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Highlights Scarce Yield: The correlation of relative global government bond returns and yield levels is becoming more positive. The trend should continue if central bankers across the developed world stick to their promises to maintain very loose monetary policy settings for at least the next two years, forcing investors to chase scarce yields while worrying less about cyclical economic and inflation factors. Country Allocations: Maintain overweights to higher-yielding government bonds (Italy, the US, Canada) versus low-yielders (Germany, France, Japan) within USD-hedged fixed income portfolios. Upgrade higher-yielders Spain and Australia to overweight, at the expense of the low-yielding UK and Germany. Feature “What is the investment rationale for buying developed market government bonds now?” We begin this week with a question posed by a BCA client in a recent meeting. It was a perfectly logical inquiry given the current microscopic level of yields on offer almost everywhere. Why bother buying a 10-year US Treasury barely yielding more than 0.5%, or a 10-year Italian BTP yielding less than 1%, with both offering little compensation for future inflation or fiscal risks? Chart of the WeekYield Chasing Is Now The Only Winning Strategy Our answer to the question – “because the Fed and ECB will do whatever is needed to prevent nominal bond yields from rising over the foreseeable future” – did little to influence the client’s view on the attractiveness of those yields (but did make her more comfortable about the equity and corporate credit exposures in her portfolio). In the current environment, where all countries are experiencing the ultimate exogenous negative growth shock – a deadly and highly contagious pandemic - the usual analysis of the cyclical economic and inflation dynamics of any single country now offers far less payoff to government bond investing. It is hard to find a country not suffering from weak growth, very low inflation, high unemployment (some of which is likely to be permanent) and ongoing uncertainty related to the spread of COVID-19. It is also hard to find a country where interest rates have not been cut to 0% (or even lower) and central banks have not ramped up bond buying activity. Increasingly, the relative performance of government bonds between countries reflects simple yield differentials, rather than differing monetary policy outlooks. Higher-yielding markets are outperforming the lower-yielding markets – a trend that has persisted throughout 2020 and is likely to intensify in the coming months (Chart of the Week). Growth? Inflation? Who Cares? Give Me Yield! Developed market government bond yields have been ignoring the usual message sent by cyclical economic indicators. The latest round of global manufacturing PMI data showed continued solid rebounds from the COVID-19 collapse in the US, UK, most of the euro area and other major regions. Nominal 10-year government bond yields in those countries typically track the path of the PMIs, but yields are now as much as 180bps (for US Treasuries) below the levels seen the last time PMIs were so elevated (Chart 2). There is an easy way to explain this discrepancy between bond yields and economic activity. In years past, markets would price in higher inflation expectations, and a greater probability of a future monetary tightening, when growth was improving. Today, policymakers worldwide are bending over backwards to let investors know that no interest rate increases should be expected for at least the next two years – even if growth is improving and inflation were to accelerate. This is having the effect of both lowering real bond yields and increasing inflation expectations, with central bankers also expressing a greater tolerance for future inflation that will limit “pre-emptive” rate increases. Our Central Bank Monitors continue to signal a need for easier monetary policies, even with the rebound in manufacturing data and economic optimism surveys witnessed in the US and UK lifting the Monitors there from the lows (Chart 3). Real bond yields are mirroring the trend in the Central Bank Monitors, indicating that some of the decline in real yields seen in the US, Europe, Canada and Australia is likely related to markets pricing in a lower-for-longer period of monetary policy rates, as we discussed in last week’s report.1 Chart 2Bond Yields Ignoring Improving PMIs Chart 3Plunging Real Yields Reflect Pressure On CBs To Stay Dovish Chart 4A Low-Volatility Backdrop Encourages Yield Chasing Behavior With bond markets having little reason to expect a shift to more bond-unfriendly monetary policies, it is no surprise that higher yielding government bond markets are outperforming low-yielders at an accelerating rate. When there is little to be gained or lost from the duration exposure of government bonds, then the expected returns on government bonds will more closely track yield levels. Fixed income investors seeking the highest returns will be forced to chase the bonds with the highest yields. The current calm volatility backdrop is also fostering an environment of yield-chasing, carry-driven strategies. Measures of yield volatility like the MOVE index of US Treasury option prices and swaption volatilities in Europe have calmed dramatically from the spike seen during February and March (Chart 4). Liquidity in government bond markets has also improved, with bid/ask spreads on 30-year US Treasuries and UK Gilts now back to normal tight levels.2 In a world of low bond volatility and yield chasing behavior, markets with the highest yields should end up outperforming lower yielding markets. Chart 5"High" Yielders Are The Winners In A Low-Yield Environment In Chart 5, we show the 2020 year-to-date government bond returns, for the 7-10 year maturity bucket, for the countries we include in our model bond portfolio (the US, Germany, France, Italy, Spain, the UK, Japan, Canada and Australia). The returns are shown both currency unhedged (in USD terms) and hedged into US dollars, with the yield levels from the start of 2020 shown at the top of each bar. The ranking of the returns does generally follow the ranking of yields at the start of the year – the US, Canada, Australia and Italy outperforming low-yielding Germany, France and Japan. What is more interesting is how that correlation between yield levels and performance has evolved over the course of 2020, and even dating back to 2019. If a dynamic of strict yield chasing behavior was gaining steam, then the performance rankings of government bonds should increasingly reflect the rankings of available yields. One way to measure such a dynamic is with a statistic called a Spearman’s rank correlation. Simply put, the Spearman’s rank shows the correlation between the rankings of two sets of variables within each set, rather than the correlation of the variables themselves. If the correlation between the rankings is increasing, this suggests that the relationship between the two variables is becoming more dependent on the levels of the variables relative to each other. We present the Spearman’s rank correlation between yield levels and subsequent bond returns for the nine countries in our model bond portfolio universe in Chart 6. Weekly correlations are calculated using the ranking of the 10-year government bond yields from those nine countries and the rankings of the subsequent weekly total returns (currency unhedged) for those same markets. We present a rolling 52-week correlation coefficient in the chart, which shows a steadily rising trend over the past year of relative bond market performance becoming more dependent on relative initial yield levels. Chart 6High' Yielders Are The Winners In A Low-Yield Environment While the Spearman’s rank correlation is still relatively low, around 0.2 on the latest data point of the 52-week moving average, that does represent the highest level seen over the past two decades. On the margin, the more recent observations are showing an even higher level of correlation – a trend that should continue given the current easy global monetary policy settings described above that should continue to promote yield-chasing behavior. Another way to measure how much more yield driven government bond markets have become is to look at the relative performance of investment strategies that focus on allocations informed by yield levels. A simple such strategy is presented in Chart 7, using a rule of going long the highest yielding 10-year bond in our list of nine countries at the start of each week and holding only that bond for the subsequent week. We show the return of that simple strategy relative to the return Bloomberg Barclays 7-10 year Global Treasury index in the top panel of the chart, all measured in US dollars on an unhedged basis. The simple strategy of picking the highest yielding bond has been delivering solid outperformance versus the benchmark over the past 2-3 years, with year-over-year relative returns of between 5-10%. The strategy performed very well during the last period similar to today in the post-crisis years of 2012-16, when global policy rates were near 0% and central banks were aggressively expanding their balance sheets through quantitative easing. The year-over-year returns of this simple strategy were always positive during the period (shaded in the chart), which included some major moves in the US dollar that influenced unhedged bond returns. A simple strategy of selecting only the highest yielding government bond has also delivered solid returns of late when focused on other bond maturities besides the 10-year point (Chart 8). The information ratios of these strategies, shown in the chart as the relative year-over-year return of each strategy versus the benchmark compared to the volatility of that relative performance, are all at similar levels in the 0.27-0.94 range. Chart 7Chase The Highest Yields During Global QE & Extended ZIRP Chart 8Yield Chasing Strategies Outperforming Across All Maturities The efficiency of these strategies will likely not return to the levels seen during that 2012-16 period of extended easy global monetary policy, given the much lower yield levels seen across all bonds including outright negative yields in places like Germany and Japan. However, in a more general sense, selecting higher yielding bonds over lower yielding ones should continue to deliver stronger returns than passive low-yielding benchmarks for as long as policymakers continue to err on the side of reflation (0% rates, more quantitative easing, even yield curve control to limit yields from rising) when setting monetary policy. Selecting higher yielding bonds over lower yielding ones should continue to deliver stronger returns than passive low-yielding benchmarks for as long as policymakers continue to err on the side of reflation. Bottom Line: The correlation of relative global government bond returns and yield levels is becoming more positive. The trend should continue if policymakers stick to their promises to maintain very loose monetary policy settings for at least the next two years, forcing investors to chase scarce yields regardless of cyclical economic and inflation trends. Investment Implications & Alterations To Our Model Bond Portfolio Chart 9Higher-Yielding Government Bonds Will Continue To Shine The intensified yield chasing behavior has obvious implications for fixed income investors. Within dedicated global government bond portfolios, exposures should be concentrated in higher yielding markets at the expense of the low yielders. Already, the relative returns year-to-date (on a USD-hedged and duration-matched basis versus the Global Treasury index) reflect that conclusion, with the US (+692bps versus the index), Canada (+458bps) and Italy (+87bps) outperforming and Germany (-111bps), France (-77bps) and Japan (-472bps) lagging (Chart 9). Our current investment recommendations, both on a medium-term strategic basis and within our more flexible model bond portfolio, are generally in line with those rankings. Our recommendations already include overweights in the US, Canada, Italy and the UK; with underweights in Germany, France and Japan. We are currently neutral Spain and Australia. The view on Spain was a relative value consideration, as we preferred an overweight on Italy as our recommended exposure within the European peripherals. For Australia, we closed our long-standing overweight stance there back in May, primarily due to signs that the Australian economy was showing signs of recovery after what was a very modest initial wave of COVID-19 cases.3 Now, we see good reasons to upgrade Spain and Australia to overweight to gain even more exposure to high-yielding government bonds in a yield-scarce, yield-chasing world. Our recommendations already include overweights in the US, Canada, Italy and the UK; with underweights in Germany, France and Japan. In Chart 10, we present a scatter chart showing 10-year government bond yields, hedged into US dollars, plotted versus the latest trailing 1-year beta of yield changes to those of the 7-10 maturity bucket for the Global Treasury index. This is a simple way to present a reward versus risk relationship, using the yield beta as the measure of risk. The chart shows that Spain and Australia offer relatively attractive yields compared to other markets with similar yield betas. This offers a way to boost the expected yield from our recommended portfolio without raising the yield beta of the portfolio. Chart 10Upgrade Spain & Australia, Downgrade The UK In Global Bond Portfolios Specifically, we see two allocation changes that can be made to our model bond portfolio to reflect this view on relative yields: Upgrade Spain to overweight, while reducing the weight on UK Gilts to neutral Upgrade Australia to overweight, funded by reducing the German underweight allocation even further. We see good reasons to upgrade Spain and Australia to overweight to gain even more exposure to high-yielding government bonds in a yield-scarce, yield-chasing world. The USD-hedged yield pickup on both of those switches is substantial, as can be seen in Table 1 where we present unhedged and USD-hedged yields for 2-year, 5-year, 10-year and 30-year government bonds across all developed markets. Switching from the UK to Spain generates a modest yield pick-up on an unhedged basis at the 10-year and 30-year maturity points. The pickup is far more attractive across all maturity points on a USD-hedged basis, ranging from +22bps for 2-year maturities to +101bps for 30-year bonds. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD In fact, UK Gilt yields across the entire maturity spectrum are now some of the lowest on offer within the developed market space, both on an unhedged and USD hedged basis. This alone is enough reason to downgrade Gilt exposure, especially with the Bank of England continuing to shoot down the notion of a move to negative UK policy rates that could also drive longer-dated Gilt yields into negative territory. As for Australia, the recent severe COVID-19 outbreak in Melbourne, the country’s second largest city, has raised fears that a new and more extended period of lockdowns may be necessary Down Under. This goes against our original thesis for downgrading Australian bond exposure a few months ago, thus a return to overweight as a yield pickup also makes sense on a fundamental basis – particularly with the RBA already using extreme measures like yield curve control to anchor the level of 3-year Australian bond yields from the short end of the curve. The yield pick-up from our recommended switch from Germany to Australia is significant from the 2-year to 30-year maturity points, ranging between 94bps to 182bps on an unhedged basis and 20bps to 109bps on a USD-hedged basis. The changes to our recommended country allocations in our model bond portfolio can be found on pages 12-13. Bottom Line: Maintain overweights to higher-yielding government bonds (Italy, the US, Canada) versus low-yielders (Germany, France, Japan) within USD-hedged fixed income portfolios. Upgrade higher-yielders Spain and Australia to overweight, at the expense of the low-yielding UK and Germany.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Are Bond Markets Throwing In The Towel On Long-Term Growth?", dated August 4, 2020, available at gfis.bcaresearch.com. 2 The bid-ask spreads shown are taken from the Bank of England’s latest Financial Stability Review, available here: https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2020/august-2020.pdf 3 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Ultimately the US Congress will pass a major stimulus bill, but short-term risks to the equity rally are elevated. President Trump’s executive actions are not sufficient stimulus in the absence of an act of Congress. Trump’s opinion polling is starting to recover. A sustainable comeback requires Trump to sign a bill, the stock market to avoid a correction, COVID-19 new cases to continue subsiding, and crime to rise such that “law and order” resonates with voters. Depending on the data, we will upgrade Trump’s odds of victory from 35%. A major Trump comeback would increase global economic policy uncertainty relative to the United States. This would support the USD and US equity outperformance relative to global in the near term, though the opposite is still likely over the long term. Feature Over the weekend President Trump resorted to executive orders to bypass the gridlock in Congress over the next round of fiscal support for the pandemic-stricken economy. He issued four decrees that would provide $400 per week in new federal unemployment benefits; defer the 6.2% payroll tax on US workers making less than $100,000 through December 31; assist renters and homeowners with monthly payments; and delay student debt repayments. These actions are politically popular and Democrats will have trouble criticizing them. But they are not ultimately sufficient for the US economy or stock market. They should be seen as part of a “stimulus hiccup” that fails to deliver the equity market from the elevated risk of a correction in the very near term. First, these measures are leaner than any compromise bill that would come from Capitol Hill. They will also be difficult to implement as US states are required to provide 25% of the unemployment benefits while individual companies are needed to manage the payroll tax. Uncertainty will be high and compliance low, especially initially.     Second, federal courts will add to uncertainty by raising legal questions about the president’s decrees, probably issuing injunctions. The president is partly redirecting funds already appropriated, which can be gotten away with (especially during emergencies and on a temporary basis), but he is flirting with making unilateral appropriations, which is unconstitutional. Legal questions will make it harder for states and firms to know whether and how to implement the orders, vitiating their effect. Thus if the president’s actions are not quickly superseded by a full relief bill from Congress, the market will be disappointed, along with business and consumer confidence and balance sheets. Fiscal policy is of utmost importance to financial markets because the major central banks are limited due to the zero lower bound. Any premature interruption in fiscal support could cause markets to go into a tailspin on the fear that household and business finances and confidence will relapse, with longer-term damage. Chart 1Volatility Rises Ahead Of Elections Volatility has not picked up much because the pandemic numbers are improving (see below) and these executive actions offer a bridge to a full stimulus bill later (Chart 1). But that means further delays will cause bigger swings – especially if Congress does not get a deal by the end of this week. With election risks and geopolitical risks also escalating, August could easily whipsaw bullish equity investors who have grown complacent with this year’s rapid rebound. Ultimately, we maintain that Congress will pass a bill. GOP senators will succumb to political pressure. Both Trump and the Republicans are looking extremely vulnerable in public opinion polling. A failure on pandemic relief would likely be the final straw for voters. Concessions to House Democrats will produce a bill of around $2.5 trillion for President Trump to sign (Table 1). Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) Chart 2Republicans Will Forgive Senate Largesse If Re-Elected The opposing risk – that Republicans will lose votes for being fiscally profligate – is a far lower bar for them to cross. Republicans worry less about Big Government when their own party runs the government (Chart 2). Assuming GOP senators get with the program and a bill is passed, markets will turn to the 2020 election battle. This election is more significant than usual because it pits an anti-establishment candidate against a political establishment that is circling the wagons, thus portending structural consequences for the US economy, particularly on trade and immigration. President Trump is the underdog because of the pandemic and recession. High unemployment is deadly for sitting presidents. Voters clearly believe he has mishandled the pandemic; they also believe he has mishandled race relations amid an explosion of racially charged social unrest. But these factors are now baked in the cake. There are three factors that can sustain Trump’s comeback in the opinion polls: Stimulus passes: Passage of a new stimulus bill will buttress the households, businesses, and the stock market. By issuing executive orders, Trump has shown he has no patience for Congress’s dithering. This will resonate with voters, but only so far. A full stimulus bill needs to be signed and disbursed to sustain his rebound in popular opinion. COVID-19 abates: COVID-19 hospitalizations and new cases are rolling over, giving society (and markets) a reason to be optimistic (Chart 3). As long as stimulus is passed, people can continue distancing without reversing the economic recovery. If the virus abates, Trump’s net approval rating will also improve. “Law and order” resonates: Trump has taken a hard line on crime, violence, and vandalism amid this summer’s social unrest. If crime rises in the suburbs in swing states, then his message may resonate with critical voters. Alternately he could gain traction for tough foreign policy on China (as long as stocks do not collapse) or Iran. Chart 3COVID-19 Hospitalizations And New Cases Rolling Over Chart 4Trump’s Comeback Begins – Is It Sustainable? Trump’s polling head-to-head against his rival, former Vice President Joe Biden, suggests that he has hit the floor in the swing states but not national polling – and it is swing states that determine the Electoral College outcome (Chart 4). If these three trends fall together, Trump’s comeback in opinion polls will be sustainable and we would need to upgrade his odds of victory, which we set at 35% in March. Global policy uncertainty would rise relative to the United States, as Trump is disruptive on the global scene. The US dollar could bounce, or at least stay flat, as near-term geopolitical risk would vie with surging debt monetization, which will weaken the dollar over the long run. US equity performance relative to global stocks would get a boost due to higher odds of more significant protectionism and trade conflict in 2021-24. By contrast, if Congress fails on stimulus, the stock market corrects, COVID reaccelerates with the school year, and the “law and order” theme flops, then Trump’s polling will see a dead-cat bounce. US policy uncertainty would rise relative to global, as Biden and the Democrats would raise regulation and taxes at home yet act with greater predictability abroad (Chart 5). Chart 5A Trump Comeback Would Boost US Equity Outperformance Until the three trends above confirm the basis for Trump to have a sustainable comeback, we maintain that his odds of victory are 35%. Our quantitative model reveals upside risk by indicating he has a 42% chance (Chart 6). Chart 6Geopolitical Strategy Quant Model: Trump Has 42% Chance Of Victory​​​​​​​ Bottom Line: Investors should be prepared for a risk-off episode in the near term in case Congress fails to compromise on a major new fiscal stimulus. Assuming they agree, President Trump will have a comeback in opinion polls that could be sustainable and justify an upgrade of his election chances. That in turn would raise the risk of significant escalation in the trade war for China (and Europe) and eliminate the risk of higher taxes and regulation in the United States in 2021. Investors who are aggressively short the dollar, or heavily invested into cyclical stocks and regions, would get blindsided in the short run by such a turn of events, even though this positioning makes sense over the long run. After all, over the long run for the dollar, the whole dynamic outlined in this report underscores that austerity is dead: if Trump wins he was rewarded for using populist spending by executive fiat; if Democrats win then their mega-spending proposition paid off. Matt Gertken  Vice President Geopolitical Strategy  mattg@bcaresearch.com ​​​​​​​