Deuda Soberana

Highlights Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside. Widespread optimism about the outlook for economic activity and earnings over the coming year has led some investors to ask whether an imminent peak in the rate of growth could be a potentially negative inflection point for richly valued risky asset prices. Using our global leading economic indicator as a guide, we find that a peak in growth momentum in and of itself is not likely to be enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). We can identify several candidates for such a shock, including the emergence of new, vaccine-resistant variants of COVID-19, the impact of higher taxes on earnings, overtightening in China, and a potentially hawkish shift in monetary policy in the developed world. But none of these risks individually appears to be likely enough to warrant reducing cyclical portfolio exposure. We continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We remain overweight global ex-US equities vs. the US, but expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials. Within a fixed-income portfolio, we recommend a modestly short duration stance, but do so primarily on a risk-adjusted basis. Feature Chart I-1Europe Is Behind The US, But On The Same Path Over the past month, developed economies have continued to transition towards a post-pandemic state. While the number of new confirmed COVID-19 cases remains relatively high on a per capita basis in the US and Europe, there continues to be significant progress on the vaccination front in all Western advanced economies. Europe continues to lag the US and the UK in terms of the share of the population that has received at least one dose of vaccine, but Chart I-1 highlights that the gap has remained constant at approximately six weeks (to the US). Panel 2 of Chart I-1 highlights that the US and UK both experienced either falling or a stable number of new cases once the number of first doses reached current European levels; Israel required significant further gains in the breadth of vaccinations before it altered COVID-19’s transmission dynamics in that country, but this appears to have occurred because of a much higher pace of spread earlier this year. The negative impact on advanced economies from reduced services activity is strongly linked to pandemic control measures (such as stay-at-home orders, curfews, forced business closures, etc). We have argued that, outside of the US, the implementation and removal of these measures is being driven by the impact of the pandemic on the medical system, rather than the sheer number of new cases and deaths. Chart I-2 highlights that, based on this framework, Europe still has further to go – current per capita hospitalizations remain much higher in France and Italy than in the US, UK, or Canada. But the nature of the disease means that hospitalizations begin to fall even if case counts remain relatively stable, and fall rapidly once new cases trend lower. Given the steady gains that European countries are making in providing first vaccine doses to their populations, it seems likely that hospitalizations there will peak sometime in the coming four to six weeks. This underscores that Europe is not on a different path than that of the US, it is simply further behind in the process (and will ultimately catch up). The transition towards a post-pandemic state is also reflected in the global macro data, which continues to positively surprise in all three major economies (Chart I-3). In Europe, the April services PMI rose back above the 50 mark, April consumer confidence surprised to the upside, and February retail sales came in better than expected (Table I-1). In the US, the March services PMI was also very strong, the labor market continued to meaningfully improve, and several measures of inflation surprised to the upside. Chart I-2Euro Area Hospitalizations Remain High, But Will Soon Decline Chart I-3The Macro Data Continues To Positively Surprise   Table I-1Services PMIs And The Labor Market Continue To Meaningfully Improve Chart I-4China's Current Contribution To Global Demand Is Strong In China, the recent tick higher in the surprise index likely reflects the recognition of some data series whose release was delayed due to the Chinese New Year, as well as significant base effects (compared with Q1 2020) in many data series recorded in year-over-year terms. On a quarter-over-quarter basis, Chinese economic activity decelerated last quarter to 0.6% from the upwardly revised 3.2% in Q4 2020 – which was below the anticipated 1.4% q/q. Still, Chinese RMB-denominated import growth closely matches (lagging) data on global exports to China (in US$ terms), with the former suggesting that China’s current contribution to global external demand remains strong (Chart I-4). This is also consistent with rising producer prices, which had fallen back into deflationary territory last year (panel 2). Peaking Growth Momentum: Should Investors Be Worried? The continued increase in the number of vaccine doses administered, positive data surprises, and bullish global growth forecasts for this year have understandably led to extremely optimistic investor sentiment. It has also naturally raised the question of “what could go wrong?”, with some investors pointing to an imminent peak in the rate of growth as a potentially negative inflection point for richly valued risky asset prices. Chart I-5 addresses this question by examining 12 episodes of waning growth momentum since 1990, defined as an identifiable peak in our global leading economic indicator. Panel 2 shows the 12-month rate of change in the relative performance of global equities versus a US$-hedged 7-10 year global Treasury index. Chart I-5Is Peaking Growth Momentum A Risk For Stocks? At first blush, the chart does support the notion that a peak in growth momentum is generally negative for risky asset prices. The subsequent 12-month relative return from stocks versus bonds following a peak in the LEI has been negative in 8 out of the 12 episodes, suggesting that the risks of an equity correction are currently quite elevated. However, there is more to the story than this simple calculation implies (Table I-2). First, two of the twelve episodes saw the global LEI peak in the context of an eventual US recession, so it is not surprising that stocks underperformed bonds in those episodes. Second, out of the six non-recessionary episodes, only two of them involved significant underperformance, in 2002 and in 2015. Table I-2Peak Growth Momentum Is An Insufficient Catalyst For Equity Underperformance US equities underperformed in the former case because of the persistently damaging impact of corporate excesses that built up during the dot-com bubble, and predominantly global ex-US equities underperformed bonds in the latter case because of a combination of the significant impact on global CAPEX from the 2014 dollar and oil price shock, as well as a major decline in global bond yields. In the four other non-recessionary examples of equity underperformance, stocks only modestly underperformed bonds, and often this occurred in the context of significant events: surprising Fed hawkishness in 1994, the Asian financial crisis in 1997, a major slowdown in China in 2013, and the combination of a domestically-driven Chinese economic slowdown coupled with the Sino/US trade war in 2017/2018. The key point for investors is that a peak in growth momentum is in and of itself not enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). What Else Could Go Wrong? There are four other plausible risks that we can identify to a bullish stance towards risky assets over the coming 6-12 months. We discuss each of these risks below. New COVID-19 Variants Chart I-6 highlights that bottom up analysts expect global earnings per share to be 12% higher than their pre-pandemic level in 12-months’ time. This expectation is driven by extraordinarily easy fiscal and monetary policy, but also the view that vaccination against COVID-19 will allow social distancing policies to end and services activity to fully recover. However, as India is clearly – and tragically – demonstrating at present, the emerging world is lagging in terms of vaccinating its population. India’s per capita case count has soared (Chart I-7), which is surprising given that the country’s COVID-19 infection rate has been significantly below that of more advanced economies over the past year. It is therefore likely that India’s case count explosion is due to new variants of the disease, and periodic outbreaks in less developed countries – as well as vaccine hesitancy in more developed economies – risks the emergence of even newer variants that may be partially or substantially vaccine-resistant. Chart I-6Earnings Expectations Already Price In A Normalization In Services Activity Chart I-7India's COVID-19 Situation Is Tragic, And Concerning   New variants of COVID-19 may prove to be less deadly, but the economic impact of the pandemic has come mainly from its potential to collapse the medical system via high rates of serious illness requiring hospitalization, not strictly from its lethality. As such, potentially new vaccine-resistant variants of the disease resulting in similar or higher rates of hospitalization pose a risk to a bullish economic outlook. Taxation Both corporate and individual tax rates are set to rise in the US over the coming 12-18 months which, at first blush, could certainly qualify as a non-recessionary event that negatively impacts earnings or raises the ERP. Corporate taxes are set to rise first as part of the American Jobs Plan, which our political strategists have argued will probably take the Biden administration most of this year to pass. The plan involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income”. In addition, as part of the American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group. Peter Berezin, BCA’s Chief Global Strategist, made two points about higher corporate taxes in a recent report.1 First, he noted that the changes would likely result in an 8% decline in forward earnings if passed as currently proposed, but that various tax credits as well as opposition to a 28% corporate tax rate from Democratic Senator Joe Manchin would likely cap the impact at 5%. Second, he argued that the behavior of 12-month forward earnings and the performance of stocks that benefitted the most from President Trump’s corporate tax cuts suggest that very little impact from these changes has been priced in. Peter argued in his report that the effect of strong economic growth will likely offset the negative impact of higher taxes on earnings, and we are inclined to agree. Chart I-8 highlights that a 5% reduction in 12-month forward earnings would reduce the equity risk premium by roughly 20-25 basis points, which would not be disastrous on its own. Still, the fact that these changes have not been priced in means that corporate tax hikes could be a more meaningful driver of lower stock prices if the impact is ultimately larger than we currently expect or if the growth outlook suddenly shifts in a negative direction. In terms of changes to individual taxes, our sense is that the proposed increase in the capital gains tax rate is more significant than the modest proposed change to the top marginal income tax rate for higher-income households. For individuals earning $1 million or more, Chart I-9 highlights that the proposed change to the capital gains rate would bring it to the highest level seen since the late 1970s. Given the rich valuation of equities, it seems inconceivable that such a change would not trigger some short-term selling of equities to lock in long-term gains at lower tax rates. Chart I-8Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Chart I-9Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks...   But like upcoming changes to corporate taxes, we see the potential for higher taxes on wealthy individuals as a risk to the equity market and not as a likely driver of stock prices over a cyclical time horizon. First, our political strategists see 50/50 odds that the American Families Plan will be passed this year, meaning that short-term tax avoidance selling may be postponed until 2022. In addition, Chart I-10 highlights that over the longer term, the relationship between the maximum capital gains tax rate and the ERP is weak or nonexistent. The chart highlights that the perception of a positive relationship rests entirely on the second half of the 1970s, when the maximum capital gains tax rate was between 30-40%. However, it seems clear from the chart that the stagflationary environment of that period was responsible for a high ERP, as the capital gains rate fell from 1977 to 1982 without any significant decline in risk premia. It took until the end of the 1982 recession and the beginning of the structural disinflationary period for the equity risk premium to decline, suggesting that there is effectively no relationship between the two (and therefore no reason to believe that higher capital gains taxes will lead to sustained declines in stock market multiples). Chart I-10…But The Effect Would Not Likely Last Overtightening In China Chart I-11Leading Indicators Of China's Economy Are Pointing Down, Not Up Even though Chart I-4 highlighted that Chinese import demand is currently strong, we expect China’s growth impulse to weaken in the second half of the year. Chart I-11 highlights that our leading indicator for China’s Li Keqiang index has done a good job of predicting Chinese import growth, and the indicator is now in a clear downtrend. Panel 2 presents the components of the indicator, and shows that all three are trending lower. Monetary conditions are potentially rebounding from extremely weak levels (due to past deflation and a rise in the RMB versus the US dollar and other Asian currencies), but money supply and credit measures are deteriorating. Leading indicators for China’s economy are deteriorating because Chinese policymakers have already tightened liquidity conditions in response to the country’s rebound from the pandemic and following a surge in the credit impulse. The 3-month repo rate returned to pre-pandemic levels in the second half of last year (Chart I-12), and consequently the private sector credit impulse (particularly that of corporate bond issuance) fell despite robust medium-to-long term loan growth. Chart I-12Chinese Interest Rates Have Already Returned To Pre-COVID Levels We noted in our January report that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private sector leveraging. Our base case view is that policymakers will not accidentally overtighten the economy, and that the credit impulse will settle somewhere between late 2019 levels and the peak rate reached in the latter half of last year. But the risk of significant oversteering cannot be ruled out, and will likely remain a downcycle risk for investors for several years to come. A Hawkish Shift In Monetary Policy In Developed Markets Last week the Bank of Canada announced that it would taper its pace of government debt purchases from 4 billion to 3 billion CAD per week. The announcement was noteworthy for many investors, as it suggested that asset purchase reductions could also be announced by the Fed and other major central banks by the end of the second or third quarter. Many investors are sensitive to the tapering question because of what transpired during the “Taper Tantrum” episode of 2013. During an appearance before Congress in late May of that year, then Chair Ben Bernanke stated that the Fed could “step down” the pace of its asset purchases in the next few FOMC meetings if economic conditions continued to improve. The result was that 10-year Treasurys fell roughly 10% in total return terms over the subsequent three-month period. While stocks rallied in response to the growth-positive implications of the move, this occurred from a much higher ERP starting point than exists today. The risk, in the minds of some investors, is that tapering today could thus lead to a correction in stock prices. There are two counterpoints to this view. First, bonds have already sold off meaningfully over the past several months in response to a significant improvement in the economic outlook, and investors already expect the Fed to raise interest rates earlier than it is publicly forecasting. It is thus difficult to see how an announcement of tapering from the Fed would significantly alter the outlook for monetary policy over the coming 6-18 months. Chart I-13Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Second, it is notable that the “Taper Tantrum” began at yield levels at the front end of the curve that are roughly similar to what prevails today. 5-year/5-year forward bond yields stood at roughly 3% at the beginning of the “Tantrum”, compared with 2.3% today. Chart I-13 highlights how high forward bond yields would need to rise in order to generate another selloff of similar magnitude from 10-year Treasury yields (roughly 3.65%). In our view, a rise to this level over the coming year is essentially impossible without a major shift in investor expectations about the natural rate of interest. We highlighted the risk of such a shift in last month’s report,2 but for now it would likely necessitate hard evidence of little-to-no permanent damage to the labor market from the pandemic. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions As noted above, there are several identifiable risks to a bullish outlook for risky assets, but none of these risks individually appear to be likely. Given this, we continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We favor value versus growth stocks, cyclical versus defensive sectors, and small versus large cap stocks, although there is more return potential over the coming year in value versus growth than the latter two positions. We also remain short the US dollar over a cyclical time horizon. Within a global equity portfolio, we remain overweight global ex-US equities vs the US, but this position has moved against us over the past two months. Chart I-14 highlights that global ex-US equities have given back all of their October – January gains versus US equities, most of which has occurred since late-February. The chart also highlights that all of this underperformance has been driven by emerging market stocks, as euro area equity performance has been mostly stable year-to-date. Chart I-15 highlights that EM underperformance has occurred both in the broadly-defined tech sector as well as when measured in ex-tech terms. To us, this suggests that EM stocks are responding to the deterioration in leading indicators for the Chinese economy that we noted above, which implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. Chart I-14Emerging Markets Have Caused Global Ex-US Stocks To Underperform Chart I-15EM's Underperformance Has Been Broad-Based   As a final point, investors should note that we are recommending a modestly short duration stance within a fixed-income portfolio, but that we make this recommendation primarily on a risk-adjusted basis. Chart I-16 highlights that Treasury market excess returns (relative to cash) have historically been driven by whether the Fed funds rate increases by more or less than what is currently priced into the market. Over the past 12 months, the Treasury index has very substantially underperformed cash without a hawkish surprise, and the rate path that is currently implied by the OIS curve is already more hawkish than the Fed is (for now) projecting. On this basis, a neutral duration stance could be justified, but we would still prefer a modestly short duration stance due to the risk of a potential increase in investor expectations for the neutral rate of interest late this year or in early 2022. Chart I-16Policy Rate Surprises Tend To Drive The Duration Call Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 29, 2021 Next Report: May 27, 2021   II. In COVID’s Wake: Government Debt And The Path Of Interest Rates The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,3 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP4 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.5 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,3 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.6 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, EM stocks have dragged down global ex-US performance, likely in response to deteriorating leading indicators for the Chinese economy. This implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. The US 10-Year Treasury yield has edged lower over the past month, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a modestly short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, are screaming higher. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are technically extended and sentiment is extremely bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Global Investment Strategy "Taxing Woke Capital," dated April 16, 2021, available at gis.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 5 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 6 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Aspectos destacados Gráfico de la semana ¿Se está transfiriendo a Canadá el manto del oso de los bonos? ¿Se está pasando el manto del oso de los bonos a Canadá? ¿Se está pasando el manto del oso de los bonos a Canadá? Bonos del Tesoro de EE. UU.: La subida sostenida de los rendimientos de los bonos estadounidenses ha dejado a los bonos con vencimientos más largos en una posición de sobreventa. Sin embargo, el impulso subyacente del crecimiento y la inflación sigue siendo bajista para los bonos y es probable que la Fed comience a preparar el mercado más adelante este año para una reducción de las compras de activos en 2022. Mantener una postura defensiva a medio plazo respecto a los bonos del Tesoro de EE. UU. (duración por debajo del índice de referencia y una asignación de país con infraponderación). Canadá: La economía canadiense está ganando un impulso positivo significativo, con un ritmo de vacunación más rápido que aumenta el optimismo a pesar de una tercera ola de COVID-19. Ahora vemos un riesgo creciente de que el Banco de Canadá cambie a una postura de política menos acomodaticia en los próximos meses, liderado por una reducción de sus compras de bonos, quizá incluso antes de que la Fed haga lo mismo (Gráfico de la semana). Rebajar la calificación de los bonos gubernamentales canadienses a infraponderación en las carteras globales de renta fija. Bonos del Tesoro de EE. UU.: La pausa que refresca Gráfico 2 La tendencia alcista del rendimiento del Tesoro de EE. UU. se ha detenido La tendencia alcista del rendimiento del UST se ha pausado La tendencia alcista del rendimiento del UST se ha pausado Tras liderar la caída del mercado global de bonos gubernamentales en los últimos meses, los rendimientos de los bonos del Tesoro de EE. UU. se han calmado últimamente. El rendimiento a 10 años del Tesoro ha caído 14 pb desde el pico más reciente de 1,74% alcanzado el 31 de marzo, mientras que el rendimiento del Tesoro a 30 años ha caído 16 pb desde el pico de 2,45% alcanzado el 18 de marzo. Estos movimientos se han concentrado en el componente de rendimiento real, con las expectativas de inflación estables, ya que los rendimientos TIPS a 10 y 30 años han bajado -15 pb y -20 pb, respectivamente, desde las fechas de esos picos en rendimientos nominales (Gráfico 2). La tendencia a la baja de los rendimientos estadounidenses se ha producido en medio de un explosivo repunte de los datos económicos de EE. UU. Las ventas minoristas subieron +9,8% en marzo respecto a febrero y un asombroso +27,7% en términos interanuales. Las encuestas regionales de manufactura de la Fed mostraron resultados muy robustos para abril, con el índice Empire State de Nueva York alcanzando su nivel más alto desde octubre de 2017 y el índice principal de la Fed de Filadelfia disparándose a un nivel no visto desde 1973. Esto sigue a los muy fuertes datos de nóminas y del ISM de marzo publicados a principios de abril. Sin embargo, los datos económicos de EE. UU. no son unánimemente positivos. Las últimas lecturas de la encuesta de confianza del consumidor de la Universidad de Michigan y de la encuesta de optimismo de pequeñas empresas de la NFIB se mantienen muy por debajo de los picos previos a la pandemia (Gráfico 3). La inflación anual del IPC subyacente apenas aumentó 0,2 puntos porcentuales en marzo hasta el 1,6%, un movimiento débil en comparación con el repunte impulsado por el efecto base que llevó la inflación anual del IPC general del 1,7% en febrero al 2,6%. Gráfico 3 Algunos mensajes mixtos de los datos recientes de EE. UU. Algunos mensajes mixtos de los datos recientes de EE. UU. Algunos mensajes mixtos de los datos recientes de EE. UU. Gráfico 4 Menos sorpresas positivas en los datos de EE. UU. Menos sorpresas positivas en los datos de Estados Unidos Menos sorpresas positivas en los datos de Estados Unidos El flujo general de datos económicos de EE. UU. ha sido decepcionante frente a las expectativas elevadas, como lo evidencia la caída casi ininterrumpida del índice de sorpresas de datos de EE. UU. de Citigroup desde su pico en julio de 2020 (Gráfico 4). Este indicador se correlacionaba de forma fiable con el impulso de los rendimientos del Tesoro antes del brote de COVID-19 y ahora, dado el combo alcista de crecimiento derivado del optimismo por las vacunas y el estímulo fiscal, el mercado de bonos vuelve a centrarse en cómo evolucionan los datos de EE. UU. frente a las expectativas y qué significa eso para las futuras acciones de la Fed en materia de política monetaria. La máxima dirección de la Fed sigue enviando un mensaje coherente sobre la política, sin aumentos de tasas esperados antes de 2024 y sin indicios de cuándo podría comenzar la reducción del estímulo cuantitativo (QE). Sin embargo, algunos funcionarios de la Fed han empezado a mostrarse algo más vocales sobre su nivel de comodidad con la postura de política acomodaticia actual y los riesgos asociados para la estabilidad financiera y la inflación. La semana pasada, el presidente de la Fed de Dallas, Robert Kaplan, señaló que le gustaría ver a la Fed comenzar a retirar su apoyo a la economía "a la primera oportunidad". El presidente de la Fed de St. Louis, James Bullard, fue aún más específico, señalando que una vez que la proporción de estadounidenses vacunados alcance niveles de "inmunidad de rebaño" del 75-80%, será el momento para que la Fed debata la reducción del QE. Por el momento, sin embargo, no hay necesidad de que la Fed actúe de forma preventiva. Nuestro Monitor de la Fed, compuesto por datos económicos, de inflación y de mercados financieros que señalarían presión para que la Fed afloje o endurezca la política, se encuentra en un nivel neutral (Gráfico 5). Nuestro descontador de la Fed a 12 meses, que mide el cambio en las tasas de interés en el próximo año que está implícito en la curva de swaps de tipo interbancario overnight de EE. UU. (OIS), está en 7 pb, coherente con una Fed que mantiene el statu quo. La última lectura de este mes de la Encuesta de Distribuidores Primarios de la Fed de Nueva York (y la Encuesta de Participantes del Mercado) no mostró cambios en la expectativa mediana de largo plazo para la tasa de fondos federales del 2,25% que ha prevalecido durante el último año (panel medio), pese a una fuerte recuperación en las expectativas de crecimiento de EE. UU. Gráfico 5 Las valoraciones de los UST están algo tensas Valoraciones de UST algo estiradas Valoraciones de UST algo estiradas El precio de mercado del próximo movimiento de la Fed sigue siendo relativamente benigno, sin expectativa de subida hasta febrero de 2023. Esto sugiere que la pausa en la tendencia de aumento de los rendimientos del Tesoro fue esencialmente el mercado adelantándose un poco al precio de rendimientos a más largo plazo más altos. Esto puede verse al observar diversas medidas de valoración. Por ejemplo, el rendimiento forward a 5 años/5 años del Tesoro ahora se sitúa en 2,4%, que está en el extremo alto del rango de expectativas de la tasa de fondos federales a más largo plazo de la encuesta a distribuidores primarios. Además, varias medidas de la prima por plazo en los rendimientos del Tesoro a 10 años han vuelto a niveles por encima de cero no vistos desde el ciclo de subidas de la Fed de 2016-2018, incluso sin que la Fed haya señalado la necesidad de endurecer la política en respuesta al aumento de las expectativas de inflación. A pesar de estas señales de valoraciones algo tensas a corto plazo para los UST, todavía no hay indicios de que los grandes inversores globales en bonos estén cómodos aumentando su exposición a los Tesoro de EE. UU. Por ejemplo, pese a que los rendimientos de los Treasuries a 10 años (cobertura en euros y yenes) parecen históricamente atractivos en comparación con los rendimientos casi nulos de los bonos del gobierno japonés y los rendimientos negativos de los bonos alemanes, los datos de flujos de capital del Tesoro estadounidense muestran que los inversores extranjeros siguen siendo vendedores netos de Treasuries (Gráfico 6). Es posible que esos compradores extranjeros necesiten más evidencia de una disminución sostenida en la volatilidad de los bonos estadounidenses antes de mover dinero a los Treasuries, donde las pérdidas por duración derivadas de mayores rendimientos podrían anular la ganancia por rendimiento de entrar en bonos estadounidenses. Aunque las valoraciones están algo estiradas para los Treasuries, los aspectos técnicos parecen muy sobrevendidos. Tanto la desviación del rendimiento del Tesoro a 10 años respecto a su media móvil de 200 días, como la tasa de cambio a 6 meses del índice de retorno total Bloomberg Barclays US Treasury, están en niveles que solo se han visto cuatro veces desde 2010 (Gráfico 7). Las encuestas de posicionamiento de duración a clientes de JP Morgan y el índice de sentimiento de Tesoro de Market Vane también se acercan a extremos bajistas posteriores a 2010. Cabe señalar que ambas medidas alcanzaron extremos aún más bajistas durante la segunda mitad del ciclo de endurecimiento de la Fed de 2026-2018, por lo que existe potencial de que el sentimiento sobre los Tesoro se vuelva aún más bajista una vez que la Fed empiece a endurecer la política monetaria, un escenario que parece cada vez más probable en los próximos 6-12 meses. Gráfico 6 Aún no hay demanda extranjera por UST Sin ofertas extranjeras por los USTs (por ahora) Sin ofertas extranjeras por los USTs (por ahora) Gráfico 7 Los UST están técnicamente sobrevendidos USTs Están Técnicamente Sobrevendidos USTs Están Técnicamente Sobrevendidos Seguimos esperando que una economía estadounidense robusta y una inflación al alza obliguen a la Fed a comenzar a preparar el mercado en la segunda mitad de 2021 para una reducción del QE en 2022, con la primera subida de tasas del próximo ciclo de endurecimiento llegando a finales de 2022. Dado que ese resultado parece en gran medida coherente con el precio actual del mercado, en medio de aspectos técnicos sobrevendidos, es probable que los rendimientos del Tesoro continúen moviéndose lateralmente al menos durante las próximas semanas. Sin embargo, hay poco que sugiera que los rendimientos han alcanzado techo y estén a punto de entrar en una nueva tendencia bajista, dado el ritmo acelerado de vacunación en EE. UU. que aumenta el optimismo sobre un eventual fin de la etapa estadounidense de la pandemia. Manténgase defensivo respecto a la exposición a los Tesoro de EE. UU., ya que el aumento cíclico de los rendimientos aún no ha terminado. Conclusión: La subida sostenida de los rendimientos de los bonos estadounidenses ha dejado a los bonos con vencimientos más largos en una posición de sobreventa. Sin embargo, el impulso subyacente del crecimiento y la inflación sigue siendo bajista para los bonos y es probable que la Fed comience a preparar el mercado más adelante este año para la reducción de las compras de activos en 2022. Mantener una postura defensiva a medio plazo respecto a los bonos del Tesoro de EE. UU. (duración por debajo del índice de referencia y una asignación de país con infraponderación). Canadá: Rebajar a infraponderación En un Informe Especial publicado en febrero junto con nuestros colegas de BCA Foreign Exchange Strategy, expusimos el caso para colocar la deuda gubernamental canadiense en "observación de rebaja" en las carteras globales de renta fija.1 Esperábamos que los rendimientos de los bonos canadienses continuaran subiendo junto con el aumento de los rendimientos globales y, por tanto, mantuvimos nuestra recomendación de exposición de duración por debajo del índice de referencia dentro de Canadá. Gráfico 8 Canadá: Un mercado de bonos de alta beta una vez más Canadá: un mercado de bonos de alta beta una vez más Canadá: un mercado de bonos de alta beta una vez más Sin embargo, concluimos que era demasiado pronto para cambiar a una postura de infraponderación total sobre los bonos gubernamentales canadienses con los casos de COVID-19 aún azotando el país, el programa de vacunación comenzando muy lentamente y el programa de QE del Banco de Canadá (BoC) impidiendo que los bonos canadienses volvieran a su estado habitual de "alta beta" dentro de los mercados de bonos de economías desarrolladas. Ahora parece que fuimos demasiado cautelosos en ese aspecto. Los bonos gubernamentales canadienses han sido uno de los mercados con peor desempeño en lo que va del año dentro del índice Bloomberg Barclays Global Government, registrando un retorno en moneda local de -4,1% - peor que el retorno de -3,5% obtenido por los bonos del Tesoro de EE. UU. hasta ahora en 2021.2 Está claro que los bonos gubernamentales canadienses vuelven a ser un mercado más sensible a los movimientos de las tasas de interés globales (Gráfico 8). En ese Informe Especial de febrero, expusimos tres factores que podrían empujar al BoC a pasar a una postura de política menos dovish, y más bajista para los bonos, más rápido de lo que esperábamos. Gran parte de esa lista ya ha comenzado a materializarse. 1) Buenas noticias sobre el despliegue de la vacuna Lamentablemente, Canadá está sufriendo una tercera ola de casos de COVID-19 que ha llevado a la provincia más poblada de la nación, Ontario, a implementar el confinamiento más severo visto hasta ahora durante la pandemia. Sin embargo, el ritmo de vacunación también ha aumentado, con la proporción de canadienses que han recibido al menos una dosis siendo ahora del 21% (Gráfico 9), superior al del conjunto de la Unión Europea (UE). Canadá está administrando ahora más vacunas diarias que tanto el Reino Unido como la UE. El ritmo acelerado de las vacunaciones ya está proporcionando un gran impulso a la confianza económica canadiense. El índice de confianza del consumidor Bloomberg Nanos está en un máximo histórico (Gráfico 10), mientras que la Encuesta de Perspectivas Empresariales del BoC para la primavera de 2021 fue increíblemente sólida. Dos tercios de las empresas de esa encuesta esperan que las ventas superen los niveles previos a la pandemia, incluso con el reciente repunte de casos de COVID-19. Gráfico 9 Mejora en el despliegue de vacunas en Canadá Algunas historias bajistas sobre bonos de ambos lados del paralelo 49 Algunas historias bajistas sobre bonos de ambos lados del paralelo 49 Gráfico 10 Optimismo en auge Optimismo en auge Optimismo en auge La Encuesta de Consumidores del BoC del primer trimestre de 2021 mostró niveles similares de optimismo. El 74% de los canadienses encuestados de entre 25 y 54 años planean participar en niveles de actividad social y económica iguales o superiores a los previos a la pandemia una vez que la mayoría esté vacunada (Gráfico 11). Una mayoría neta (18%) de los encuestados planea gastar más en los tipos de servicios "de alto contacto" no disponibles durante la pandemia, como viajes, cine y comer en restaurantes, una vez que la mayoría esté vacunada (Gráfico 12). Gráfico 11 Los canadienses están listos para divertirse de nuevo Algunas historias bajistas sobre bonos desde ambos lados del paralelo 49 Algunas historias bajistas sobre bonos desde ambos lados del paralelo 49 Todos los datos de encuestas canadienses envían un mensaje claro: un despliegue de vacunación más rápido conducirá a un gasto mucho más rápido por parte de consumidores y empresas. 2) Señales de riesgos para la estabilidad financiera El amor de los canadienses, altamente endeudados, por los bienes raíces siempre ha preocupado al BoC. Aunque una combinación de recorte de las tasas de política a cero y el aumento del QE ayudó a estabilizar los mercados financieros canadienses durante el shock pandémico de 2020, también ha desencadenado un nuevo auge de la especulación inmobiliaria. Según la encuesta de consumidores Bloomberg Nanos, el 67% de los canadienses ahora espera que los precios de la vivienda se revaloricen. La demanda de viviendas ha dado un impulso a la economía canadiense a través de un aumento en los inicios de viviendas nuevas (la inversión residencial representa el 8% del PIB real canadiense), mientras empuja la inflación nacional de los precios de la vivienda nuevamente por encima del 10% (Gráfico 13). Gráfico 12 Un aumento del gasto "de alto contacto" espera a la inmunidad de rebaño canadiense Algunas historias bajistas sobre bonos desde ambos lados del paralelo 49 Algunas historias bajistas sobre bonos desde ambos lados del paralelo 49 A medida que los hogares canadienses ya endeudados contraen más deuda para participar en otra fiesta nacional de compra de viviendas, el BoC debe ahora preocuparse por los riesgos de estabilidad financiera derivados de un aumento demasiado rápido del valor de la vivienda. Gráfico 13 Otro auge inmobiliario canadiense Otro auge inmobiliario canadiense Otro auge inmobiliario canadiense En un discurso reciente, la subgobernadora del BoC, Toni Gravelle, señaló que el BoC tuvo que introducir QE en 2020 para ayudar a combatir la disfunción relacionada con el COVID en una variedad de mercados financieros canadienses, incluidos los bonos gubernamentales donde la liquidez se secó.3 Gravelle también señaló que el BoC comenzaría a reducir el QE una vez que quedara claro que los mercados financieros ya no necesitaban el apoyo del QE. Con las acciones canadienses en auge y los diferenciales de los bonos corporativos canadienses cerca de los niveles más bajos de la última década (Gráfico 14), parece evidente que el BoC puede comenzar a reducir su programa de compra de bonos gubernamentales si ya no es necesario y probablemente esté alimentando otra burbuja inmobiliaria. 3) Estímulo fiscal adicional de gran envergadura El gobierno liberal gobernante de Canadá del primer ministro Justin Trudeau entregó una gran cantidad de estímulo fiscal a la economía canadiense afectada por la pandemia en 2020. En el presupuesto federal 2021/22 anunciado ayer, se introdujo otro gran paquete de gasto, equivalente a 101.000 millones de dólares canadienses o 4,2% del PIB canadiense durante los próximos tres años. El gasto fue descrito como otro paquete de ayuda por COVID, pero incluyó muchos programas a largo plazo como cuidado infantil nacional, aumento del salario mínimo e incremento de las inversiones verdes. Según las proyecciones del último World Fiscal Monitor del FMI, el "empujón fiscal" para Canadá –el cambio en el saldo primario cíclicamente ajustado como proporción del PIB– se proyectó que pasara de un estímulo de +9% en 2020 a un lastre de -2% en 2021 (Gráfico 15). El gasto anunciado en el último presupuesto eliminará efectivamente ese lastre durante los próximos tres años. Esto proporcionará un gran impulso a una economía que ya probablemente verá un fuerte crecimiento pospandemia. Gráfico 14 El QE del BoC ya no es necesario La QE del BoC ya no es necesaria La QE del BoC ya no es necesaria Gráfico 15 Ahora no se espera arrastre fiscal en 2021 Algunas historias bajistas sobre bonos de ambos lados del Paralelo 49 Algunas historias bajistas sobre bonos de ambos lados del Paralelo 49 Gráfico 16 Los rendimientos reales canadienses son demasiado bajos Los rendimientos reales canadienses son demasiado bajos Los rendimientos reales canadienses son demasiado bajos Dada la combinación de aumento de las vacunaciones, el repunte de la confianza, un renovado auge inmobiliario y mercados financieros en alza, será difícil para el BoC mantener su configuración de política actual por mucho más tiempo. Este es un banco central que accedió a hacer QE con reticencia el año pasado y numerosos funcionarios del BoC han declarado –incluso en los peores días de la pandemia global– que comenzarían a retirar la acomodación una vez que ya no fuera necesaria. Los mercados de tasas de interés ya han pasado a descontar un ciclo de endurecimiento completo del BoC. La curva OIS canadiense ahora descuenta el "despegue" (una subida completa de 25 pb) en octubre de 2022, con 163 pb de subidas de tasas descontadas hasta finales de 2024 (Gráfico 16). La trayectoria proyectada de las tasas está por debajo de las previsiones de inflación del BoC hasta 2023. Por tanto, se espera que la tasa de política real implícita canadiense permanezca negativa durante los próximos dos años, aunque el BoC estima que el rango de la tasa de política neutral es del 1,75% al 2,75%, es decir, -0,25% a +0,75% en términos reales después de restar el punto medio de la banda objetivo de inflación del BoC del 1-3%. En otras palabras, los mercados de tasas de interés canadienses son vulnerables a cualquier cambio del BoC en una dirección menos dovish, como parece cada vez más probable en algún momento de los próximos meses. Nuestro Monitor del BoC se está alejando rápidamente de la zona de "se requiere política más acomodaticia" (Gráfico 17), y la rápida mejora en la situación del empleo canadiense sugiere que el BoC estará bajo más presión para comenzar a señalar un camino hacia la retirada del apoyo de la política. Esto comenzará con un anuncio de reducción de las compras de QE, quizás incluso antes de cualquier señal de la Fed de que hará lo mismo (Gráfico 18). Esto justifica una postura más cautelosa sobre la exposición a la renta fija canadiense. Gráfico 17 Rebajar los bonos gubernamentales canadienses a infraponderación Rebajar a infraponderados los bonos del Gobierno de Canadá Rebajar a infraponderados los bonos del Gobierno de Canadá Gráfico 18 ¿Podría el BoC comenzar a reducir antes que la Fed? ¿Podría el BoC comenzar a reducir sus compras de activos antes que la Fed? ¿Podría el BoC comenzar a reducir sus compras de activos antes que la Fed? Aunque un anuncio de reducción del BoC antes que la Fed probablemente presionaría al alza al dólar canadiense frente al dólar estadounidense, sería algo con lo que el BoC podría convivir si la economía estuviera ganando fuerza rápidamente, especialmente porque nuestros estrategas de divisas creen que el "loonie" está infravalorado. Por tanto, estamos rebajando formalmente nuestra asignación estratégica recomendada a los bonos gubernamentales canadienses a infraponderación (2 de 5, ver la tabla en la página 16). También mantenemos nuestra recomendación de exposición de duración por debajo del índice de referencia dentro de las carteras dedicadas a bonos canadienses. También estamos reduciendo la asignación a Canadá a infraponderación en nuestra cartera modelo de bonos y colocando los ingresos tanto en EE. UU. como en la Europa central (ver páginas 14-15). Conclusión: La economía canadiense está ganando un impulso positivo significativo, con un ritmo de vacunación más rápido que aumenta el optimismo a pesar de una tercera ola de COVID-19. Ahora vemos un riesgo creciente de que el Banco de Canadá cambie a una postura de política menos dovish en los próximos meses, liderado por una reducción de sus compras de bonos. Rebajar los bonos gubernamentales canadienses a infraponderación en las carteras globales de renta fija.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Notas al pie 1 Consulte el Informe Especial de BCA Research Foreign Exchange Strategy/Global Fixed Income Strategy, "¿La recuperación canadiense liderará o se rezagará respecto al ciclo global?", fechado el 12 de febrero de 2021, disponible en fes.bcaresearch.com y gfis.bcaresearch.com. 2 Ese rendimiento canadiense es prácticamente el mismo después de cubrirse a dólares estadounidenses, por lo que ese rendimiento en moneda local se puede comparar con el rendimiento del mercado de Tesoro denominado en dólares estadounidenses. 3https://www.bankofcanada.ca/2021/03/market-stress-relief-role-bank-canadas-balance-sheet Recomendaciones La cartera recomendada por GFIS frente al índice de referencia personalizado Algunos relatos bajistas sobre bonos de ambos lados del paralelo 49 Algunos relatos bajistas sobre bonos de ambos lados del paralelo 49 Duración Asignación regional Productos de spread Operaciones tácticas Rendimientos & retornos Rendimientos de bonos globales Rentabilidades históricas

Highlights Global Inflation: The case for maintaining a strategic overall allocation to inflation-linked bonds (ILBs) versus nominal government debt in dedicated global fixed income portfolios remains intact. Global growth expectations are accelerating as vaccinations increase, spare capacity is increasingly being absorbed across the developed world and central banks (led by the Federal Reserve) continue to show no inclination to tighten policy anytime soon. Inflation-Linked Bond Allocations: ILB valuations, however, are no longer uniformly cheap across all countries. Real yields are now moving in a less coordinated fashion as markets try to sort out the timing and pace of eventual future central bank tightening. We recommend shifting inflation-linked bond exposure from Canada to Germany, as both markets have similar valuations but the Bank of Canada is likely to turn less dovish well ahead of the ECB. Feature Chart of the WeekMarkets Remain Unconcerned About An Inflation Overshoot The global reflation trade over the past year has been highly rewarding to investors. Equity and credit markets worldwide have delivered outstanding returns on the back of highly stimulative monetary and fiscal policies implemented to deal with the negative economic effects of COVID-19. The global INflation trade has also paid off for investors in inflation-linked bonds (ILBs), which have outperformed nominal government debt across the developed economies dating back to last spring. The rising trend for global inflation breakevens remains intact, but is approaching some potential resistance points. A GDP-weighted average of 10-year breakeven inflation rates among the major developed economies is just shy of the 2% level that has represented a firm ceiling over the past decade (Chart of the Week). At the same time, the Bloomberg consensus forecast for headline CPI inflation for that same group of countries calls for an increase to only 1.8% by year-end before slowing to 1.7% in 2022. The latest forecasts from the IMF are similar, calling for headline inflation in the advanced economies to reach 1.6% in 2021 and 1.7% in 2022. If those modest forecasts for realized inflation come to fruition, then there is likely not much more upside in inflation breakevens, in aggregate. Country selection within the ILB universe will become more important over the next 6-12 months, as divergences in growth, realized inflation and central bank reactions will lead to a more heterogeneous path for global inflation breakevens. Underlying Inflation Backdrop Still Supports Rising Breakevens On a total return basis, ILBs enjoyed an extended run of success prior to this year. The cumulative total return of the asset class (in local currency terms) between 2012 and 2020 was a whopping 61% in the UK, 25% in Canada, 22% in the US and 21% in the euro area (aggregating the individual countries in the region with inflation-linked bonds). However, the absolute performance of ILBs has been more disperse on a country-by-country basis so far in 2021. ILBs are down year-to-date in Canada (-6.2%), the UK (-5.0%) and the US (-1.4%). On the other hand, euro area ILBs have delivered a positive total return of +0.5% so far in 2021. Real bond yields have climbed off the lows in the US, UK and, most notably, Canada where the overall index yield on the Bloomberg Barclays inflation-linked bond index is now in positive territory for the first time since before the pandemic started (Chart 2). At the same time, real bond yields have been drifting lower in the euro area. These real yield moves are related to shifting perceptions of central bank responses to the global growth upturn. For example, pricing in overnight index swap (OIS) curves have pulled forward the timing and pace of future interest rate increases in the US and Canada – i.e. real policy rates will become less negative - while there has been comparatively little change in euro zone rate expectations. While the absolute returns for ILBs have become less correlated, the relative trade between nominal and inflation-linked government bonds in all countries remains intact. 10-year breakeven inflation rates have been steadily climbing in the US and UK, while depressed Japanese breakevens have crept modestly higher (Chart 3). Even Europe, where inflation has remained subdued for years, has seen a significant shift higher in inflation breakevens. (Chart 4). The turn in breakevens has occurred alongside a major change in investor perceptions of future inflation, with surveys like the ZEW showing an overwhelming majority of financial professionals expecting higher inflation in the US, Europe and the UK. Chart 2A Fading Bull Market In Inflation-Linked Bonds Chart 3A Solid Recovery In Inflation Expectations Chart 4European Inflation Expectations Starting To Normalize Inflation forecasts have shifted in response to faster global growth expectations on the back of vaccine optimism and aggressive US fiscal stimulus. Yet inflation forecasts remain modest compared to the huge growth figures expected for 2021 and 2022. In its latest World Economic Outlook published last week, the IMF upgraded its global real GDP forecast to 6.0% for 2021 and 4.4% for 2022. This represented an increase of 0.5 and 0.4 percentage points, respectively, from the last set of forecasts published back in January. While growth upgrades occurred across all major developed and emerging economies, the biggest upgrades came in the US and Canada, for both 2021 and 2022. As a result, the IMF projects the output gap in both countries to turn positive over 2022 and 2023, and be nearly closed in core Europe, Australia and Japan (Chart 5). The IMF is not projecting a major inflation surge on the back of those upbeat growth forecasts, though. While headline inflation in the US is expected to climb to 2.3% in 2021 and 2.4% in 2022, the same measure in Canada is only projected to rise to 1.7% and 2.0% over the same two years. European inflation is expected to remain subdued, reaching only 1.4% this year and drifting back to 1.2% in 2022 despite real GDP growth averaging 4.1% over the two-year period. The IMF attributes the benign inflation outcomes, even in the face of booming growth rates and the rapid elimination of output gaps, to the structural disinflationary backdrop for so-called “non-cyclical” inflation (Chart 6). The IMF defines this as the components of inflation indices that are less sensitive to changes in aggregate demand. The IMF estimates show that the contribution from non-cyclical components to overall inflation in the advanced economies had fallen to essentially zero at the end of 2020. Chart 5A Big Expected Narrowing Of Output Gaps Chart 6Non-Cyclical Components Still Weighing On Global Inflation There is considerable upside risk for the more cyclical components of inflation that could result in inflation overshooting the IMF projections (Chart 7). Chart 7Cyclical Backdrop Is Inflationary For example, in the US, the Prices Paid component of the ISM Manufacturing index remains elevated at post-2008 highs, while the year-over-year change in the Producer Price Index soared to 6% in March. Across the Atlantic, the European Commission business and consumer surveys have shown a big surge in the net balance of respondents expecting higher inflation in manufacturing and retail trade. Previous weakness in the US dollar and surging commodity prices are playing a major role in this rapid pick-up in price pressures seen in many countries. Given the current backdrop of strong global growth expectations, with actual activity accelerating as vaccinations increase and more parts of the global economy reopen, inflation pressures are unlikely to fade in the near term. With realized inflation rates set to spike due to base effect comparisons to the pandemic-fueled collapse one year ago, the upward pressure on global ILB inflation breakevens will persist in the coming months – especially with breakevens still below levels that would prompt central banks to turn less dovish sooner than expected. Bottom Line: The case for maintaining a strategic overall allocation to inflation-linked bonds (ILBs) versus nominal government debt in dedicated global fixed income portfolios remains intact. Global growth expectations are accelerating as vaccinations increase, spare capacity is increasingly being absorbed across the developed world and central banks (led by the Federal Reserve) continue to show no inclination to tighten policy anytime soon. Assessing Value In Developed Market Inflation-Linked Bonds Chart 8USD Outlook Now More Mixed Although the current backdrop remains conducive to a continuation of the rising trend in global ILB breakevens, there are factors that could begin to slow the upward momentum. The future path of the US dollar is now a bit less certain (Chart 8). While the DXY index is still down 7.4% compared to a year ago, it is up 2.4% so far in 2021. Shorter-term real interest rate differentials between the US and the other major developed markets remain dollar-bearish. At the same time, longer-term real yield differentials have risen in favor of the US (middle panel). Furthermore, US growth is outperforming other developed economies, typically a dollar-bullish factor (bottom panel). Given the usual negative correlation between the US dollar and commodity prices, a loss of downside dollar momentum could also slow the pace of commodity price appreciation. This represents a risk to additional global ILB outperformance versus government bonds. Our GDP-weighted aggregate of 10-year ILB breakevens for the major developed economies is currently just under 2% - levels more consistent with oil prices over $80/bbl than the current price closer to $60/bbl (Chart 9). Chart 9Breakevens Consistent With Much Higher Oil Prices Given some of these uncertainties over the strength of any future inflationary push from a weaker US dollar and rising commodity prices, a broad overweight allocation to ILBs across the entire developed market universe may no longer generate the same strong returns versus nominal government bonds seen over the past year. With the “easy money” already having been made in the global breakeven widening trade, country allocation within the ILB universe has now become a more important dimension for bond investors to consider. To assess the relative attractiveness of individual ILB markets, we turn to a few valuation tools. Our regression-based valuation models for 10-year ILB breakevens in the US, UK, France, Italy, Germany, Japan, Canada and Australia are all presented in the Appendix on pages 14-17. The two inputs into the model are the annual rate of change of the Brent oil price in local currency terms (as a measure of shorter-term inflation pressure) and a five-year moving average of realized headline CPI inflation (as a longer-term trend that provides a structural “anchor” for breakevens based off actual inflation outcomes). We first presented these models in April 2020, but we have now made a change in response to some of the unprecedented developments witnessed over the past year.1 Despite the strong visual correlation between the level of oil prices and inflation breakevens in most countries, we chose to use the annual growth of oil prices, rather than the level, in our breakeven models. This is because we found it more logical to compare a rate of change concept like inflation (and breakevens) to the rate of change of oil. However, the oil input into our breakeven models could produce nonsensical results during periods of extreme oil volatility that did not generate equivalent swings in breakeven inflation rates. A good example of that occurred in 2016, when the annual rate of change of the Brent oil price briefly surged toward 100%, yet 10-year US TIPS breakevens did not rise above 2% (Chart 10). An even bigger swing in oil prices has occurred over the past year, with oil prices up over +200% compared to the collapse in prices that occurred one year ago. Putting such an extreme move into our US model would have pushed the “fair value” level of the 10-year TIPS breakeven to 4% - an implausible outcome given that the 10-year breakeven has never risen to even as high as 3% in the entire 24-year history of the TIPS market. Chart 10Pass-Through Of Extreme Oil Moves Has Limits To deal with this problem, we have truncated the rate of change of oil prices in all our breakeven models at levels consistent with past peaks of breakevens. Going back to the US example, we have “capped” the rate of change of the Brent oil price at +40%, as past periods when oil price momentum was greater than 40% did not translate into any additional increase in TIPS breakevens. We then re-estimated the model using this truncated oil price series to generate fair value breakeven levels. Chart 11A Mixed Impact Of USD Moves On Non-US Breakevens We did this for all eight of our individual country breakeven models and in all cases, truncating extreme oil moves improved the accuracy of the model. Interestingly, we did not truncate the downside momentum of oil prices, as there was no obvious “cut-off” point where periods of collapsing oil prices did not generate equivalent declines in breakevens. Oil prices remain the most critical short-term variable to determine ILB breakeven valuation. While it is intuitive to think that currency movements should also have a meaningful impact on inflation (both realized and expected), the effect is not consistent across countries. For example, euro area breakevens appear to be positively correlated to the euro, while Japanese breakevens rarely rise without yen weakness (Chart 11). One other factor to consider when evaluating the value of breakevens is the possible existence of an inflation risk premium component during periods of higher uncertainty over future inflation. Such uncertainty could result in increased demand for ILBs from investors driving up the price of ILBs (thus lowering the real yield) relative to nominal yielding bonds, leading to wider breakevens that do not necessarily reflect a true rise in expected inflation. A simple way to measure such an inflation risk premium is to compare market-based breakevens to survey-based measures of inflation forecasts taken from sources like the Philadelphia Fed's Survey of Professional Forecasters and the Bank of Canada’s Survey Of Consumer Expectations. The assumption here is that the survey-based measures represent a more accurate (or, at least, less biased) depiction of underlying inflation expectations in an economy. We present these simple measures of inflation risk premia, comparing 10-year breakevens to survey-based measures of inflation expectations, in Chart 12 and Chart 13. Breakevens had been trading well below survey-based measures of inflation expectations after the negative pandemic growth shock in 2020 in all countries shown. After the steady climb in global breakevens seen over the past year, those gaps have largely disappeared, with breakevens now trading slightly above survey based inflation expectations in the US, UK and Australia. Chart 12No Major Inflation Risk Premia In These Markets Chart 13Canadian & Australian Breakevens In Line With Inflation Surveys Chart 14Assessing The Value Of Breakevens In Chart 14, we show the valuation residuals from our 10-year ILB breakeven models, along with two other measures of potential breakeven valuation: a) the distance between current breakeven levels and their most recent pre-pandemic peaks; and b) the difference between breakevens and the survey-based measures of inflation expectations. The model results show that breakevens are furthest below fair value in France, Japan and Germany, and the most above fair value in the UK and Australia. The message of undervaluation from our models is confirmed in the other two metrics for France, Japan, Germany, Canada and Italy. The overvaluation message for Australia is consistent across all three valuation metrics, while the signals are mixed for US and UK breakevens. In Japan, while the combined signals of all three valuation metrics indicate that breakevens are far too low, the very robust positive correlation between Japanese breakevens and the USD/JPY exchange rate implies that a bet on wider breakevens requires a much weaker yen. In Canada, while the 10-year breakeven does appear cheap, the real yield has also climbed faster than any of the other countries over the past several months as markets have rapidly repriced a more hawkish path for the Bank of Canada. Recent comments from Bank of Canada officials have leaned a bit hawkish, hinting at a possible taper of its bond-buying program, as the central bank appears unhappy with the renewed boom in Canadian housing values. An early tightening of monetary conditions would likely cap any additional upside in Canadian inflation breakevens. In Europe, the undervaluation of breakevens is more compelling. The ECB is likely to maintain its dovish policy settings into at least 2023, even if growth recovers later this year as increased vaccinations lead to the end of lockdowns. As shown earlier, European breakevens can continue to rise even if the euro is also appreciating versus the US dollar, especially if growth is recovering and oil prices are rising. Euro area breakevens are likely to continue drifting higher over at least the rest of 2021. Currently in our model bond portfolio, we have allocations to ILBs out of nominal government bonds in the US, France, Canada and Italy, with no allocations in Germany, Japan, Australia or the UK. After assessing our valuation measures, we are comfortable with the ILB exposure in France and Italy and lack of positions in the UK and Australia. We still see the upside case for US breakevens, with the economy reopening rapidly fueled further by fiscal policy, and the Fed likely to maintain its current highly dovish forward guidance until much later in 2021. We are reluctant to add exposure to Japanese ILBs, despite attractive valuations, as we are not convinced that USD/JPY has enough upside potential to help realize that undervaluation of Japanese breakevens. Thus, as a new change to our model portfolio this week that reflects our assessment of ILB breakeven valuations and risks, we are closing out the exposure to Canadian ILBs and adding a new position in German ILBs of equivalent size (see the model bond portfolio tables on pages 18-19). Bottom Line: ILB valuations are no longer uniformly cheap across all countries. Real yields are now moving in a less coordinated fashion as markets try to sort out the timing and pace of eventual future central bank tightening. We recommend shifting inflation-linked bond exposure from Canada to Germany, as both markets have similar valuations but the Bank of Canada is likely to turn less dovish well ahead of the ECB.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. Appendix Chart A1Our US 10-Year Inflation Breakeven Model Chart A2Our UK 10-Year Inflation Breakeven Model Chart A3Our France 10-Year Inflation Breakeven Model Chart A4Our Italy 10-Year Inflation Breakeven Model Chart A5Our Japan 10-Year Inflation Breakeven Model Chart A6Our Germany 10-Year Inflation Breakeven Model Chart A7Our Canada 10-Year Inflation Breakeven Model Chart A8Our Australia 10-Year Inflation Breakeven Model Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Q1/2021 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark index by +55bps during the first quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +68bps, led overwhelmingly by our underweight to US Treasuries (+63bps). Spread product allocations underperformed by -11bps, primarily due to an overweight on UK corporates (-8bps). Portfolio Positioning For The Next Six Months: We are sticking with an overall below-benchmark portfolio duration stance, given accelerating global growth momentum, expanding vaccinations and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield given more stretched valuations in other credit sectors. On the margin, we are making the following changes to the portfolio allocations: downgrading both UK Gilts and UK investment grade corporates to neutral, while cutting the overall allocation to EM USD credit to neutral. Feature The first quarter of 2021 saw a sharp sell-off in global bond markets on the back of rising growth expectations, fueled by US fiscal stimulus and vaccine optimism. The US was near the front of the pack, with 10-year Treasuries having their biggest first quarter sell-off since 1994. Accommodative financial conditions, fueled by a highly stimulative mix of monetary and fiscal policies and improving sentiment, have lit a fire under a global economy set to reopen from pandemic lockdowns. Going forward, we expect US growth to continue leading the way, with implications for the dollar, commodity prices, and the expected path of policy rates. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the first quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2021 Model Portfolio Performance Breakdown: Steering Clear Of Duration Chart 1Q1/2021 Performance: Bearish UST Bets Pay Off The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -1.83%, dramatically outperforming the custom benchmark index by +55bps (Chart 1).1 This follows modest outperformance in 2020 which was driven largely by overweights on spread product initiated after the pandemic shock to markets. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +68bps of outperformance versus our custom benchmark index while the latter underperformed by -11bps. Our allocations to inflation-linked bonds in the US, Canada and Europe - which were a source of outperformance in 2020 - modestly underperformed this quarter (-2bps) as global real yields finally began to pick up. Our outperformance this quarter was driven overwhelmingly by our decision to go significantly underweight US Treasuries, and to position for a bearish steepening of the Treasury curve, ahead of last November’s US presidential election (Table 2). That resulted in the US Treasury allocation generating a massive +63bps of excess return in Q1/2022 as longer-term US yields surged higher. Table 2GFIS Model Bond Portfolio Q1/2021 Overall Return Attribution The size of the US underweight was unusually large as we maintained only a neutral exposure to the other “high beta” markets that are typically positively correlated to US yield moves, Canada and Australia. Although the returns for those two government bond markets were very similar to that of US Treasuries in Q1, so the choice to stay neutral even with a bearish directional view on US yields did not impact the overall portfolio performance. Overweights to the more defensive “low beta” markets of Germany, France and Japan contributed a combined +4bps. We did see some losses on nominal government bonds in peripheral Europe (Italy: -0.6bps; Spain: -1.9bps), however, with the narrowing in spreads thrown off by a botched vaccine rollout. In spread product, underperformance came from overweights to UK investment grade corporates (-8bps), US CMBS (-4bps), and EM USD-denominated corporates (-2bps). This was despite the fact that spreads for UK corporates remained flat while US CMBS spreads actually narrowed. These losses were slightly offset by the overweight to lower-rated US high-yield (+3bps) and underweight to US agency MBS (+2bps). Our spread product losses, in total return terms, highlight the importance of considering duration risk when making a call on spread product, especially at a time when sovereign yields are rising and spreads offer little “cushion”. Duration also played a big part in nominal government bond outperformance, with a whopping +43bps of our total +55bps outperformance concentrated in just US Treasuries with a maturity greater than 10 years. In other words, overweighting overall global spread product and underweighting government bonds still generated major portfolio outperformance, even if there was a more mixed bag of returns within that credit overweight. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2021 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2021 Spread Product Performance Attribution By Sector Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+43bps), maturity between 7 and 10 years (+11bps), and with a maturity between 5 and 7 years (+7bps) Overweight US high-yield (+3bps) Underweight US agency MBS (+2bps) Overweight Italian inflation-indexed BTPs (+2bps) Biggest Underperformers: Overweight UK investment grade corporates (-8bps) Overweight US agency CMBS (-4bps) Overweight Spanish government bonds (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2021 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. On that front, our portfolio allocations performed exceptionally well in Q1. In total return terms, the global bond market sell-off was a disaster for both government bonds and spread product. US high-yield, one of our longer-standing overweights, was the only sector to emerge unscathed, delivering a positive return of +42bps. Within our government bond allocation, the “defensive” markets—Japan (-44bps), Germany, (-261bps) and France (-371bps)—were nevertheless shaken by rising yields. On the other hand, we limited our downside by maintaining a neutral stance on the higher beta markets such as Canada (-406bps), New Zealand (-415bps), and the UK (-1389bps). Gilts sold off especially sharply as the UK outperformed global peers on COVID-19 vaccinations while inflation expectations continued to pick up. Our two underweights, US Treasuries (-426bps) and European high-yield (-426bps), were prescient. The latter market was one we chose to underweight given that spreads didn’t offer nearly enough compensation on a default-adjusted and breakeven basis. Bottom Line: Our model bond portfolio outperformed its benchmark index in the first quarter of the year by +55bps – a positive result driven by our underweight allocation to the US Treasury market and overall below-benchmark global duration stance. Future Drivers Of Portfolio Returns & Scenario Analysis Chart 5More Growth-Driven Upside For Global Yields Ahead Looking ahead, the performance of the model bond portfolio will continue to be driven predominantly by the future moves of global government bond yields, most notably US Treasuries. Our most favored leading indicators for global bond yields continue to signal more upside over at least the next six months (Chart 5). Our Global Duration Indicator, comprised of measures of future economic sentiment and momentum, remains at an elevated level. The ongoing climb in the global manufacturing PMI, which typically leads global real bond yields by around six months, suggests that the recent uptick in real yields can continue into the second half of 2021. We are still maintaining a bias towards bearish yield curve steepening across all the countries in the model bond portfolio. It is still far too soon to see bearish flattening of yield curves given the dovish bias of global central banks, many of which are actively targeting an overshoot of their own inflation targets. The US will be the first central bank to see any bearish flattening pressure, as the market more aggressively pulls forward the liftoff date of the next Fed tightening cycle in response to strong US growth, but that is an outcome we do not expect until well into the second half of 2021. With regards to country allocations within the government bond segment of the model bond portfolio, we continue to focus our maximum underweight on the US, while limiting exposure to the markets that are more sensitive to changes in US interest rates (Chart 6). Those “lower yield beta” markets (Germany, France and Japan) will continue to outperform the higher beta markets (Canada, Australia) over the latter half of 2021. We currently have Canada on “downgrade watch”, as economic momentum is accelerating and the housing bubble looks to be reflating, both of which will make the Bank of Canada turn more hawkish shortly after the Fed does. We are more comfortable keeping Australia at neutral, as Australian inflation is likely to remain too underwhelming for the Reserve Bank of Australia to turn less dovish and risk a surge in the Australian dollar. UK Gilts are a more difficult case, atypically acting like a lower beta market over the past few years. As we discussed in a Special Report published last month, we attribute the declining Gilt yield beta to the rolling shocks the UK has suffered over the past thirteen years – the 2008 global financial crisis, the 2012 euro area debt crisis, Brexit and, now, COVID-19 – that have hamstrung the Bank of England’s ability to try even modest interest rate hikes.2 With the impact of those shocks on UK growth now diminishing, we see the central bank under greater pressure to begin normalizing UK monetary policy over the couple of years. We downgraded our cyclical stance on UK Gilts and UK investment grade corporates to neutral from overweight in that Special Report and, this week, we are making the same reduction in UK weightings in our model bond portfolio (see the portfolio tables on pages 20-21). After that change, the overall duration of the model bond portfolio remains below that of the custom benchmark index, now by -0.75 years (Chart 7). Chart 6Low-Beta Markets Will Continue To Outperform USTs Chart 7Overall Portfolio Duration: Stay Below Benchmark We continue to see the dovish bias of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt (Chart 8). Yes, the “easy money” has been made betting on a recovery of inflation expectations from the bombed-out levels seen after the COVID-19 recession in 2020. However, within the major developed economies with inflation-linked bond markets, 10-year breakevens have already climbed beyond the pre-pandemic levels of early 2020 (Chart 9). The next targets are the previous cyclical highs seen in 2018 (and 2019 for the UK). Chart 8Dovish Central Banks Still Positive For Inflation-Linked Bonds Chart 9Inflation Breakevens Returning To Past Cyclical Peaks Chart 10Still A Supportive Backdrop For Global Corporates The 10-year US TIPS breakeven is already past that 2018 peak of 2.18%, and with the Fed showing no sign of concern about US growth and inflation accelerating, the 10-year US breakeven should end up moving into the high end of our expected 2.3-2.5% target range before the Fed begins to turn less dovish. Thus, we are maintaining a core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy, France and Canada. The same aggressive easing of global monetary policy that has been good for relative inflation-linked bond performance continues to benefit global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England remains an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). With the combined balance sheet now expanding at a 55% pace, corporate bonds are still likely to continue to outperform government debt over the remainder of 2021. Much of that expected return outperformance of corporates will come via carry rather than spread compression, though. Our preferred measure of the attractiveness of credit spreads, the historical percentile ranking of 12-month breakeven spreads, shows that only US high-yield spreads are above the bottom quartile of their history among the credit sectors in our model portfolio (Chart 11). Given the absence of spread cushion in those other markets, we are maintaining an overweight stance on US high-yield in the model bond portfolio – especially versus euro area high-yield where we are underweight - while staying neutral investment grade credit in the US and Europe. Chart 11US High-Yield: The Last Bastion Of Attractive Spreads Within the euro area, we continue to prefer owning Italian government bonds over investment grade corporates, given the European Central Bank’s more explicit support for the former through quantitative easing (Chart 12). We expect Italian yields and spreads to converge down to Spanish levels, likely within the next 6-12 months, while there is limited downside for euro area investment grade spreads given tight valuations. Chart 12Favor Italian BTPs Over Euro Area IG We are not only looking at relative valuation considerations in developed market credit. Emerging market (EM) USD-denominated credit has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices. We have positioned for that in our model portfolio through an overall overweight stance on EM USD credit, but one that favors investment grade corporates over sovereigns. Now, with the Chinese credit impulse likely to slow in the latter half of 2021 as Chinese policymakers look to rein in stimulus, a slower pace of Chinese economic growth represents a risk to EM credit (Chart 13). The same can be said for the US dollar, which is no longer depreciating with US bond yields rising and the markets questioning the Fed’s dovish forward guidance on future rate hikes (Chart 14). A strong US dollar would also be a risk to the commodity price rally that has supported EM financial assets. Chart 13Global Policy Mix Becoming Less Supportive For EM Chart 14A Stronger USD Is A Risk For EM Corporates Vs Sovereigns Chart 15A Moderate Overweight To Spread Product Vs Government Debt In response to these growing risks to the bullish EM backdrop, we are downgrading our overall EM USD credit exposure in the model bond portfolio to neutral from overweight. We are maintaining our relative preference for EM investment grade corporates over sovereigns, however, within that overall neutral allocation. Summing it all up, we are sticking with a moderately overweight stance on global spread product versus government debt in the model portfolio, equal to four percentage points (Chart 15). That overweight comes entirely from the US high-yield allocation. After the changes made to our UK and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 41bps (Chart 16). This is an unsurprising outcome given that the current positioning is focused so heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral. That will change as 2021 progresses but, for now, our highest conviction views are in US fixed income. One final point – the relatively concentrated positioning leaves the portfolio “flat carry”, with a yield roughly equal to that of the benchmark index (Chart 17). Chart 16Limited Use Of Portfolio 'Tracking Error' Chart 17Model Portfolio Yield Close To Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the UK and EM, we now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries Base case: Ongoing global vaccinations lead to more of the global economy reopening over the summer, with excess savings built up during the pandemic – augmented by ongoing fiscal support – starting to be spent. US economic growth will be most robust out of the major economies, given the additional boost from fiscal stimulus, while China implements actions to slow credit growth and the euro area lags on vaccinations. The Fed stands its ground and maintains no rate hikes until at least 2023, and US TIPS breakevens climb to levels consistent with the Fed’s 2% inflation mandate (2.3-2.5%). The US Treasury curve continues to bear-steepen, with the 10-year US yield rising to 2%. The VIX falls to 15, the US dollar is flat, the Brent oil price rises +5%, and the fed funds rate is unchanged at 0%. Optimistic case: A rapid pace of global vaccinations leads to booming growth led by the US but including a reopening euro area. Chinese policymakers tighten credit by less than expected. Markets begin to pull forward the timing and pace of future central bank interest rate hikes, most notably in the US but also in the other countries like Canada and the UK. Real bond yields continue to climb globally, but inflation breakevens stay elevated. The steepening trend of the US Treasury curve ends, and mild bear flattening begins with the 10-year reaching 2.2% and the 2-year yield climbing to 0.4%. The VIX stays unchanged at 18, the US dollar rises +5%, the Brent oil price climbs +2.5% and the fed funds rate stays unchanged. Pessimistic case: Setbacks on the pandemic, either from struggles with vaccine distribution or a surge in variant cases, lead to a slower pace of global growth momentum. Europe cannot reopen, China tightens credit policy faster than expected, and US households hold onto to excess savings amid lingering virus uncertainty. Diminished economic optimism leads to a pullback in global equity values and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.5%. The VIX rises to 25, the US dollar falls -2.5% and the fed funds rate stays at 0%. The inputs into the scenario analysis are shown in Chart 18 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 19. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Chart 18Risk Factor Assumptions For The Scenario Analysis Chart 19US Treasury Yield Assumptions For The Scenario Analysis Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The model bond portfolio is expected to deliver an excess return over the next six months of +46bps in the base case and +54bps in the optimistic scenario, but is only projected to underperform by -27bps in the pessimistic scenario. Bottom Line: We are sticking with an overall below-benchmark portfolio duration stance, given accelerating global growth momentum, expanding vaccinations and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield given more stretched valuations in other credit sectors. On the margin, we are making the following changes to the portfolio allocations: downgrading both UK Gilts and UK investment grade corporates to neutral, while cutting the overall allocation to EM USD credit to neutral.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Why Are UK Interest Rates Still So Low?", dated March 10, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth.  The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31ST, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of March 31ST, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 43 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 43 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of March 31st, 2021) Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance

  The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations     We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion     Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Chart 6Labor Market Still Well Away From Full Employment   BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star   Chart 11Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing   Chart 13Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions         This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months.   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk.   How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities.   Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years.   How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Global Economy Chart 18US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization.   Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials.   Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21).   Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector.   Government Bonds Chart 23Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months.   Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance.   Commodities Chart 26Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4).   Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight.   Alternatives Chart 28Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3).   Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty   Chart 31China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation  

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

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

Informe especial

Highlights UK Interest Rates: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Implications for Gilts & GBP: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Maintain below-benchmark duration on Gilts, while downgrading UK allocations within dedicated global fixed income portfolios to neutral. The pound has upside in this environment, especially if depressed UK productivity starts to recover. Feature Chart 1UK Real Yields: Deeply Negative The UK has become one of the more peculiar corners of the global fixed income universe. The outright level of longer-term Gilt yields is in the middle of the pack among the major advanced economies. The story is much different, however, when breaking those nominal UK yields into the real and inflation expectations components. The deeply negative real yields on UK inflation-linked Gilts are the lowest among the majors, even in a world where sub-0% real yields are prevalent in most countries (Chart 1). The flipside of that deeply negative real yield is a high level of inflation expectations. The breakeven inflation rate derived from the difference between the nominal and real 10-year Gilt yields is 3.3%, the highest in the developed “linkers” universe. Inflation expectations in UK consumer surveys are at similar levels, well above the 2% inflation target of the Bank of England (BoE), suggesting little confidence in the central bank’s ability or willingness to hit its own inflation goals. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy and Foreign Exchange Strategy, we investigate why UK real interest rates have remained so persistently negative and assess the possibility of a shift in the low interest rate regime in a post-Brexit, post-pandemic UK – a move that could be quite bearish for UK fixed income markets and bullish for the British pound. Can The BoE Ignore Cyclical Upward Pressure On UK Bond Yields? The UK has suffered from a series of shocks, starting with the 2008 crisis, that have limited the ability of the BoE to attempt to tighten monetary policy. The 2011/12 European debt crisis hurt the UK’s most important trading partners, while the 2016 Brexit vote began a multi-year process of uncertainty over the future of those trading relationships. The COVID-19 pandemic is the latest shock, triggering a recession of historic proportions. The UK economy contracted by -10% in 2020, the largest decline since “The Great Frost” downturn of 1709. UK bond yields collapsed in response as the BoE cut rates to near-0% and reinforced that easy stance with aggressive quantitative easing and promises to keep rates unchanged over at the next few years. Today, UK financial markets are waking up to a world beyond the current COVID-19 lockdowns. The UK is running one of the world’s most successful vaccination rollouts, with 23 million jabs, or 35 per 100 people, already having been administered. UK Prime Minister Boris Johnson recently unveiled a bold plan to fully reopen the UK economy from the current severe lockdowns by mid-year. The UK government’s latest budget called for additional spending measures over the next year, including maintaining the work furlough scheme that has supported household incomes during the pandemic. As a result, UK growth expectations have exploded higher. According to the Bloomberg consensus economics survey, UK nominal GDP growth is expected to surge to 8.4% over calendar year 2021, an annual pace not seen since 1990 (Chart 2). Nominal Gilt yields have begun to reprice higher to reflect those surging growth expectations, with the 5-year/5-year forward Gilt yield climbing 67bps so far in 2021. Real Gilt yields are also moving higher with the 10-year inflation-linked Gilt climbing 38bps year to date, providing additional interest rate support that has fueled a surge in the pound versus the dollar (bottom panel). Our own BoE Monitor - containing growth, inflation and financial variables that typically lead to pressure on the central bank to adjust monetary policy – is signaling a reduced need for additional policy easing (Chart 3). The momentum of changes in longer-maturity UK Gilts and the trade-weighted UK currency index are usually correlated to the ebbs and flows of the BoE Monitor. The latest surge higher in yields and the currency suggests that the markets are anticipating the type of recovery that will put pressure on the BoE to tighten. Chart 2A Growth-Driven Repricing Of Gilts & GBP Chart 3Gilts & GBP Sniffing Out A Less Dovish BoE? It may take a while to see the BoE turn more hawkish, however. The BoE has become one of least active central banks in the world over the past decade. After the BoE cut its official policy interest rate, the Bank Rate, by 500bps during the 2008 financial crisis and 2009 recession, rates were kept in a range between 0.25% and 0.75% for ten consecutive years. The BoE cut rates aggressively in response to the COVID-19 pandemic, lowering the Bank Rate in March 2020 from 0.75% to 0.1%, where it still stands. The BoE has used quantitative easing (QE) and forward guidance to try and limit movements in bond yields whenever cyclical surges in inflation could have justified tighter monetary policy. That has led to an extended period of a negative BoE Bank Rate, something not seen since the inflationary 1970s (Chart 4). Back then, the BoE was lagging the surge in UK inflation, but still hiking nominal interest rates. Today, the central bank is keeping nominal rates near 0% with much lower levels of inflation. Chart 4Over A Decade Of Negative Real UK Interest Rates Short-term interest rate markets are still pricing in a very slow response from the BoE to the current growth optimism. Only 36bps of rate hikes over the next two years are discounted in the UK overnight index swap (OIS) curve. This go-slow response is in line with the BoE’s guidance on future rate hikes which, similar to the language used by other central banks like the Fed, calls for no pre-emptive rate hikes before inflation has sustainably returned to the BoE target. That combination would be consistent with current forward market pricing on both short-term interest rates and inflation. Chart 5BoE Keeping Real Rates Well Below R* In Chart 5, we show the real BoE Bank Rate, constructed by subtracting UK core CPI inflation from the Bank Rate. We also show a forward real rate calculated using the forward UK OIS and CPI swap curves. The market-implied path of the real Bank Rate shows very little change over the next decade, with the real Bank Rate expected to average around -2.5%. This is far below the estimates of a neutral UK real rate (or “r-star”) of just under 2%, as calculated by the New York Fed or recent academic studies. The neutral UK real rate has likely dipped because of the pandemic. The UK Office For Budget Responsibility (OBR) estimates that there has been a long-term “scarring” of the UK economy from COVID-19 through supply-side factors like weaker investment spending, lower productivity growth and diminished labor force participation – equal to three percentage points of the level of potential GDP.1 The BoE estimates a smaller “scarring” of 1.75 percentage points of potential output, but coming with a 6.5% reduction in the size of the UK capital stock. While these are significant reductions in the supply-side of the UK economy, they are not enough to account for the 4.5 percentage point difference between pre-pandemic estimates of the UK r-star and the market-implied path of the real BoE Bank Rate over the next decade. The implication is that the markets are not expecting the BoE to deviate from its strategy of doing very little with interest rates, even as growth recovers from the pandemic shock. That can be seen in the recent upturn in UK inflation expectations that is evident in both market-implied and survey-based measures. Chart 6UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation The 5-year/5-year forward UK CPI swap rate now sits at 3.6%, not far off the 3.3% level of 5-10 year consumer inflation expectations from the latest YouGov/Citigroup survey (Chart 6). The fact that inflation expectations can remain so elevated at a time when headline CPI inflation is struggling to avoid deflation is striking. This indicates a belief that the BoE will do very little in the future to stop a booming UK economy that is expected to put sustained downward pressure on the UK unemployment rate over the next few years (bottom panel). This is from a relatively low starting point of the unemployment rate given the massive government support programs that have limited the amount of pandemic-related layoffs over the past year. The BoE should have reasons to be more concerned about a resurgence of UK inflation. In its latest Monetary Policy Report, the BoE published estimates showing that the entire collapse in UK inflation in 2020 was attributable to weaker demand for goods and services – especially the latter (Chart 7). This suggests that UK inflation could rebound by a similar amount as the UK economy reopens from pandemic lockdowns. According to the UK OBR, 21% of UK household spending is on items described as “social consumption”, like restaurants and hotels (Chart 8). This is a much larger proportion than seen in other major developed economies (excluding Spain) and explains why consumer spending plunged so much more dramatically in the UK during 2020 than in other countries. Chart 7Only A Temporary Drag On UK Inflation From COVID-19 Chart 8UK Households More Focused On “Social Consumption” If the UK pandemic-related restrictions are eased as planned over the next few months, the potential for a sharp snapback in UK consumer spending is significant. The BoE estimates that UK households now have £125bn of “excess” savings thanks to government income support and reduced spending on discretionary items like dining out and vacations. This is the fuel to support a rapid recovery in consumption over the next 6-12 months, especially as personal income growth will get a boost as furloughed workers begin returning to work (Chart 9). Chart 9UK Economy On The Mend Chart 10Big Boost To UK Growth From Housing & Government Spending A similar argument can be made for investment spending – the BoE estimates that UK businesses have amassed £100bn pounds of excess cash, and the latest reading on the BoE’s Agents' Survey of UK firms shows a slight increase after months of decline (bottom panel). With a Brexit deal with the EU finally reached at the start of 2021, UK businesses can also look to increase investment spending that had been delayed because of the years of Brexit uncertainty. The UK economy is already getting a boost from a recovery in the housing market fueled by low interest rates, high household savings and improving consumer confidence. Mortgage approvals have soared to the highest level since 2007, while house prices are now expanding at a 6.4% annual rate (Chart 10). Add it all up, and the economic momentum in the UK is positive and likely to accelerate further in the coming months as a greater share of the population becomes vaccinated. The BoE’s dovish policy stance is likely to appear increasingly inappropriate relative to accelerating UK growth and inflation trends over the next several months. Thus, on a cyclical basis, UK bond yields, both nominal and real, have more upside potential even after the recent increase. Bottom Line: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Structural Forces Keeping UK Interest Rates Low Are Fading Looking beyond the cyclical drivers, the structural factors that have held down UK interest rates in recent years are also starting to fade. The supply side of the UK economy has suffered because of Brexit uncertainty. The OECD’s estimate of potential UK GDP growth fell from 1.75% in 2015 to 1.0% in 2020 (Chart 11). This was mostly due to declining productivity growth – a consequence of years of very weak business investment. The 5-year annualized growth rate of real UK investment spending fell to -3% in 2020, a contraction only matched during the past 30 years after the 1992 ERM crisis and 2008 financial crisis. That plunge in investment coincided with almost no growth in UK labor productivity over that same 5-year window. Chart 11The Road To Faster Potential UK Growth Starts With Investment Slowing population growth also weighed on UK potential growth, slowing to the lowest level in 15 years in 2019 as immigration from EU countries to the UK fell sharply. COVID-19 also hurt immigration flows into the UK last year. The UK Office for National Statistics estimated that the non-UK born population in the UK fell by 2.7% between June 2019 and June 2020. Diminished potential GDP growth is a factor that would structurally reduce the equilibrium real UK interest rate. We are likely past the worst for that downward pressure on potential growth and real rates. Population growth should also stabilize as the UK borders open up again and pandemic travel restrictions are loosened. Measured productivity is already starting to see a cyclical recovery, while investment spending is likely to improve as cash-rich UK companies began to ramp up capital spending plans deferred by Brexit and COVID-19. While the process leading from faster investment spending into speedier productivity growth is typically slow, the key point is that the worst of downtrend is likely over. This is an important development that has implications for UK fixed income markets. When looking at an international comparison of real central bank policy rates within the developed economies, the UK has fallen into the grouping of countries with persistently negative policy rates, namely Japan, the euro area, Switzerland, Sweden and Norway (Chart 12). We have dubbed that group the “Secular Stagnation 5”, after the term made famous by former US Treasury Secretary Lawrence Summers describing a state where the “natural” real rate of interest (r-star) that equates savings with investment is structurally negative. Chart 12Does The UK Belong In The 'Secular Stagnation 5'? Does the UK belong in the “Secular Stagnation 5”? As a way to assess this, we made some comparisons of selected UK data with the same data for those five countries. When looking at potential GDP growth and population growth, the UK sits right in the middle of the range of those growth rates for the five countries (Chart 13). UK productivity growth has underperformed the others recently but, prior to the 2016 Brexit shock, UK productivity was also in the middle of the Secular Stagnation 5 range. Chart 13Brexit Became A Major Hit To UK Potential Growth Chart 14UK Economy Less Focused On Investment & Exports On other measures, the UK is nothing like those other countries. The UK’s economy is far less geared towards exports and investment (Chart 14) and is more tilted towards consumer spending. That can be seen most clearly when looking at the data on savings/investment balances. The UK continuously runs a current account deficit, as opposed to the persistent surpluses seen in the Secular Stagnation 5 (Chart 15). Put another way, the UK is not a “surplus” country that saves more than it invests on a structural basis, a condition that typically depresses real interest rates. Chart 15The UK Is Not A Surplus Country Chart 16Gilts Will Not Become A Low-Beta Market Based on these cross-country comparisons, it is unusual for the UK to have such persistently low real interest rates. This has implications for UK bond yields. Over the past few years, Gilts have been transitioning from a status as a “high yield beta” market – whose yield movements are more correlated to swings in the overall level of global bond yields. The lower beta markets are in countries like Germany, France and Japan – all members of the Secular Stagnation club (Chart 16). The UK does not appear to warrant a permanent membership in that low-yielding group, based on structural factors. That is evident when looking at how Gilt yields are rising even with the BoE absorbing an increasing share of the stock of outstanding Gilts (bottom panel). We conclude that the transition of the UK to a low-beta market is related to the Brexit uncertainty post 2016 and the pandemic shock that has hit the consumer-focused UK economy exceptionally hard – both factors that are set to fade over the next year. Bottom Line: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Investment Conclusions Chart 17Downgrade Gilts To Underweight Our assessment of the cyclical and structural drivers of UK interest rates leads us to the following conclusions on UK fixed income and currency strategy: Duration: Maintain a below-benchmark exposure to UK interest rate movements. Gilt yields will rise by more than is discounted in the forwards over the next 6-12 months (Chart 17), coming more through rising real yields as the UK economy continues its post-Brexit, post-pandemic recovery. Country Allocation: Downgrade strategic allocations to UK Gilts to neutral from overweight in dedicated fixed income portfolios. Our long-standing view that Brexit uncertainty would lead to the outperformance of Gilts versus other developed bond markets is no longer valid. It is still too soon to move to a full underweight stance on Gilts – a better opportunity will develop by mid-year once it is more evident that the current success on UK vaccinations leads to a faster reopening of the UK economy. Yield Curve: Maintain positioning for a bearish steepening of the UK Gilt yield curve. While there is limited scope for more steepening through an even larger increase in inflation breakevens from current elevated levels, the long end of the Gilt curve can move higher by more than the front end as the market re-rates Gilts to a higher-beta status with a higher future trajectory for UK interest rates. Corporate Credit: Downgrade UK investment grade corporate bond exposure to neutral from overweight in dedicated fixed income portfolios. UK corporate spreads have returned to the 2017 lows and, while an improving growth dynamic is not overly bearish for credit, there is no longer a compelling valuation-based case for staying overweight UK investment grade corporates. This move brings our recommended UK allocation in line with our neutral stance on US and euro area investment grade corporates. Chart 18GBP/USD Appears Cheap On A PPP Basis Chart 19Low Productivity Is Weighing On The Pound Currency: A growth-driven path towards interest rate normalization should be positive for the British pound, which remains undervalued versus the US dollar on a purchasing power parity basis (Chart 18).2 A move to 1.45 on GBP/USD is possible within the next six months. A broader move towards pound strength will require an improvement in business investment, as the trade-weighted pound looks fairly valued on our productivity-based model (Chart 19). We do maintain our view that EUR/GBP can approach 0.80 by year-end based on a relatively stronger cyclical improvement in UK growth versus the euro area.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For further details on the OBR estimates of UK growth, inflation and fiscal policy, please see the March 2021 OBR Economic & Financial Outlook, which can be found here: https://obr.uk/ 2 Please see BCA Research Foreign Exchange Strategy Report, "Thoughts On The British Pound", dated December 18, 2020, available at fes.bcaresearch.com.

Highlights Rising Global Yields: The increased turbulence in global bond markets is part of the adjustment process to a more positive outlook for global economic growth. Rising real yields are now the main driver of nominal yield movements, with stable inflation expectations indicating that investors are not overly concerned about a sustained inflation overshoot. Duration: Central bankers will eventually be forced to shift to less dovish interest rate guidance to reflect the new reality of faster growth and increased inflation pressures, but this is likely to not occur until much later in 2021, starting with the Fed. Maintain a below-benchmark cyclical duration stance in global bond portfolios. UST Yields & Spreads: The selloff in US Treasuries has pushed US yields to levels that are starting to look a bit stretched relative to yields from other major developed economies like Germany and Japan. This is especially true on a volatility-adjusted basis. As a result, we are closing our tactical US-Germany spread widening trade in bond futures at a profit of 1.8%. Feature Chart of the WeekBond Yields Are Rising Because Of Growth The rapid surge in global bond yields seen so far in 2021 has led some commentators to declare that the dreaded “bond vigilantes” have returned to dole out punishment for overly stimulative fiscal and monetary policies (most notably in the US). The rapid pace of the bond selloff, with the 10-year US Treasury yield reaching 1.6% on an intraday basis last week, has raised fears that spiking yields could damage a fragile global economic recovery. This logic is backwards – it is surging growth expectations that are driving bond yields sustainably higher from deeply depressed levels. Global growth is projected to accelerate at a very rapid pace over the rest of this year and 2022. The combination of the Bloomberg consensus real GDP growth and inflation forecasts for the major developed economies suggest that nominal year-over-year GDP growth is expected to climb to 7.2% in the US, 8.4% in the UK and 6.4% in the euro area by year-end (Chart of the Week). Nominal growth in 2022 is expected to grow by another 5-7% across the same regions, suggesting a return to a slightly faster pace than prevailed during the pre-pandemic years of 2017-19 - even after a boom in 2021. Nominal longer-term global government bond yields, which had been priced for a pandemic-stricken economic backdrop, are now playing catch-up to the new reality of a post-pandemic, vaccinated world. Bond investors understand that the need for extreme monetary accommodation is ebbing, especially in the US where there will be an enormous fiscal impulse to growth in 2021 (and beyond). As a result, interest rate expectations are moving higher, fueling a repricing towards higher bond yields around the world. This process has more room to run. A Global Move Higher In Yields, For The Right Reasons Chart 2Reflationary Bear-Steepening Of Global Yield Curves The cyclical rise in developed market bond yields that began last summer was initially focused on longer-maturity yields boosted by rising inflation expectations (Chart 2). The very front-ends of bond yield curves – which are more sensitive to expectations of changes in central bank policy rates – have remained subdued. The upward pressure on global bond yields is starting to infect some shorter maturities, however. 5-year government bonds yields in the UK, Canada and Australia rose 44bps, 42bps and 35bps, respectively, during the month of February. The latter two represented a near doubling of the level of the 5-year yield. In the case of the UK, the surge in 5-year Gilt yields came from a starting point of negative yields at the end of January. Last week, the 5-year US Treasury yield jumped a massive 22bps on a single day due to a poorly received US Treasury auction. Year-to-date, longer-term global bond yields have been rising more through the real yield component than higher inflation expectations (Charts 3A & 3B). This is a change in the dynamics from the latter half of 2020 when inflation expectations were the dominant force pushing global yields higher. Chart 3AReal Yields Are Driving The Recent Bond Selloff … Chart 3B… Even In The Lower-Yielding Markets This shift in “leadership” of the global bond market selloff has been broad-based. 10-year real yields from inflation-linked bonds have surged higher in the US (+35bps year-to-date), UK (+40bps), Australia (+44bps) and Canada (+25bps). Real 10-year yields have even inched up in France (+9bps), despite euro area growth suffering because of COVID-19 lockdowns. This coordinated rise in real bond yields comes on the heels of a sharp improvement in overall global economic momentum and improving expectations for future growth. Manufacturing PMIs, a reliable leading indicator of real yields in the developed markets, began a cyclical improvement in the middle of last year and, right on cue, global bond yields bottomed out toward the end of 2020 (Chart 4). The link between that strong growth momentum and real bond yields comes from expected changes in central bank policies. Our Central Bank Monitors for the US, euro area, UK, Japan, Canada and Australia – designed to measure cyclical pressures on monetary policy - have all moved significantly higher since mid-2020 (Chart 5). This suggests a diminished need for additional monetary stimulus because of rebounding economic growth and intensifying inflation pressures. The Monitors have climbed to above pre-pandemic levels in the US and Australia. Chart 4Real Yields Starting To Catch Up To Solid Growth Chart 5Markets Starting To Discount Rate Hikes In 2023 Interest rate markets are responding to this cyclical pressure to tighten monetary policies by repricing the expected timing and pace of the next rate hiking cycle. Our 24-month discounters, which derive the amount of interest rate changes priced into overnight index swap (OIS) curves up to two years in the future, are now pricing in higher policy rates in the US (+40bps), the UK (+32bps), Australia (+36bps) and Canada (a whopping +82bps) by the first quarter of 2023. This repricing of interest rate expectations does conflict with current central bank forward guidance, to varying degrees. For example, the Fed continues to signal that there will not be any rate hikes until at least the end of 2023. Policymakers will not be overly concerned about higher government bond yields and shifting interest rate expectations, however, if there is limited spillover into broader financial market performance. In the US, the latest increase in real Treasury yields to date has had minimal impact on US equity market valuations or corporate bond yields (Chart 6A), suggesting no tightening of financial conditions that could impact future US economic growth. A similar situation is playing out in Europe, where higher longer-term real yields have had little impact on equity market valuations or the borrowing rates that the ECB is most concerned about, like Italian BTP yields (Chart 6B). Chart 6ANo Tightening Of Financial Conditions In The US... Chart 6B...Or Europe Currency valuations are a more important indicator of financial conditions for other central banks. For example, the Reserve Bank of Australia (RBA) has been explicit that its current policies – near-zero policy rates, yield curve control to anchor the level of 3-year bond yields and quantitative easing (QE) to moderate the level of longer-term yields – are intended to not only keep borrowing costs low but also dampen the value of the Australian dollar. At the moment, the US dollar is being pulled in different directions by the typical fundamental drivers. Real rate differentials between the US and other major developed economies remain unattractive for the greenback, even with the latest rise in US real yields (Chart 7). At the same time, growth differentials between the US and the other major economies are turning more USD-positive. For now, rate differentials are the more dominant factor for the US dollar and will remain so until the Fed begins to shift to a less dovish policy stance – an outcome that we do not expect until much later this year when the Fed will begin to prepare the market for a tapering of asset purchases in 2022. A sustainable bottoming of the US dollar, fueled by a shift to a less accommodative Fed, will also likely mark the end of the rising trend for global inflation expectations, given the links between the dollar, commodity prices and inflation breakevens (bottom panel). Central banks outside the US will continue to resist any unwelcome appreciation of their own currencies versus the US dollar. That means doing more QE when bond yields rise too quickly, as the RBA did this week and the ECB has threatened to do in recent comments from senior policymakers (Chart 8). Increasing the size of asset purchases is unlikely to sustainably drive non-US bond yields lower, however, in an environment of improving global growth that is causing investors to reassess the future path of interest rates. All more QE can hope to do at this point in the global business cycle is limit how fast bond yields can increase. Chart 7The USD Remains The Critical Reflationary Variable Chart 8More QE Is Less Effective At Capping Bond Yields   Chart 9Markets With A Lower Yield Beta To USTs Are Outperforming From an investment strategy perspective, the current growth-fueled move higher in global real bond yields does not change any of our suggested tilts. We continue to recommend a below-benchmark overall duration stance within global bond portfolios. Within our recommended country allocation among developed market government bonds, we continue to prefer a large underweight to US Treasuries and overweights to markets that are less susceptible to changes in US Treasury yields like Germany, France, Japan and the UK (Chart 9). We also continue to recommend only neutral allocations to Canadian and Australian government bonds (with below-benchmark duration exposure within those allocations), although we are on “downgrade alert” for both given their status as higher-beta bond markets with central banks more likely follow the Fed down a less dovish path later this year. Bottom Line: Rising real yields are now the main driver of nominal yield movements, with stable inflation expectations indicating that investors are not overly concerned about a sustained inflation overshoot. Central bankers will eventually be forced to shift to less dovish interest rate guidance to reflect the new reality of faster growth and increased inflation pressures, but this is likely to not occur until much later in 2021, starting with the Fed. Maintain a below-benchmark cyclical duration stance in global bond portfolios, with a large underweight allocation to US Treasuries. The UST-Bund Spread Widening Looks Stretched Chart 10Yield Chasing Has Been A Losing Strategy In 2021 Last August, we published a report discussing how “yield chasing” – a strategy of consistently favoring the highest yielding government bond markets – had become the default strategy for bond investors during the early months of the pandemic.1 We concluded that yield chasing would be a successful strategy for only as long as central banks stuck to their promises to maintain very loose monetary policy for the next few years. Investors would be forced to chase scarce yields in that environment, while worrying less about cyclical economic and inflation factors that could push up bond yields. Yield chasing has performed quite poorly so far in 2021. A basket of higher-yielding markets like the US, Canada and Australia has underperformed a basket of low-yielders like Germany, France and Japan by -1.4 percentage points (Chart 10). Obviously, such a carry-driven strategy would be expected to perform poorly during an environment of rising bond volatility as is currently the case. Markets that have been offering relatively enticing yields, like the US or Australia (Table 1), are actually generating the largest total return losses. Those higher-yielders have suffered more aggressive repricing of interest rate expectations, as discussed in the previous section of this report, leading to losses from duration that are dwarfing the higher yields. This is especially true in the US, where there remains the greater scope for an upward repricing of interest rate and inflation expectations. Table 1Government Bond Yields: Unhedged & Hedged Into USD This suggests that investors must be cautious on determining when to consider increasing exposure to higher yielders like the US, even after Treasury yields have increased substantially. One way to evaluate that is to look at the spreads between US Treasuries and low yielders like Germany and Japan, relative to US bond volatility. In Chart 11, we show the spread of 10-year US Treasuries to 10-year German Bunds. To facilitate a fair comparison between the two, we hedge the Treasury yield into euros while adjusting the spread for duration difference between the two bonds. The currency-hedged and duration-matched Treasury-Bund spread is shown in the middle panel of the chart. In the bottom panel, we adjust that spread for US interest rate volatility by dividing the spread by the level of the MOVE index of US Treasury option volatility. On an unadjusted basis, the 10-year yield gap now sits at 175bps, +70bps higher than the lows seen in August 2020. That spread is narrower on a currency hedged basis, with the 10-year US Treasury yield hedged into euros +73ps higher than the 10-year German bund yield. Two conclusions stand out from the chart: The currency-hedged and duration-matched spread is still well below the prior peaks dating back to 2000; The volatility-adjusted spread is already one standard deviation above the mean value since 2000. In other words, there is scope for US Treasuries yields to continue rising relative to German Bund yields based on levels reached in past cycles. Yet at the same time, the spread provides a reasonable level of compensation compared to the riskiness (volatility) of Treasuries, also based on past cycles. We show the same chart for the spread between 10-year US Treasuries and 10-year Japanese government bonds (JGBs) in Chart 12. In this case, there is also scope for additional spread widening although the volatility-adjusted spread is still not as attractive as at previous peaks since 2000. Chart 11UST-Bund Spread Looking Stretched Vs UST Vol Chart 12UST-JGB Spread Getting Stretched Vs UST Vol The message from the volatility-adjusted Treasury-Bund spread lines up with that of the momentum measures of the unadjusted spread. The latter is historically stretched relative to its 200-day moving average, while the change in the spread over the past six months has been as rapid as any of the moves seen since the 2008 financial crisis (Chart 13). Adding it all up, positioning for additional widening of the Treasury-Bund spread is a much poorer bet from a risk versus reward perspective than it was even a few months ago. On a fundamental medium-term basis, however, there is still room for the Treasury-Bund spread to widen further. Relative inflation and unemployment (spare capacity) trends both argue for relatively higher US bond yields (Chart 14). In addition, the Fed is almost certainly going to start tightening monetary policy well before the ECB, thus policy rate differentials will underpin a wider bond spread – although that is already largely discounted in the spread on a forward basis (top panel). Chart 13UST-Bund Spread Momentum Looks Stretched Chart 14Fundamentals Still Support A Wider UST-Bund Spread Chart 15Stay Underweight US Vs. Germany On A Strategic Basis Our fundamental fair value model of the 10-year Treasury-Bund spread shows that the spread is still cheap relative to fair value, which is rising (Chart 15). This suggests more medium-term upside in the spread, perhaps even by more than currently priced into the forwards over the next year. Based on this analysis, we see a case for maintaining a core strategic (6-12 month holding period) underweight position for the US versus Germany in our recommended country allocation within our model bond portfolio. At the same time, with the spread looking a bit stretched on some of the momentum and volatility-adjusted measures, we are taking profits on our tactical (0-6 month holding period) 10-year Treasury-Bund spread widening trade using bond futures, realizing a 1.8% return (see the Tactical Overlay table on page 18). Bottom Line: The selloff in US Treasuries has pushed US yields to levels that are starting to look a bit stretched relative to yields from other major developed economies like Germany and Japan. This is especially true on a volatility-adjusted basis. As a result, we are taking profits on our tactical US-Germany spread widening trade. However, we are maintaining our strategic overweight for Germany versus the US in our model bond portfolio, as fundamentals argue for a wider Treasury-Bund spread on a cyclical and strategic basis.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns