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Overweight We recently upgraded the S&P materials index to overweight via boosting the steel index to an above benchmark allocation and subsequently we also put on a market-neutral trade: long materials / short utilities; we reiterate all three recent moves. The top panel of the chart shows that Chinese stocks are capturing the reflationary policy trifecta (credit, monetary and fiscal) that the Chinese authorities are instituting and deep cyclical materials stocks will likely be the primary beneficiaries of such efforts. Importantly, Chinese construction materials industrial production (IP) is expanding at an accelerating pace (bottom panel), and is the mirror image of still decelerating overall Chinese IP growth prints. Recovering Chinese demand for construction materials on the back of increasing infrastructure spending underpins the recent firming commodity price backdrop and suggests that S&P materials profits are on a solid footing. Bottom Line: Stay overweight the S&P materials index.

Underweight (High-Conviction) Home Depot, the S&P home improvement retail (HIR) index heavyweight, reported earnings yesterday that missed expectations as same store sales fell well short of estimates. The company also added guidance that this key figure would moderate in the coming year from 2018 levels. While a slower rate of top line growth this quarter was fairly predictable, given the Q4 collapse in lumber prices (recall that HIR earns a markup on lumber), the outlook does not bode well. This tough operating environment is captured by our model that, even with a modest recovery in lumber prices, still points to a significant decline in the S&P HIR index (third panel). Still, the HIR index trades at a premium to the broad index despite the headwinds facing the sector (bottom panel). A premium valuation seems misplaced and we accordingly reiterate our high-conviction underweight recommendation on the sector. We further point investors to our market neutral trade going long homebuilders/short HIR.1 The ticker symbols for the stocks in this index is BLBG: S5HOMI – HD and LOW.   1       Please see BCA U.S. Equity Strategy Report, “Dissecting 2019 Earnings,” dated January 22, 2019, available at uses.bcaresearch.com.

Highlights Fed: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again in the second half of this year. The best way to position for the resumption of rate hikes is to sell the 5-year or 7-year part of the Treasury curve and buy a duration-matched barbell consisting of the short and long ends of the curve. These sorts of positions currently offer positive carry, meaning you get paid as you wait for the market to price rate hikes back in. Corporate Spreads: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economy: Tracking estimates for 2018 Q4 and 2019 Q1 real GDP have fallen significantly during the past two weeks. The decline in tracking estimates is heavily influenced by an abnormal December retail sales report. That impact will reverse in 2019. Feature The Federal Reserve’s “on hold” strategy is now well known and has been completely discounted in the market. In fact, the overnight index swap curve is priced for 9 bps of rate cuts during the next 12 months and 21 bps of cuts during the next 24 months (Chart 1). Chart 1Primary Dealers Still Looking For Hikes At this point, the only thing that’s unclear is how the Fed will respond to the economic data going forward. Will it be eager to re-start rate hikes at the first sign of calm? Or perhaps the Fed is leaning toward a strategy where the next move will be a rate cut in the face of flagging economic growth? Survey Says Unfortunately, last month’s FOMC meeting was not accompanied by an updated Summary of Economic Projections. We therefore don’t know how policymakers have revised their rate hike expectations since December. However, the New York Fed’s Survey of Primary Dealers was updated in January, and it shows that the median primary dealer still expects two rate hikes this year. The only change between the December and January surveys is that the median primary dealer now expects one of the 2019 rate hikes in June and the other in December. In the December survey, both 2019 rate hikes were anticipated before the end of June (Chart 1). Typically, the median primary dealer and the median FOMC participant have very similar views on the future interest rate trajectory. Counting The Minutes The next stop on our search for clarity is the minutes from the January FOMC meeting, which were released last week. The January minutes provide a lot of insight into the thought processes of different FOMC participants. Unfortunately, they also reveal a serious lack of cohesion amongst the group. All in all, the document might confuse more than it clarifies. A few key excerpts from the document drive this point home. Referring to “global economic and financial developments”: Many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as “patient” and might then use different language. This suggests that many Fed participants view the pause in rate hikes as a result of slower non-U.S. growth and tighter financial conditions. They also suggest that if global growth improves and financial conditions ease it would be appropriate to abandon a “patient” stance. … several […] participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. This second statement is much more dovish than the first. It suggests that several participants think that even improving global growth and an easing of financial conditions would not be sufficient to re-start rate hikes. They would also need to see inflation come in stronger than expected. Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year. Finally, this last statement reveals that several other participants disagree with the view that an unexpected rise in inflation is a pre-condition for further rate hikes. What can we make of all this mess? The first thing that seems clear is that all Fed members view easier financial conditions as a pre-condition for further rate hikes. In this regard, we are already well on our way. Financial conditions have eased considerably since the start of the year, with the stock-to-bond total return ratio up sharply and credit spreads, the VIX and the dollar all off their highs (Chart 2). Chart 2Financial Conditions Are Easing Second, all FOMC participants need more confidence that inflation will return to target before re-starting rate hikes, but this bar seems higher for some than for others. Year-over-year core and trimmed mean CPI are currently running at 2.15% and 2.19%, respectively. This is slightly below the 2.4% level that is consistent with the Fed’s inflation target (Chart 3).1 The minutes suggest that some FOMC participants would be comfortable re-starting rate hikes as long as core inflation moves higher in the next few months and approaches the Fed’s target from below. Some others, however, may need to see an overshoot of the Fed’s inflation target before recommending rate hikes. Chart 3Core Inflation Needs To Move Higher Depressed inflation expectations, as seen in the TIPS market or the Michigan Consumer Sentiment survey, are a related issue (Chart 3, bottom 2 panels). The Fed will probably want to see upward movement in both of these measures before resuming rate hikes. In fact, New York Fed President John Williams warned last week that the “persistent undershoot of the Fed’s [inflation] target risks undermining the 2 percent inflation anchor.” He added that “the risk of the inflation expectations anchor slipping toward shore calls for a reassessment of the dominant inflation targeting framework.”2 Williams has long been an advocate for a monetary policy framework where the Fed targets an overshoot of its inflation target in the future to “make up” for undershooting its target in the past, i.e. some form of price level targeting. The Fed is currently conducting a year-long investigation into whether it should switch to this sort of regime and we learned last week that the Fed will announce the results of its investigation in the first half of 2020. Our own sense is that the Fed will eventually adopt some sort of “history dependent” inflation target as a way to avoid continuously bumping up against the zero-lower bound on interest rates. But this change will not occur this year and maybe not even next year. Of course, the more immediate concern for bond investors is whether inflation pressures will be meaningful enough in the next few months for the Fed to resume rate hikes in 2019. We expect they will be. We have previously shown that base effects alone will pressure year-over-year core CPI higher as we head toward mid-year.3 Meanwhile, other signs also point toward rising core inflation (Chart 4): Chart 4Inflation Pressures Building The New York Fed’s Underlying Inflation Gauge is running close to 3% (Chart 4, top panel). The ISM Manufacturing PMI is off its highs, but is still consistent with rising year-over-year core CPI (Chart 4, panel 2). Our CPI Diffusion Index is deep in positive territory, pointing to further near-term upside in the core measure (Chart 4, bottom panel). Bottom Line: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again this year. January’s FOMC minutes imply that several Fed members want to see an overshoot of the inflation target before advocating for the resumption of rate hikes, but until the Fed changes its inflation targeting regime they will likely be out-voted. The Best Way To Trade The Fed We continue to recommend a below-benchmark duration bias in U.S. bond portfolios, on the view that rate hikes will exceed depressed market expectations on a 12-month horizon. However, this is not the most attractive way to position for the resumption of Fed rate hikes. The best way to trade the Fed in the current environment is by initiating a duration-neutral yield curve trade where you buy a barbell consisting of the long and short ends of the curve, and sell the 5-year or 7-year maturity. In a prior report we demonstrated that the 5-year and 7-year Treasury yields are most sensitive to changes in our 12-month fed funds discounter.4 That is, when the market starts to price-in more Fed rate hikes, the 5-year and 7-year Treasury yields increase more than other maturities. Similarly, the 5-year and 7-year yields fall the most when our discounter declines. Clearly, this means that if you are short the 5-year/7-year part of the curve versus the wings, you will make money as rate hikes are priced back into the market. Usually the problem with implementing such a trade is that it has negative carry. That is, the 5-year or 7-year bullet typically offers a greater yield than what you would earn on a duration-matched 2/10 or 2/30 barbell. If you don’t time the trade properly, you end up losing money waiting for Fed rate hike expectations to move. However, this is not a problem at the moment. In fact, duration-matched barbells are now positive carry propositions relative to 5-year and 7-year bullets (Chart 5). Chart 5 Barbell Yields Greater Than Bullet Yields In other words, if you think rate hikes will resume at some point, you are currently getting paid to wait for the market to catch on. The only way to lose money in this sort of trade is if our 12-month fed funds discounter falls further from its current -9 bps level. We view that as an unlikely scenario. Bottom Line: The best way to position for the resumption of Fed rate hikes is to sell the 5-year or 7-year part of the Treasury curve, and buy a barbell consisting of the long and short ends of the curve. We currently recommend being short the 7-year and long the 2/30 barbell. This trade has positive carry, meaning that you will earn money as you wait for rate hikes to get priced back in.  Corporate Spread Targets As we have discussed in prior reports, we think the Fed’s pause opens up a window where corporate bond spreads have room to tighten during the next few months.5 However, we also acknowledge that the window for outperformance is limited. Once financial conditions ease and the Fed resumes rate hikes, the environment will quickly become more difficult for corporate bonds. For this reason, in last week’s report we presented Chart 6. The diamonds in Chart 6 show where corporate 12-month breakeven spreads are today relative to past “Phase 2” periods, which are environments similar to today when the yield curve is quite flat but still positively sloped.6 We argued that we would be quick to reduce corporate bond exposure when the breakeven spreads reach the historical median for Phase 2 periods, i.e. when the diamonds fall to the 50% line in Chart 6. However, we acknowledge that this is not a helpful guide for investors who don’t have timely access to our valuation metrics. So this week we present Charts 7A and 7B. These charts estimate the option-adjusted spread (OAS) levels for each credit tier of the Bloomberg Barclays corporate bond indexes that would be consistent with the 50% line in Chart 6. To make these estimates we need to assume that the average duration of each index remains constant. The results show the following spread targets: For Aa we target 55 bps. The current OAS is 61 bps. For A we target 84 bps. The current OAS is 94 bps. For Baa we target 128 bps. The current OAS is 161 bps. For Ba we target 186 bps. The current OAS is 236 bps. For B we target 298 bps. The current OAS is 391 bps. For Caa we target 571 bps. The current OAS is 813 bps. We do not recommend an overweight allocation to Aaa-rated corporate bonds, where spreads are already expensive relative to past Phase 2 periods (Chart 7A, top panel). Chart 7aInvestment Grade Spread Targets Chart 7BHigh-Yield Spread Targets   Bottom Line: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economic Update We will finally receive GDP data for the fourth quarter of 2018 on Thursday, and investors should ready themselves for a weak number. In fact, the most recent tracking estimates from the New York Fed have real GDP coming in at 2.35% in Q4 and a mere 1.20% in 2019 Q1 (Chart 8). Chart 8Poor GDP Tracking Estimates ... It will come as no surprise that the trend in GDP growth is vital to our interest rate call. In fact, we showed in a recent report that when year-over-year nominal GDP growth falls below the 10-year Treasury yield it is often a good signal that monetary policy has turned restrictive and that interest rates have peaked for the cycle.7 With that in mind, if we add 1.2% expected real growth in Q1 to the 1.7% average growth rate of the GDP deflator (Chart 8, bottom panel), we can roughly estimate nominal GDP growth of 2.9% in Q1. This remains above the current 10-year Treasury yield, suggesting that monetary conditions would still be accommodative, but just barely. However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York Fed’s model, the weak December retail sales report trimmed 0.41% from its Q1 growth forecast and this report increasingly looks like an aberration. In contrast to the retail sales number, the Johnson Redbook index of same-store sales is growing at a rate close to 5%, and indexes of consumer confidence remain elevated (Chart 9). Chart 9...Driven By Abnormal Retail Sales Even the Fed staff’s economic report, as presented in the January FOMC minutes, suggests that December should have been a good month for consumer spending: The release of the retail sales report for December was delayed, but available indicators – such as credit card and debit card transaction data and light motor vehicle sales – suggested that household spending growth remained strong in December. Bottom Line: However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York it seems likely that the partial government shutdown influenced the collection of the December retail sales data and led to an abnormal print. Since the retail sales data feed directly into GDP, the impact will be felt in the next GDP report. But the impact will prove fleeting.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 The Fed’s target is for 2% PCE inflation. CPI tends to run about 0.4% above PCE. 12-month core PCE is currently 1.88%, but data only go to November. This is why we refer to CPI in this report, which has data through January. 2 https://www.newyorkfed.org/newsevents/speeches/2019/wil190222 3 Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 For more detail on the different phases of the economic cycle please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification