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In yesterday’s Sector Insight report we stripped out the base effect from SPX earnings growth. Today, we repeat this exercise and look at a two-year annualised growth rate for US headline CPI as well as some of its categories. Using 2019 as a benchmark year reveals that the headline number is at 3%, sitting on par with the 2011 level – a sharp contrast to the regular 12-month YoY CPI rate (6%) that is close to pre-GFC highs. In fact, the key food & energy categories also appear contained despite the former perking up during the pandemic (Chart 1). 2021/2020 comparison of food and energy prices yields 2.4% and 7.5% YoY inflation respectively. There are also exceptions: The used cars category is clearly accelerating (19%) even compared to 2019, albeit it is just a small component of the headline CPI number. For completion purposes, Chart 2 on the next page also shows data for some of the pandemic-scared industries including airlines and shelter, for which prices are still below pre-pandemic highs. Bottom Line: While optically the 2021 US inflation is surging, our analysis suggests that numbers are exaggerated by the base effect from the pandemic. Chart 1 Chart 2    

Highlights Global Yields: Falling global bond yields, led by US Treasuries, are an oversized response to some modest cooling of growth momentum. Global growth will remain above-trend over the next year, which will keep global inflation rates elevated and maintain pressure on central banks (outside of Europe and Japan) to withdraw monetary accommodation. Stay below-benchmark on duration exposure, and underweight US Treasuries, in global bond portfolios. ECB Strategy Review: The ECB’s new monetary policy framework is a dovish move, as it gives the central bank the leeway to maintain accommodative policy settings even if euro area inflation temporarily rises above 2%. Maintain overweights to European government bonds, both in the core and the Periphery. Model Portfolio Benchmark: We are formally including inflation-linked bonds (ILBs) in our model bond portfolio custom performance benchmark index. Stay neutral ILBs in the US, overweight ILBs in Europe and Japan, and underweight ILBs in the UK, Canada, and Australia. Letting Some Air Out Of Reflation Trades Chart of the WeekA Bear-Market Correction For Bond Yields The growth acceleration narrative that drove much of the performance of global financial markets in 2021 has frayed a bit, led by US bond yields. The 10-year US Treasury yield declined to an intraday low of 1.25% last week, but has since recovered to 1.36%. That is well off the 2021 intraday high of 1.78% seen in late March. The yield decline has been concentrated in longer-maturity bonds, resulting in a bullish flattening of the US Treasury yield curve. While the inflation expectations component of yields has drifted lower, the big surprise move has been a fall in US real yields, with the benchmark 10-year TIPS yield falling back to -1% (Chart of the Week). This positive price action in bonds has led to investors questioning their faith in the so-called US Reflation Trade. US small-cap stocks – a proxy for the companies that would benefit as the US economy recovers from the pandemic - have been underperforming large-caps since March. Economically-sensitive commodity prices have lost much of the sharp upward momentum seen earlier this year, with the price of copper peaking in May and lumber futures prices down more than 40% over the past month. Technology-laden growth stocks have been outperforming value stocks since May, as investors have sought the reliable earnings of the US tech giants. Markets are likely getting a bit more jittery about the near-term growth outlook given the global spread of the Delta COVID-19 variant, which raises the risk of a reversal of “reopening momentum”. Yet nominal economic growth in the major developed economies is still projected to be above the pace seen during the pre-pandemic years - when global bond yields were much higher than current levels - until at least the end of 2022, according to Bloomberg consensus forecasts of real GDP growth and headline inflation (Chart 2). This suggests that global bond yields will begin climbing again, led by the US, as persistent above-trend growth limits how much US realized inflation cools after the Q2 spike, which would go a long way towards reestablishing the bond-bearish reflation narrative. Some pullback in US reflation trades was inevitable, given crowded positioning and a growing number of US data releases disappointing versus highly elevated expectations (Chart 3). Yet forward-looking US indicators like the Conference Board leading economic indicator and the Goldman Sachs financial conditions index are still pointing to strong US growth in the second half of 2021. Chart 2Nominal Growth Expected To Remain Above Pre-COVID Pace Chart 3No Reason To Be Pessimistic On US Growth The reflation narrative has also been challenged by policy tightening in China. Last week, the reserve requirement ratio (RRR) for Chinese banks was cut by 50bps, while the credit data for June showed a stabilization of the credit impulse that has been declining since October (Chart 4). Our China strategists are not convinced that the RRR cut was the start of a full-blown easing cycle, but any additional positive policy surprises from China would help boost global growth expectations and breathe new life into the reflation narrative. For global bond markets, however, the Fed’s next moves remain critical. The FOMC minutes released last week reinforced the message from the June policy meeting, that the Fed has moved incrementally towards starting the process of monetary policy normalization. Lower real US real bond yields are the part of the reflation trade unwind that is most inconsistent with a Fed inching towards QE tapering in 2022 as the US labor market continues to tighten. The fall in US Treasury yields now looks overdone, with the 5-year/5-year forward Treasury yield now below the range of median longer-term fed funds rate forecasts from the New York Fed’s Primary Dealer Survey (Chart 5). Once the overhang of short positioning in the Treasury market is fully worked off, likely in the next month or two, Treasury yields will begin to rise again driven by steady US growth and Fed tightening expectations. Chart 4Is China Moving Towards Fresh Stimulus? Chart 5UST Yields Have Fallen Too Far Bottom Line: Falling global bond yields, led by US Treasuries, are an oversized response to some modest cooling of growth momentum. Global growth will remain above-trend over the next year, which will keep global inflation rates elevated and maintain pressure on central banks (outside of Europe and Japan) to withdraw monetary accommodation. Stay below-benchmark on duration exposure, and underweight US Treasuries, in global bond portfolios. The ECB Finds A New Way To Stay Dovish The ECB unveiled the results of its strategic review last week, with some noteworthy tweaks to the policy framework. The central bank shifted to a symmetric inflation target of 2%, a change from the prior goal of aiming for inflation “just below” 2%. While that may seem like a small distinction, it does the give the ECB some leeway in tolerating temporary bouts of inflation above the 2% target. This removes one of the rigidities of the prior framework, where the 2% level was considered to be a ceiling, a breach of which would force the ECB to tighten policy. Of course, the ECB has not had to deal with a +2% inflation rate for some time (Chart 6). The last time euro area headline inflation, core inflation and inflation expectations (using 5-year/5-year forward euro CPI swaps) were all at or above 2% was back in 2012. Today, headline inflation is at 1.9%, while core inflation is a mere 0.9% and inflation expectations are at 1.6%. ECB President Christine Lagarde noted in the press conference announcing the strategy change that policymakers wanted to break out of the current situation where a too-rigid interpretation of the inflation target could result in sustained low longer-run inflation expectations when actual inflation was persistently low. Lagarde noted that the ECB needed room to “act forcefully” if needed when inflation expectations were too low, especially give the constraint of the lower bound on policy rates. Yet with nominal policy rates already in negative territory and the ECB balance sheet now nearly €8 trillion, there is limited scope for any new policy that could be considered sufficiently “forceful”. Our measure of the market-implied path of the real ECB policy rate, derived from the forward rates from overnight index swaps and CPI swaps, shows that the market already expects negative real rates to persist in the euro area well into the next decade (Chart 7). The ECB has had to resort to cutting nominal rates below 0%, as well as embarking on massive bond buying programs and cheap bank funding programs (TLTROs), in order to appear accommodative enough to try, unsuccessfully, to raise inflation expectations back to the 2% target. Chart 6The ECB's Old 'Just Below 2%' Inflation Target Was Not Credible Chart 7Negative ECB Rates Were A Product Of Persistent Sub-2% Inflation The ECB Governing Council realized that it had a credibility problem with its prior one-sided approach to the 2% inflation target, given the persistent undershooting of that level. By moving to allow a tolerance for inflation above 2%, policymakers hope to be perceived as being more flexible – and, thus, more dovish - as even inflation above 2% would not require immediate monetary tightening.This is especially important as the neutral real interest rate (or “r-star”) has likely stopped falling with potential growth in the euro area drifting higher over the past few years, according to the OECD (Chart 8). Euro area r-star should continue to drift higher in the next few years, especially given the potential for faster productivity growth on the back of Next Generation European Union (NGEU) government investments (Chart 9). This opens a window for the ECB to implement an even more accommodative monetary stance without doing anything, by leaving policy rates untouched while the equilibrium interest rate increases. To the extent that inflation also goes up at the same time, that will further depress real interest rates and widen the gap of real rates to r-star. This will help lift euro area inflation expectations closer to the 2% target over time. Chart 8Equilibrium Interest Rates In Europe Have Stopped Falling Chart 9NGEU Investments Could Help Boost Potential Growth In Europe In the end, the new ECB framework was a likely compromise between the various Governing Council members, who do not share the same degree of tolerance of higher inflation. For example, it is hard to imagine the Bundesbank being a willing participant to any monetary policy that permits above-target inflation, especially in a year when the German central bank is forecasting domestic inflation to hit a 14-year high of 2.6%. This poses a future communication problem for the ECB, as no guidance was provided about how much of an inflation overshoot above 2% would be tolerated, and for how long. That is likely because there was no agreement yet within the ECB Governing Council on those parameters. The current underlying inflation dynamics in the euro area are still weak, with ample spare capacity in labor markets still dampening wage pressures. Previous episodes of euro area headline inflation climbing above 2% occurred alongside euro area wage growth of at least 3% (Chart 10). With wage growth now slowing to 2.1% after the brief pandemic-fueled spike to 5% in 2020, the euro area needs a sustained period of above-trend growth to absorb spare economic capacity and push up weak domestically-driven inflation. The ECB has given themselves the opening to stay dovish with their new policy framework. Even a forecast of inflation moving above 2% will not necessarily suggest that policy should be tightened in any way, including tapering asset purchases. Our view remains that the Pandemic Emergency Purchase Program (PEPP) will not be allowed to expire without some form of replacement program.1 The ECB simply cannot allow markets to tighten financial conditions through higher bond yields on Italian government bonds or euro area corporate debt, or through a stronger euro – all outcomes that would be likely to unfold if the ECB announced that it was letting the PEPP roll off - with inflation expectations still too low (Chart 11). Chart 10ECB Hawks Do Not Have To Fear An Inflation Overshoot Chart 11The ECB Will Fold The PEPP Into The APP We expect the ECB to make an announcement about the future of the PEPP – including the upsizing of the existing Asset Purchase Program (APP) and, potentially, the introduction of more flexibility of the rules governing the APP – at the next ECB meeting on July 22. Some changes to the ECB’s forward guidance, on both rates and future TLTROs, will likely also be unveiled in response to the new policy framework. In the end, the new strategy only confirms what most investors already know – the ECB is going to stay with a highly accommodative monetary policy for a very long time, keeping European interest rates among the lowest in the world for the next several years. Bottom Line: The ECB’s new monetary policy framework is a dovish move, as it gives the central bank the leeway to maintain accommodative policy settings even if euro area inflation temporarily rises above 2%. Maintain overweights to European government bonds, both in the core and the Periphery. Benchmarking Our Inflation-Linked Bond Allocations A little over a year ago, we added inflation-linked bonds (ILBs) to our model bond portfolio.2 At the time, our rationale was that inflation breakevens seemed extraordinarily depressed, far more than was justified by fundamentals, across developed markets. So, to gain exposure to the inevitable rebound in inflation expectations, we made an “opportunistic” addition of ILBs to the portfolio while giving them zero weighting in our model bond portfolio custom performance benchmark. Chart 12Global Inflation Breakevens Have Recovered From The Pandemic Shock Effectively, this constrained us to either a zero or a long-only allocation to ILBs in the portfolio. At the time, such an approach was effective with ILBs extraordinarily cheap in all developed markets. However, with inflation expectations having rebounded and now above pre-pandemic levels across the developed markets, there are grounds for a more nuanced approach (Chart 12). Today, we are formally making inflation-linked bonds part of our custom performance benchmark. With this addition, we can now take positions relative to benchmark, as we do for all other categories included in our portfolio, rather than being restricted to absolute allocations to ILBs. Not only does this approach allow us to take proper short and neutral positions on ILBs, it is also more in line with the practices followed by global fixed income portfolio managers and many of our clients, who maintain a position in ILBs at all times and include them in their own benchmarks when measuring performance. As we have for all the other categories in our Model Bond Portfolio, we are basing the relative size of our allocations off the Bloomberg Barclays Indices. We will now include in our benchmark all the major ILB markets in developed economies – the US, UK, France, Italy, Japan, Germany, Spain, Canada, and Australia (Chart 13). Together, these amount to 98.7% of the $3.8 trillion Bloomberg Barclays World Government Inflation-Linked Index.3 Chart 13World Government Inflation-Linked Bond Index: Market Shares By Country To help inform our ILB allocations, we turn to our Comprehensive Breakeven Indicators (CBIs), which combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. (Chart 14). These indicators suggest that ILBs are still attractive in Europe and Japan while valuations look stretched in the other developed markets – Australia, US, Canada, and the UK. Globally, we think it is too early to position for falling breakevens even though real yields will play an increasingly important part in the continuing cyclical rise in bond yields. With a neutral global allocation to ILBs in mind, we are adding a neutral US TIPS allocation to our model portfolio, while adding a new small overweight to Japanese ILBs. We are introducing a below-benchmark allocation to the large UK ILB market, while staying completely out of smaller and less liquid Australian and Canadian ILBs. We are maintaining our existing European ILB overweights in Germany, France and Italy where our CBIs show that breakevens have the most upside potential. Even though US breakevens do look stretched on our CBIs, it is impossible, given the sheer size of the US and UK ILB markets, to go underweight on both while maintaining an overall neutral allocation globally. We are more willing to be ILB-bearish in the UK, as we currently have the UK on “downgrade watch” given our view that the Bank of England will withdraw monetary accommodation faster than the markets expect over the next couple of years – an outcome that will likely push up real yields and lower UK breakeven inflation rates. As part of this exercise, we are also rebalancing the market weights and updating durations for the existing categories in our benchmark. After this rebalancing, government bonds in total make up 59% of the benchmark, with ILBs making up 11% of that allocation. The rest goes to spread product, which now makes up 41% of the benchmark, falling a single percentage point from before the rebalancing (Chart 15). Our rebalanced benchmark and allocations can be found on pages 14-15. Chart 14Stay Overweight Euro Area Inflation-Linked Bonds Bottom Line: We are formally including inflation-linked bonds in our GFIS Custom Performance Benchmark. Stay neutral ILBs in the US, overweight ILBs in Europe and Japan, and underweight ILBs in the UK, Canada, and Australia. Chart 15GFIS Custom Performance Benchmark: Rebalanced Allocations   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy/US Bond Strategy Special Report, "A Central Bank Timeline For The Next Two Years", dated June 1, 2021, 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 Bloomberg Ticker: BCIW1A Index. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Earnings season is upon us again. Time just flies! This quarter, according to Refinitiv, Net Income is expected to increase by 64.9% YoY on Revenue growth of 18.5%. EPS growth is expected to be 68.1% - it is higher than income growth by 3.2% thanks to the projected share repurchases. BCA Model expects a 3.6% buyback yield. These numbers are truly spectacular, and yet a little suspicious. So what do we make of them? Similar to the inflation story, Q2-21 earnings season growth numbers look so high because they are dominated by the base effect: growth is computed against the worst quarter of the pandemic, Q2-20. To strip out the base effect, we calculated quarterly earnings growth with respect to Q2 of 2019 for the S&P 500 as well as its GICS1 sectors. Looking at the cleaner numbers reveals that SPX quarterly EPS growth sits at a respectable 12.2%. This number appears manageable, in sharp contrast to eyewatering growth calculated based on Q2-20 comparables.  Bottom Line: The implication is that once we take out the once in a lifetime pandemic effect, we observe that earnings growth is normalizing, and expectations are rather reasonable.  

Highlights Duration: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. Stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, we expect the 10-year Treasury yield to reach a range of 2% to 2.25% by the end of 2022 when the Fed is ready to lift rates. Maintain below-benchmark portfolio duration. Employment: The static unemployment rate and sub-50 readings from ISM employment indexes will prove to be short-lived phenomena driven by labor supply constraints. These constraints will vanish in the fall when schools re-open and expanded unemployment benefits lapse. Yield Curve: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Feature Last week was another dramatic one in the bond market. Bond yields fell sharply as doubts emerged about the pace of economic recovery and the economy’s progress back to full employment. The 10-year Treasury yield started the week at 1.44% before hitting an intra-day low of 1.25% on Thursday. It then rebounded somewhat to end the week at 1.36%. One catalyst for the move was Tuesday morning’s ISM Non-Manufacturing report that printed at 60.1, below consensus expectations of 63.5. But in truth, economic momentum had already been slowing for several months before that release. The 10-year Treasury yield peaked at 1.74% on March 31st, right around the same time that the New York Fed’s Weekly Economic Index and both the ISM Manufacturing and Non-Manufacturing indexes leveled-off (Chart 1). Last week simply saw the “slowing growth” narrative pick up steam. One noteworthy feature of last week’s market action is that the Treasury curve flattened as yields fell. While the 10-year yield is now at its lowest since February, the 2-year yield remains higher than it was just prior to the June FOMC meeting (Chart 2). This suggests that part of the drop in long-maturity bond yields is due to a fear that the Fed will over-tighten in the face of slowing growth. This fear likely stems from the Fed’s apparent hawkish pivot at the June FOMC meeting.1 Chart 1"Peak Growth" Hits The Bond Market Chart 2A Flatter Curve Since March   It’s also worth mentioning that the bulk of last week’s drop in yields was concentrated in long-maturity real yields (Chart 2, bottom 2 panels). TIPS breakeven inflation rates have fallen somewhat since the end of March. But, at 2.3% and 2.23% respectively, the 10-year and 30-year TIPS breakeven inflation rates are not that far below the Fed’s 2.3% - 2.5% target range. Chart 3Bond Rally Not Confirmed By Commodities Finally, many have suggested that “technical factors” are responsible for last week’s bond market strength. That is, factors related to the supply and demand for bonds but unrelated to economic fundamentals conspired to push yields lower. This is a difficult thesis to prove or disprove, but we will point out that the 10-year Treasury yield has diverged significantly from the CRB Raw Industrials / Gold ratio (Chart 3). The 10-year yield and the CRB/Gold ratio tend to track each other very closely but, in contrast to yields, the CRB/Gold ratio has actually increased since March 31st. This lends some credence to the argument that last week’s drop in yields is not purely a reflection of economic weakness, and it could be an overreaction to weaker-than-expected data that was exacerbated by extreme short positioning in the market (Chart 3, bottom panel). Three Reasons Why The Decline In Treasury Yields Is Overdone We do in fact think that the recent decline in Treasury yields is overdone, and we continue to see the 10-year Treasury yield reaching a range of 2% - 2.25% by the end of next year when the Fed is ready to lift rates. We present three reasons why the recent drop in Treasury yields is overdone. First, the bond market is making too much of the “slowing growth” narrative. Yes, it’s certainly true that the economic indicators shown in Chart 1 are no longer accelerating, but in level terms they remain consistent with a robust economic recovery where GDP growth is well above trend. This sort of growth environment is consistent with a falling unemployment rate that will eventually bring Fed rate hikes into play. Bond yields will move higher as this tightening cycle approaches. Second, it is not just the pace of economic growth that matters for bond yields. The output gap matters as well.2 That is, the same rate of economic growth will coincide with higher bond yields when the unemployment rate is 5% than it will when the unemployment rate is 10%. With that in mind, we observe that the output gap has closed significantly during the past year. The prime-age employment-to-population ratio is 77%, up from a 2020 low of 70%. Similarly, capacity utilization is 75%, up from a 2020 low of 64% (Chart 4). Unless we expect economic growth to slow enough for progress on these two fronts to reverse, then we should see significantly higher bond yields this year compared to last year. This makes it difficult to see how Treasury yields can fall much further from current levels. Another way to conceptualize the relationship between the output gap and long-maturity bond yields is to look at how long-dated yields move relative to short-dated yields. Since the Fed moves the funds rate in response to changes in the output gap, we can model the 10-year Treasury yield relative to the fed funds rate and expectations for near-term changes in the fed funds rate to get a sense of how well the output gap explains changes in long-maturity bond yields. Chart 5 presents a simple model of the 10-year Treasury yield relative to the fed funds rate and the 24-month fed funds discounter. It shows that last week’s decline in the 10-year yield caused it to diverge significantly from the model’s fair value. Chart 4The Output Gap Matters Chart 5Long-Maturity Yields Are Too Low   Third, the Fed’s pledge to keep rates at the zero-lower-bound at least until the labor market reaches “maximum employment” means that the labor market outlook is critical for bond yields. Our view is that the labor market is on the cusp of a rapid recovery that will cause the Fed to lift rates before the end of 2022. However, recent labor market data have been mixed and there is considerable uncertainty in the market about the future pace of employment gains. The next section delves deeper into the outlook for the labor market. Making Sense Of The Employment Data Chart 6ISM Employment Below 50 ... Overall, it seems safe to say that the labor market data have been disappointing in recent months. Yes, nonfarm payroll growth has averaged a robust +543k this year, but the minutes of the June FOMC meeting revealed that “some participants” viewed employment gains as “weaker than they had expected”. The recent dips in the employment components of both the ISM Manufacturing and Non-Manufacturing indexes to below the 50 boom/bust line only add to the sense of pessimism about the labor market. Historically, sub-50 readings from the ISM employment indices (particularly from the non-manufacturing ISM) have coincided with slowing employment growth (Chart 6). This time, however, we don’t see the ISM employment indexes staying below 50 for very long. The more demand-focused components of the ISM indexes – production, new orders and backlog of orders – remain elevated (Chart 7). This tells us that demand is strong and that hiring is only weak because of labor supply constraints, a topic we have covered repeatedly in this publication.3 Our view is that by September, once schools re-open and expanded unemployment benefits lapse, we will see a surge in hiring and a jump in the ISM employment components as people are enticed back into the workforce. A clearer picture of the labor market will then emerge, and it will catalyze a jump in bond yields. It’s not just weak ISM employment readings that are giving investors doubts about the labor market. The unemployment rate’s decline has also slowed markedly in recent months (Chart 8). Our adjusted measure of the U3 unemployment rate currently sits at 6.1%, above the headline U3 measure of 5.9% and significantly above the range of 3.5% to 4.5% that the Fed estimates is consistent with full employment. Chart 7... But Demand Indicators Are Elevated Chart 8Slow Progress On Unemployment Chart 9Labor Supply Is The Problem We adjust the U3 unemployment rate to include a number of people that are currently being classified as “employed but absent from work” when they should be classified as “temporarily unemployed”. The number of people describing themselves as “employed but absent from work” jumped sharply in March 2020 and has remained elevated. This is the result of workers that were placed on temporary furlough during the pandemic and who should be counted as unemployed. We make our adjustment by taking the difference between the number of people that are “employed but absent from work for other reasons” each month and a baseline calculated as that month’s average between 2015 and 2019. We then add this excess amount to the number of temporarily unemployed. This gives us adjusted readings for both the U3 unemployment rate and the temporary unemployment rate (Chart 8, top 2 panels). The Appendix of this report updates our scenarios for the average monthly nonfarm payroll growth required to reach “maximum employment” to consider both this new adjustment and June’s employment figures. Technical adjustments aside, the main takeaway for investors is that progress toward “maximum employment” has been relatively slow during the past few months. This is particularly true if we look at the unemployment rate excluding those on temporary furlough (Chart 8, panel 3) and the labor force participation rate (Chart 8, bottom panel). This slow progress toward “maximum employment” is undoubtedly a reason why bond yields remain low. But, once again, we think it’s only a matter of time before labor supply constraints ease and the unemployment rate falls rapidly, catching up to indicators of labor demand that have already surpassed pre-COVID levels (Chart 9). Bottom Line: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. The labor market also continues to make progress toward maximum employment (and Fed rate hikes) though that progress has slowed during the past few months. We anticipate that stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, the economy will reach full employment in time for the Fed to lift rates in 2022. We expect that the 10-year Treasury yield will be in a range of 2% to 2.25% by then. Maintain below-benchmark portfolio duration. A Quick Note On The Yield Curve Chart 105y5y Still Close To Fair Value While we view the recent drop in the level of bond yields as an overreaction, we are less inclined to view recent curve flattening as temporary. To see why, let’s look at the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate. We like to think of the 5-year/5-year forward Treasury yield as a market proxy for the long-run neutral fed funds rate, so a range of estimates of that rate is a logical fair value target. The 5-year/5-year forward Treasury yield has fallen a lot during the past few weeks. But, at 2%, it is still within the range of neutral rate estimates from the New York Fed’s Survey of Market Participants and only just outside of the same range from the Survey of Primary Dealers (Chart 10). The fact that the 5-year/5-year yield remains relatively close to its fair value range tells us that there is very limited scope for curve steepening. Recent periods of significant curve steepening have tended to coincide with one of the following two developments: The Fed is cutting rates (coincides with a bull-steepening) The 5-year/5-year forward Treasury yield moves into its fair value range after starting out well below it (coincides with a bear-steepening) This second sort of curve steepening occurred during the 2013 taper tantrum, after the 2016 presidential election and again after the 2020 presidential election. It’s conceivable that the yield curve could re-steepen somewhat during the next few months, if the 5-year/5-year forward yield moves back to its prior highs. But we expect the next major move in the Treasury market to be a bear-flattening as the rest of the yield curve catches up to the 5-year/5-year. This is the sort of curve flattening that occurred in 2017 and 2018 when the Fed was lifting rates (Chart 10, bottom 2 panels). A bear-flattening of the yield curve is also the most likely outcome if we start to see significant positive employment surprises later this year, as we anticipate. These employment surprises would bring forward the timing and pace of rate hikes but wouldn’t necessarily cause investors to question their views about the long-run neutral fed funds rate. Bottom Line: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +484k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart helps us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021. 2 For a description of the five macro factors that determine bond yields please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019. 3 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021.   Fixed Income Sector Performance Recommended Portfolio Specification