So, while supply side factors have had an outsized effect on energy deficient countries like Germany, the UK, Sweden and, to an extent Japan, inflation is also well above target in Canada, Australia, Norway, New Zealand, and many other developed and emerging market countries. In fact, the inflation impulse is slowing in the US, relative to a basket of G10 countries (Chart 4). Related Report  Foreign Exchange StrategyLessons From Fed Interest Rate Hikes Falling inflation will be a welcome relief valve from the tension in markets over much tighter financial conditions. It will also lower the probability of a global recession. For currency markets however, the starting point is that the market has priced the Fed to continue leading the tightening cycle until something breaks. If inflation does subside, then hawkish expectations by the Fed will be heavily priced out of the curve, which will remove a key source of support for the greenback. From a chartist point of view, the dollar has already overshot the level of rates the markets expect from the Fed, relative to more dovish central banks (Chart 5). This suggests a hefty safety premium is already embedded in the dollar. Chart 4US Inflation Is Peaking, Relative To Other ##br##Economies Chart 5The Dollar Has Overshot The Path Implied By Interest Rates The Dollar And Global Growth If the Fed and other central banks tame the inflation genie, then we will have achieved a soft landing. The dollar has tended to track the path of the US yield curve, and a flattening usually underscores longer-term worries about a recession (Chart 6). A steepening curve will signal mission accomplished. In the view of the Foreign Exchange Strategy service, recession risks could be relatively balanced. While major central banks have been tightening policy (the US and most of the G10), China, a big whale in terms of its monetary policy impact, has been easing monetary conditions. Chart 7 highlights that most procyclical currencies have tracked the Chinese credit impulse tick for tick. Bond yields in China are near the lows for the year. Unless China enters another economic down-leg in growth that matches the 2015 slowdown, we might just witness a rotation in economic vigor from the US towards other economies, led by China, allowing the world to achieve a soft landing. Chart 6The Dollar Is Tracking The US Yield ##br##Curve Chart 7Commodity Currencies Are Tracking The Chinese Credit Impulse   In the currency world, typical recessionary indicators are not yet flashing red. Cross-currency basis swaps remain well contained, suggesting dollar funding pressures, or that the ability to service dollar debt abroad remains healthy. The Fed’s liquidity swap lines, which allow foreign central banks to obtain dollar funding, also remain untapped (Chart 8). That said, currency put-call ratios are rising, suggesting the cost of obtaining downside protection has increased. Chart 8The Fed"s Recession Models Are Still Sanguine The Dollar And Portfolio Flows Aside from hedging against downside protection for the EUR, the AUD or even the CAD, one driver of dollar strength has been huge portfolio inflows into US Treasurys (Chart 9). That has occurred while equity inflows have collapsed. Admittedly, this took us by surprise since by monitoring the big Treasury whales (Japan and China), holdings have been rolling over for quite some time (Chart 10). This has also occurred amidst an accumulation of speculative short positions on US Treasurys. Chart 9A Tremendous Inflow Into US Government Bonds Chart 10Japan And China Remain Treasury Sellers Historically, bond inflows are the driver of portfolio flows into the US, but the equity market has also dictated the trend in the dollar from time to time. Overall, the basic balance in the US, sum of all portfolio flows, has done a good job capturing turning points in the dollar. Our focus on equity flows this time around is due to the conundrum the US faces. Relative profits tend to drive the performance of relative stock prices, and US profits tend to be more defensive – rising on a relative basis when bond yields and commodity prices are collapsing and falling otherwise (Chart 11). As such, the rise in bond yields has already derated US equity multiples but profits have held up remarkably well. An underperformance in US equities during a downturn has been unprecedented with a strong dollar since the end of the Bretton Woods system. So should a market shakeout lead to a violent rotation out of US equities, the profile for the dollar could be a mirror image of what we witnessed in 2008 or even 2020. The conundrum for bond inflows is that according to traditional measures, real rates in the US remain deeply negative, but they have improved significantly under the lens of market-based measures (Chart 12). This partly explains the dollar overshoot. A scenario of faster growth outside the US could see real rates improve more quickly abroad. Chart 11US Profits Have Held Up Remarkably Well Chart 12Market-Based Real Yields In The US Have Improved A final point: managing currencies is about anticipating the next macroeconomic driver. In our view, this could be fears about balance of payments dynamics, especially as the world becomes marginally less globalized. Since the 1980s, we have never had a configuration where the dollar is very overvalued, US real rates are extremely low, and the trade deficit is near a record high (meaning it needs to be financed externally). A bet on US exceptionalism has a natural limit, as competitiveness abroad is improving tremendously vis-à-vis many of the goods and services the US exports. Currencies And Valuations Currencies should revert to fair value. The question then becomes "which fair value should they mean-revert to?" In our view, simple works best – purchasing power parity values. A simple chart shows that selling the dollar when it is expensive and buying it when cheap according to its purchasing power generates alpha over the long term (Chart 13). In A Simple Trading Rule For FX Valuation Enthusiasts, we showed that a shorter-term trading strategy also based on valuation adds value. Granted, the dollar started to become overvalued in 2015, but it is now sitting close to a historical extreme. A fair assessment is that currencies will revert to their fair value, but that takes time (3-5 years). As such, longer-term investors should be slowly accumulating assets in countries where fundamentals make sense, and their currencies are deeply undervalued. These include Japan, Australia, Sweden and even Mexico (Chart 14). Chart 13The Dollar Is Overvalued On a PPP Basis Chart 14The Real Effective Exchange Rate For The Dollar Is High The Dollar And Momentum There is quite simply a dearth of dollar bears. Internally at BCA, a lot of strategists who see more downside to US (and global) equities, simply cannot be negative on the dollar. Within the foreign exchange strategy, we have been short the DXY index since 104.8, and are sticking with that bet on a 12-18-month horizon. For risk management purposes, our stop loss is at 107. First, we are seeing record long positions by speculators (Chart 15). Fielding clients, or even the media, no one wants to be a dollar bear when the Fed is clearly an inflation vigilante. If inflation keeps surprising to the upside, then speculators will keep bidding up the dollar. But it is also fair to say that most investors who want to be long the greenback at this point already have that position on.  Our intermediate-term indicator, a combination of technical variables, also warns against initiating dollar-long positions at the current juncture (Chart 16). This series mean-reverts quite quickly, so it does not dictate the trend in the dollar, but warns of capitulation extremes. Chart 15Speculators Are Very Long The Dollar Chart 16Technical Dollar Indicators Are Overbought Finally, the dollar has been used as a bet on rising volatility. The dollar is well above levels that a correction in the S&P 500 index would dictate (Chart 17). It has also moved in tandem with bond volatility (Chart 18). This suggests much of equity downside risk has been priced into the dollar. Chart 17The Dollar Has More Than Compensated For The Drawdown In Equities Chart 18The Dollar Is Tracking ##br##Volatility 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 Summarizing Our Main Investment Themes In One Chart Our current strategic recommendations are centered around four key themes: global inflation will slow over the rest of 2022, Europe remains too weak to handle significantly higher interest rates, corporate default risk in the US and Europe is relatively low, and the fundamental backdrop for emerging markets is poor. If we are going to be proven wrong on any of those themes, it will most likely be because global inflation remains high for longer due to resilient commodity prices and lingering supply chain disruptions. A sluggish economy will handcuff the ECB’s ability to raise rates as fast as markets are discounting over the next year. The state of corporate balance sheet health in the developed world is not problematic, on average, even with some sectors taking on more leverage in response to the 2020 COVID downturn. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. Bottom Line: We remain comfortable with our main fixed income investment recommendations: maintaining neutral global portfolio duration, overweighting core European bonds versus US Treasuries, favoring high-yield corporates over investment grade (both in the US and Europe), and underweighting EM hard currency debt. Feature One of the foundations of a sound medium-term investment process is to allocate capital towards highest conviction views, while constantly assessing - and reassessing - if those views are unfolding as expected. Trades that are not going according to plan may need to be reconstructed, if not exited entirely, to avoid losses. We feel the same way about the investment recommendations highlighted in the pages of our reports, which represent our portfolio, as it were. With this in mind, in this report we identify the four most critical themes underpinning our current main investment recommendations and evaluate the potential risks that our views will not turn out as expected. Theme #1: Global Inflation Will Decline In The Latter Half Of 2022 Our biggest theme for the rest of this year is that global inflation will cool off after the massive acceleration over the past year. Many of our current fixed income investment recommendations across the developed markets – maintaining neutral overall global duration exposure, underweighting global inflation-linked bonds versus nominal government debt, betting against additional yield curve flattening (especially in the US) – are predicated on reduced inflationary pressure on interest rates. Related Report  Global Fixed Income StrategyA Crude Awakening For Bond Investors The expectation of lower inflation is based on some easing of the forces that first caused the current inflationary overshoot – booming commodity prices and rapidly accelerating goods prices due to supply-chain disruptions. Already, the commodity price factor is starting to fade, on an annual rate-of-change basis that matters for overall inflation, thanks to more favorable comparisons to the commodity surge in 2021 (Chart 1). The year-over-year growth rate of the CRB index has decelerated from a peak of 54.4% in June 2021 to 19.3% today, even with many commodity prices seeing big increases in response to the Russia/Ukraine war. This is because the increases in commodity prices were even larger one year ago when much of the global economy reopened from COVID-related economic restrictions. Favorable base effect comparisons are not the only reason why commodity inflation has slowed. Commodities are priced in US dollars, and the steady appreciation of the greenback, with the trade-weighted dollar up 5% on an year-over-year basis, has also helped to slow commodity price momentum (Chart 2). Slower global growth, coming off the overheated pace of 2021, has also acted as a drag on overall commodity price inflation (middle panel). Beyond the commodity space, some easing of global supply chain tensions has resulted in indicators of shipping costs seeing meaningful declines even with supplier delivery times still elevated (bottom panel). Chart 1Our Main Strategic Theme: Decelerating Global Inflation​​​​​​ Chart 2Disinflationary Momentum From Commodities Already Underway​​​​​ A more fundamental factor that should help moderate global inflation momentum this year beyond the commodity/supply chain effects relates to a lack of broad-based global "excess demand", even as the world economy continues to recover from the massive pandemic shock in 2020. The IMF’s latest projections on output gaps – estimates of the amount of spare economic capacity – show that few major developed or emerging market economies are expected to have positive output gaps over 2022 and 2023 (Chart 3). The US is the most notable exception, with an output gap projected to average +1.6% this year and next. Most other developed market countries are projected to have an output gap close to zero. This suggests that the US is facing the most inflationary pressure from an overheating economy, which is why we continue to see the Fed as being the most hawkish major developed market central bank over the next couple of years. Chart 3Few Countries Expected To Have Inflationary Output Gaps In 2022/23 Yet even with so much of the macro backdrop supporting our call for slower global inflation in the coming months, there are several potential risks to that view. Chart 4A Risk To Our Lower Inflation View: Resilient Oil Prices Another war-related upleg in global oil prices Our commodity strategists continue to see oil prices settling down to the low $90s by year-end. Yet oil has seen tremendous volatility since the Ukraine war began as prices had to factor in the potential loss of Russian oil supplies in an already tight crude market. The benchmark Brent oil price briefly hit $140 in the immediate aftermath of the Russian invasion. A similar move sustained over the latter half of 2022 would trigger a reacceleration of oil momentum, putting upward pressure on overall global inflation rates. A renewed bout of energy-induced inflation would push global interest rate expectations, and bond yields, even higher from current levels – a challenge to both our neutral duration stance and underweight bias on global inflation-linked bonds (Chart 4). More supply-chain disruption from China Chinese authorities are clamping down hard on the current COVID wave sweeping across China. The current lockdowns in major cities like Shanghai could shave as much as one percentage point off Chinese real GDP growth for 2022, according to our China strategists. Those same lockdowns in a major transportation and shipping hub like Shanghai are already causing supply chain disruption within China. Supplier delivery times saw big increases in the March PMI data (Chart 5), while the number of cargo ships stuck outside Shanghai has soared. The longer this lasts, the greater the risk that supply chains beyond China would be disrupted, erasing the improvements in global supplier delivery times seen over the past few months. That could keep goods price inflation elevated for longer. Stubbornly resilient services inflation A big part of our lower inflation view is related to a rebalancing of consumer demand in the developed world away from goods towards services as economies move away from COVID restrictions. This implies an easing of the excess demand pressures that have triggered supply shortages for cars and other big-ticket consumer goods. The result would be a sharp slowing of goods price inflation, with the result that overall inflation rates in the major economies would gravitate towards the slower rate of services inflation. The latter, however, is accelerating in the US, UK and Europe (Chart 6) – largely because of soaring housing costs – which raises the risk that overall inflation will fall to a higher floor in 2022 as goods inflation slows. Chart 5Another Risk To Our Lower Inflation View: China Lockdowns​​​​​ Chart 6One More Risk To Our Lower Inflation View: Sticky Service Prices In the end, we see the balance of risks still tilted towards much slower global inflation this year. However, if we are going to be proven wrong on any of our major investment themes in 2022, it will most likely be because global inflation remains resilient for longer. Theme #2: Europe’s Economy Is Too Fragile To Handle Higher Interest Rates Beyond the global inflation call, our next highest conviction view right now is that markets are overestimating the ECB’s ability to tighten euro area monetary policy. Markets are now pricing in 85bps of ECB rate hikes by the end of 2022, according to the euro area overnight index swap (OIS) curve, which would take policy rates back to levels last seen before the 2008 financial crisis. The war has put the ECB in a difficult spot vis-à-vis its next policy move. High euro area inflation, with annual headline HICP inflation climbing to 7.4% in March and core HICP inflation reaching 2.9%, the highest level of the ECB era dating back to 1996, would justify a move to begin hiking policy interest rates as soon as possible.   However, European growth momentum has slowed significantly so far in 2022. Initially this was due to the spread of the Omicron COVID variant that resulted in a wave of economic restrictions. That was followed by the shock of the Russian invasion of Ukraine, that has hit European economic confidence and raised fears that Europe would lose access to Russian energy supplies. Our diffusion indices of individual country leading economic indicators and inflation rates within the euro area highlight the pickle the ECB finds itself in (Chart 7). All countries have headline and core inflation rates above the ECB’s 2% target, yet only 60% of euro area countries have an OECD leading economic indicator that is higher than year ago levels. In the three previous tightening cycles of the “ECB era” since the inception of the euro in 1998, the diffusion indices for both growth and inflation reached 100% - in other words, every euro area economy was seeing faster growth and above-target inflation. Chart 7The ECB Will Have Difficulty Hiking As Much As Expected Chart 8Warning Signs On European Growth Other economic data are also sending worrying messages. The euro area manufacturing PMI fell to the lowest level since January 2021 in March, while the European Commission consumer confidence index and the ZEW expectations index have plunged to levels last seen during the depths of the 2020 COVID recession (Chart 8). Euro area export growth has also decelerated sharply, with exports to China contracting on a year-over-year basis. Simply put, these are not the kind of growth data consistent with a central bank that needs to begin tightening policy aggressively. The inflation data also does not paint a clean picture for the ECB. ECB President Christine Lagarde has repeatedly noted that the central bank is on the lookout for any “second round effects” from the current commodity-fueled surge in European inflation on more lasting inflationary measures like wages. On that front, European wage growth remains stunningly subdued. European annual wage growth was only 1.6% in Q4/2021, despite the unemployment rate for the whole euro area falling below the OECD’s full employment NAIRU estimate of 7.7% (Chart 9). Unit labor costs only grew at an 1.5% annual rate at the end of 2021, suggesting little underlying pressure on European inflation from wages. Chart 9No Inflationary Pressures From Wages In Europe​​​​​ Chart 10European Bond Yields Discount Too Much ECB Hawkishness Without a bigger inflation boost from labor costs, the ECB will feel less pressured to begin tightening monetary policy as rapidly and aggressively as markets are discounting – especially if global goods/commodity inflation slows as we expect. We remain comfortable with our overweight recommendation on core European government bonds (Germany and France), both within a global bond portfolio but especially versus the US. The Fed is far more likely to deliver the aggressive rate hikes discounted in money markets compared to the ECB (Chart 10). Theme #3: Corporate Default Risk In The US And Europe Is Relatively Low Another of our main investment themes relates to corporate credit risk. Specifically, we see high-yield debt in the US and Europe as being relatively more attractive than investment grade credit, even in a typically credit-unfriendly environment of tightening global monetary policy and slowing global growth momentum. Our Corporate Health Monitors are highlighting that corporate finances are in relatively good shape on either side of the Atlantic (Chart 11). This is primarily related to strong readings on interest coverage, free cash flow generation and profit margins, all of which are helping to service higher levels of corporate leverage. Defaults are expected to rise over the next year in response to slowing growth momentum, but the increase is projected to be moderate. Moody’s is forecasting the US and European high-yield default rates to be virtually identical, climbing to 3.1% and 2.6%, respectively, by February 2023. Those relatively low default rates, however, are for the aggregate of all high-yield borrowers. Default risks may be higher for some companies and industries that were more severely impacted by the pandemic. Chart 11US/Europe Default Risk Remains Relatively Modest​​​​​ Chart 12The IMF Sees Fewer Financially Vulnerable Firms​​​​​​ Chart 13Default-Adjusted HY Spreads Still Offer Some Value An analysis of global private sector debt included in the latest IMF World Economic Report highlighted that companies that suffered the most significant declines in revenues in 2020 also took on greater amounts of debt than companies whose businesses were least impacted by the 2020 growth shock (Chart 12). Industries that were “worst-hit” by COVID also saw significant worsening of debt servicing capability, described by the IMF analysts as the percentage of firms among the “worst-hit” that had interest coverage ratios less than one (middle panel). Importantly, the IMF report noted that the “worst-hit” industries have seen significant improvements in interest coverage since 2020, reducing the number of financially vulnerable firms (those with high debt-to-assets ratios and interest coverage less than one). The IMF analysis uses corporate data from a whopping 71 countries, but the conclusions are like those from our Corporate Health Monitors for the US and Europe – corporate credit quality has improved, on the margin, since the dark days of the 2020 COVID recession for an increasing number of borrowers. Default-adjusted spreads for high-yield bonds in the US and Europe, which subtract expected default losses from high-yield index spread levels, show that high-yield bonds currently offer decent compensation for expected credit losses (Chart 13). This is especially true for European high-yield, where the default-adjusted spread is just below the average level since 2000. This fits with our current recommendation to maintain neutral allocations to both US and European high-yield. We have a bias to favor the latter, however, due to better valuation metrics and a more dovish outlook on ECB monetary policy compared to the Fed. Theme #4: The Fundamental Backdrop For Emerging Markets Is Poor Chart 14The Backdrop Remains Challenging For EM We have been negative on emerging market (EM) credit dating back to the latter months of 2021. Specifically, we are now underweight EM USD-denominated debt, both sovereigns and corporates. This is a high-conviction view and one that remains fundamentally supported. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China policy stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. While we expect the latter to occur in the coming months, there are meaningful risks to that view, as described earlier. Meanwhile, the situation in Ukraine appears to be worsening with Russia pushing the offensive and showing no desire for reengaging talks with Ukraine. Chinese policymakers are starting to respond to slowing Chinese growth, made worse by the COVID lockdowns, with some easing measures on monetary policy. Credit growth has also started to pick up, but the credit impulse remains too weak to warrant a more positive view on Chinese growth and import demand from EM countries (Chart 14). Finally, the US dollar remains well supported by a hawkish Fed and widening US/non-US interest rate differentials. This may be the most critical variable to watch before turning more positive on EM credit, given the strong historical correlation between the US dollar and EM hard currency spreads (bottom panel). For now, the trend of the US dollar remains EM-negative. Concluding Thoughts Chart 15Summarizing Our Main Investment Themes In One Chart Our four main investment themes, and associated recommendations, are summarized in Chart 15. The credit-related themes – underweighting high-yield bonds in the US and Europe versus investment grade equivalents, and underweighting EM USD-denominated debt – are already performing as expected. The interest rate related themes – slower global inflation and fading European rate hike expectations – should unfold in favor of our recommendations over the balance of 2022.   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 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 The Market Has Priced An Aggressive Path For US Rate Hikes The Federal Reserve has joined other G10 central banks in increasing interest rates this week. However, this has been well priced by both the dollar and short rates in the US (Feature Chart). The key call for currencies therefore is whether the Fed delivers more or less hikes than is currently priced by markets over the course of the next few months. More aggressive rate hikes will boost US bond yields, and send the dollar higher. But it will also undermine US equity multiples, given the tight correlation between the price-to-earnings ratio in the US and the real bond yield. More importantly, US equity market leadership has been an important driver of portfolio inflows into the dollar. Should the Fed deliver less hikes than the aggressive path currently priced by markets, currency investors will also be caught offside. This conundrum puts the DXY at risk. The caveat is that if the US economy is genuinely stronger than the rest of the world, and more insulated from the Russo-Ukrainian conflict, this will warrant higher real US interest rates. We went short NOK/SEK last week given our bias that oil prices had overshot. Tighten stops to protect profits. Bottom Line: Being long the dollar is a consensus trade. While in the near term, this could prove to be the right call, the dollar is also expensive and overbought, which is bearish from a contrarian perspective. Feature The 25 basis point interest rate hike by the Federal Reserve this week has probably been one of the most telegraphed macro events. Interest rate expectations in the US have risen sharply compared to last year (Chart 1). More importantly, as Chart 2 shows, two-year bond yields (a proxy for short rates) have climbed in the US relative to pretty much every other G10 country. Correspondingly, rising interest rate expectations in the US have led to substantial speculative flows into the US dollar. Chart 2The Market Expects The Fed To Hike Faster Than Other Central Banks This Year Chart 1The Market Has Priced An Aggressive Path For US Rate Hikes On the flipside, the outperformance of the US equity market is being threatened by rising interest rates. If rates rise substantially, that could derate US equity multiples, as portfolio inflows are curtailed. US profits also tend to underperform when rates rise. However, if US rates rise by less than what the market expects, net long speculative positioning in the dollar will surely reverse. Non-US Markets Benefit More When Bond Yields Rise Profits tend to drive the equity market over the short run, with valuation starting to matter over longer horizons. When it comes to the US, it is also true that profits tend to underperform the rest of the world as bond yields rise. Why it matters for the dollar is because a better profit picture in the US helps drive portfolio flows into US equities, buffeting the exchange rate (Chart 3). Related Report  Global Investment StrategyA Two-Stage Fed Tightening Cycle Chart 4 shows that US profits lag the rest of the world when bond yields are in an uptrend. This is because of the composition of the US equity market. Specifically, the US equity market is underweight financials, energy, materials, and industrials, while overweight information technology, health care, and communication services. Rising inflation benefits commodity-linked sectors, the income statements of which are directly juiced by rising prices. Similarly, banks tend to do better as interest rates rise because net interest margins improve. In a nutshell, rising rates and inflation tend to be better for the profits of value stocks and cyclicals, sectors that are underrepresented in the US. Chart 3The Dollar And US Equities Chart 4Bond Yields And US Profits There is also a valuation angle to higher rates. Because the US market is more overweight sectors with cash flows that backwardated, higher rates will undermine the valuation premium currently commanded by these sectors. This is true both in absolute terms and relative to other markets (Chart 5A and 5B). Chart 5AThe S&P 500 P/E Ratio And Real ##br##Yields Chart 5BThe Valuation Premium In The US Is Inversely Correlated To Bond Yields The key point is that the US equity market is at risk relatively from higher global yields that could undermine relative profit growth and its valuation premium. The US trade deficit currently runs at $90 billion. In 2021, at least 45% of that was financed via foreign equity purchases. A reversal in these flows could undermine the dollar. The Dollar And Relative Interest Rates While portfolio flows into US equities have been reversing, bond inflows have improved (Chart 6). Over the long term, bond flows tend to be the key driver of the US dollar. As Chart 2 shows, most market participants expect the Fed to be among the most hawkish central banks in 2022 and beyond. In fact, December Eurodollar contracts are pricing the Fed to hike interest rates by 218 bps more than the ECB, and 235 bps more than the Bank of Japan (allowing for a small risk premium in this pricing) (Chart 7). Chart 7Investors Are Very Bullish On US Rate Expectations Chart 6Investors Have Been Aggressively Purchasing US Treasurys There are two key risks to a hawkish Fed view, relative to other central banks: First, the Fed is already behind the curve relative to its G10 counterparts. The BoE, RBNZ, BoC, and the Norges Bank have already increased rates. Even the rhetoric at the ECB is shifiting. Relative bond yields do not reflect this reality. Second, and related, rising inflation is a global phenomenon and not specific to the US. Almost every central bank is acknowledging that inflation is a key risk to their mandate, compared to the transitory narrative last year. Chart 8 plots headline inflation across G10 countries. On this basis, it becomes difficult to justify why two-year yields in the UK, for example, are much lower, compared to the US. Chart 8Rising Inflation Is Not A US-Centric Problem If inflation does indeed prove to be sticky, other central banks will have to keep hiking interest rates along with the Fed. If inflation subsides, the Fed might not be as aggressive in tightening policy as the market expects. On a relative basis, this suggests there is a mispricing of how the market views Fed action, relative to other central banks. The key risk to this view is that the US economy can actually withstand much higher rates compared to the rest of the world. While this could be the case, higher rates in Norway and New Zealand are not yet hurting domestic conditions. In fact, it can be argued that weakness in their currencies has unwound a lot of the tightening in financial conditions from higher interest rates. A commodity boom also suggests that these currencies will benefit from rising terms of trade. Conclusion Bond markets have priced higher relative rates in the US, but the Fed could actually lag market expectations, especially relative to commodity-linked currencies (Chart 9). Chart 9Commodity Currencies Have Been Tracking Rate Expectations With A Lag Specifically, higher rates than the market expects in the US will undermine US equity market leadership, reversing substantial portfolio inflows in recent years. This is already occurring at the margin. On the other hand, fewer rate hikes will severely unwind speculative inflows into the US dollar. Housekeeping We went short NOK/SEK on the expectation that oil prices had overshot, especially relative to forward markets (Chart 10). We are tightening the stop loss on this trade to 1.09. Finally, the Bank of England met this week and its transcript reinforced our stance that the BoE will be cornered as it attempts to raise rates amidst a slowing economy. Stay long EUR/GBP. Chart 10Stay Short NOK/SEK But Tighten Stops   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Highlights Indonesian domestic demand is struggling to recover in the face of a very tight policy settings. Exceptionally high real borrowing costs continue to hurt non-financial sectors. This will hurt banks too as credit is stymied and NPLs rise. Equity investors should fade the rebound and stay underweight Indonesia in an EM equity portfolio. Indonesia’s external accounts will deteriorate, as the Chinese slowdown weighs on resource prices. Softening commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. Domestic bond investors should tactically downgrade Indonesia from neutral to underweight within an EM bond portfolio. Sovereign EM credit investors, however, should stay overweight Indonesia. Feature Chart 1Indonesian Stock Rebound Will Be Short-Lived After years of underperformance, Indonesian stocks have rebounded in absolute terms and inched up relative to the EM benchmark (Chart 1). Could this be the beginning of a sustainable outperformance? Our research indicates that the answer is no. The Indonesian economy is still struggling. Domestic demand remains lackluster, hamstrung as it is by very high real interest rates and a tight fiscal stance. A flexing export sector, the sole source of strength so far, is set to dissipate as well. Weaker exports will weigh on the nation's financial markets. A budding softness in EM financial markets – emanating from a slowing China and rising US bond yields – will be yet another headwind for Indonesian assets over the next several months. Investors therefore should fade the current rebound and remain underweight this bourse in EM equity portfolios. EM domestic bond portfolios should consider downgrading this market from neutral to underweight relative to its EM peers. Currency investors may consider shorting the rupiah versus the US dollar. Sovereign EM credit investors, however, should stay overweight Indonesia in an EM US dollar bond portfolio. Straightjacketed The main drag to Indonesia’s economic recovery is coming from prohibitively high interest rates in the country. Real borrowing costs for the private sector, of the order of 10% (Chart 2, top panel), are extremely restrictive for any economy to handle, let alone one trying to recover from a debilitating recession. The real rates in Indonesia are also much higher than anywhere else in Asia – for both the private sector as well as for the government (Chart 2, bottom panel). Chart 2The Economy Is Struggling In the Face Of Very High Real Interest Rates Chart 3Absence Of Fiscal Support Is Making The Recovery Harder The fiscal stance does not appear to be very supportive either. The government is planning to rein in the fiscal deficit next year to 4.8% of GDP from an expected 5.7% this year. The IMF projects that the cyclically- adjusted fiscal thrust in 2022 will be a negative 0.8% of potential GDP, and a further negative 1.5% in 2023 (Chart 3). The consequence of such restrictive settings is that domestic consumption and consumer confidence are languishing well below pre-pandemic levels (Chart 4). Consistently, loan demand is also very weak. Bank credit for both consumption and production purposes (both working capital and term loans) have barely risen after having shrunk outright last year (Chart 5). Chart 4Domestic Demand Is Soft As Consumer Confidence Remains Low Chart 5All Types Of Bank Credit Are Weak Chart 6Disinflationary Pressures Are Entrenched In The Economy Weak domestic demand is reinforcing deflationary forces. Inflation has been undershooting the lower band of the central bank target for almost two years now. Core and trimmed mean CPI measures have been averaging below 1% over the past year. Headline CPI is below the lower target band despite high oil and food prices (Chart 6, top panel). At the same time, nominal wages are barely rising (Chart 6, bottom panel). Hence, household income growth is subdued, which is sapping consumer demand. Notably, the very high real interest rates in Indonesia today are an outcome of monetary policy falling behind the disinflation curve. In the 2000s, the country’s consumer price inflation would often flare up to double digits, and the central bank used to keep interest rates consistently high. Over the past 10 years or so, however, inflationary pressures have gradually given way to deflationary forces. Even though the central bank has reduced its policy rate, it has not reduced it sufficiently enough to offset the drop in inflation. As a result, real interest rates have risen. Banks, on their part, also refused to fully pass along the rate cuts accorded by the central bank. As such, banks’ lending rates to the private sector, in both nominal and real terms, remained much higher compared to their peers elsewhere in Asia (Chart 2, above).  Part of the reason why the central bank has fallen behind the disinflation curve has to do with the exchange rate stability and Indonesia’s dependence on foreign debt capital inflows. The country needs to offer high real rates to continue to attract enough foreign capital so that it can finance the current account deficit. As long as the central bank has rupiah stability (as a means for price stability) as its mandate, it will not reduce real interest rates. Incidentally, a bill to include economic growth and employment within the central bank’s mandate was submitted to Parliament earlier this year. Discussion over the bill, however, has been delayed. This means that elevated real interest rates will prevail for now in Indonesia, hampering economic growth. Fading Bright Spot Chart 7The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes In contrast to domestic demand, Indonesia’s exports did phenomenally well over the past few quarters. That said, there are signs that those heady days are coming to an end: The main reason exports did so well is that commodity prices went vertically up. Export volumes, on the other hand, stayed quite low. This is also evident in the case of coal and palm oil – Indonesia’s two main export items (Chart 7). Since it’s not the volume that drove up the export revenues, the latter is vulnerable to the whims of global commodity prices – of which Indonesia is a price-taker. And commodity prices, in general, have already begun to soften. China is by far the largest destination for Indonesian exports (22% of total), and demand in the Middle Kingdom has been among main reasons behind the recent surge in Indonesian exports. Yet, the fact that China’s credit and money impulses have turned negative is a major concern for Indonesian exports going forward. If history is of any guide, negative impulses will cause a contraction in Indonesian exports over the next year or so (Chart 8). Odds are therefore that the country’s trade surplus will roll over and the current account balance will slip back to a deficit (Chart 9, top panel). Chart 8Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Chart 9Indonesia's Trade And Current Account Balances Have Peaked Chart 10A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah Meanwhile, Indonesia’s financial account is struggling to stay in surplus as capital inflows have dwindled significantly over the past couple of years (Chart 9, middle panel). FDI inflows are also showing few signs of revival (Chart 9, bottom panel). This indicates that Indonesia’s envisioned reforms, under the ‘Omnibus bill’, are yet to gain much traction and produce meaningful improvements in the economy’s structural backdrop. All in all, the outlook for the country’s external accounts is much less sanguine in the months ahead. That will not bode well for the rupiah, which has benefitted from robust external accounts so far. A material drop in Chinese credit and fiscal impulse has never been positive for the Indonesian currency. In the months ahead, therefore, the path of least resistance for the rupiah appears to be down (Chart 10, top panel). The link is via commodity prices (Chart 10, bottom panel). Notably, most capital inflows into Indonesia are in the form of debt capital inflows. Equity inflows are paltry. The reason is straightforward: foreign bond investors like the extremely high real rates that the country has been offering, whereas the equity investors do not. Yet, in the past couple of years, even debt capital inflows have subsided (Chart 9, middle panel). Should foreign investors turn nervous about the rupiah outlook due to falling commodity prices and/or rising US interest rates, those debt inflows would further subside. Deteriorating capital inflows would cause further weakness in the rupiah in a self-fulfilling prophecy. Domestic Bonds Chart 11Indonesian Domestic Bonds' Outperformance Is Late Indonesian local currency bonds have significantly outperformed their EM counterparts over the past several months (Chart 11, top panel). We have been positive on Indonesian domestic bonds. Going forward, however, the nation’s local bonds will find it difficult to rally in absolute terms and will likely underperform their EM peers. One reason for this is that, given Indonesian yields are already close to post-pandemic lows, it will be harder for them to fall much more. The relative performance of domestic bonds versus their EM peers will also be beset by a vulnerable rupiah – as explained above. The bottom panel of Chart 11 shows that periods of a weaker rupiah are usually associated with Indonesia underperforming overall EM domestic bonds. This is because foreign investors (who hold 21% of Indonesian local bonds) usually head for the exit once the rupiah begins to depreciate. Finally, as was explained in our report last week, various EM assets classes are in for a period of volatility – prompted by a deepening slowdown in China and rising US bond yields. Periods of EM stress do not augur well for Indonesian local bonds’ relative performance vis-à-vis their EM brethren. This is because the relative yield differential of Indonesia with that of EM widens in such periods – as occurred during the 2013 taper tantrum, the 2015 EM slowdown, and the 2020 pandemic (Chart 11, bottom panel). Since another EM risk-off period is around the corner, investors will be well advised to book profits on Indonesian domestic bonds’ recent outperformance and tactically downgrade this market to underweight in an EM domestic bond portfolio. Sovereign Credit Unlike the case of local currency bonds, Indonesia's sovereign credit has metamorphosed into a defensive market over the past several years. Investors now consider Indonesian sovereign credit to be among the safest within EM. This is an upshot of low public debt, including very low foreign currency public indebtedness, and years of orthodox fiscal and monetary policies. Chart 12Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods In previous risk-off periods (such as the GFC in 2008 and the taper tantrum in 2013), Indonesian sovereign credit would typically underperform their EM counterparts. Yet, in more recent episodes (such as the EM slowdown in 2015 and the COVID-19 pandemic in 2020), Indonesian sovereign credit massively outperformed the EM benchmark. These recent instances suggest that during the oncoming risk-off period investors should stay overweight Indonesian sovereign credit in an EM basket.  Notably, the regime change in Indonesia’s sovereign credit characteristics has led to its relative performance (versus overall EM) being decoupled from the rupiah (Chart 12). While the rupiah remains a cyclical currency, the significant improvement in sovereign creditworthiness has turned Indonesian credit markets into a defensive play within EM. Therefore, a weakness in the rupiah in the months ahead will not jeopardize its relative performance. Share Prices Chart 13Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling The Indonesian equity market is structurally beset by an uneven playing field, where the country’s banking sector has benefitted at the expense of all others. This is a consequence of banks maintaining high real lending rates as well as very wide net interest rate margins for far too long. The outcome is evident in financial and non-financial sectors’ diverging performance over the past decade (Chart 13). Given that the bull market in bank stocks has been contingent on banks’ net interest margins (NIM), any reduction therein will hurt bank stocks (Chart 14). At the same time, maintaining current lending rates and net interest margins will continue to hurt non-financial sectors (i.e., borrowers). In other words, for non-financial sectors to benefit, it will have to come at the expense of banking sector. Since banks and the rest of the stock market have very similar weights in this bourse, this dynamic will make it hard for this market to rally overall in a sustainable manner. Notably, bank stocks have failed to breach their pre-pandemic highs. This is despite net interest margins being quite elevated. The reason is that high real borrowing costs in a weak economy not only discourage credit off-take, but also threaten to raise NPLs further. Indonesian bank stocks are quite expensive as well: their ‘price/book value’ ratio is 2.6 while that of their EM counterparts is 1.1. As such, they will be hard pressed to have another sustainable rally. The other half of Indonesian equity markets, non-financials, are expectedly doing worse in the face of persistently high borrowing costs. So are the small cap stocks – where non-financial firms make up 85% of the market cap (Chart 13, bottom two panels). Notably, since Indonesia is a commodity producer, Indonesian stock prices usually do well during periods of rising commodity prices. Yet, headwinds emanating from weak domestic demand prevented Indonesia from benefitting much from high commodity prices this past year (Chart 15). Going forward, with the dissipating commodity tailwind, the Indonesian market will likely falter anew. Chart 14Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Chart 15Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Furthermore, a period of overall EM volatility is also a negative for Indonesian stocks’ absolute and relative performances. Investment Conclusions An impending relapse in commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. In view of the likely weakness in the rupiah, dedicated EM local currency bond portfolios should pare back their exposure to Indonesia and tactically downgrade this market from neutral to underweight. Expected softness in domestic demand in the face of high real rates, faltering commodity prices and an impending volatility in EM assets - all entail that investors should stay underweight this bourse in an EM equity portfolio.   Finally, given the new defensive stature of Indonesian sovereign credit, asset allocators should stay overweight Indonesia in dedicated EM US dollar bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes