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Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await Chart 6Global Arms Build-Up Continues   We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

The drubbing in the US/EMU sovereign bond spread is cause for concern for the SPX’s slingshot recovery off the March 23 lows, especially given the tight positive correlation of these two series over the past three decades (top panel). Typically, higher relative yields attract capital to US shores and vice versa, and some of that capital inevitably leaks into US stocks. Moreover, theory would suggest that relative yields move with the ebb and flow of relative return on capital. Indeed, the bottom panel of the chart highlights such an empirical relationship. Currently, euro area return on assets is narrowing the gap with the US which usually happens in recessions. The persistent unresponsiveness in the 10-year UST yield near the zero line which stands closer to the ECB’s NIRP, likely spells short-term trouble for the SPX. Bottom Line: We remain cautious on the near-term prospects of the S&P 500 until the election uncertainty lifts in November.   

Highlights Butterflies & Yield Curve Models: With bond market volatility now back to the subdued levels seen prior to the COVID-19 market turbulence earlier in 2020, it is a good time to update our global yield curve valuation models to look for attractive butterfly trade ideas. Valuations: The models generally indicate that flattener trades offer better value across all countries. Our medium-term strategic bias, however, is towards steeper yield curves with policy rates on hold and depressed global inflation expectations likely to continue drifting higher over the latter half of the year. Yield Curve Trades: We are initiating the first set of yield curve trades within our rebooted Tactical Trade Overlay: going long a 7-year bullet vs. a 5-year/10-year barbell in the US; long a 2-year/30-year barbell vs. a 5-year bullet in France; long a 5-year/30-year barbell vs. a 10-year bullet in Italy; and long a 3-year/20-year barbell vs. a 10-year bullet in the UK. Feature In a Special Report published back in February of this year, we dusted off our model-based framework to find value in trades focused on the shape of government bond yield curves.1 By comparing the market-implied short-term interest rate expectations extracted from our curve models to our own macro views, we are able to come up with actionable buy or sell signals across the yield curve in nine developed markets: the US, Germany, France, Italy, Spain, the UK, Japan, Canada, and Australia. Table 1Most Attractive Butterfly Trades Given the extreme market turbulence around the time we published that report, as the full scope of the COVID-19 pandemic was becoming evident, we chose not to recommend any curve trades from our models until global volatility subsided to acceptable levels. The vigorous action from central banks to manipulate bond yields since then - quantitative easing, aggressive forward guidance, outright yield curve control in Japan and Australia, and other unconventional monetary policy measures - introduced another layer of difficulty in implementing successful curve trades using models estimated in more normal times. With global bond market volatility now back down to pre-COVID levels, we feel that the time is right to use our curve models to help identify opportunities. Specifically, we are implementing new recommended yield curve trades in the US, France, Italy, and the UK. Table 1 shows the most attractive butterfly trades across all the markets covered in this analysis. Note that three of the four trades we are initiating include very long-dated bonds where yields are less susceptible to direct central bank influence. The only exception is our US long 7-year bullet vs. 5-year/10-year barbell trade, the reasoning for which we outline later in this report. Three of the four trades we are initiating include very long-dated bonds where yields are less susceptible to direct central bank influence. The only exception is our US long 7-year bullet vs. 5-year/10-year barbell trade. Before delving into our analysis proper, a quick note: in the interest of brevity, we will limit ourselves to a simple explanation of butterfly strategies and our yield curve models in this report. For those interested in a deeper explanation of the curve modeling framework, please refer to our February 25, 2020 Special Report. A Recap On Butterflies And An Update On Our Yield Curve Models A butterfly fixed income strategy involves two main components: a barbell (a weighted combination of long-term and short-term bonds) and a bullet (a medium-term bond that sits within the yield curve segment selected in the barbell). To implement a butterfly strategy, a bond investor would go long (short) the barbell while simultaneously going short (long) the bullet. By weighting the combination of the long- and short-term bonds in the butterfly such that the weighted sum of their duration equals the duration of the medium-term bond in the bullet, we achieve immunization to parallel shifts in the yield curve. At the same time, due to the relatively higher duration of the longer-term component of the butterfly, we get exposure to specific changes in the slope of the yield curve. In general, the barbell will outperform the bullet in a flattening yield curve environment, and vice-versa. Chart of the WeekButterfly Spreads & Yield Curves To actually decide how, and on which parts of the yield curve, to implement our butterfly strategies, we make use of our yield curve models. These models rely on the positive relationship typically observed between the butterfly spread and the slope of the yield curve. When the curve steepens, the butterfly spread widens, and vice-versa (Chart of the Week). This has to do with mean reversion: as the curve steepens, it increases the odds that the curve will flatten in the future since it cannot steepen indefinitely. Consequently, investors will ask for greater compensation to enter a curve steepener trade when the curve is already steepening. As a result, we can create simplified models of the yield curve by regressing any butterfly spread on its corresponding curve slope. Deviations from these fair value models indicate which butterfly strategies are cheap or expensive. However, the model output does not by itself constitute a buy or sell signal and must be integrated with our macro view on the slope of the curve. For example, a butterfly strategy with an expensive bullet implies that there is already a certain amount of steepening discounted in the yield curve. If the yield curve flattens, or even steepens by an amount smaller than what is discounted in the yield curve over the investment horizon, the barbell will outperform, as expected. However, if we see more steepening than is discounted in the yield curve, the bullet will outperform, even though it was already at relatively expensive levels. Therefore, it is crucial to integrate our macro view on how much the curve will steepen or flatten over the investment horizon into our curve trade selection framework. In recent reports, we have emphasized our high-conviction view that global inflation expectations will drift higher in the coming months, driven by reflationary fiscal and monetary policy and a continued rebound in global commodity prices (most notably, oil).2 However, a rise in inflation expectations does not necessarily translate to a “one-to-one” rise in nominal yields if it is offset by a compression in real bond yields. To disentangle this, we look at the 3-year rolling betas of nominal 10-year government bond yields to the corresponding 10-year breakeven inflation rates using inflation-linked bonds (Chart 2). The data suggest a currently weaker relationship between inflation expectations and nominal yields, with all betas well below their post-crisis maxima. Our overall macro bias is towards a global steepening in yield curves, but given our strong belief in a rebound in inflation expectations, we would be more willing to enter steepener trades in higher-beta regions such as Germany, Canada, the US, and Australia where it is more likely that a rise in inflation expectations will translate to higher nominal yields. Conversely, we are less hesitant to enter flatteners in the lower-beta regions such as the UK, France, Italy, and Japan. Chart 2The Link Between Nominal Yields And Inflation Expectations Has Weakened When we said earlier this year that we were “dusting off” our yield curve models, that was not just a figure of speech. The models date back originally to 2002, meaning that they are old enough to vote—perhaps even for a popular rapper. Even though we have been refining and updating it along the way, one of our concerns was that this model was estimated for a pre-crisis sample period before near-zero rates became ubiquitous in developed markets. Our overall macro bias is towards a global steepening in yield curves, but given our strong belief in a rebound in inflation expectations, we would be more willing to enter steepener trades in higher-beta regions such as Germany, Canada, the US, and Australia. To test that the curve relationships within our models are maintained when global central banks are pinning policy rates near 0%, we have re-estimated all the regressions for the post-financial crisis period from 2009 to 2017 when most central banks kept rates near the zero bound. Chart 3 shows the results for the representative 2-year, 5-year and 10-year portions of the yield curve. On the whole, the coefficients are weaker but still positive with the exception of Japan, where many years of zero rates and quantitative easing have caused the 2-year/5-year/10-year butterfly spread to become largely unmoored from the 2-year/10-year slope. Chart 3Looking For Structural Shifts In Our Yield Curve Models Therefore, we still see value in our curve modeling approach, even in the current environment where central banks are likely to be on hold for a period measured in years, not months. Bottom Line: Butterfly strategies are an effective way to position for changes in the slope of the yield curve without exposure to shifts in the curve. Our current strategic bias is to expect steepening of developed market yield curves through rising longer-term inflation expectations, but our global yield curve models indicate better value in most flattening trades. Thus, we need to be extremely selective in recommending trades based on the results of our yield curve models. Yield Curve Models And Trades By Region In the remaining pages of this report, we present the current read-outs from of our yield curve models for each of the major developed markets. More specifically, we provide the deviations from fair value for different combinations of bullets and barbells and highlight the most attractive butterfly strategy. The deviations from fair value shown in Tables 2-10 are standardized to facilitate comparisons between the different butterfly combinations. In addition, for each country we provide a quick assessment of the performance of these butterfly strategies over time by applying a simple mechanical trading rule. Every month, we enter the most attractive butterfly strategy, i.e. the one with the highest absolute standardized deviation from its model fair value. The overall message from the models is that barbells appear attractive relative to bullets across all the countries shown. However, we will only initiate trades in cases where the model output and our macro outlook complement each other. US Looking solely at our model output, US Treasury curve flatteners appear most attractive, with the long 3-year/30-year barbell vs. 5-year bullet trade displaying the greatest deviation from fair value with a residual of -1.55 (Table 2). However, we are inclined to agree with our colleagues at BCA Research US Bond Strategy on how to interpret Treasury curve valuation in the current environment. They argue that even though steepeners in the US are currently expensive, valuations can become even more overstretched with the Fed signaling no rate increases for at least the next two years and the market priced for an extended period of near-zero rates.3 Table 2US: Butterfly Strategy Valuation: Standardized Residuals Our fundamental bias is towards US Treasury curve steepening, with the Fed locking down the front end of the curve and rising inflation expectations putting upward pressure on longer-term yields. Thus, we are entering into the long 7-year bullet vs. 5/10 barbell trade which has a small but positive model residual of +0.17. That represents a better valuation starting point than the other US butterfly spreads, and is therefore a more efficient and profitable way to position for steepeners becoming even more expensive going forward. As highlighted earlier, nominal yields in the US are also more sensitive to rising inflation expectations—another reason to enter into a curve steepener. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Nominal yields in the US are also more sensitive to rising inflation expectations—another reason to enter into a curve steepener.  The 7-year bullet appears just 1bp cheap according to our model and would only underperform its counterpart given a flattening in the 5-year/10-year Treasury slope greater than 22bps, which we believe is unlikely given the reasons outlined above (Chart 4A). Chart 4AUS 5/7/10 Spread Fair Value Model Chart 4BUS Butterfly Strategy Performance Following the mechanical trading rule has delivered steady returns with only a few periods of negative year-over-year returns (Chart 4B). Germany The most attractively valued butterfly combination on the German yield curve is going long the 1-year/30-year barbell and shorting the 5-year bullet, which is almost one standard deviation above its model-implied fair value, with a standardized residual of -0.97 (Table 3). Table 3Germany: Butterfly Strategy Valuation: Standardized Residuals The 5-year bullet appears 29bps expensive according to our model and would only outperform its counterpart given a steepening in the 1-year/30-year German curve slope greater than 50bps (Chart 5A). Chart 5AGermany 1/5/30 Spread Fair Value Model Chart 5BGermany Butterfly Strategy Performance Following the mechanical trading rule has been quite profitable, delivering consistently positive year-over-year returns for all but the initial period of our sample (Chart 5B). France The most attractively valued butterfly combination on the French OAT yield curve is going long the 2-year/30-year barbell and shorting the 5-year bullet (Table 4). This combination is a little less than one standard deviation over its model-implied fair value with a standardized residual of -0.84. Nominal yields in France are also relatively less correlated with inflation expectations, which makes this a prime candidate for a flattener trade. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Table 4France: Butterfly Strategy Valuation: Standardized Residuals The 5-year bullet appears 21bps expensive according to our model and would only outperform its counterpart given a steepening in the 2-year/30-year French curve slope greater than 48bps (Chart 6A). Chart 6AFrance 2/5/30 Spread Fair Value Model Chart 6BFrance Butterfly Strategy Performance As with Germany, following the mechanical trading rule in the French OAT market has also been profitable, with only three periods of negative year-over-year returns in our sample period (Chart 6B). Italy And Spain In Italy, the most attractively valued butterfly combination is going long the 5-year/30-year barbell and shorting the 10-year bullet – a combination with a standardized residual of -0.79 (Table 5). In Spain, going long the 3-year/30-year barbell and short the 5-year bullet seems most attractive with a standardized residual of -0.83 (Table 6). Of the two peripheral euro area countries, we are choosing to put on a trade in the relatively larger and more liquid Italian government bond market. As with France, Italian nominal yields also display a relatively low beta to inflation breakevens. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Table 5Italy: Butterfly Strategy Valuation: Standardized Residuals Table 6Spain: Butterfly Strategy Valuation: Standardized Residuals In Italy, the 10-year bullet appears 22bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/30-year Italian curve slope greater than 153bps (Chart 7A). Following the mechanical trading rule in Italy has yielded strong excess returns, with only one very short period of negative year-over-year returns in our sample period (Chart 7B).  As with Italy, following the mechanical trading rule in Spain has yielded some of the strongest excess returns on a cumulative and year-over-year basis. Chart 7AItaly 5/10/30 Spread Fair Value Model Chart 7BItaly Butterfly Strategy Performance In Spain, the 5-year bullet appears 14bps expensive according to our model and would only outperform its counterpart given a steepening in the 3-year/30-year Spanish curve slope greater than 47bps (Chart 8A). As with Italy, following the mechanical trading rule in Spain has yielded some of the strongest excess returns on a cumulative and year-over-year basis (Chart 8B). Chart 8ASpain 3/5/30 Spread Fair Value Model Chart 8BSpain Butterfly Strategy Performance UK On the UK Gilt yield curve, the most attractive butterfly combination is holding a 3-year/20-year barbell versus a 10-year bullet, which currently displays a standardized residual of -1.08 (Table 7). As with France and Italy, not only is this flattener trade attractively valued, the UK is also one of the countries where inflation breakevens are relatively less correlated with nominal yields, making this another excellent candidate for our Tactical Trade Overlay. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27. Table 7UK: Butterfly Strategy Valuation: Standardized Residuals The 10-year bullet appears 13bps expensive according to our model and would only outperform its counterpart given a steepening in the 3-year/20-year Gilt curve slope greater than 52bps (Chart 9A). Chart 9AUK 3/10/20 Spread Fair Value Model Chart 9BUK Butterfly Strategy Performance Following the mechanical trading rule in the UK has produced consistent returns on a year-over-year basis (Chart 9B). Canada The most attractively valued butterfly combination on the Canadian yield curve is favoring the 5-year/30-year barbell versus the 7-year bullet, which currently displays a standardized residual of -1.41 (Table 8). Table 8Canada: Butterfly Strategy Valuation: Standardized Residuals The 7-year bullet appears 7bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/30-year Canadian curve slope greater than 42bps (Chart 10A). Chart 10ACanada 5/7/30 Spread Fair Value Model Chart 10BCanada Butterfly Strategy Performance Following the mechanical trading rule in Canada has historically been a good strategy, but we do note two periods of minor losses in 2013 and 2019 (Chart 10B). Japan The most attractively valued butterfly combination on the JGB yield curve is the 5-year/20-year barbell versus the 7-year bullet, which currently has a standardized residual of -1.03 (Table 9). As we noted earlier, however, valuations in the JGB market are likely distorted due to the Bank of Japan’s long-running programs of quantitative easing, zero policy rates and Yield Curve Control that aims to keep the 10-year JGB yield around 0%. Table 9Japan: Butterfly Strategy Valuation: Standardized Residuals The 7-year bullet appears 6bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/20-year Japan curve slope greater than 23bps (Chart 11A). Following our mechanical trading rule has produced decent returns, especially given the dormant nature of the JGB market, with only a couple minor periods without positive year-over-year returns. Chart 11AJapan 5/7/20 Spread Fair Value Model Chart 11BJapan Butterfly Strategy Performance Following our mechanical trading rule has produced decent returns, especially given the dormant nature of the JGB market, with only a couple minor periods without positive year-over-year returns (Chart 11B). Australia The most attractively valued butterfly combination on the Australian yield curve is going long the 2-year/10-year barbell versus the 7-year bullet, displaying a standardized residual of -1.73 (Table 10). Table 10Australia: Butterfly Strategy Valuation: Standardized Residuals The 7-year bullet appears 15bps expensive according to our model and would only outperform its counterpart given a steepening in the 2-year/10-year Australian curve slope greater than 101bps (Chart 12A). Chart 12AAustralia 2/7/10 Spread Fair Value Model Chart 12BAustralia Butterfly Strategy Performance Compared to the other markets in our analysis, following the mechanical trading rule in Australia has not produced stellar returns (Chart 12B). However, excess returns on a year-over-year basis have been positive barring two periods.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Special Report, "Global Yield Curve Trades: Follow The Butterflies", dated February 25, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research US Bond Strategy Weekly Report, "Take A Look At High-Yield Technology Bonds", dated June 23, 2020, available at usbs.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