Gov Sovereigns/Treasurys
Highlights The call on EM local bonds boils down to the outlook for EM exchange rates. Forthcoming EM currency depreciation will halt the rally in local bonds. EM currencies positively correlate with commodities prices but not with domestic real interest rates. Widening U.S. twin deficits are not a reason to be long EM currencies. There has historically been no consistent relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. For investors who have to be invested in EM domestic bonds, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Feature The stampede into EM local currency bonds has persisted even amid recent jitters in global equity markets. Notably, surging U.S./DM bond yields have failed to cause a spike in EM local yields, despite past positive correlations (Chart I-1). Chart I-1Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? The main reason is the resilience of EM currencies. The latter have not sold off even during the recent correction in global share prices. In high-yielding EM domestic bond markets, total returns are substantially affected by exchange rates. Not only do U.S. dollar total returns on local bonds suffer when EM currencies depreciate, but also weaker EM exchange rates cause spikes in domestic bond yields (Chart I-2). Consequently, the call on EM local bonds, especially in high-yielding markets, boils down to the outlook for EM exchange rates. Chart I-2EM Currencies Drive EM Local Yields We are negative on EM currencies versus the U.S. dollar and the euro. The basis for our view is two-fold: Strong growth in the U.S. and higher U.S. bond yields should be supportive of the greenback vis-à-vis EM currencies; the same applies to euro area growth and the euro against EM exchange rates; Weaker growth in China should weigh on commodities prices and, in turn, on EM currencies. So far, this view has not played out. In fact, negative sentiment on the U.S. dollar has recently been amplified by concerns about America's widening fiscal and current account deficits. In fact, one might argue that EM local bonds stand to benefit from the potential widening in U.S. twin deficits and the flight out of the U.S. dollar. We address the issue of U.S. twin deficits first. Twin Deficits And The U.S. Dollar... The recent narrative that the dollar typically depreciates during periods of widening twin deficits is not supported by historical evidence. We are not suggesting that twin deficits lead to currency appreciation. Our argument is that twin deficits have historically coincided with both appreciation and depreciation of the U.S. dollar. Chart I-3 exhibits the relationship between the U.S. dollar and the fiscal and current account balances. It appears that there is no consistent relationship between the fiscal and current account balances and the exchange rate. Chart I-3No Stable Relationship Between U.S. Twin Deficits And Dollar To produce a quantitative measure of the twin deficits, we sum up both the fiscal and current account balances. Chart I-4 demonstrates the relationship between the latter measure and the trade-weighted U.S. dollar. This analysis encompasses the entire history of the floating U.S. dollar since 1971. Chart I-4Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar The vertical lines denote the tax cuts under former U.S. President Ronald Reagan in 1981 and 1986, and under former U.S. President George W. Bush in 2001 and 2003. As can be seen from Chart I-4, there is no stable relationship between the twin deficits and the greenback. In the 1970s, there was no consistent relationship at all; In the first half of the 1980s, the twin deficits widened substantially, but the dollar rallied dramatically. The tailwind behind the rally was tightening monetary policy and rising/high real U.S. interest rates; From 1985 through 1993, there was no consistent relationship between America's twin deficits and the currency; From 1994 until 2001, the greenback appreciated as the twin deficits narrowed, particularly the fiscal deficit; From 2001 through 2011, the dollar was in a bear market as the twin deficits expanded; From 2011 until 2016, the shrinking-to-stable twin deficits were accompanied by a U.S. dollar rally. Bottom Line: We infer from these charts that there has historically been no stable relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. ... And A Missing Variable: Interest Rates Twin deficits are often associated with rising inflation. In fact, a widening current account deficit can mask hidden price pressures. In particular, an economy that over-consumes - consumes more than it produces - can satisfy its demand via imports without exerting pressure on the economy's domestic productive capacity. Booming imports will lead to a widening trade deficit rather than higher consumer price inflation. Hence, in an open economy, over-consumption can lead to a widening current account deficit, rather than rising inflation. A currency is likely to plunge amid widening twin deficits if the central bank is behind the inflation curve. In such a case, the low real interest rates would undermine the value of the exchange rate. If the central bank, however, embarks on monetary tightening that is adequate, the currency can in fact strengthen amid growing twin deficits. In this scenario, rising real interest rates would support the currency. With respect to the U.S. dollar today, its future trajectory depends on the Fed, and the market's perception of its policy stance. If the market discerns that the Fed is behind the curve, the greenback will plummet. By contrast, if the market reckons that the Fed policy response is appropriate, and U.S. real interest rates are sufficiently high/rising, the dollar could in fact appreciate amid widening twin deficits. Specifically, the U.S. dollar was in a major bull market in the early 1980s, with Reagan's tax cuts in 1981 and the ensuing widening of the country's twin deficits doing little to thwart the dollar bull market (Chart I-4). In turn, the Bush tax cuts in 2001 and 2003 were followed by a major dollar bear market. The main culprit between these two and other episodes was probably real interest rates. U.S. real interest rates/bond yields rose between 1981 and 1985, generating an enormous dollar rally. In the decade of the 2000s, by contrast, U.S. real interest rates fell and that coincided with a major bear market in the greenback (Chart I-4). Overall, the combination of U.S. twin deficits and real bond yields together, help better explain U.S. dollar dynamics than twin deficits alone. We agree that America's twin deficits will widen materially. That said, odds are that the Fed commits to further rate hikes and that U.S. bond yields continue to rise. In fact, not only are U.S. inflation breakeven yields climbing, but TIPS (real) yields have also spiked significantly. Rising real yields, which in our opinion have more upside, should support the U.S. dollar. As a final point, if the Fed falls behind the curve and the dollar continues to tumble, the markets could begin to fear a material rise in U.S. inflationary pressures. That scenario would actually resemble market dynamics that prevailed before the 1987 stock market crash. Although this is a negative scenario for the U.S. currency and is, by default, bullish for EM exchange rates and their local bonds, this is not ultimately an optimistic scenario for global risk assets. Bottom Line: Twin deficits are not solely sufficient to produce a currency bear market. Twin deficits accompanied by a central bank that is behind the inflation curve - i.e., combined with low/falling real interest rates - are what generate sufficient conditions for currency depreciation. EM Currencies And Commodities Many EM exchange rates - such as those in Latin America, as well as South African, Russian, Malaysian and Indonesian currencies - are primarily driven by commodities prices. Not surprisingly, the underlying currency index of the EM local bond benchmark index (the JPM GBI index) - which excludes China, India, Korea and Taiwan - positively correlates with commodities prices (Chart I-5). Hence, getting commodities prices right is of paramount importance to the majority of high-yielding EM local bonds. We have the following observations: First, investors' net long positions in both oil and copper are extremely elevated (Chart I-6). The last datapoint is as of February 16. Any rebound in the U.S. dollar or mounting concerns about China's growth could produce a meaningful drop in commodities prices as investors rush to close their long positions. Second, we maintain that China's intake of commodities is bound to decelerate, as decelerating credit growth and local governments' budget constraints lead to curtailment of infrastructure and property investment (Chart I-7). Chart I-5EM Currencies Positively Correlate ##br##With Commodities Prices Chart I-6Investors Are Very Long##br## Copper And Oil Chart I-7Slowdown In ##br##China's Capex Strong growth in the U.S. and EU will not offset the decline in China's intake of raw materials (excluding oil). China accounts for 50% of global demand for industrial metals. America's consumption of industrial metals is about 6-7 times smaller. For crude oil, China's share of global consumption is 14% compared with 20% and 15% for the U.S. and EU, respectively. We do not expect outright contraction in China's crude imports or consumption. The point is that when financial markets begin to price in weaker mainland growth or the U.S. dollar rebounds, oil prices will retreat as investors reduce their record high net long positions. Finally, even though EM twin deficits have ameliorated in recent years, they remain wide (Chart I-8). In turn, the majority of these countries have been financing their deficits by volatile foreign portfolio flows, as FDIs into EM remain largely depressed. If commodities prices relapse and EM currencies depreciate, there will be a period of reversal in foreign portfolio inflows into EM. While EM real local bonds yields are reasonably high, they are unlikely to prevent outflows if the U.S. dollar rallies. In the past, neither high absolute EM real yields nor their wide spreads over U.S. TIPS prevented EM currency depreciation (Chart I-9). Chart I-8AEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-8BEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-9EM Local Real Yields Do Not ##br##Drive Their Currencies EM Local Bonds: Country Allocation Strategy Chart I-10 attempts to identify pockets of value in EM domestic bonds. It exhibits the sum of current account and fiscal balances on the X axis, and domestic bond yields deflated by headline inflation on the Y axis. Chart I-10Identifying Pockets Of Value In EM Domestic Bonds Markets in the upper-right corner should be favored as they offer high real yields and maintain healthy fiscal and current account balances. Bond markets in the lower-left corner should be underweighted. They have low inflation-adjusted yields and large current account and fiscal deficits. Based on these metrics as well as fundamental analysis, our recommended country allocation for EM domestic bond portfolios has been and remains: Overweights: Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Neutral: Brazil, Mexico, Indonesia, Hungary, Chile and Colombia. Underweights: Turkey, South Africa and Malaysia. The below elaborates on Brazil, Russia and South Africa. Russia Fiscal and monetary policies are extremely tight. While they are curtailing the economic recovery, they are very friendly for creditors. Interest rates deflated by both headline and core consumer price inflation are at their highest on record, government spending is lackluster, and the new fiscal rule has replenished the country's foreign currency reserves (Chart I-11). Besides, the government's budget assumption for oil prices is very conservative - in the low-$40s per barrel for this year and 2019. Commercial banks have been increasing provisions, even though the NPL ratio is falling. In fact, Russia is well advanced in terms of both corporate and household deleveraging as well as banking system adjustment. On the whole, having experienced two large recessions in the past 10 years and having pursued extremely orthodox fiscal and monetary policies, Russian markets have become much more insulated from negative external shocks than many of their peers. In brief, Russian financial markets have become low-beta markets,1 and they will outperform their EM peers in a selloff even if oil prices slide. Brazil Brazilian local bonds offer the highest inflation-adjusted yields. However, unlike Russia, Brazil has untenable public debt dynamics, and its politics remain a wild card. The public debt-to-GDP ratio is 16% in Russia and 80% in Brazil. The fiscal deficit in Brazil stands at a whopping 8% of GDP, and interest payments on public debt are equal to 6% of GDP. Without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. High real interest rates are not only holding back the recovery but are also making public debt dynamics unsustainable. Chart I-12 illustrates that nominal GDP growth is well below local government bond yields. Chart I-11Continue Favoring ##br##Russian Local Bonds Chart I-12Brazil: Borrowing Costs Are Dreadful ##br##For Public Debt Dynamics Brazil needs either much higher nominal growth or major fiscal tightening to stem the surge in the public debt-to-GDP ratio. The necessary fiscal reforms - social security restructuring or primary budget surpluses - are not politically feasible right now. Meanwhile, materially higher nominal growth can be achieved only if interest rates are brought down quickly and drastically and the currency is devalued meaningfully. Hence, the primary risk to Brazilian local bonds is the exchange rate. The currency is at risk from potentially lower commodities prices on the external side, and continuous public debt deterioration, debt monetization or drastic interest rate cuts on the domestic side. Remarkably, Chart I-13 demonstrates that historically real interest rates in Brazil do not explain fluctuations in the real. The currency, rather, positively correlates with commodities prices (Chart I-14). Chart I-13Brazil: No Relationship Between##br## Real Yields And Currency Chart I-14The Brazilian Real And ##br##Commodities Prices It is possible that policymakers find an optimal balance between these adjustment paths, and financial markets continue to rally. However, with the current government lacking any political capital and great uncertainty surrounding the October presidential elections; the outlook is very risky, We recommend a neutral allocation to Brazilian local bonds for EM domestic bond portfolios. South Africa The South African rand and fixed-income markets have surged in the wake of Cyril Ramaphosa's win of the ANC leadership elections and his taking over of the presidency from Jacob Zuma. This has been devastating to our short rand and underweight local bonds positions. Chart I-15The South African Rand And Metals Prices There is no doubt that President Ramaphosa will adopt some market-friendly policies. This will constitute a major change from Zuma's handling of the economy in the past nine years. Yet the outlook for the rand is also contingent on global markets. If commodities prices do not relapse and EM risk assets generally perform well, the rand will continue strengthening, and local bond yields will decline further. However, if metals prices begin to drop and EM currencies sell off, it will be hard for the South African currency to rally further (Chart I-15). While we acknowledge the potential for positive political announcements and actions from the new political leadership, the main drivers of the rand, in our opinion, remain the trends in the U.S. dollar and commodities prices. Some investors might be tempted to compare South Africa to Brazil in terms of political headwinds turning into tailwinds. From a political vantage point, it is a fair comparison. Nevertheless, investors should put Brazil's rally into perspective. If commodities prices did not rise in 2016-2017, the Brazilian real would not have rallied. In brief, external tailwinds are as - if not more - important for EM high-yielding currencies than domestic political developments. Positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our bet on yield curve steepening in South Africa. This position was stipulated by unorthodox macro policies of the previous government. This trade has been flat since its initiation on June 28, 2017. Weighing pros and cons, we are reluctant to upgrade the South African rand and its fixed-income market at the moment because of our negative view on metals prices and EM currencies versus the U.S. dollar. Investment Conclusions The broad trade-weighted U.S. dollar is at record oversold levels (Chart I-16). Given the forthcoming U.S. fiscal stimulus, the Fed will likely lift its dots and the greenback will rebound. This is bearish for EM currencies, especially if China's growth slows and commodities prices roll over, as we expect. EM exchange rate depreciation will halt the rally in local bonds, especially in high-yielding markets. Foreign holdings of EM local bonds are elevated (Table I-1). Hence, risks of unwinding of some positions are not trivial. Chart I-16The U.S. Dollar Is Due For A Rally Table I-1Foreign Ownership Of EM Local Bonds Is High Nevertheless, as we have argued in the past, EM local bonds offer great diversification benefits to all type of portfolios, as their correlations with many asset classes are low. For domestic bond investors who have to be invested, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. As to the sovereign and corporate credit markets, asset allocators should compare these with U.S. corporate credit. Consistent with our negative view on EM currencies and equities vis-à-vis their U.S. counterparts, we recommend favoring U.S. corporates versus EM sovereign and corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, titled "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Stage 1: The first stage of the bond bear market is being driven by a re-anchoring of inflation expectations. This stage will be complete when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. Stage 2: How high Treasury yields rise in Stage 2 of the bond bear market will be determined by expectations for the terminal fed funds rate. Assuming a 3% terminal rate, we would expect the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%. Risks: If our model suggests that economic surprises are likely to turn negative at a time when we also see extended net short bond positioning, then that would likely present an opportunity to tactically increase portfolio duration even though the cyclical bond bear market would remain intact. The risk of a growth slowdown emanating from China or other emerging markets also bears monitoring. Feature Some degree of calm returned to financial markets last week. The S&P 500 bounced back above 2700 and the VIX fell back below 20. Corporate bond spreads also tightened somewhat - the average High-Yield index spread tightened from 369 bps to 341 bps and the investment grade spread tightened from 95 bps to 93 bps - but the factors we are monitoring to determine the end of the credit cycle continue to send warning signs (Chart 1). We view the recent turmoil as markets adjusting to a Fed that must now become less responsive to financial conditions because inflationary pressures are mounting. As we discussed in last week's report, this dynamic is best explained using our Fed Policy Loop.1 It follows from our Fed Policy Loop analysis that we should track measures of inflation and inflation expectations and start taking credit risk off the table as these indicators rise. In that regard, neither TIPS breakeven inflation rates nor commodity prices - an indicator of pipeline inflation pressure - corrected much in the past few weeks (Chart 1, bottom panel). This suggests that the end of the credit cycle is approaching. We reiterate our view that it will soon be time to scale back the credit risk in our recommended portfolio. We will likely begin this process once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We discuss the intuition behind this target range in the section titled "A Fair Value For TIPS Breakevens" below. Currently, the 10-year TIPS breakeven inflation rate sits at 2.09% and the 5-year/5-year forward rate is 2.18%. Unlike credit spreads, the sell-off in Treasuries did not abate at all last week. Volatility also returned to the rates market, coinciding with a steeper yield curve (Chart 2). We are not nearly as anxious to increase the duration of our recommended portfolio as we are to scale back on credit risk, and believe that Treasury yields still have considerable cyclical upside. Chart 1No Correction In Breakevens Chart 2No Correction In Bond Yields In this week's report we discuss how we see the Treasury bear market proceeding in two stages, and also start the process of thinking about how high the 10-year Treasury yield can get before the next recession hits. We also highlight several near-term risks that could temporarily derail the cyclical bond bear market. The Two-Stage Treasury Bear Market. Stage 1: Re-Anchoring Of Inflation Expectations For some time it has been our view that the economic recovery is unlikely to end before inflation returns to the Fed's 2% target. This is simply because when inflation is very low the Fed has an incentive to keep policy accommodative, and restrictive monetary policy is typically a pre-condition for recession. It therefore struck us as odd that as recently as June 2017 the 10-year TIPS breakeven inflation rate was only 1.66%, well below levels consistent with the Fed's target. It was as though the market expected that inflation would never move higher no matter how long the Fed maintained an easy policy stance. That notion always seemed far-fetched, and this is why the first stage of the cyclical bond bear market was always likely to be driven by the re-anchoring of inflation expectations. This is the stage we are in currently, and indeed it is almost complete. We will deem that inflation expectations have become re-anchored (and the first stage of the cyclical bond bear market is complete) when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. This means that, assuming unchanged real yields, the nominal 10-year Treasury yield has another 21 bps to 41 bps of upside in Stage 1. A Fair Value For TIPS Breakevens To arrive at our fair value target for the inflation compensation embedded in the 10-year Treasury yield, we looked back to the last period when inflation was well-anchored around the Fed's 2% target. This occurred between July 2004 and June 2008. We note that during this timeframe the 10-year TIPS breakeven inflation rate spent 56% of its time between 2.3% and 2.5%. The 5-year/5-year forward TIPS breakeven rate spent 73% of its time in that range (Chart 3).2 The 2.3% to 2.5% range therefore seems like a good starting point, but we must also consider whether something has changed since the mid-2000s that might lead to a different fair value range today. One possible difference would be if the spread between CPI and PCE inflation changed significantly. The Fed targets 2% PCE inflation, but TIPS are linked to CPI inflation. CPI inflation was somewhat higher than PCE inflation in the mid-2000s, and this is one reason why TIPS breakevens were somewhat higher than 2% throughout that period. At present, we observe that the spread between CPI and PCE inflation is only slightly above where it was in the mid-2000s (Chart 4), and note that it will probably trend lower in the coming months. Chart 3TIPS Breakevens When Inflation Is ##br##Anchored (July 2004 to June 2008) Chart 4CPI Versus ##br##PCE The two biggest reasons for divergences between PCE and CPI inflation are: The different treatment of medical care inflation in the two indexes. CPI includes only out-of-pocket medical care expenses. PCE includes spending by the government on a person's behalf. The greater weight of shelter in CPI. Lately, the difference in medical care inflation between the two indexes has narrowed considerably and our models suggest that shelter inflation will continue to moderate in the months ahead (Chart 4, bottom 2 panels). This suggests that the spread between CPI and PCE inflation will continue to tighten. If the spread were to fall much below its average level from the mid-2000s, then we would revise our target range for TIPS breakevens down accordingly. The second reason why the fair value range for TIPS breakevens might be different than it was in the mid-2000s is if the inflation risk premium has undergone a structural shift. The compensation for inflation priced into bond yields can be split into (i) an expectation for future inflation and (ii) a risk premium to compensate investors for the uncertainty in that expectation. Other factors, such as changes in the post-crisis regulatory environment that impact the attractiveness of TIPS as an investment vehicle, could also potentially cause a structural shift in the inflation risk premium. We addressed this possibility in a report last year, but so far we see no conclusive evidence that such a structural shift has occurred.3 Indeed, the fact that breakevens have risen back close to their pre-crisis range in recent months suggests that the inflation risk premium is probably not structurally lower. Bottom Line: The first stage of the bond bear market is being driven by a re-anchoring of inflation expectations. This stage will be complete when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. The nominal 10-year Treasury yield has another 21 bps to 41 bps of upside before this phase of the bear market is complete. The Two-Stage Treasury Bear Market. Stage 2: Fed Rate Hikes & The Terminal Rate Debate Once inflation expectations are re-anchored the cyclical bond bear market will shift into Stage 2. With no further upside in the cost of inflation protection the emphasis in this stage will be on the path of real yields. The main question will be: How high will the Fed have to lift the real interest rate to contain inflationary pressures? Or alternatively: What is the terminal fed funds rate in this cycle? The answers to the above questions will ultimately determine how high the real 10-year Treasury yield can rise, and provide us with an end-of-cycle target for the nominal 10-year yield. Anchoring Around The Fed's Projections Chart 5Stage 2 Is All About The Terminal Rate At the moment, most FOMC participants estimate the terminal fed funds rate to be in the range of 2.75% to 3%. This may or may not be proven correct, but at least for now the market is likely to anchor around that expectation. In other words, the only way we will find out if that projection is too low is if the fed funds rate is lifted close to the 2.75% to 3% range but inflation continues to rise and economic growth shows no signs of slowing. With the fed funds rate still at 1.42%, we are at least four rate hikes away from that range. This means that any potential upward revisions to the Fed's terminal rate projections are more likely a story for late-2018 or early-2019. Notice in Chart 5 that the Fed has responded to falling inflation by lowering its median projected terminal fed funds rate, but has been more hesitant to increase its projection in response to rising inflation. This means the Fed could wait until inflation is much closer to its target before making any significant upward revisions to its terminal rate projection. The market would likely react more quickly than the Fed, but not by much. Notice that the decline in the 5-year/5-year forward overnight index swap rate was more or less coincident with the downward revisions to the Fed's projected terminal rate between 2014 and 2016 (Chart 5, bottom panel). Our view is that the market will anchor around the Fed's terminal rate projections for at least the next six months. With that in mind, we can make some back-of-the-envelope calculations for how high the 10-year Treasury yield will get before the end of the cycle. To do this we consider that the nominal 10-year yield consists of four components: Inflation expectations Inflation risk premium Real rate expectations Real risk premium Our target range of 2.3% to 2.5% for the 10-year TIPS breakeven inflation rate encompasses both the inflation expectations and inflation risk premium components. If we then assume a terminal fed funds rate of 3%, we get a real rate expectation of 1% (we subtract the Fed's 2% inflation target). This means that even if we assume no real risk premium, we get a conservative estimate for the end-of-cycle level of the nominal 10-year Treasury yield of 3.3% to 3.5%. Turning To The Models As a check on our back-of-the-envelope calculations we created simple fair value models for both the 2-year and 10-year Treasury yields (Chart 6). Both models have three independent variables: The fed funds rate Our 12-month fed funds discounter (to capture expectations for future changes in the fed funds rate) The MOVE index of implied interest rate volatility (as a proxy for the term premium) These models allow us to input various scenarios for the expected path of rate hikes and implied volatility, and then come up with appropriate fair value targets for the 10-year and 2-year Treasury yields. The results from various scenarios are shown in Table 1. Chart 6Treasury Yield Models Table 1End-Of-Cycle Treasury Yield Projections Under Different Scenarios For example, let's assume that the terminal fed funds rate is 3%. Let's also assume that the Fed delivers four rate hikes this year and the market moves to expect another two rate hikes in 2019. That would mean the market is pricing-in a fed funds rate of 2.92% by the end of 2019 - very close to a 3% terminal rate assumption. If we further assume that implied rate volatility stays flat at its current level, then our model gives us a target of 3.59% for the 10-year Treasury yield. This would seem like a reasonable end-of-cycle target for the 10-year Treasury yield in an environment with a 3% terminal fed funds rate. Table 1 also demonstrates the importance of interest rate volatility. If we assume the exact same scenario for rate hikes but also allow the MOVE index to return to its recent lows, then our end-of-cycle target for the 10-year Treasury yield falls to 3.08%. Conversely, if we allow the MOVE index to rise to its historical average, the target for the 10-year yield rises to 4.25%. As we discussed in last week's report, interest rate volatility is more likely to fall than rise between now and the end of the cycle.4 This is due to the strong correlation between interest rate volatility and the slope of the yield curve. As the Fed tightens and the curve flattens, implied volatility tends to decline. In fact, because of its strong correlation with the slope of the yield curve, any scenario where implied rate volatility increases significantly would coincide with an environment where the terminal fed funds rate is being revised higher. If 3% turns out to be a reasonable estimate for the terminal fed funds rate, then implied rate volatility is much more likely to fall than rise. All in all, if we assume that the fed funds rate will only return to 3% before the next recession, then we should expect the 10-year Treasury yield to eventually settle into a range between 3.08% and 3.59% by the end of the second stage of the cyclical bond bear market. We plan to explore whether 3% is a reasonable expectation for the terminal fed funds rate in future reports. Bottom Line: How high Treasury yields rise in Stage 2 of the bond bear market will be determined by how expectations for the terminal fed funds rate evolve. If, for now, we assume that the Fed's 3% terminal rate projection is roughly correct, then the 10-year Treasury yield will peak somewhere between 3.08% and 3.59%. Three Risks To The Bond Bear Market It is important to point out that the two-stage cyclical bond bear market described above may not play out un-interrupted. In this section we highlight three potential risks that could cause us to, at least temporarily, increase the duration of our recommended portfolio. Risk 1: Positioning One risk that could flare up in the near-term is that short positioning in the Treasury market has ramped up significantly in recent weeks. Since the financial crisis, net short positions in 10-year Treasury futures have often coincided with a lower 10-year Treasury yield three months later (Chart 7). Similarly, we have also seen positioning in oil futures become extremely net long (Chart 7, bottom panel). In a recent report we analyzed the strong correlation between oil prices and TIPS breakeven inflation rates and concluded that the correlation would likely persist throughout Stage 1 of the bond bear market.5 A significant relapse in oil prices would very likely filter through to lower bond yields. Chart 7Risk 1 = Positioning Risk 2: Unrealistic Expectations Much like how consensus is forming around short bond positions, consensus economic expectations are also being revised higher. This is what happens when the economic data surprise positively for a significant period of time. Expectations eventually ratchet up and then become too optimistic for the data to surpass. It is this dynamic that causes the Economic Surprise Index to be mean reverting (Chart 8). In previous reports we have shown that months with negative data surprises tend to coincide with falling Treasury yields, and vice-versa.6 While negative data surprises are not an imminent risk - a simple auto-regressive model of the Economic Surprise Index shows we should expect an index reading of +15 in one month's time - the surprise index will eventually move below zero and this will likely coincide with at least some pull-back in bond yields. Risk 3: Global Growth Slowdown A third risk to the cyclical bond bear market is that we see a relapse in global growth that derails the economic recovery before Treasury yields reach our target range. At the moment our 2-factor Treasury model - based on Global Manufacturing PMI and bullish sentiment toward the dollar - still posits a fair value 10-year Treasury yield of 3.01% (Chart 9), but a significant growth scare emanating from outside the U.S. would cause both the Global PMI to fall and bullish sentiment toward the dollar to rise. Both of those factors are bullish for U.S. bonds. Chart 8Risk 2 = Economic Surprises Chart 9Risk 3 = China/EM Slowdown For now there is no strong signal that global growth is about to slow, but some trends in China and other emerging markets bear monitoring. Our Foreign Exchange strategists' Carry Canary Indicator tracks the performance of EM / JPY carry trades.7 These trades go short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian Real, Russian Ruble or South African Rand), and as such they are highly geared to a positive global growth back-drop. Historically, a deterioration in the performance of these carry trades has often coincided with a slowdown in global growth and we notice that the outperformance of these trades has moderated in recent weeks (Chart 9, panel 2). Further, we have also seen some coincident and leading indicators of Chinese economic activity start to roll over (Chart 9, bottom 2 panels). The slowdown appears relatively benign for now but could eventually morph into a significant global event. This could occur if the growth deterioration accelerates and infects the Global PMI, or if Chinese policymakers react too strongly to slowing growth and engineer a sharp depreciation of the currency (as in August 2015). The latter scenario would impart increased bullish sentiment to the U.S. dollar and cause U.S. bond yields to fall. Both risks seem low at the moment, but are still worth monitoring during the next few months. Bottom Line: If our model suggests that economic surprises are likely to turn negative at a time when we also see extended net short bond positioning, then that would likely present an opportunity to tactically increase portfolio duration even though the cyclical bond bear market would remain intact. The risk of a growth slowdown emanating from China or other emerging markets also bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 2 Percentages calculated using daily values. 3 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 7 Please see Foreign Exchange Strategy Weekly Report, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The ascent in Treasury yields is likely to flatten out over the coming months, now that rate expectations have almost converged to the Fed dots. This should provide some near-term support for stocks. The structural outlook for bonds remains quite bearish, however. Exploding budget deficits, a retreat from globalization, and the withdrawal of well-paid baby boomers from the labor force will all combine to push up inflation. As inflation increases, the positive correlation between bond yields and stock prices will break down. This will cause bond term premia to rise, pushing yields even higher. Investors should use any bond rally as an opportunity to reduce duration risk. They should also look to scale back exposure to equities later this year in advance of a recession starting in late-2019 or 2020. Feature More Than A Technical Correction Global equities moved higher this week following last week's drubbing. We noted in our February 6th report that the correction was amplified by technical factors.1 Rising volatility led to a wave of forced selling in so-called risk parity funds. These funds automatically adjust their exposure to stocks based on how volatile they are. When volatility spiked, the funds started selling stocks. This pushed down equity prices, causing volatility to rise further, which led to even more forced selling. The good news is that the losses suffered by investors in these funds have had little effect on the underlying health of the financial system. This is a major difference from 2008, when delinquent mortgages led to huge losses for banks and other highly levered institutions. The equity selloff has also made stocks more attractive. Even after this week's rebound, the S&P 500 trades at a forward P/E of 18 - roughly where it stood in early 2017 and not much higher than it was in 2015 (Chart 1). Chart 1A Healthy Valuation Reset If that were all there was to the story, one could breathe a sigh of relief. Unfortunately, there is more to it than that. When a building collapses during an earthquake, does one blame mother nature or the company that built it? Sometimes the answer is both. The stock market had been ripe for a correction for a long time. Why did it happen last week? The answer, at least in part, is that the foundation on which the equity bull market was built - the presumption that monetary policy would stay easy for as far as the eye could see - began to crumble. The timing is too conspicuous to ignore. Stocks began to swoon just as the payrolls report revealed that average hourly earnings had surprised on the upside. Investors began to fret that the remaining runway for low inflation was not as long as they had supposed. Bond Yields Should Level Off In The Near Term... Are investors correct to be concerned? As we argue in detail below, over the long term, the answer is definitely yes. Over the next 12 months, however, the picture is much more nuanced. Actual inflation remains fairly tame. Even after this week's higher-than-expected CPI print, core CPI excluding shelter is up by only 0.8% year-over-year. Moreover, despite their recent climb, global bond yields are still quite low in absolute terms. The yield on the JP Morgan global bond index stands at 1.7%, close to half of what it was in 2011 (Chart 2). Chart 2AYields Are Still Low By Historic Standards (I) Chart 2BYields Are Still Low By Historic Standards (II) Chart 3Market Pricing Has Almost ##br##Caught Up To The Fed's Dots Market expectations now place the fed funds rate at the level implied by the dots for end-2018 and only slightly below the dots for end-2019 (Chart 3). Expectations for the first ECB rate hike in the second half of 2019 have also converged with what the central bank is targeting. The nearly two rate hikes for the Bank of England that are priced in this year may, if anything, be too aggressive. The latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in global bond yields will level off, and perhaps even temporarily reverse. This should give some support to stocks. ... But The Long-Term Direction For Yields Is Up While bond yields are due for a pause, the long-term trend remains firmly to the upside. BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016.2 As luck would have it, this was the same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. We argued at the time that both cyclical and structural forces would conspire to put in a bottom for yields. Since then, the global economy has continued to grow at an above-trend pace. This has caused output gaps to shrink in every major economy (Chart 4). The U.S. has now reached full employment. Wage growth tends to accelerate once the unemployment rate falls below NAIRU (Chart 5). Faster wage growth will give households the wherewithal to spend more. With little spare capacity left, this will fuel inflation. Chart 4Output Gaps Have##br## Shrunk In Advanced Economies Chart 5U.S. Wage Growth Set##br## To Accelerate Further The shift from fiscal austerity to largesse across much of the world is adding to the inflationary pressures. The Trump tax cuts are starting to look like chump change compared to the massive amount of spending coming down the pike. The Senate agreed last week to raise the caps on spending by $153 billion in FY2018 and an additional $143 billion in FY2019. This does not even include the $80 billion that has already been allocated to disaster relief, the still-to-be-negotiated sum for infrastructure spending, or up to $25 billion in additional annual spending that our Geopolitical Strategy team estimates would result if "earmarks" are reinstated (Chart 6).3 Chart 6Let The Good Times Roll Meanwhile, Japan is on track to ease fiscal policy this year.4 In Germany, the Grand Coalition deal was only concluded after Chancellor Angela Merkel conceded to demands for more spending on everything from education to public investment on technology and defense. Globalization, which historically has been a highly deflationary force, is on the back foot. Global trade nearly doubled as a share of GDP from the early 1980s to 2008, but has been stagnant ever since (Chart 7). Donald Trump pulled the U.S. out of the Trans-Pacific Partnership and he may very well pull it out of NAFTA. Opposition towards open-border immigration policies is rising. More Mexicans left the U.S. over the past eight years than entered it. On the demographic front, the three decade-long increase in the global ratio of workers-to-consumers has finally reversed (Chart 8). As baby boomers leave the labor force, the amount of GDP they produce will plummet. However, their spending on goods and services will continue to rise once health care expenditures are included in the tally. The combination of more consumption and less production is inflationary. Against a backdrop of slow potential GDP growth, policymakers will welcome rising inflation as the only viable tool left to deflate away high debt levels. Chart 7Global Trade Has Crested Chart 8Peak In The Ratio Of Workers-To-Consumers Productivity Stuck In The Slow Lane Faster productivity growth could help stave off this outcome. Unfortunately, so far, a sustained productivity revival is more of a dream than a reality. Chart 9 shows that G7 productivity has been rising at a disappointingly slow pace since the mid-2000s. Optimists like to tout the impact of robotics and the "Amazon effect". However, as my colleague Mark McClellan discussed in a series of reports, neither factor is quantitatively all that important.5 In the case of the Amazon effect, profit margins in the retail sector are close to record highs (Chart 10). This calls into doubt claims that online shopping has undermined businesses' pricing power. Recent productivity growth in the U.S. distribution sector has actually been slower than in the 1990s, a decade that produced large productivity gains from the displacement of "mom and pop" stores with "big box" retailers such as Walmart and Costco. Chart 9G7 Productivity: Not What It Used To Be Chart 10Retail Sector Profit Margins Near Record Highs Meanwhile, student test scores across the OECD have declined over the past decade (Chart 11). The accumulation of human capital has been the single most important driver of rising living standards over the past few centuries.6 This tailwind is now dissipating at an alarmingly fast pace. Chart 11AThe Contribution To Growth From ##br##Rising Human Capital Is Falling Chart 11BStudent Test Scores Are ##br##Declining In Many Countries Will The Stock-Bond Correlation Flip? As inflation becomes a greater concern over the coming years, the bond term premium will rise. Chart 12 shows that the term premium has often been negative in the recent past. This means that investors have been willing to accept a discount on holding long-term bonds relative to what they would get by rolling over short-term bills. Chart 12The Term Premium Has Been Negative Over The Past Three Years It is not surprising that this has been the case. Since the late 1990s, Treasury prices have tended to go up when the stock market sells off (Chart 13). This has made owning bonds a good hedge against bad economic news. Chart 13Bond Prices Have Tended To Rise When Equity Prices Fall Since The Late 1990s The last few weeks have seen a reversal of this pattern. Since January 26, the 10-year yield has risen by 25 basis points while the S&P 500 has fallen by 4.9%. When economies are operating at full capacity, anything that adds to aggregate demand will lead to higher inflation rather than faster growth. The latter is good for stocks because it means stronger earnings. The former is bad for stocks if it leads to a more rapid pace of rate hikes. As bond yields temporarily level off, the positive correlation between yields and equity prices should return. However, this may simply prove to be the last hurrah for this relationship. Over the long haul, bonds and equities will become more alike in the sense that they will prosper or suffer at the same time. The equity risk premium will shrink not because equities will be revalued upwards but because bonds will be revalued downwards. The runoff of the Fed's balance sheet and a slower pace of central bank bond purchases elsewhere will only compound the damage to bonds. Investment Conclusions Global bond yields are on a structural upward trajectory, however the progression will be a choppy one. The rapid rise in bond yields will flatten out, but the 10-year Treasury yield will nevertheless finish the year at about 3.25% - around 25 basis points above the forwards. Yields will continue to rise into next year. The resulting tightening in financial conditions will cause the U.S. economy to slow, ultimately setting the stage for a recession in late-2019 or 2020. The next downturn will see inflation and bond yields dip again. However, they will do so from higher levels than today. As in the 1970s, bond yields and inflation will trend higher over the coming years, reaching "higher highs" and "higher lows" with every passing business cycle (Chart 14). Investors should use any bond rally as an opportunity to reduce duration risk. They should also look to scale back exposure to equities later this year. A structurally high path for inflation is not good for the dollar. However, the coming stagflationary era will not be unique to the U.S. Many other countries actually have higher debt levels and weaker growth prospects than the U.S. More relevant to the current environment, the increasingly popular narrative that attributes the dollar's ongoing decline in 2018 to heightened fears of large budget deficits does not really mesh with what is happening to real rates. Real yields have actually surged since the start of the year (Chart 15). In this respect, today's landscape looks a bit like the early 1980s, a period when massive tax cuts and increased defense expenditures led to rising real yields and a stronger dollar. Chart 14A Template For The Next Decade? Chart 15Real Yields Have Surged Since The Start Of The Year Momentum is a powerful force in currency markets. This is particularly true for the dollar, which scores higher than all other currencies on our Foreign Exchange Strategy team's "momentum factor"7 (Chart 16). Today, the trend is definitely not the dollar's friend. Nevertheless, the fundamentals may be shifting in favor of the greenback. EUR/USD has decisively decoupled from the 30-year Treasury/bund spread (Chart 17). If the relationship had held, the cross would be trading at 1.12, rather than today's level of 1.25. The latest BofA Merrill Lynch survey reported "short USD" as one of the most crowded trades among fund managers. Going long the dollar could be a successful non-consensus trade for the next few months. Chart 16USD Is A ##br##Momentum Winner Chart 17EUR/USD Has Diverged From##br## Interest Rate Spreads This Year Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The Return Of Vol," dated February 6, 2018. 2 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 3 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018. 4 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018. 5 Please see BCA The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017; and Special Report, "The Impact Of Robots On Inflation," dated January 25, 2018. 6 Please see BCA Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; and BCA The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011. 7 Please see BCA Foreign Exchange Strategy Special Report, "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Spread Product: TIPS breakeven inflation rates are holding firm despite the correction in equity markets. Remain overweight spread product versus Treasuries for now, but be prepared to reduce exposure once long-maturity TIPS breakevens reach our target range of 2.4% to 2.5%. Volatility: While implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. Municipal Bonds: After-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. MBS: The option-adjusted spread offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to an investment grade corporate bond. Feature Chart 1Corporate Spreads Are Stoic The stock market is down and volatility is up dramatically. At least so far the pass through to credit spreads has been relatively mild (Chart 1), but this does not make us more optimistic. Rather, our sense is that last week's market action is yet another sign that we are approaching the end of the credit cycle. Same Loop, Different Day Last week's equity sell off is best viewed through the lens of the Fed Policy Loop that we introduced in 2015 (Chart 2).1 The Fed Policy Loop is a framework for understanding the interplay between monetary policy and risk assets. Its recent dynamics can be summarized as follows: The perception of easy Fed policy fuels the outperformance of risk assets, and seven months of falling inflation between last January and August kept that perception in place for all of 2017. The end result is that financial conditions eased dramatically - stock prices soared and credit spreads tightened. But easing financial conditions also sow the seeds of their own destruction. Easier financial conditions eventually beget stronger growth and stronger growth eventually begets higher inflation (Chart 3). Last week the market finally caught a whiff of inflation and started to price-in a more hawkish Fed reaction function. Chart 2The Fed Policy Loop Chart 3Financial Conditions Lead Growth And Growth Leads Inflation On a positive note, the Loop framework also tells us that the Fed will eventually ease policy in response to tighter financial conditions and this will allow the risk-on rally to resume. While this is undoubtedly true, the Fed's breaking point is also a lot higher when inflationary pressures are more pronounced. This is why we have repeatedly stressed that our cyclical call on spread product hinges on the path of long-dated TIPS breakeven inflation rates.2 Chart 4No Correction Here Last year, when the 10-year TIPS breakeven inflation rate was down around 1.6% - well below the 2.4% to 2.5% range that is consistent with inflation anchored around the Fed's target - the market understood that the Fed's tolerance for tighter financial conditions was quite low. This made it very difficult for risk assets to sell off meaningfully. But now, with the 10-year TIPS breakeven rate at 2.05% and the 5-year/5-year forward breakeven rate at 2.27%, the Fed can clearly tolerate more market pain. The bad news from a cyclical perspective is that, despite the equity correction, the market's assessment of inflationary pressure in the economy has barely budged. Long-maturity TIPS breakeven inflation rates are holding firm, as are the prices of crude oil and other commodities - prices that tend to correlate with TIPS breakeven rates (Chart 4).3 In other words, last week's correction didn't give our overweight spread product position any further room to run. While it may take a few more sessions, our sense is that the market and the Fed will hash out a new equilibrium in the near-term and that the true bear market in risk assets won't occur until inflationary pressures are even more pronounced. We continue to look for a range of 2.4% to 2.5% on long-maturity TIPS breakeven inflation rates before we scale back our cyclical overweight exposure to spread product. The inflation data take on extra significance between now and then, as each incoming report will help confirm or deny the message priced into TIPS breakevens. Every weak inflation print buys the credit cycle more time, every strong print hastens its demise. Next up: tomorrow morning's CPI. Don't Fear Rising Rate Vol The return of volatility was the other big story last week. The VIX index of implied equity volatility was as low as 9 in early January, but stood at 33 as of last Friday's market close. With rising inflation starting to weaken the "Fed put" in risk assets we think it is unlikely that equity volatility will return to its previous cycle lows.4 But what about the volatility in rates markets? The MOVE index of implied interest rate volatility also jumped last week, and its path going forward is of critical importance for Treasury yields. Chart 5 shows that the Kim & Wright estimate of the term premium embedded in the 10-year Treasury yield is highly correlated with the MOVE index, while the expectations component implied by that term premium is the mirror image of the fed funds rate. It follows that a surge in rate volatility would lead to much higher Treasury yields, particularly if the Fed continues to hike. However, it would be quite unusual for the MOVE index to increase significantly while the Fed is lifting rates. To see this we can simply observe the tight correlation between the MOVE index and the slope of the yield curve (Chart 6). The crucial question then becomes: Does the slope of the yield curve drive volatility or does volatility drive the slope of the curve? Chart 5Volatility And The Term Premium Chart 6Volatility And The Yield Curve Like most things in economics, the answer is a little bit of both. Chart 7Forecasters In Agreement It is relatively straightforward to see why higher rate volatility might lead to a steeper yield curve. To the extent that the slope of the yield curve reflects a term premium to compensate investors for the extra price risk in a long-dated bond, then investors should demand greater compensation to bear that extra risk when rate volatility is elevated. But that analysis ignores the other reason why the yield curve might be steep. Namely, the yield curve might be steep because the market expects the Fed to hike rates substantially. It would seem logical to expect that investors would be more uncertain about a forecast that calls for many rate hikes than they would be about a forecast that calls for only a few rate hikes. It therefore follows that an environment where the market expects a large change in the fed funds would also be an environment of elevated rate volatility. The two-way causation between rate volatility and the slope of the yield curve is reinforced by the fact that both trends also correlate with forecaster uncertainty about the macro environment. Chart 7 shows that the dispersion of individual forecasts for the 3-month T-bill rate and GDP growth correlate with both the MOVE volatility index and the slope of the yield curve. At the moment, disagreement amongst professional forecasters remains low relative to history. All in all, our sense is that once long-maturity TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5% they are unlikely to move much higher. Fed hawkishness will ramp up considerably and the yield curve will be much more likely to flatten. This means that while implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. We are not overly concerned about a huge spike in rate volatility leading to a blow-out in bonds. Two Attractive Ways To De-Risk As stated in the first section of this report, the higher that TIPS breakeven inflation rates rise the closer we get to calling the end of the credit cycle. If current trends continue, then it is likely we will begin to de-risk the spread product side of our recommended portfolio in the not-too-distant future. With that in mind, we have identified two lower risk spread sectors that are starting to look attractive. 1) Municipal Bonds Like all spread sectors, at first blush municipal bonds appear quite expensive relative to Treasuries. Chart 8 shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, relative to equivalent-maturity Treasury yields. The message is quite clear. Municipal bonds offer far less excess compensation relative to Treasuries than has been typical in the past. However, the valuation picture changes completely when we consider municipal bonds versus investment grade corporates. Chart 9 once again shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, but this time relative to equivalent-duration corporate bonds. We do not attempt to match credit quality in Chart 9, so Aaa-rated municipal bonds are being compared to the corporate bond index which has an average credit rating of A3/Baa1. Chart 8Munis Expensive Versus Treasuries Chart 9Munis Cheap Versus Corporates Chart 9 shows that after-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. In fact, a 10-year Aaa-rated municipal bond currently offers only 13 bps less yield than an equivalent duration A3/Baa1-rated corporate bond. In addition, whenever the after-tax yield on a 10-year Aaa-rated municipal bond has exceeded the yield on a 10-year corporate bond in the past, it has been a fairly good signal that investment grade corporates are too expensive and due for a correction. Not only did municipal bonds look more attractive than corporates before the crisis in 2007, but also before corporates sold off in 2011 and 2014 (Chart 9, bottom panel). Agency MBS Chart 10An Opportunity In MBS? As with munis, the option-adjusted spread (OAS) offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to investment grade corporate bonds (Chart 10). Further, in a rising rate environment the risk of a large increase in mortgage refinancings is low and this should keep MBS spreads well contained. The biggest potential risk for MBS spreads is that a large spike in Treasury yields causes MBS duration to extend, and sparks a spread widening. In our report from two weeks ago we introduced a model for excess MBS returns in an attempt to quantify what sort of increase in Treasury yields would be necessary to make duration extension a meaningful risk for MBS.5 We modeled monthly excess returns for conventional 30-year MBS relative to duration-matched Treasuries using the following equation: Formula The monthly change in Treasury yields enters the equation with a positive sign because it proxies for refinancing risk. Higher yields lead to lower refis, and lower refis lead to MBS outperformance. The squared change in yields enters the equation with a negative sign because it proxies for extension risk. If yields rise too much during the month, then MBS duration will extend and the sector will underperform. Chart 11Refi Risk Is Low From that equation we calculated that, holding the change in OAS flat, it would take a monthly increase in yields of at least 72 bps to lead to negative monthly excess returns. However, in January this appeared not to work very well. The duration-matched Treasury yield in our equation increased only 38 bps in January and the OAS was virtually flat, but MBS still managed to underperform Treasuries by 16 bps on the month. Upon further investigation, the reason our model failed in January is that mortgage refinancings actually increased on the month even though Treasury yields rose (Chart 11). This behavior is unusual and we would not expect it to persist going forward. However, we also made one modification to our model that we expect will lead to more accurate results on a real-time basis. Specifically, we removed the intercept term from the prior model and replaced it with a 1-month lag of the average index OAS. The rationale is that since the intercept term is in the equation to capture the carry return in an MBS trade, we should use a more accurate measure of MBS carry rather than relying on the regression to calculate the historical carry. Our new equation is as follows: Formula Chart 12 Interestingly, using our new equation we find that the monthly increase in Treasury yields required to spark MBS underperformance is now a function of the current average OAS of the MBS index. This would seem to make sense. If the carry buffer is higher, then it should take a greater duration extension for capital losses to overcome the carry and lead to negative excess returns. The relationship between the required monthly increase in yields and the index OAS is illustrated in Chart 12. At the current average index OAS of 31 bps, our equation suggests that a monthly increase in Treasury yields of 58 bps or higher is required for extension risk to become meaningful. Bottom Line: Both municipal bonds and Agency MBS are starting to look attractive relative to investment grade corporate bonds. We stand ready to upgrade these sectors at the expense of investment grade corporate bonds when the time comes to de-risk our spread product portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 For further details on the correlation between TIPS breakevens and commodity prices please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 4 Please see BCA Research Special Report, "The Return Of Vol", dated February 6, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Global Bond Rout: Overheated financial markets are going through a much needed correction with higher bond yields being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however. Monetary policy settings remain accommodative in almost all major economies, while global growth momentum is showing no signs of slowing. The current turbulence is an early indication of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. Fixed Income Strategy: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Feature Risk assets worldwide are finally correcting after the relentless run-up seen in January, with the trigger being the steady rise in global bond yields seen since the beginning of the year. The big decline in U.S. equity markets, particularly after the release of last Friday's U.S. employment data which featured the highest year-over-year growth rate in wages seen in almost a decade, suggests that investors are growing increasingly worried about accelerating inflation and a more aggressive tightening response from central banks (NOTE: markets were undergoing another bout of selling yesterday as this publication went to press, but the conclusions reached in this report are unchanged). Chart of the WeekThe Cyclical Rise In Yields##BR##Has Room To Run However, taking a step back to look at the big picture, nothing has really changed in the past few days. Global growth remains strong, which has already steadily increased pressure on policymakers to raise interest rates according to our own BCA Central Bank Monitors (Chart of the Week). In the U.S. - the epicenter of the latest bout of market angst - financial conditions remain highly accommodative and supportive for future growth, while bond volatility remains low by historical standards even after the most recent upward blip. Credit spreads and equity valuations in non-U.S. markets, from Europe to the emerging world, are also no impediment to future growth in those regions. We have been expecting global bond yields to rise in 2018 as markets adjust to both a normalization of global inflation expectations and a shift to a less aggressive pace of bond buying by the Fed, European Central Bank (ECB) and Bank of Japan (BoJ). As we described in our 2018 Outlook report published last December:1 The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. The current market sell-off is likely too soon to be the ultimate realization of that forecast. Monetary policy settings remain accommodative and inflation is still below central bank targets in almost all major economies, while global growth momentum is showing no signs of slowing. This is an early indication, however, of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. We continue to recommend a pro-growth fixed income investment strategy, staying below-benchmark overall duration, focusing on lower-beta government bond markets, overweighting corporate debt over sovereign debt, and prioritizing inflation protection in bond portfolios. In the coming weeks, however, we will begin to discuss strategies to play for the shift to a more hostile investment backdrop that we expect later in 2018. The U.S. Bond Vigilantes Are Back In Charge Global monetary policies that remain "too" accommodative given robust growth and some pickup in realized inflation have prompted bond markets to reprice, through both higher inflation expectations and real yields. Rising yields have triggered a spike in market volatility measures like the U.S. VIX index, although there were also several bouts of higher volatility in 2017 (Chart 2). Growth-sensitive financial assets shrugged off those higher volatility episodes, mainly because growth expectations were not impacted. We see no reason why this current bout of market turbulence should differ from last year's volatility spikes, and have any meaningful impact on forecasts for future economic growth (and, by extension, corporate profits). At least, not without a more meaningful tightening of global monetary policy, particularly in the U.S. where inflation pressures are gaining steam. The December Payrolls report released last week may finally contain that missing piece of the inflation puzzle - faster wage growth. Headline Average Hourly Earnings expanded 2.9% on a year-over-year basis, with the 3-month annualized growth rate surging to pre-crisis levels above 4% (Chart 3). Coming at a time when the U.S. labor market remains tight by any measure (top panel), a pickup in wage growth supports the other evidence indicating that U.S. inflation is on the upswing, like the modest acceleration in core PCE inflation (3rd panel) and steady climb in TIPS breakevens (bottom panel).2 Chart 2This Is A Correction,##BR##Not A Reversal, In Risk Assets Chart 3U.S. Wage Inflation##BR##Finally Appears A faster inflation backdrop is making the Fed's current monetary policy plans more credible for investors. The U.S. Overnight Index Swap (OIS) curve is now fully pricing in the Fed's three planned interest rate hikes for 2018, and has almost priced in the additional 50bps of hikes the Fed is projecting for 2019 (Chart 4). Rate expectations even further out the curve have been climbing, as well. Our measure of the market's expectation for the so-called "terminal rate" - the 5-year U.S. OIS rate, 5-years forward - is now up to 2.66%, only 9bps below the current median projection ("dot") for the terminal rate. Markets have been highly skeptical that the Fed would ever be able to raise rates as high as its projections in recent years - justifiably so, given that U.S. realized inflation has been persistently falling short of the Fed's 2% inflation target. Now, with core inflation having clearly bottomed out and shorter annualized rates of change closing in on 2%, markets are coming around to the idea that the Fed inflation forecasts will be realized. If that happens, then the Fed should be expected to follow through on its published projections, not only for 2018 but for the remainder of the current tightening cycle. On that basis, there is not a lot more room for the market's pricing of the expected path of U.S. interest rates to converge to the Fed's projections. That suggests that the shorter-end of the U.S. Treasury curve may be approaching a cyclical peak - unless the Fed were to begin revising up its "dots" in response to a faster pace of U.S. economic growth and inflation. That would require the Fed to start believing that a faster pace of rate hikes, or a higher equilibrium real interest rate, was required in the U.S. The current real interest rate remains around 0% (subtracting core PCE inflation from the fed funds rate), as the Fed's rate hikes since beginning the tightening cycle in December 2015 have matched the increase in realized inflation. Measures of the so-called "r-star" equilibrium rate, like the Williams-Laubach measure, are also indicating that the real fed funds rate should be around 0% (Chart 5). The real fed funds rate has historically been highly correlated to the employment/population ratio in the U.S., and the current level of that ratio (60%) suggests that the Fed does not have to target a real funds rate above 0%. The conclusion is that it would take a sign of even greater U.S. labor market utilization - i.e. a rising employment/population ratio - for the Fed to conclude that it must raise its interest rate projections. Chart 4Market Pricing Has Caught Up##BR##To The Fed's Forecasts Chart 5A 0% Real Fed Funds Rate##BR##Is Still Appropriate Without such a boost to the Fed's expected path of interest rates, any remaining increases in U.S. Treasury yields will have to come from higher inflation expectations. On that front, the current level of the 10-year TIPS breakeven at 2.14% remains 30-40bps below the 2.4-2.5% range that is consistent with the Fed's 2% inflation target (adjusting for the typical gap between CPI and PCE inflation and allowing for a small inflation risk premium). That suggests that the 10-year nominal Treasury yield can rise to the 3.10-3.25% range to fully discount a sustainable return of inflation to the Fed's target, with the Fed delivering on its interest rate projections in response. That target range is also not far from the current fair value from our 2-factor 10-year U.S. Treasury yield model, which has risen to 3.01% (Chart 6).3 It will be critical to watch the future behavior of the parts of the U.S. economy that are most sensitive to interest rates, like consumer durables and housing, for signs that the latest rise in U.S. bond yields is having any negative effect on U.S. growth. A slowing trajectory for U.S. growth in response to higher interest rates would certainly give the Fed some second thoughts on moving ahead with its rate hike plans. On that note, the year-over-year change in the 10-year Treasury yield is now in positive territory, which has typically led to a slower contribution to U.S. real GDP growth from consumer durables (Chart 7, top panel). The rise in U.S. mortgage rates should also lead to slower growth in residential investment, although housing has already been providing very little marginal contribution to U.S. growth over the past two years (2nd panel). Chart 6Fair Value On The 10-Year##BR##UST Yield Is 3%...And Rising Chart 7Rising U.S. Capex Should Offset##BR##Slowing Interest-Sensitive Spending The potential offset to any slowdown in interest-sensitive spending, however, is capital spending by businesses, which is being boosted by easy financial conditions (bottom panel), loosening bank lending standards and a rise on the expected after-tax return on investment following the Trump corporate tax cuts. It will likely take higher interest rates, and much tighter financial conditions, before the capex cycle peaks out. Bottom Line: Overheated financial markets are going through a much needed correction, with higher bond yields, most notably in the U.S., being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however, and monetary policies will need to tighten further in response to strong growth and rising inflation pressures. The cyclical interest rate tipping point for risk assets has not yet been reached, even in the U.S., but is getting incrementally closer. Don't Forget The Other Factor Driving Global Bond Yields - Reduced Central Bank Buying Amidst all the worries about higher inflation and the related impact on global bond yields, it should not be forgotten that the major developed market central banks have been cutting back on their bond purchases. Global bond yields have been correlated to the growth rate of the combined balance sheet of the "G-4" central banks (Fed, ECB, BoJ and Bank of England) since the ECB started its bond buying program in 2015 (Chart 8). The current rise in global yields has been in line with the projected slower pace of aggregate bond buying by those central banks. Based on our projection for the year-over-year growth rate of the G-4 central bank balance sheets - which incorporate the Fed letting maturing bonds run off its balance sheet and cutbacks in the pace of buying of new bonds by the ECB and BoJ - there is still more room for bond yields to rise over the course of 2018. A slower pace of central bank "liquidity" creation is something that we anticipated to weigh on risk asset returns in 2018. By driving down the yields on safe assets like government debt to highly unattractive levels, central banks induced huge inflows into global equity and credit markets, both in the developed and emerging worlds. As central banks are now buying fewer bonds, however, there is not only reduced downward pressure on government bond yields but also diminished scope for additional inflows into riskier assets. Looking at the growth rate of the G-4 central bank balance sheet versus the rolling 12-month returns on global equities and credit, the current pullback in overheated risk assets is merely bringing returns back down to levels consistent with central banks taking their foot off the monetary accelerator (Chart 9). Chart 8The Central Bank Impact On##BR##Bond Yields Is Slowly Unwinding... Chart 9...Which Impacts Risk Asset##BR##Returns, As Well For global fixed income markets, we had anticipated that 2018 would be a year of much lower expected returns on spread product like global corporate debt, although those would still beat the returns likely from government debt - at least until government bond yields reached our cyclical targets. Our view has not changed, even in light of the current pullback in risk assets and yesterday's decline in government bond yields. For now, we continue to recommend an overweight stance on global corporate debt, but favoring U.S. Investment Grade and High-Yield debt over European equivalents (and over Emerging Market hard currency debt). We will discuss our eventual recommended exit strategy in upcoming reports, but for now, our advice is to sit tight and ride out this current bout of market turbulence. Bottom Line: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th, 2017, available at gfis.bcaresearch.com. 2 It is interesting to note that it took a sharp pickup in the Average Hourly Earnings measure to get the market's attention about wage inflation. Many Fed officials and market commentators (including here at BCA!) have consistently pointed out the inherent flaws in looking at Average Hourly Earnings as an accurate measure of wage pressures in the U.S. Yet the big market response to the latest surge in Average Hourly Earnings is a sign that investors still look at that indicator as the "true" measure of wage inflation. 3 The standard deviation of the fair value estimate from that model is 17bps, which means that yields could rise as high as 3.18% before reaching an "undervalued" level for U.S. Treasuries - assuming no further increases in fair value, of course. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Chart 1Waiting For A Signal TIPS breakeven inflation rates are fast approaching our end-of-cycle targets (Chart 1). The 10-year and 5-year/5-year rates are currently 2.14% and 2.36% respectively, only slightly below our target range of 2.4% to 2.5%. If this trend continues it is highly likely that we will start to slowly reduce the credit risk in our portfolio in the coming weeks. Already, we find that some lower risk spread products (Foreign Agency bonds and Munis) are attractively valued relative to corporates. But there are also risks to exiting credit too early. First and foremost is that the recent widening in TIPS breakevens might reverse before it bleeds into higher core inflation. As we noted in last week's report, the St. Louis Fed's Price Pressures Measure is still supportive of an overweight allocation to corporate bonds (Chart 1, bottom panel) and core PCE inflation has only just risen to 1.5% year-over-year.1 Investors should maintain below-benchmark duration and an overweight allocation to corporate bonds for now, but be wary that the time to make end-of-cycle preparations is drawing nearer. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 72 basis points in January. The average index option-adjusted spread tightened 7 bps on the month, and currently sits at 85 bps. Investment grade corporate bond spreads continue to tighten, and with each additional basis point the evidence of extreme overvaluation grows. As of today, the 12-month breakeven spread for an A-rated corporate bond has only been tighter 3% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 4% of the time (panel 3). Further, the average spread on the Foreign Agency bond index is now 3 bps greater than the average spread of an equivalent-duration corporate bond, despite having an average credit rating that is three notches higher (Aa2/Aa3 versus A3/Baa1). Even a 10-year Aaa-rated Municipal bond now offers 7 bps greater after-tax yield than a duration-equivalent corporate bond for investors in the top marginal tax bracket (see page 9). The bottom line is that with such poor value in investment grade corporate spreads, we only need to see a stronger signal from our inflation indicators before reducing exposure.2 Depending on how inflation (and TIPS breakevens) evolve, that time could come relatively soon. The Federal Reserve's Senior Loan Officer Survey, released yesterday, showed that lending standards for commerical & industrial (C&I) loans eased somewhat in the fourth quarter of 2017, and also noted that banks expect to ease standards further on C&I loans to large and middle-market firms in 2018. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 149 basis points in January. The average index option-adjusted spread tightened 24 bps on the month, and currently sits at 324 bps. Last week's equity sell-off and spike in the VIX suggest that some near-term junk spread widening could be in the cards (Chart 3). However, we expect it is still a bit too soon to move out of junk bonds for the cycle. That decision will be made based on whether our inflation indicators continue to rise in the coming weeks and/or months, suggesting that the monetary policy back-drop is becoming less accommodative. In terms of value, high-yield corporates offer better risk-adjusted value than their investment grade brethren. The 12-month breakeven spread for a Ba-rated high-yield bond has currently been tighter than it is today 14% of the time since 1995. The same figure comes in at 25% for a B-rated bond and 31% for a Caa-rated bond. Similar measures for investment grade corporates are significantly lower (see page 3). Further, assuming a default rate of 2.35% for the next 12 months and a recovery rate of 51%, we calculate that a position in high-yield bonds will return 209 bps in excess of Treasuries if spreads stay flat at current levels. Another 100 bps of spread tightening would imply an excess return of just over 6%, but this would bring junk spreads to all-time tight valuations and is probably too optimistic. Remain overweight high-yield for now. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in January. The conventional 30-year zero-volatility MBS spread narrowed 2 bps on the month, all concentrated in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) was flat on the month, and currently sits at 29 bps. After having widened for most of last year, the OAS for a conventional 30-year mortgage bond is now more attractive relative to an equivalent-duration investment grade corporate bond than at any time since 2014 (Chart 4). This makes MBS a reasonably attractive sector for investors looking to shift away from corporate bonds and de-risk their spread product portfolios. Further, there would appear to be very little risk of spread widening in the MBS sector. First, the schedule of run-off from the Fed's mortgage portfolio is already well known, and likely in the price. Second, mortgage refinancings are likely to stay contained in a rising interest rate environment (bottom panel). Finally, the risk of duration extension in MBS only becomes material when Treasury yields spike higher very quickly - on the order of 72 bps or more in a month - as we showed in last week's report.3 Investors should stay at neutral on MBS for now, but stand ready to increase exposure when the time comes to move out of corporate bonds for the cycle. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in January. Sovereign bonds outperformed by 118 bps, Local Authorities by 67 bps, Foreign Agencies by 54 bps, Domestic Agencies by 8 bps and Surpranationals by 3 bps. USD-denominated Sovereign bonds continue to look expensive compared to Baa-rated U.S. Credit (Chart 5), yet they still managed to deliver almost identical excess returns during the past 12 months because of the U.S. dollar's large depreciation. Going forward, with the dollar's rapid decline unlikely to accelerate, we would avoid Sovereign bonds in favor of U.S. corporates. Valuation is more attractive elsewhere in the Government-Related index. Foreign Agency bonds now offer greater spreads than equivalent-duration U.S. corporate bonds, despite benefitting from higher credit quality (panel 4). Local Authority spreads also look attractive compared to recent history (bottom panel). We continue to recommend overweight allocations to both sectors. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 12 bps and 16 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 29 bps and 40 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 53 basis points in January (before adjusting for the tax advantage). The average AAA-rated Municipal / Treasury (M/T) yield ratio was flat on the month. Two market technicals spurred Muni outperformance in January. First, supply plunged after many advance refunding issues were pulled forward in anticipation of the U.S. tax bill (Chart 6). Second, the repeal of the state and local tax deduction led to increased demand for Munis, as evidenced by the recent jump in fund inflows (panel 3). In terms of credit quality, state and local government net borrowing as a percent of GDP likely fell to 0.9% in 2017 Q4 - assuming that corporate tax revenues are held constant. This is consistent with current low yield ratios (panel 4). Meanwhile, tax revenue growth should stay strong in the coming quarters due to recent increases in property prices and retail sales. While M/T yield ratios remain low compared to history, excessive valuations in investment grade corporate bonds mean that Munis are starting to look attractive by comparison. For example, for investors in the top marginal tax bracket, we calculate that the after-tax yield on a Aaa-rated municipal bond is 7 bps higher than the duration-equivalent yield offered by the investment grade corporate bond index, even though the corporate bond index offers an average credit rating of only A3/Baa1. While the bottom panel shows that this yield differential has been higher in the past, it is nevertheless an indication that we are approaching the end of the credit cycle. Stay underweight Munis for now, though an upgrade is likely when it comes time to exit our corporate bond overweights. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear steepened out to the 10-year maturity point in January, as bond markets started to price-in a rebound in inflation. The 2/10 slope steepened 7 basis points on the month and the 5/30 slope flattened 11 bps. The 2/10 slope steepened even further in the first five days of February and currently sits at 69 bps, up from its recent low of 50 bps. More near-term curve steepening is possible if long-maturity TIPS breakeven inflation rates continue to widen, especially since the Fed's median projected rate hike path for the next 12 months is already fully discounted (Chart 7). However, the yield curve is much more likely to be flatter by the end of the year than it is today. In large part because the upside in long-maturity yields will be limited once TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5%. In terms of positioning, we continue to advocate a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell. The 5-year continues to look very cheap on the curve (panel 3), or put differently, our model suggests that the 2/5/10 butterfly spread is currently priced for 29 bps of 2/10 curve flattening during the next six months (panel 4).4 This seems excessive for the time being. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate increased 15 bps on the month. At 2.14% and 2.36%, respectively, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are still below our target range of 2.4% to 2.5%, but only modestly so. The big run-up in TIPS breakeven rates coincided with a jump in oil prices and, as we discussed in a recent report, this is no coincidence (Chart 8).5 The Fed has an asymmetric ability to influence inflation - it has an unlimited ability to tighten policy but its ability to ease policy is restricted by the zero-lower bound on interest rates. It is for this reason that when TIPS breakeven inflation rates become un-anchored to the downside, they also become much more sensitive to swings in commodity prices. In these environments the market sees inflation as increasingly determined by price pressures in the economy and not by the Fed's reaction function. The logical conclusion is that we should expect the tight correlation between oil prices and long-maturity TIPS breakeven rates to persist until breakevens reach our target fair value range of 2.4% to 2.5%. At that point, it is unlikely that further increases in commodity prices would filter through to long-maturity breakevens, because the market would anticipate a tightening response from the Fed. Stay overweight TIPS versus nominal Treasury securities for now. We will reduce exposure when our fair value target of 2.4% to 2.5% is achieved. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in January. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 2 bps on the month and now stands at 33 bps, only 6 bps above its all-time low (Chart 9). All in all, a 33 bps spread is still reasonably attractive for a sector that is Aaa rated with an average duration of 2. By way of comparison, the intermediate maturity Aaa Credit index offers an OAS of only 17 bps and has an average duration above 3. However, credit trends are clearly shifting against the Consumer ABS sector. The consumer credit delinquency rate has put in a bottom, albeit from a very healthy level, and the trend in the household debt service ratio suggests that delinquencies will continue to rise (panel 3). Further, the Federal Reserve's Senior Loan Officer Survey shows that lending standards on auto loans have tightened on net in each of the past 7 quarters, while credit card lending standards have tightened for 3 consecutive quarters. Even though lending standards on both auto loans and credit cards moved slightly closer to net easing territory in the fourth quarter of 2017, the reading from lending standards is still consistent with a rising delinquency rate (bottom panel). We retain a neutral allocation to consumer ABS due to still attractive spreads for a low-duration, high credit quality sector. However, if the uptrend in consumer delinquencies is sustained then our next move will probably be to reduce allocation to this sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 7 bps on the month and currently sits at 59 bps. The spread is now only 8 bps above the lowest level seen since the inception of the index in 2000 (Chart 10). Much like in the Consumer ABS sector, historically low CMBS spreads are observed at a time when lending standards are tightening in the commercial real estate (CRE) sector. The Federal Reserve's most recent Senior Loan Officer Survey shows that lending standards for nonfarm nonresidential CRE loans have tightened for 10 consecutive quarters, though they have been tightening less aggressively of late (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in January. The index option-adjusted spread narrowed 1 bp on the month and currently sits at 40 bps. With an average spread of 40 bps and an average duration of around 5, this sector is not quite as attractive as Consumer ABS on a spread per unit of duration basis. However, it still offers greater expected compensation than a position in Conventional 30-year residential MBS which has an option-adjusted spread of 29 bps and a similar duration. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 3.01% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 3.06%. The Global PMI actually ticked down in January, but only slightly from 54.5 to 54.4. This small decline was more than offset in our model by the large drop in dollar sentiment, which just moved into "net bearish" territory (bottom panel). Of the four major economic blocs, PMIs increased in the U.S. and Japan, ticked down from an extremely high level in the Eurozone and held steady in China. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.84%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 4 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)