CMBS

Highlights Chart 1More Upside From Inflation bca.usbs_pas_2016_12_06_c1 bca.usbs_pas_2016_12_06_c1 We moved to below benchmark duration on July 19, when the 10-year Treasury yield was 1.56%. As of last Friday's close, the 10-year Treasury yield was 2.4% and above the fair value reading from our global PMI model. While our economic outlook still justifies higher Treasury yields on a 12-month horizon, the selloff in bonds has moved too far, too quickly. We recommend tactically shifting to a benchmark duration stance. Longer run, the upside in Treasury yields will be concentrated in the inflation component. The cost of 10-year inflation compensation can rise another 49 bps before it is consistent with the Fed's target. But that adjustment will proceed gradually next year, alongside a shallow uptrend in realized inflation (Chart 1). Higher inflation compensation can occasionally be offset by lower real yields, but this only occurs when the increase in inflation compensation results from an easing of Fed policy, as in 2011-2012. With the Fed in the midst of a hiking cycle, the downside in real yields is limited. We would not be surprised to see the 10-year Treasury yield re-visit the 2%-2.2% range during the next month or two. At that point we would re-initiate a below benchmark duration stance, on the view that the 10-year yield will reach 2.80%-3% by the end of 2017. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in November. The index option-adjusted spread tightened 3 bps on the month and, at 129 bps, it is now slightly below its historical average (134 bps). Spread per unit of gross leverage1 for the nonfinancial corporate sector is slightly above its historical average (Chart 2). But unusually, spreads have been tightening this year despite sharply rising gross leverage. Since 1973, there has only been one other period when spreads tightened despite rising gross leverage. That was in 1986-88 when, similar to today, spreads were tightening from extremely oversold levels. Much like today, elevated spreads in 1986 resulted from distress in the energy sector that dissipated as oil prices recovered. This caused corporate spreads to widen dramatically and then tighten, while in the background gross leverage persistently climbed higher. The current recovery in oil prices could lead to further corporate spread tightening early next year. Indeed, energy sector credits still appear cheap on our model and we continue to recommend overweighting those sectors. This month we also upgrade Paper from neutral to overweight (Table 3). Table 3Corporate Sector Relative Valuation And Recommended Allocation* Too Far Too Fast, But The Bond Bear Is Still Intact Too Far Too Fast, But The Bond Bear Is Still Intact Table 3BCorporate Sector Risk Vs. Reward* Too Far Too Fast, But The Bond Bear Is Still Intact Too Far Too Fast, But The Bond Bear Is Still Intact However, corporate credit fundamentals are deteriorating rapidly and spreads will be at risk when the Fed adopts a more hawkish policy stance, possibly as early as the second half of next year.2 High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 128 basis points in November. The index option-adjusted spread tightened 23 bps on the month and, at 450 bps, it is 71 bps below its historical average. A model based on lagged spreads and default losses explains more than 50% of the variation in 12-month excess junk returns. This model currently forecasts excess junk returns of close to zero during the next 12 months (Chart 3), a forecast that is based on our expectation of a modest improvement in default losses (bottom panel). In a recent report,3 we examined the relationship between default-adjusted spreads and excess junk returns in more detail. We showed that a model based purely on ex-ante estimates of default losses explains around 34% of the variation in excess junk returns. We also showed that, historically, negative excess returns to junk bonds are only likely if the ex-ante default-adjusted spread is below 100 bps. Our current ex-ante default-adjusted spread is 201 bps. Historically, when the ex-ante default-adjusted spread is between 200 bps and 250 bps, junk earns positive excess returns 81% of the time. However, junk earns positive excess returns only 65% of the time if the spread is between 150 bps and 200 bps. Although our economic outlook for next year is fairly optimistic, high-yield valuations are stretched and we expect to get a better entry point from which to upgrade the sector during the next couple of months. MBS: Underweight Chart 4MBS Market Overview bca.usbs_pas_2016_12_06_c4 bca.usbs_pas_2016_12_06_c4 Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in November. Other than municipal bonds, MBS has been the worst performing fixed income sector relative to Treasuries, earning year-to-date excess returns of -17 bps. The conventional 30-year MBS yield rose 53 bps in November, driven by a 59 bps increase in the rate component. The compensation for prepayment risk (option cost) declined 10 bps, while the option-adjusted spread widened by 4 bps. Prior to the election, we had been tactically overweight MBS on the view that higher Treasury yields would lead to a lower option cost, benefitting MBS in the near term. Now that Treasury yields have moved substantially higher, our focus returns to the extremely depressed levels of MBS option-adjusted spreads (Chart 4). Extremely low option-adjusted spreads coupled with a housing market that should continue to recover - leading to steadily increasing net supply (bottom panel) - make for a poor risk/reward trade-off in MBS relative to other fixed income sectors. Against this back-drop, MBS are only worth a tactical trade if you have high conviction that Treasury yields are about to rise and option costs about to tighten. We do not expect the Fed to cease the reinvestment of its MBS purchases in 2017. But, if Janet Yellen is replaced as Fed Chair in early 2018, then it is possible that the new Fed will seek to end its involvement in the MBS market. This is a tail risk for MBS in 2018. Government Related: Overweight Chart 5Government Related Market Overview bca.usbs_pas_2016_12_06_c5 bca.usbs_pas_2016_12_06_c5 The government-related index underperformed the duration-equivalent Treasury index by 19 basis points in November (Chart 5). Domestic Agency bonds and Local Authority bonds outperformed the Treasury index by 2 bps and 61 bps, respectively. Sovereign debt underperformed by 122 bps, Foreign Agency debt underperformed by 54 bps and Supranationals underperformed by 6 bps. More than half of the underperformance in the Foreign Agency sector came from Mexico's state oil company, Pemex, in the aftermath of Donald Trump's election win. Losses in the Sovereign debt sector were similarly concentrated in Mexican issues. Strength in oil prices should permit Foreign Agency debt to outperform going forward, while the strong U.S. dollar will remain a drag on Sovereign debt. Local Authority and Foreign Agency debt both continue to offer attractive spreads relative to U.S. investment grade corporate bonds, after adjusting for duration and credit rating. In contrast, Supranationals and Sovereigns both appear expensive. We continue to recommend an underweight allocation to Sovereign debt within an otherwise overweight allocation to the government related sector. Bullet Agency issues outperformed callable Agency bonds in November, despite the large increase in Treasury yields (bottom panel). We expect this trend will soon reverse, and remain overweight callable versus bullet Agencies. Municipal Bonds: Underweight Chart 6Municipal Market Overview bca.usbs_pas_2016_12_06_c6 bca.usbs_pas_2016_12_06_c6 Municipal bonds underperformed the duration equivalent Treasury index by 83 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio rose from 99% to 107% in November, and is now above its post-crisis average (Chart 6). We downgraded municipal bonds to underweight on November 15,4 following Donald Trump's election victory. Lower tax rates under the new administration will undermine the tax advantage in municipal bonds, leading to outflows and higher M/T yield ratios. ICI data show that outflows have already begun. Net outflows from Muni funds have exceeded $7 billion in the four weeks since the end of October (panel 4). There are also longer-run concerns related to supply and state & local government credit quality. Depending on how it is structured, increased infrastructure spending next year could lead to a large increase in municipal bond supply. Also, state & local government downgrades are likely to increase later next year, following the lead of the corporate sector. Both of these issues are discussed in more detail in a recent Special Report.5 In October, the SEC finalized new liquidity management standards for open-ended investment funds. Funds must now determine a minimum percentage of net assets that must be invested in highly liquid securities, and no more than 15% of assets can be invested in securities deemed illiquid. At the margin, the new rule could limit funds' appetites for municipal bonds. Treasury Curve: Laddered Chart 7Treasury Yield Curve Overview bca.usbs_pas_2016_12_06_c7 bca.usbs_pas_2016_12_06_c7 November's bond rout was concentrated in the belly (5-10 years) of the Treasury curve. The 2/10 Treasury slope steepened 28 basis points on the month, while the 5/30 slope flattened by 8 bps. We believe that the yield curve has room to steepen further in 2017, based largely on the expectation that the Fed will maintain an accommodative stance of monetary policy at least until TIPS breakeven inflation rates are at levels more consistent with the Fed's 2% inflation target (Chart 7). In our view, this level is between 2.4% and 2.5% for long-dated TIPS breakevens. However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. Although we view a "dovish hike", i.e. an increase in the fed funds rate with no upward revision to the Fed's interest rate forecasts, as the most likely outcome. If we are wrong, an upward revision to the Fed's forecasts would cause the curve to bear-flatten on the day. At present, the market expects 55 bps of rate hikes during the next 12 months (panel 1). If expectations remain at these levels until after next week's FOMC meeting they will be consistent with the Fed's median forecast, assuming there are no upward revisions. Also, as we pointed out on the front page of this report, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year. TIPS: Overweight Chart 8TIPS Market Overview bca.usbs_pas_2016_12_06_c8 bca.usbs_pas_2016_12_06_c8 TIPS outperformed the duration-equivalent nominal Treasury index by 148 bps in November. The 10-year breakeven rate increased 21 bps on the month, and currently sits at 1.91%. The 5-year, 5-year forward TIPS breakeven inflation rate has risen to 2.06% from its early 2016 trough of 1.41%. However, it still has room to rise before it returns to levels that are consistent with the Fed's 2% target for PCE inflation (Chart 8). As economic growth improves next year the Fed will be keen to allow TIPS breakevens to rise toward its target, and will be slow to shift to a less accommodative policy stance. As such, we maintain our recommendation to overweight TIPS relative to nominal Treasuries, with a target of 2.4% to 2.5% for the 5-year, 5-year forward TIPS breakeven rate. While breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. With the Fed in the midst of a tightening cycle, it will be difficult for the Fed to lead inflation expectations sharply higher as in past cycles. Trends in realized inflation will be more important for long-dated breakevens this time around. Core and trimmed mean PCE inflation continue to grind slowly higher, a trend that is supported by the PCE diffusion index (panel 4). Assuming the current trend remains in place, core PCE inflation should finally reach the Fed's 2% target before the end of next year. ABS: Maximum Overweight Chart 9ABS Market Overview bca.usbs_pas_2016_12_06_c9 bca.usbs_pas_2016_12_06_c9 Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in November, bringing year-to-date excess returns up to +111 bps. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps on the month, while non-Aaa issues outperformed by 5 bps. Credit card ABS outperformed by 14 bps, while auto ABS outperformed by 7 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps in November and, at 43 bps, it is well below its average pre-crisis level. Last month we observed that after adjusting for trailing 6-month spread volatility, Aaa-rated auto loan ABS no longer offer a compelling spread pick-up relative to Aaa-rated credit card ABS. We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 9 days of average spread widening for Aaa-rated credit card ABS to underperform (Chart 9). This spread cushion is not sufficient to compensate for the fact that credit card quality metrics are in much better shape than those for auto loans. The auto loan net loss rate has entered a clear uptrend, while credit card charge-offs are still near all-time lows (bottom panel). CMBS: Underweight Chart 10CMBS Market Overview bca.usbs_pas_2016_12_06_c10 bca.usbs_pas_2016_12_06_c10 Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in November, bringing year-to-date excess returns up to +269 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 16 bps in November, and has now fallen below its average pre-crisis level (Chart 10). Rising delinquency rates and tightening lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Further adding to our caution is that more than 6000 commercial real estate loans backing public conduit CMBS deals are set to mature in 2017. This is almost 5x the number that matured last year, according to data from Trepp. Agency CMBS outperformed the duration-equivalent Treasury index by 52 basis points in November, bringing year-to-date excess returns up to +158 bps. Agency CMBS still offer 45 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (43 bps) and greater than what is offered by conventional 30-year MBS (22 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model bca.usbs_pas_2016_12_06_c11 bca.usbs_pas_2016_12_06_c11 The current reading from our 3-factor Global PMI model (which includes global PMI, dollar sentiment and global policy uncertainty) places fair value for the 10-year Treasury yield at 1.82%. However, the low reading mostly reflects a large spike in global policy uncertainty in November. Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor Global PMI model (which includes only global PMI and dollar bullish sentiment) as more representative of 10-year Treasury yield fair value at the moment. The fair value reading from our 2-factor model is currently 2.26% (Chart 11). At the time of publication the 10-year Treasury yield was 2.4%. For further details on our Global PMI model please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium bca.usbs_pas_2016_12_06_c12 bca.usbs_pas_2016_12_06_c12 Chart 13Fed Funds Rate Scenarios bca.usbs_pas_2016_12_06_c13 bca.usbs_pas_2016_12_06_c13 Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Secular Stagnation Vs. Trumponomics", dated November 15, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, 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)

Highlights Chart 1Targeting 2% bca.usbs_pas_2016_11_08_c1 bca.usbs_pas_2016_11_08_c1 The Fed did its best to avoid roiling markets so close to today's election, but still managed to hint at a December rate hike. The post-meeting statement was tweaked so that now only "some further evidence" rather than "further evidence" is required in order to lift the funds rate. We remain below benchmark duration in anticipation of a December rate hike. Before the end of the year we expect our 12-month discounter to reach at least 40-50bps (meaning the market will expect a further 1-2 hikes in 2017) from its current level of 28bps, and for the 10-year Treasury yield to reach 1.95-2%. While our global PMI model pegs fair value for the 10-year Treasury yield at 2.27%, the uptrend in the 10-year yield will face severe technical resistance as it approaches 2% (Chart 1). Positioning has already moved to net short duration, signaling that the bond sell-off is becoming stretched. While a Clinton victory would all but ensure a December rate hike, a Trump victory could cause a large enough market riot that the Fed delays until 2017. This would only be a brief hiccup in the return of the 10-year yield to the 1.95-2% range, and would not signal a long-lasting trend reversal. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview bca.usbs_pas_2016_11_08_c2 bca.usbs_pas_2016_11_08_c2 Investment grade corporate bonds outperformed the duration-equivalent Treasury index by +56bps in October, but have already given back -26bps of those gains so far this month (Chart 2). The index option-adjusted spread is -2bps tighter than at the end of September and, at 136bps, it remains very close to its historical average. Corporate credit performance faces two immediate risks. The first is today's election and the second is the prospect of a Fed rate hike in December. A Clinton victory would likely prompt a knee-jerk rally in risk assets and virtually ensure a rate hike next month. In that case we would be inclined to further trim exposure to credit risk in the coming weeks as the rate hike approaches. Already, we recommend investors avoid the Baa credit tier within a neutral allocation to investment grade corporates. In a recent report we pointed out that highly-rated credit (A-rated and above) performed well in the initial stages of last year's run-up in rate hike expectations, but then started to suffer once market-implied rate hike probabilities approached 100%.1 Conversely, a Trump victory would likely prompt a flight-to-safety event in markets which, depending on its severity, could also cause the Fed to delay the next rate hike into 2017. In that event, the prospect of delayed Fed tightening would make us more likely to increase credit exposure in the near term, especially if any knee-jerk sell-off in risk assets creates better value in corporates. Table 3Corporate Sector Relative Valuation And Recommended Allocation* (Continued) "Some"thing To Talk About "Some"thing To Talk About Table 3BCorporate Sector Risk Vs. Reward* "Some"thing To Talk About "Some"thing To Talk About High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by +92bps in October, but has already underperformed the Treasury benchmark by -108bps so far in November. The index option-adjusted spread is +25bps wider since the end of September and, at 505bps, it is 16bps below its historical average. In a Special Report2 published last week we noted that while the default rate will not re-visit its previous lows (at least until after the next recession), it should decline from 5.4% to close to 4% during the next 12 months (Chart 3). However, even a slightly brighter default outlook will not be enough for junk bonds to sustain their current pace of outperformance. A simple model of lagged junk spreads and default losses explains more than 50% of the variation in 12-month high-yield excess returns. This model suggests that even with lower default losses, excess junk returns will be +264bps during the next 12 months (panel 3). The reason is that lower default losses are more than offset by the lower starting point for spreads. Junk spreads should also come under widening pressure in the very near term, as a December Fed rate hike spurs an increase in implied volatility. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. MBS: Overweight Chart 4MBS Market Overview bca.usbs_pas_2016_11_08_c4 bca.usbs_pas_2016_11_08_c4 Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +2bps in October, but are underperforming the benchmark by -7bps so far in November. Year-to-date, MBS have outperformed the duration-equivalent Treasury index by a mere +22bps. Since the end of September, the conventional 30-year MBS yield has risen +23bps, driven by a +21bps increase in the rate component. The option-adjusted spread has widened +2bps, while the compensation for prepayment risk (option cost) has remained flat. Unattractive option-adjusted spreads and the prospect of further increases in issuance make for bleak long-run return prospects in MBS. However, the likelihood that Treasury yields will continue to rise in the near-term means that MBS could outperform due to a decline in the option cost component of spreads (Chart 4). We will likely reduce exposure to MBS once a December rate hike has been fully digested by the market, and the uptrend in Treasury yields starts to taper off. The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to ease standards on GSE-eligible mortgage loans, while demand for these same loans continues to increase. The combination of easing lending standards and strengthening demand means that issuance is likely to continue its march higher, as does the persistent uptrend in existing home sales (bottom panel). Government Related: Overweight Chart 5Government Related Market Overview bca.usbs_pas_2016_11_08_c5 bca.usbs_pas_2016_11_08_c5 The government-related index outperformed the duration-equivalent Treasury index by +5bps in October, but has already underperformed the Treasury benchmark by -9bps so far in November. The Foreign Agency and Local Authority sub-sectors drove October's outperformance, returning +24bps and +14bps in excess of Treasuries respectively. Domestic Agency debt outperformed the Treasury benchmark by +3bps, while Supranationals (-7bps) and Sovereigns (-10bps) both underperformed. After adjusting for differences in credit rating and duration, Foreign Agency and Local Authority bonds still appear attractive relative to investment grade U.S. corporate debt. Sovereigns, on the other hand, appear modestly expensive. We continue to recommend avoiding Sovereign issues while remaining overweight the other sub-sectors of the government related index. In a recent report,3 we observed that the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the U.S. dollar. As such, a continued bull market in the U.S. dollar will remain a significant headwind for sovereigns. At the country level, the only nations whose USD-denominated debt offers a spread advantage over Baa-rated U.S. corporate debt are Hungary, South Africa, Colombia and Uruguay. Unusually, bullet agency debt outperformed callable agency debt last month even though Treasury yields moved higher (Chart 5). Within Domestic Agency bonds, we continue to favor callable over bullet issues on the expectation that this divergence will not persist. Municipal Bonds: Overweight Chart 6Municipal Market Overview bca.usbs_pas_2016_11_08_c6 bca.usbs_pas_2016_11_08_c6 Municipal bonds underperformed the duration-equivalent Treasury index by -12bps in October, dragging year-to-date excess returns down to -152bps (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio is largely unchanged since the end of September, and remains close to its post-crisis average. In recent months, trends in M/T yield ratios have fluctuated alongside the betting market odds for today's Presidential election. A Trump victory would cause yield ratios to widen sharply, as President Trump's promised tax cuts would substantially de-value the tax advantage in municipal bonds. We expect yield ratios to tighten in the event that Clinton prevails, as any expectation of a Trump victory works its way out of the price. Due to attractive yield ratios relative to recent history, we are inclined to remain overweight municipal bonds in the near-term. However, we will likely downgrade the sector if yield ratios move back to previous lows. As we detailed in a recent Special Report,4 historical lags between the corporate and municipal credit cycles suggest that municipal bond downgrades will start to increase in the second half of next year, alongside a deterioration in state & local government balance sheets. Further, state & local government investment spending is poised to move higher next year, regardless of the election result, leading to even greater muni issuance (Chart 6). Elevated fund flows have offset the impact of strong issuance this year, the risk is that they will not keep pace going forward. Treasury Curve: Stay In Flatteners Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve has bear-steepened significantly since the end of September. The 2/10 Treasury slope has steepened +16bps and the 5/30 slope has steepened +14bps. As a result, our two curve flattener trades have struggled. Our 2/10 Treasury curve flattener has returned -41bps since initiation on September 6. Our 10/30 Treasury curve flattener has returned -25bps since initiation on September 20. Our other tactical trade - short December 2017 Eurodollar - has returned +16bps since initiation on July 12. All three of the above tactical trades are premised on the view that the Fed will deliver a rate hike in December, and that such a rate hike has not yet been fully discounted by the market. At present, we calculate that the market-implied probability of a December rate hike is 62%, as discounted in fed funds futures. The historical pattern suggests the yield curve should bear flatten as the rate hike probability approaches 100%. Unusually, the correlations between both the 2/10 and 10/30 Treasury slopes and the level of Treasury yields have moved into positive (bear-steepening) territory (Chart 7). This is especially unusual for the 10/30 slope, where the correlation has been firmly in negative (bear-flattening) territory since 2013. We continue to recommend holding curve flatteners, and expect both correlations to revert into negative (bear-flattening) territory in advance of a December rate hike, as they did last year. Any surge in bullish dollar sentiment between now and December would only increase the flattening pressure on the curve (bottom panel). So far bullish dollar sentiment has remained relatively flat, but we cannot discount a large increase in the run-up to the next rate hike, as occurred last year. TIPS: Overweight Chart 8TIPS Market Overview bca.usbs_pas_2016_11_08_c8 bca.usbs_pas_2016_11_08_c8 TIPS outperformed the duration-equivalent nominal Treasury index by +112bps in October. The 10-year breakeven rate has increased +8bps since the end of September, and currently sits at 1.68%. The 10-year TIPS breakeven rate has increased substantially during the past couple months, and has now converged with the fair value reading from our TIPS Financial model (Chart 8). Rising expectations of a Fed rate hike and a flatter Treasury curve will weigh on TIPS during the next month, and we would not be surprised to see breakevens temporarily cease their uptrend as attention turns to Fed hawkishness following today's election. But we also expect that TIPS breakevens will resume their uptrend heading into next year. As we flagged in a recent report,5 the sensitivity of TIPS breakevens to core inflation has increased since the financial crisis. We posit that the reason for this increased sensitivity is that the Fed's ability to control long-dated inflation expectations has been impaired by the zero-lower bound on rates. As a result, the trend in breakevens is increasingly taking its cue from the realized inflation data. Realized inflation continues to trend steadily higher (bottom two panels), and diffusion indexes suggest that further gains are ahead (panel 4). Given that breakevens remain well below pre-crisis levels, we intend to remain overweight TIPS relative to nominal Treasuries and ride out any near-term volatility related to a Fed rate hike. ABS: Maximum Overweight Chart 9ABS Market Overview bca.usbs_pas_2016_11_08_c9 bca.usbs_pas_2016_11_08_c9 Asset-Backed Securities outperformed the duration-equivalent Treasury index by +10bps in October, bringing year-to-date excess returns up to +101bps. Aaa-rated ABS outperformed the Treasury benchmark by +8bps on the month, while non-Aaa issues outperformed by +24bps. The index option-adjusted spread for Aaa-rated ABS has tightened -3bps since the end of September and, at 45bps, is considerably below its pre-crisis average (Chart 9). According to our days-to-breakeven measure, there still exists a valuation advantage in Aaa-rated auto ABS relative to Aaa-rated credit card ABS, but that advantage is rapidly evaporating (panel 3). We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 10 days of average spread widening for Aaa-rated credit card ABS to underperform. Moreover, credit card ABS exhibit superior collateral credit quality relative to autos. Credit card charge-offs remain near all-time lows, while the auto net loss rate appears to have bottomed (bottom panel). Further, the Fed's senior loan officer survey shows that auto lending standards have tightened for two consecutive quarters, while credit card lending standards were unchanged in Q3 following 25 consecutive quarters of net easing (panel 4). We recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans within a maximum overweight allocation to consumer ABS. CMBS: Underweight Chart 10CMBS Market Overview bca.usbs_pas_2016_11_08_c10 bca.usbs_pas_2016_11_08_c10 Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date outperformance up to +194bps. The index option-adjusted spread for non-agency Aaa-rated CMBS has tightened -3bps since the end of September, and remains very close to its pre-crisis average (Chart 10). The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to tighten standards on all classes of commercial real estate (CRE) loans (panel 3). The survey also shows that CRE loan demand continues to increase, though at a less rapid pace than in prior quarters. While CRE prices continue to march higher (bottom panel), tightening lending standards and a rising delinquency rate (panel 4) make us cautious on non-agency CMBS. Agency CMBS outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date excess returns up to +105bps. Agency CMBS still offer 56bps of option-adjusted spread. This is greater than what is offered by Aaa-rated consumer ABS (45bps) and conventional 30-year MBS (19bps) for a similar amount of spread volatility. We continue to recommend overweight positions in Agency CMBS. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our Global PMI Treasury model places fair value for the 10-year Treasury yield at 2.27% (Chart 11). This model is based on a linear regression of the 10-year Treasury yield on three factors, using a post-financial crisis time interval.6 The three factors are: Global Growth: Measured using the Global Manufacturing PMI (sourced from JP Morgan and Markit) Global Growth Divergences: Proxied by bullish sentiment toward the U.S. dollar (sourced from Marketvane.net) Economic Uncertainty: Measured using the Global Economic Policy Uncertainty Index (sourced from policyuncertainty.com) The correlation between the global PMI and the 10-year Treasury yield is strongly positive (panel 3). However, improving global growth is offset by any increase in bullish sentiment toward the U.S. dollar. For a given level of global growth any increase in bullish sentiment toward the dollar represents a drag on interest rate expectations. As such, bullish dollar sentiment enters our model with a negative sign (panel 4). The final component of our model - global economic policy uncertainty - captures changes in Treasury yields related to headline risk and "flights to quality". This factor enters our model with a negative sign - more uncertainty correlates with lower bond yields (bottom panel). Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium bca.usbs_pas_2016_11_08_c12 bca.usbs_pas_2016_11_08_c12 Chart 13Fed Funds Rate Scenarios bca.usbs_pas_2016_11_08_c13 bca.usbs_pas_2016_11_08_c13 Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 6 For additional details on the model please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, 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)

There are two key risks that could derail a bear-flattening of the yield curve. The first is a Trump election victory, the second is a flaring of stress in the non-U.S. banking sector.

With recent comments strongly hinting that the Fed is on track for a rate hike in December, the dy-namics of the Fed Policy Loop make spread product appear extremely vulnerable.

Eventually the easing of financial conditions will strengthen the Fed's resolve to lift rates. Rate hike probabilities will rise and risk assets will struggle to cope with higher Treasury yields.

Some near-term upside in Treasury yields is very likely as flight to safety flows begin to unwind. However, given that global growth divergences remain in place, we will continue to look for an opportunity to increase duration on any meaningful back-up in yields.

Assuming last month's weak employment report is not the start of a trend, the market is still discounting too low a probability that the Fed will lift rates this year. This means the Treasury curve should bear-flatten in the coming months, providing an opportunity to move to above-benchmark duration.

Financial conditions will continue to ease during the next few months, and the Fed will use its June statement to prepare the markets for a rate hike in September.

Some tentative signs of life in the global manufacturing data suggest that Treasury yields have some room to move higher in the near term.

Fed policymakers will soon shift their focus toward the strong employment and inflation data and stress that further rate hikes this year are likely. This will stem the rally in risk assets and cap the upside in long-dated yields.