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Highlights 10-Year Yield: In this week’s report we run through different macro factors that could be used to create a macroeconomic model of the 10-year Treasury yield, and describe the current outlook for each one. On balance, the indicators suggest that the 10-year Treasury yield is near its floor. Global Growth: Leading indicators have hooked up recently, suggesting that the Global Manufacturing PMI – a key driver of the 10-year Treasury yield – may rise in the coming months. Wages: Average hourly earnings softened in March, but survey measures suggest that wage growth remains in an uptrend. We show that rising wages have put considerable upward pressure on the 10-year yield in recent years, and should continue to do so going forward. Sentiment: The depressed Economic Surprise Index suggests that investor economic sentiment is downbeat. This means that the bar for positive data surprises (and higher bond yields) is relatively low. Feature Chart 1CRB/Gold Ratio On The Rise Treasury yields stabilized during the past week, and investors are trying to figure out whether the next big move will be higher or lower. We’re on the record as predicting that yields will eventually head higher, and have flagged the CRB Raw Industrials / Gold ratio as an important indicator to watch to time the next big move.1  Encouragingly, this indicator has risen during the past few weeks (Chart 1). Though the message from the CRB/Gold index is promising, the outlook for the 10-year Treasury yield remains uncertain. To shed some light on this important investment question, in this week’s report we run through different macroeconomic indicators that could be used to create a model of the 10-year Treasury yield. By performing this exercise out in the open, our goal is to present readers with a good way to think about the linkages between the economy and the 10-year Treasury yield. Recipe For A 10-Year Treasury Yield Model Ingredient #1: Growth Factors The first logical factor to include in any model of the 10-year Treasury yield is some measure of economic growth. We have found that the Global Manufacturing PMI is often highly correlated with the 10-year yield (Chart 2). Interestingly, the manufacturing PMI correlates more strongly with the 10-year yield than do the services or composite (manufacturing + services) PMIs. The Global PMI also correlates more strongly with the U.S. 10-year yield than does the U.S. PMI. It only takes a quick glance at the Global Manufacturing PMI to see why the 10-year Treasury yield fell this year. The Global PMI has been in a sharp downtrend for some time, driven mostly by the Euro Area and China. U.S. PMIs have also weakened in recent months, though they remain above levels seen in Europe and China. Another global growth indicator that correlates tightly with the 10-year Treasury yield is investor sentiment toward the U.S. dollar (Chart 3). Since the dollar is a countercyclical currency that appreciates when global growth slows and depreciates when it quickens, we observe that the 10-year Treasury yield tends to be lower when investors are extremely bullish on the U.S. dollar and higher when they are more bearish on the dollar. Chart 2Growth Factor Ingredient 1: Global Manufacturing PMI Chart 3Growth Factor Ingredient 2: Dollar Bullish Sentiment     Notice in Charts 2 and 3 that the Global Manufacturing PMI and dollar bullish sentiment are both close to levels seen near the 10-year yield’s mid-2016 trough. At 50.6, the PMI is only slightly above its 2016 low of 49.9. Meanwhile, dollar bullish sentiment is currently 79%. It maxed out at 82% in 2016. Interestingly, despite the fact that our economic growth indicators paint a similar growth back-drop as 2016, the 10-year yield remains well above its mid-2016 low of 1.37%. Logically, we must conclude that some other “non-growth” factor is propping yields up (more on this below). The 10-year Treasury yield tends to be lower when investors are extremely bullish on the U.S. dollar and higher when they are more bearish on the dollar.  Looking ahead, we remain optimistic that the most important global growth indicators (Global Manufacturing PMI and dollar bullish sentiment) will soon reverse course, as some leading global growth indicators have recently turned a corner. We already saw that the CRB Raw Industrials index has broken out (Chart 1). Additionally: Chart 4The Worst Is Behind Us? The Global ZEW Economic Sentiment index has risen in two consecutive months (Chart 4, top panel). Our Global LEI Diffusion Index shows that more than half of the countries in our sample now have improving leading economic indicators (Chart 4, panel 2). Our BCA Boom/Bust Indicator – an indicator based on the CRB index, Global Metals equities and U.S. unemployment claims – has also jumped (Chart 4, bottom panel). Ingredient #2: Output Gap As noted above, the 10-year Treasury yield looks too high relative to our preferred economic growth indicators. This could be because yields haven’t yet caught up to the deteriorating global economy, but more likely it is because our bond model is still missing some key ingredients. The next most obvious factor to incorporate into our model is some measure of the output gap. If an economy is operating at very close to its peak capacity, with a small output gap, then it doesn’t take much additional growth to spark inflation. Conversely, even rapid economic growth will not be inflationary if the output gap is large. As long as the central bank is expected to lean against rising inflation with higher interest rates, then some measure of the output gap should be included in our bond model. Unfortunately, appropriate output gap measures are difficult to find. We could rely on the CBO or IMF’s output gap estimates, but those are often subject to large ex-post revisions – not ideal if we want to create a bond model that is useful in real time. Since the Fed tends to lift rates when the output gap closes, another option would be to include the fed funds rate as an independent variable in our model. However, this is also not ideal since we would expect the macroeconomic data and the 10-year yield to lead changes in the policy rate. Some measure of inflation might be the best factor to include. However, we find that the correlation between different price inflation measures and the 10-year Treasury yield is incredibly unstable over time. This is likely because the Fed targets price inflation explicitly, making its correlation with bond yields less empirically apparent. Wage growth is the best “output gap” measure to include in a 10-year Treasury yield model.  In fact, our analysis reveals that wage growth is the best “output gap” measure to include in a 10-year Treasury yield model. Specifically, average hourly earnings from the monthly employment report. Not only does the fed funds rate respond – with a lag – to changes in average hourly earnings, but average hourly earnings also line up reasonably well with the 10-year yield over time (Chart 5). Looking at Chart 5, we can now clearly see why the 10-year yield is above its mid-2016 low, despite the poor readings from our growth indicators. Wages have risen sharply since mid-2016, indicating that the output gap has closed, and the Fed has hiked rates 8 times as a result. The obvious conclusion is that in the present situation, with a much smaller output gap than in 2016, it would require a Global Manufacturing PMI well below 50 to produce a 10-year yield near 2% or below. Going forward, we see the uptrend in wage growth continuing for some time. The proportion of workers quitting their jobs each month, a signal of worker bargaining power, remains very high relative to history. Meanwhile, many more households continue to describe jobs as “plentiful” as opposed to “hard to get” (Chart 6). Chart 5Output Gap Ingredient: Average Hourly Earnings Chart 6More Room For Wages To Grow Ingredient #3: Policy Uncertainty The third ingredient we’ll add to our 10-year Treasury yield model is a measure of policy uncertainty. Specifically, the index of Global Economic Policy Uncertainty created by Baker, Bloom and Davis.2  Investors often flock to the safety of U.S. Treasuries in times of economic distress. But Treasuries can also benefit from flight-to-quality flows during periods of stable economic growth but heightened political turmoil. In other words, elevated political uncertainty can make investors fear a downturn in the future, and drive a flight into the safety of U.S. Treasuries. The Global Economic Policy Uncertainty index also shows a relatively strong correlation with the 10-year Treasury yield over time (Chart 7). Chart 7Policy Uncertainty Ingredient: Global Economic Policy Uncertainty Index Looking more closely at Chart 7, we see that global policy uncertainty is currently as high as it was in mid-2016, when the 10-year Treasury yield hit its cycle low. This lines up pretty well with intuition, since investors are understandably quite nervous about the state of Brexit negotiations and U.S./China trade relations. In that context, it is reasonable to expect that some geopolitical risk premium is currently priced into the 10-year Treasury yield, though a smaller output gap than in 2016 is preventing the 10-year yield from reaching mid-2016 levels. Going forward, though political uncertainty will probably stay elevated compared to history. It seems increasingly likely that a “hard Brexit” will be avoided and that President Trump will seek some sort of agreement with China in advance of the 2020 U.S. election.3 The political risk premium in 10-year notes could unwind somewhat in the coming months. Ingredient #4: Sentiment The fourth and final ingredient we’ll add to our 10-year Treasury yield model is a component related to investor sentiment. Our favorite being the U.S. Economic Surprise Index. Chart 8Sentiment Ingredient: Economic Surprise Index Investors don’t often think of the Surprise index as a sentiment indicator, but in fact that’s exactly what it is. It measures whether the economic data exceeded or fell short of expectations during the past 30 days, a measurement that is heavily influenced by whether investor expectations are optimistic or pessimistic. When economic expectations are extremely downbeat it doesn’t take much good news to generate a positive surprise, and vice-versa. Also, investor expectations are influenced in one direction or the other by whether the recent economic data are positive or negative. This behavioral dynamic causes the Economic Surprise Index to be a mean-reverting series, one that we can even describe with a simple auto-regressive model, as shown in Chart 8. More importantly, we have found that the Economic Surprise Index is tightly correlated with the change in the 10-year Treasury yield. A given month that ends with the Surprise index above zero is usually a month when the 10-year Treasury yield increased, and vice-versa (Chart 9). This correlation also holds relatively well over 3-month and 6-month horizons (Charts 10 & 11), but breaks down beyond that.4   The U.S. data surprise index is deeply negative at present, and has been for several weeks. But the longer the data continue to disappoint, the more downbeat investor expectations become and the more likely it is that the surprise index will rise in the future. Right now, our simple auto-regressive model projects that the surprise index will be slightly higher in one month’s time, though still deeply negative. Nevertheless, the Surprise index suggests we are approaching a turning point in investor sentiment. Mix Well, Cover, Stir Occasionally We’ve now presented what, in our view, is a fairly complete list of factors that should be included in a macroeconomic model of the 10-year Treasury yield. Importantly, each factor complements the other ones in the sense that they each capture a different element of the economic landscape. At this stage, it would be nice to weight all of the factors together and arrive at a fair value estimate for the 10-year yield. Unfortunately, we won’t be performing that exercise in this report (we may do so in the future). The key challenge in combining all of the indicators together is that the sensitivity of the 10-year yield to each of the above factors changes over time. For example, there are periods when policy uncertainty appears to be a very significant driver of the 10-year yield, and other times when it appears to not matter much at all. The macro indicators listed in this report generally signal that the 10-year yield is near its trough. While it is often useful to boil all of the important drivers down into a point estimate of the 10-year yield, such an exercise can also create problems if it causes us to zero-in on the model’s output and avoid thinking critically about what the different macro inputs are telling us. As of today, we think the macro indicators listed above generally signal that the 10-year yield is near its trough. Leading global growth indicators have hooked up, suggesting that the Global Manufacturing PMI will improve during the next few months and that bullish dollar sentiment could soften. Survey indicators suggest that the labor market remains tight, and that wage growth will stay in an uptrend. Policy uncertainty will probably continue to apply some downward pressure to yields, but a long Brexit extension and/or trade agreement between the U.S. and China could cause that impact to wane in the next few months. Economic sentiment is likely quite depressed, meaning that the bar for positive surprises is low. All in all, our investment strategy is unchanged. We recommend that investors maintain below-benchmark duration in U.S. bond portfolios, while focusing short positions on the 5-year and 7-year maturities.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 The rationale for tracking the CRB/Gold ratio can be found in U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 2 www.policyuncertainty.com 3 Please see Global Investment Strategy Quarterly Outlook, “From Dead Zone To End Zone”, dated March 29, 2019, available at gis.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “How Much Higher For Yields?”, dated October 31, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights As long as Chinese policymakers remain committed to their anti-pollution campaign, we believe high-grade iron ore prices will remain supported by demand from newer steelmaking technologies. A continuation of the much-needed consolidation in steelmaking capacity in China – wherein larger, more efficient operators force their less competitive rivals from the market – will reinforce this trend (Chart of the Week). Chart of the WeekChina's Steel Sector Will Continue Consolidating Over time, the iron ore market will resemble other developed markets – e.g., crude oil – where higher- and lower-grades of the commodity are regularly traded against each other (Chart 2). As this develops, hedgers and investors will be able to fine tune exposures with greater precision, and prices from these markets will better reflect supply-demand fundamentals. The central and local governments also will have a valuable window on how policy is affecting fundamentals as they pursue their “blue skies” policies. We are initiating tactical spread, getting long spot high-grade 65% Fe vs. short spot 62% Fe at today’s Custeel Seaborne Iron Ore Price Index levels, consistent with our view.1 Chart 2Iron Ore Spread Markets Will Continue To Develop Highlights Energy: Overweight. The Trump administration is reviving the Monroe Doctrine with its demand Russia remove its troops and advisors from Venezuela immediately, based on comments by the U.S. National Security Advisor John Bolton. In addition, a “senior administration official” said waivers for eight of Iran’s largest crude oil importers could be allowed to expire May 4, and that the administration is considering additional sanctions against Iran.2 Brian Hook, the special U.S. envoy for Iran, this week said three of eight countries granted waivers to U.S. sanctions agreed to take oil imports to zero.3 In a related development, OPEC crude oil output fell to a four-year low of 30.4mm b/d in March, according to a Reuters’s survey, as Venezuelan output falls and Saudi Arabia continues to over-deliver on its production cuts. Base Metals: Neutral. Codelco’s mined copper ore output fell to 1.8mm MT last year, down 1.6% vs. 2017 levels. This took refined output down almost 3% to 1.7mm MT, according to Metal Bulletin. The Chilean state-owned company cited reduced ore content in its mined production as a reason for the decline. MB’s copper treatment and refining charges index for the Asia Pacific region is at its lowest level since March 26, 2018, reflecting the lower concentrate supplies. We remain long spot copper on the back of low inventories, and an expected recovery in demand. Precious Metals: Neutral. Strength in equities has taken some of the luster off gold’s rally in the near term as investors move to increase stock exposures, but we continue to favor gold as a portfolio hedge and remain long. Agriculture: Underweight. USDA’s corn planting intentions report released last week came in much stronger than earlier estimates. Corn and soybeans traded lower following the release of the report, but recovered some this week on the back of positive news from Sino - U.S. trade talks. The USDA estimated farmers intended to plant 92mm acres of corn, and 85mm acres of soybeans this year. Ahead of the report, a Farm Bureau survey estimated corn and soybean acreage would average 91.3mm acres of corn and 86.2mm acres of beans. Trade Recommendations: Our 1Q19 trade recommendations were up an average of 41% at end-March (Quarterly Performance Table below). Including recommendations that were open at the beginning of 1Q19, the average was 31%. Feature China’s push to reduce pollution in its steelmaking sector will continue to support demand for Brazil’s high-grade ores – i.e., ores with iron (Fe) content higher than 65%. Transitory Brazilian iron ore supply losses notwithstanding, China’s push to reduce pollution in its steelmaking sector will continue to support demand for Brazil’s high-grade ores – i.e., ores with iron (Fe) content higher than 65%. This will allow the continued development of an active spread market, not unlike spread markets in commodities like oil, which will expand hedging and trading opportunities for producers, consumers and investors (Chart 2). Older, more polluting steelmaking technology in China will continue to be replaced by plants that favor Brazil’s high-grade ores, then Australia’s benchmark-type grades (62% Fe), then, as a last resort, the lower quality domestic ores. In a steelmaking market still suffering significant overcapacity, we expect policymakers will, at some point, discover the benefit of letting markets forces do the work of forcing older technology offline, as happened with the country’s domestically produced lower-quality iron ore, which has lower iron content and higher impurities than Brazilian and Aussie imports.4 We believe growth in China’s steel and steel products demand – hence iron ore demand – likely has peaked and is in the process of flattening or declining slightly, which will alter the composition of iron ore imports and tilt them in favor of high-grade Fe imports from Brazil over the next 3 - 5 years (Chart 3). This leveling off in steel demand growth will put a premium on more efficient technology to meet future demand, particularly with the pollution constraints that will, we believe, be an enduring feature of this market.5 Chart 3China's Steel Demand Growth Likely Has Peaked Impurities found in lower-grade iron ore raise steelmaking costs by increasing unwanted mineral build-ups in blast furnaces, increase pollution and lower mills’ efficiency.  With inventories re-building following the winter steelmaking hiatus in China, imports will continue to grow market share at the expense of indigenous lower-quality ores (Chart 4). Imports from Australia, which mostly price to the 62% Fe benchmark, will continue to grow, but we strongly believe that in China’s post-anti-pollution-campaign market, Brazilian imports will see growth increasing (i.e., the 2nd derivative) at a higher rate (Chart 5). Chart 4Chinese Iron Ore Inventories Fall Relative To Steel Production Chart 5China's Brazil, Australia Import Growth Will Recover These imports are lower in cost, and higher in quality than the domestic iron ore. This is particularly important when it comes to keeping costs under control – impurities found in lower-grade iron ore raise steelmaking costs by increasing unwanted mineral build-ups in blast furnaces, increase pollution and lower mills’ efficiency. Extended Output Cuts Favor High-Grade Ores The biggest reason supporting our view high-grade iron ores will continue to grow market share at the expense of lower-quality domestic supply and benchmark 62% Fe material is the recent behavior of the central government and local governments vis-a-vis pollution. Both have shown they are not averse to extending operating restrictions on high-polluting industrial plants, even in provinces where steelmaking is a large employer. Last year, major steel producing regions– Hebei, Jiangsu, Shandong, Liaoning – increased production during the winter months, likely driven by higher margins at the steelmakers (Chart 6). This indicates compliance with anti-pollution regulations fell significantly (Chart 7). In turn, this led to higher pollution, according to the latest available data from China’s National Environmental Monitoring Centre, which shows concentrations of particulate matter 2.5 micrometers or less in diameter (i.e., PM2.5) rose again this year (Chart 8). Chart 6Higher Margins, Higher Output Consequently, Chinese authorities decided to tighten anti-pollution measures by extending production cuts beyond the heating season into 3Q and 4Q19.6 Furthermore, the top producing city, Tangshan, in the province of Hebei extended its most elevated level of smog alert on March 1 and deepened production cuts to 70% from 40%, with reported cases of complete operations being halted. Chart 8China's Pollution Is Increasing; Steelmaking Curbs Will Persist Last month, Chinese Communist Party (CCP) officials in Hebei announced plans to cut steel production by 14mm MT this year and next. Going forward, China’s environment ministry said winter restrictions will be extended for a third year during the 2019-2020 winter period. As we argued last year, winter curbs likely will become a permanent feature of China’s steelmaking landscape. Combined with China’s steel de-capacity reforms, iron ore and steel markets will continue to evolve to a less-polluting presence in the country.7 As a consequence, IO grade and form differentials are now crucial input in our analysis.8 We believe a wider than usual premium will remain until new high-grades and pellets supplies come on line in the next few years. Credit Stimulus Vs. Battle For Blue Skies The reversal in China’s credit cycle and in the Fed’s monetary policy stance will be supportive of steel and iron ore prices going forward. In fact, our credit cycle proxy suggests global industrial activity will increase in the next few months (Chart 9).9 Additionally, our geopolitical strategists’ base case suggests a resolution of the Sino-U.S. trade war likely will occur this year. This will support EM income growth, which will stimulate commodity demand generally at the margin. Chart 9Upturn in China's Credit Cycle Will Support Iron Ore Prices We believe China’s credit cycle bottomed in 1Q19 and that Chinese authorities will modestly increase stimulus in 2H19.10 As discussed previously, we do not expect this new round of stimulus to be as large as previous rounds; China’s economy is in better shape now than it was at the start of previous expansionary credit cycles, hence the magnitude of the stimulus needed to revive the economy is lower. Nonetheless, this stimulus will be sufficient to strengthen China’s and EM’s steel-intensive activities in the coming months. As long as China maintains its anti-pollution drive, high-grade iron ore will continue to grow market share. Historically, these sectors correlated positively with the 62% Fe content benchmark (Chart 10). However, the expected stimulus works against Beijing’s critically important battle for blue skies. A revival of China’s industrial activity would increase PM2.5 concentrations above targets. Chart 10China's Stimulus Will Stoke Iron Ore Demand These constraints, we believe, mean China’s policymakers will have to incentivize steelmakers to favor lower-polluting high-grade iron ore (Fe > 65%), in order to maximize steel output subject to their emissions target. This will widen the form and grade premiums ahead of next year’s winter period. Bottom Line: As long as China maintains its anti-pollution drive, high-grade iron ore will continue to grow market share, as steelmakers upgrade their technology and inefficient mills are shuttered. This will favor Brazilian exports going forward, and we expect the rate of growth in these imports to increase. In line with our view, we are opening a long 65% Fe spot vs. a short 62% Fe spot position at tonight’s close. This is a tactical position, but could easily become a strategic recommendation.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      This index is published by Beijing Custeel E-Commerce Co., Ltd. 2      We flagged this risk in our February 21, 2019, report entitled “The New Political Economy of Oil.” We noted the odds of a U.S. – Russia military confrontation are low, and that “the U.S. would revive the Roosevelt Corollary to the Monroe Doctrine, and that Russia and China most likely would concede Venezuela is within the U.S.’s sphere of influence, as neither intends to project the force and maintain the supply lines … a confrontation would require.” That said, there is always the risk such a confrontation could go kinetic, or that either or both sides could lunch a cyberattack to disable its adversary. The Roosevelt Corollary refers to U.S. President Theodore Roosevelt’s extension of the Monroe Doctrine at the beginning of the 20th century, which has been used by the U.S. to justify the use of military power in the Western Hemisphere. Our February 21 report is available at ces.bcaresearch.com, as is a Special Report on Venezuela published November 22, 2018, entitled “Venezuela: What Cannot Go On Forever Will Stop,” which discusses Venezuela’s debts to China and Russia, et al. See also “Exclusive: Trump eyeing stepped-up Venezuela sanctions for foreign companies – Bolton” and “Oil hits 2019 high on OPEC cuts, concerns over demand ease,” published by reuters.com March 29 and April 2, 2019, respectively. 3      Please see “Three importers cut Iran oil shipments to zero - U.S. envoy” published April 2, 2019, by reuters.com. 4      According to Platts, “at least half of China’s previous 300 million mt plus iron ore mining capacity has left the market for good.” Please see “China’s quest for cleaner skies drives change in iron ore market,” published January 30, 2019, by S&P Global Platts. CRU estimates average iron content in China’s ores is 30%, which means they must undergo costly upgrading to be useful to steelmakers. 5      Australian miners are expected to bring on significant volumes of high-grade iron ore beginning in 2022 - 23, with Fe content as high as 70%, according to the Department of Industry, Innovation and Science’s March 2019 Resources and Energy Quarterly. 6      Please see “Tangshan mulls output curbs for 2nd, 3rd quarters of 2019” published January 22, 2019, by metal.com. 7      Please see China to extend winter anti-smog measures for another year published March 6, 2019, by reuters.com. 8      Grade premium: The chemistry of iron ore supply varies widely in terms of Fe content. Higher Fe content reduces production cost and pollution per unit of steel output. The higher the quality, the higher the volume of steel produced relative to energy consumed. The current global benchmark iron ore is 62% Fe, but China’s evolution to a less-polluting steelmaking sector will raise the importance of higher-grade markets. Form premium: A steelmaker’s blast furnace typically consumes iron ore in pellets, fines or lumps combined with coking coal. Fines are the most common form of iron ore, and account for ~ 75% of total seaborn IO market. This form cannot be directly fed in the blast furnace and requires an extra sintering step. Sintering is highly polluting and coal-intensive process that compresses fines into a more useable form. This process is usually conducted on-site at steel mills. On the other hand, lumps and pellets are direct feedstock and therefore completely avoid the highly polluting sintering step. Both types of premium are primarily affected by environmental policies in consuming countries, coke prices and steelmills’ profitability. 9      Modeling historical iron ore prices remains difficult because of the short sample available for spot iron prices – i.e., the benchmark 62% Fe. Before 2009, iron ore prices were determined using a producer pricing system. Once a year, prices were negotiated by miners and steelmakers and would be fixed for the remaining of the year. Given that iron ore supply was plentiful relative to demand, prices were fairly stable and this mechanism was used for over four decades. The rapid rise of emerging economies – mainly China – during the 2000s forced the pricing system to adjust toward a spot-market pricing system. The short spot-price time series available for analysis increases the distortion of policy-driven exogenous shocks like China’s de-capacity and winter restriction policies. This makes it difficult to identify the underlying relationships between its price and potential explanatory variables, and forces us to rely on theory and analogous experience in other markets like crude oil. 10     Please see BCA Commodity and Energy Strategy Weekly Report titled “Bottoming Of China’s Credit Cycle Bullish For Copper Over Near Term,” published March 14, 2019. It is available at ces.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights So what? EM elections bring opportunities as well as risks. Why?   Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3.  First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy   If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle –  which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14.   Chart 10Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits...   Chart 20...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup.   Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2      See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com.  3      The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4      See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com.   Geopolitical Calendar

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. All of our country Monitors are now forecasting monetary policy on hold, apart from Australia and New Zealand where looser policy is warranted (Chart of the Week). However, with early leading indicators now flagging a trough in global growth, and with labor markets mostly tight, the Monitors may not signal a need for incremental easing since inflationary pressures have not decelerated much. Given how far global bond yields have fallen in response to the weaker growth backdrop over the past year, any sign of the Monitors finding a floor would herald a turnaround in overbought global government bond markets – most notably in the U.S. and core Europe, where a below-benchmark strategic duration stance is most appropriate. Feature Chart of the WeekA Synchronized Pullback In The BCA Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Bond Yields Have Fully Adjusted To Our CB Monitors The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Our current recommended country allocations for global government bonds reflect the trends seen in the Central Bank Monitors, even as they have all shifted lower. We are favoring countries where the Monitors are falling (Australia, the U.K., Japan, New Zealand and Canada) relative to regions where the Monitors appear to be stabilizing (the U.S., core Europe). In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the components of the Monitors, grouped into those focusing on economic growth and inflation, plotted against money market yields curves (the spread between 1-year government bond yields and central bank policy rates, to measure expected changes in interest rates). Fed Monitor: No Rate Cuts Needed Our Fed Monitor has drifted lower over the past several months and now sits just above the zero line (Chart 3A). That indicates no pressure to hike interest rates, which is consistent with the Fed’s recent dovish turn. Yet the Monitor is also not yet in the “easier money required” zone that would suggest a need for the Fed to lower the funds rate - even though that is an outcome now discounted in the U.S. yield curve. Markets have gotten ahead of themselves with the expectation of Fed rate cuts. Markets have gotten ahead of themselves with the expectation of Fed rate cuts. Yes, the U.S. has finally seen some negative impact from slower global growth and the late-2018 tightening of U.S. financial conditions. However, those factors are now starting to become less negative for growth – most notably the across-the-board rally in equity and credit markets in Q1 that has eased financial conditions. There is little danger of a shift to a sustained period of below-trend growth (i.e. less than 2%) in 2019 that would free up spare capacity, and ease inflation pressures, in the U.S. economy (Chart 3B).   Chart 3AU.S. Treasury Rally Looks Overdone Chart 3BA Big Pullback In U.S. Inflation Is Unlikely Among the three sub-components of the Fed Monitor (growth, inflation and financial conditions), all are close to the zero lines (Chart 3C), suggesting that the current neutral signal from the Monitor is broad-based. The rally in the U.S. Treasury market now looks stretched, however, with the 10-year yield now lower than levels of a year ago – an outcome that, in that past, has usually coincided with the Fed Monitor falling well below zero (Chart 3D). A below-benchmark duration stance in the U.S. is appropriate, as the risk/reward profile favors higher Treasury yields from current depressed levels. Chart 3CFed Monitor Components All Near Zero, Validating Current Fed Pause Chart 3DU.S. Treasury Rally Looks Overdone BoE Monitor: The Window For A Rate Hike Has Closed Our Bank of England (BoE) Monitor, which had been in the “tighter money required” zone between 2016-18, has fallen back to the zero line (Chart 4A). The obvious culprit is the ongoing Brexit uncertainty, which has damaged confidence among both businesses and consumers. Overall economic growth has held in better than expected given the Brexit noise – for example, the manufacturing PMI now sits at 55.1, comfortably above the boom/bust 50 threshold. Yet leading economic indicators continue to deteriorate and growth is likely to remain under downward pressure in the coming months. Despite estimates showing a lack of spare capacity in the U.K. economy (a closed output gap, an unemployment rate well below NAIRU), both headline and core inflation have fallen back to the BoE’s 2% target (Chart 4B). The central bank has changed its policy bias as a result, with even the more hawkish members of the Monetary Policy Committee signaling that there is no longer any pressing need for rate hikes.   Chart 4AU.K.: BoE Monitor Chart 4BU.K. Inflation Back To BoE Target When looking at the split between the growth and inflation components of our BoE Monitor, it is clear that the former has triggered the large fall in the Monitor (Chart 4C). Yet even the inflation component has fallen below the zero line. With no pressure from any corner to alter monetary policy, the BoE can continue to sit on its hands and wait for some clarity to develop on the Brexit front. Chart 4CHit To U.K. Economy From Brexit Uncertainty Keeping BoE On Hold We continue to recommend overweighting U.K. Gilts within global government bond portfolios, given the weakening trend in U.K. leading economic indicators and persistent Brexit uncertainty (Chart 4D). Chart 4DA Deeper U.K. Growth Slowdown Needed To Drive Down Gilt Yields ECB Monitor: Bund Yields Have Fallen Too Far Our European Central Bank (ECB) Monitor is slightly below the zero line, signaling no real need for any change to euro area monetary policy (Chart 5A). The sharp slowing of economic growth last year, driven primarily by plunging exports, is the main reason why the Monitor has stayed subdued. Despite the weaker growth momentum, however, there remains far less spare capacity in the euro area economy than at any time since before the 2009 global recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEuro Area Inflation More Stable At Full Employment   Nonetheless, the ECB has already back-pedaled on policy normalization announced last December. The central bank announced a new program of cheap funding for euro area banks (TLTRO3) to begin this September, replacing the expiring loans from the previous funding program. The backdrop is turning less bullish for core European bond markets, where yields have fallen much further than justified by our ECB Monitor. There are some tentative signs that euro area growth may be stabilizing, such as increases in the expectations component of the ZEW and IFO surveys. If this is the beginning of a true cyclical turnaround, then the downward pressure on our ECB Monitor from a weak economy will soon reverse (Chart 5C). Chart 5COffsetting Growth & Inflation Components In The ECB Monitor The ECB is now signaling that it will keep policy rates unchanged until the end of the year, on top of the new TLTRO. In addition, faster global growth in the latter half of 2019 will provide a boost to the euro area economy via the export channel. The backdrop is turning less bullish for core European bond markets, where yields have fallen much further than justified by our ECB Monitor (Chart 5D). We recommend only a neutral allocation to core European government bonds, but our next move is likely a downgrade. Chart 5DBund Rally Looks Stretched Versus ECB Monitor BoJ Monitor: No Inflation, No Change In Policy Our Bank of Japan (BoJ) Monitor has drifted back to the zero line after a brief cyclical stay in the “tighter money required” zone in 2017/18 (Chart 6A). Such is life in Japan, where even an unemployment rate of 2.3% – the lowest in decades – cannot generate inflation outcomes anywhere close to the BoJ’s 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Chart 6BNo Spare Capacity In Japan, But Still No Inflation The slowing of global trade activity and weakness in Chinese economic growth has hit the export-sensitive Japanese economy hard. Industrial production is now contracting, export volumes fell –6.8% year-over-year in January, and the widely-followed Tankan survey showed the biggest quarterly drop in business confidence among manufacturers in Q1/2019 since 2011. Household confidence has also taken a hit and retail sales growth has stagnated. Against such a weak economic backdrop, the soft growth component of our BoJ Monitor is fully offsetting the relative strength of the inflation component (Chart 6C). The latter is mostly related to the tightness of Japan’s labor market, which has pushed nominal wage inflation to 3.0% - the fastest pace since 1990. Core inflation at 0.4% has not followed suit, however. Chart 6CStill Not Enough Growth To Justify Any Reduction in BoJ Accommodation We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings – especially compared to the rest of the developed markets – until there is much higher realized core inflation in Japan. There is no chance of the BoJ moving any part of the Japanese yield curve it effectively controls (all interest rates with maturity of 10 years of less) until both growth and inflation move durably higher (Chart 6D). Chart 6DNo Pressure On JGB Yields To Rise BoC Monitor: Neutral Across The Board Our Bank of Canada (BoC) Monitor has fallen sharply since mid-2018 and now sits right at the zero line, suggesting no pressure to change monetary policy (Chart 7A). The main cause is weakness in the Canadian economy, which has responded negatively to the combination of previous BoC rate hikes, diminished business confidence and slower global growth. The central bank was surprised by how rapidly the Canadian economy lost momentum at the end of last year, when real GDP expanded an anemic 0.4% annualized pace in Q4/2018. That prompted the BoC to signal a halt to the rate hikes, even with core inflation measures hovering close to the midpoint of the BoC’s 1-3% target band (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BIs Economic Slack Underestimated In Canada? Canadian money markets now discount -20bps of rate cuts over the next year. In the past, market pricing of BoC rate expectations has tended to be more correlated to the inflation component of our BoC Monitor (Chart 7C). The latest downturn in the Monitor, however, has been driven by declines in both the growth and inflation components. The BoC’s dovish turn is validated by broad-based weakness in the Canadian data. Chart 7CBoC Monitor Components Both Consistent With No Change In Interest Rates We closed our long-standing underweight recommended allocation for Canadian government bonds on March 19.1 We are now at neutral weight, although we may shift to an overweight stance if the coming rebound in global growth that we expect does not carry over into the Canadian economy and trigger some stabilization in our BoC Monitor (Chart 7D). The BoC’s dovish turn is validated by broad-based weakness in the Canadian data. Chart 7DCanadian Yields Will Not Rise Again Without A Rebound In Growth RBA Monitor: More Pressure To Cut Rates The Reserve Bank of Australia (RBA) Monitor has been below the zero line since September 2018, indicating a need for easier monetary policy (Chart 8A). A slumping economy has been weighed down by sluggish consumption, weak exports and falling house prices in the major cities. Combined with inflation stubbornly below the 2-3% RBA target band, this has driven Australian bond yields to new lows. -41bps of RBA rate cuts over the next year are now discounted in the Australian OIS curve. Delivering on those rate cut expectations, however, will likely require some weakening of the labor market (Chart 8B). Chart 8AAustralia: RBA Monitor Chart 8BAustralia: RBA Monitor As depicted in Chart 8C, both the growth and inflation components of our RBA Monitor have fallen below the zero line. Over the past quarter-century, when both components of the RBA Monitor were as far below zero as they are now, shorter-dated bond yields have ended up falling below the Cash Rate as markets move to price in an easing cycle. That 1-year/Cash Rate spread has not yet gone negative, suggesting there is more room for the entire Australian government yield curve to be dragged lower by the front-end if the economy does not soon improve. Chart 8CSoft Inflation Is Why Our RBA Monitor Is Calling For Cuts The positive correlation between the RBA Monitor and changes in the 10-year Australian government bond yield suggests that downward pressure on yields will persist until economic growth or inflation begins to revive. The positive correlation between the RBA Monitor and changes in the 10-year Australian government bond yield suggests that downward pressure on yields will persist until economic growth or inflation begins to revive (Chart 8D). With Australia’s leading economic indicator still decelerating, and with any boost to exports not likely until later this year, we continue to recommend an overweight stance on Australian government bonds. Chart 8DStay Long Australian Bonds RBNZ Monitor: Setting Up For A Rate Cut Our Reserve Bank of New Zealand (RBNZ) monitor has been below the zero line since September 2018, indicating that easier monetary policy is required. (Chart 9A). The central bank made a significant dovish shift in its forward guidance at the March meeting, noting that the balance of risks for the New Zealand (NZ) economy was now tilted to the downside and the next move is more likely to be a rate cut. That dovish turn is consistent with the underwhelming performance of NZ inflation (Chart 9B). The RBNZ does not expect inflation to hit 2% until the end of 2020, even with the unemployment rate at a ten-year low of 4.3% and wages growing at a 2.9% annual rate. Chart 9ANew Zealand: RBNZ Monitor Chart 9BNZ Inflation Has Struggled To Breach 2% Over the past two decades, market pricing of RBNZ rate moves has been more correlated to the growth component of our RBNZ Monitor. In the years since the Global Financial Crisis, however, the growth and inflation components have been highly correlated to each other and to expectations for interest rates (Chart 9C). With markets now discounting -45bps of rate cuts over the next year, the NZ yield curve appears appropriately priced relative to our RBNZ Monitor. Chart 9CBoth Inflation & Growth Components Of The RBNZ Monitor Signaling Rate Cuts We have maintained a bullish recommendation on NZ government bonds versus both U.S. Treasuries and German Bunds since mid-2017, and we see no reason to close this highly profitable position, even if the RBNZ fails to fully deliver on discounted rate cuts. Both Treasuries and Bunds look overvalued amid signs of U.S. and European growth stabilizing, while the deterioration in our RBNZ Monitor suggests NZ yields have far less upside (Chart 9D). Chart 9DStay Long New Zealand Government Bonds Riksbank Monitor: Rate Hikes Delayed, Rate Cuts Unlikely Our Riksbank Monitor is currently slightly below zero and market is now priced for -17bps of rate cuts over next year (Chart 10A). The market has judged that the recent bout of weaker Swedish economic data has effectively derailed the Riksbank’s plans to hike rates in the second half of 2019. However, given the dearth of spare capacity in the Swedish economy (Chart 10B), and with the policy rate still negative, rate cuts are unlikely to be delivered. At best, the central bank can delay rate hikes if growth continues to disappoint, which also supports easier monetary conditions via a weaker exchange rate (the krona is down -4.7% year-to-date). Chart 10ASweden: Riksbank Monitor Chart 10BSweden Inflation Cooling Off A Bit The Riksbank stated in its February Monetary Policy Report that low Swedish productivity growth is leading to cost pressures through higher unit labor costs. It also forecasts that faster wage growth over the next year will help keep inflation near the 2% Riksbank target. The implication is that it will take much weaker growth, and higher unemployment, before the central bank will completely abandon its quest to normalize Swedish interest rates. The relationship between the growth/inflation components of our Riksbank Monitor and the market’s interest rate expectations has been weak since the central bank cut rates below zero and introduced quantitative easing in late 2014 (Chart 10C). Prior to that, however, it was the growth component that was more correlated to short-term interest rate expectations. On that note, the rebound in global growth that we are expecting will help support the Swedish economy, which is highly geared to global economic activity, and put a floor under Swedish bond yields (Chart 10D). Chart 10CRiksbank Can Stay On Hold Chart 10DNo Pressure For Higher Sweden Bond Yields Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see Global Fixed Income Weekly Report “March Calmness,” published March 19, 2019. 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