Developed Countries

Executive Summary Dollar Still The Largest Global Reserve Currency The rise of cryptocurrencies like stablecoins theoretically pose risks to fiat currencies and their general use. In the US, the Federal Reserve will look to adopt a Central Bank Digital Currency (CBDC) – a digital dollar – this decade, to stave off these risks and usher in a new era of central bank money. A digital dollar would likely be integrated as seamlessly as possible into the current monetary regime, thereby maintaining an intermediated role played by existing financial sector actors as well as operating alongside existing circulating currency. The US dollar will eventually face rising competition from digital currencies, both at home and abroad. While other central banks make headway into developing their own CBDCs, China is by far the most advanced. China’s digital yuan will not resolve all of China’s problems with internationalizing its currency but it will create new opportunities. Public and political pushback will occur and will slow adoption of a digital dollar. Gridlock in 2023 may prove to be another headwind. To adopt a digital dollar, politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation, especially as foreign competition on CBDCs rises. Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 10.7% Bottom Line: Policymakers will adopt a CBDC – a digital dollar – this decade. Political pushback may slow adoption, but foreign competition will overcome domestic constraints. Feature Technological innovation over the past decade has given rise to a new asset class – digital assets. Investors are most familiar with cryptocurrencies, and to a lesser extent, non-fungible tokens and decentralized finance-based lending, among others. These assets have witnessed a boom and bust over the past few years (Chart 1). Chart 1Manias: Then And Now Cryptocurrencies have been touted to have money-like characteristics, the most popular being Bitcoin, and others like stablecoins. Stablecoins are mostly used as a medium of exchange between fiat money and cryptocurrencies and vice versa. They are pegged to fiat money and often backed by highly liquid traditional assets1 to maintain their pegs. But cryptocurrencies do not exhibit the traits of durable money today. However, the technological innovation of digital currency represents a natural evolution of money that is irreversible and could someday possess the main characteristics of money: a medium of exchange, a unit of account, and store of value. Cryptocurrencies with money-like qualities theoretically pose a challenge to fiat currencies, i.e. those issued by governments that are not backed by any underlying real asset but rather by trust in government institutions, including the treasury and central bank. Not that trust is a poor basis for a currency. But that trust could fail and new trust could be placed in cryptocurrencies. Governments could eventually lose control of the money supply and payments system, suffer from financial instability, fail to provide regulatory oversight, or fail to prevent the illicit use of digital assets for criminal gain. The same technology driving growth in digital assets has led central banks the world around to research and in some cases develop CBDCs. For an introductory guide to CBDCs, see BCA’s “The Investor’s Guide To Central Bank Digital Currencies.” CBDC research and development are at varying stages across the world’s central banks.2 In the US, the Federal Reserve (Fed) continues to research a CBDC (digital dollar) and its use-case, or justification for being. The Fed has made no commitment to designing a digital dollar anytime soon. But we bet that the Fed’s position will change in coming years. Introducing a digital dollar will reduce the various risks associated with cryptocurrencies whilst also creating efficiencies in the US economy. These efficiencies will also transverse into cross-border efficiencies. Globally, central banks are showing increasing activity in developing CBDCs and introducing a digital dollar would help the Fed maintain monetary dominance across the world while staving off cryptocurrencies, especially stablecoins. The Fed won’t sit idle as a global monetary revolution unfolds. But the policy front is fraught with challenges. Policy makers in the US have expressed mixed views on adopting a digital dollar. Some suggest the Fed would exercise even more control over monetary policy than it does today. Others note risks to consumer data privacy, which could be exploited by government. Public opinion is also mixed with no clear understanding of or need for a digital dollar. Commercial bank business interests may come under attack too, with a digital dollar scalping profit margins from banks, depending on the type and extent of the CBDC operating model employed. Ultimately, the US will want to maintain its position as the global monetary leader. Continued dollar dominance in the global economy is strategically advantageous for the US, especially in a hypo-globalizing world (Chart 2). Ensuring ongoing monetary dominance while rooting out domestic competition from stablecoins will be aided by adopting a digital dollar. Chart 2Dollar Still Dominating Global Reserves Bottom Line: The Fed will most likely adopt a digital dollar within the decade. The Fed And A Digital Dollar The Fed has been actively researching a digital dollar for several years with growing research on design, implementation, and necessity. As it stands, the Fed has not committed to introducing a digital dollar in the foreseeable future. But what would a digital dollar look like and what role would it play in the economy if the Fed decided to introduce one? CBDC Model Briefly, the Fed could choose from three different CBDC operating models: unilateral, synthetic, or intermediated (Diagram 1). A unilateral model would mean the Fed performs all CBDC related functions including direct interaction with end-users. A synthetic model would mean non-Fed actors issuing money backed by Fed assets. Diagram 1Three CBDC Operating Models Realistically, a unilateral and synthetic digital dollar are unlikely. The former would crowd out traditional banking services, while the latter would let actors other than the Fed issue money, violating the Federal Reserve Act. Hence the Fed will most likely pursue an intermediated CBDC model. This model entails digital dollar issuance by the Fed but includes a role for private sector firms to interact with end-users. The intermediary role would be filled by financial firms but also other types of companies such as payment service providers and mobile phone operators. This means the Fed would not totally crowd out existing players across the payment and financial services space. An intermediated model would require the central bank to regulate and oversee other actors, which adds an extra layer of legal and operational complexity to implementation. But it is the model most consistent with the US’s combination of federal government and liberal capitalism, and the model cited by the Fed to most likely be adopted.3 The intermediated model will align with the current two-tier system currently in place (Diagram 2). Digital dollars will feature in both wholesale and retail transactions. Wholesale involves commercial banks and regulated financial intermediaries, while retail involves individuals and non-financial businesses. The model would also operate alongside existing paper money. A digital dollar would be a liability on the Fed, denominated in dollars, and would form an integral part of base money supply (M0). It would be distributed like, and act as a complement to, dollar bills and could be used in transactions conducted in currency and reserves. It would be legal tender just like the paper dollar. Diagram 2Two-Tier Monetary Regime System Digital Dollar Needs The Fed has stated that a digital dollar should, among other things, meet certain criteria before adoption (Table 1). Some of these criteria are already met. Others will be met with adoption. A digital dollar will benefit households, businesses, and the economy at large. For example, a digital dollar would enhance payment transparency, thereby supporting the Fed’s objective to promote safe and efficient payments. And depending on design choices, digital transactions could offer degrees of traceability and aggregate payment data could be analyzed in real time to provide insights into economic health and activity. Table 1Fed Criteria For CBDC Adoption Further, a digital dollar would promote diversification of the payments system, thereby increasing the safety and efficiency of US payment infrastructure. It may also attract new actors offering services related to the digital dollar, spurring financial innovation and fostering financial integration. The payments system is already broadly efficient but adding another layer of digitization with a digital dollar would mean that the US economy would be better positioned for the evolution of the digital economy over the next decade and beyond. The need for broad stakeholder support will be a difficult criterion to meet, however. There would need to be more engagement with the public, inter-government agencies, and Congress. For now, these “needs” outlined by the Fed are more than half met, signaling that a digital dollar could come to fruition within the decade from a policy perspective. International advances on this front will spur US policy makers into action even if they are disinclined. Bottom Line: The needs outlined by the Fed to adopt a digital dollar have been mostly met which ticks off one of the policy implementation checkboxes. There are gains to be had across the economy by introducing a digital dollar, ranging from a more efficient payments system to financial inclusion and decreasing transactions costs. Domestic Competition The proliferation of stablecoins has been noted by government agencies around the world. The Fed too has been keeping note. By the end of 2021, stablecoins had a relatively small market capitalization compared to the broader cryptocurrency market, approximately 6%. Now, stablecoins account for almost 16% of cryptocurrency market capitalization. But trading volumes point to stablecoins having a much larger role in transactions (Chart 3). Stablecoins resolve some of the problems of faith and trust that bedevil cryptocurrencies not backed by traditional assets. Chart 3Stablecoins Rise In Popularity Stablecoins pose two key threats that a digital dollar will essentially nullify: Systemic risk: A growing stablecoin market that is increasingly backed by traditional, high liquid assets could create systemic risk in traditional asset markets. An excessive rise or fall in demand for stablecoins would cause volatility in the liquid assets that back them. Moreover, for example, a fire sale in the stablecoin market would cause demand to fall excessively relative to the backing asset. Prices between stablecoins and the backing asset would diverge, potentially breaking the peg and resulting in further price divergence. And more broadly, high volatility from crypto markets can penetrate traditional or risk-free markets. A digital dollar would render stablecoins unnecessary, allowing cryptocurrency users to transact and convert digital dollars to cryptocurrency while enjoying the backing of the Fed on the value of digital dollars. Cross-border transactions: Stablecoins are also increasingly used for cross-border transactions. According to Fed data, the US pays 5.4% in fees on average per cross-border transaction, which also takes several days to settle. Stablecoins settle almost instantaneously and have much lower transaction fees. So too can a digital dollar. It would settle just as quickly as a stablecoin, if not quicker, and reduce transaction costs for cross-border payments. And because stablecoins are designed to maintain their pegs, they have more potential than cryptocurrencies to act as mediums of exchange outside of the crypto market and economy, potentially threatening the ongoing use of fiat money. Bottom Line: The Fed will design a CBDC around its existing monetary and payments system to allow for seamless integration. There are not many reasons holding back digital dollar adoption from a point of need and benefit. By adopting a digital dollar, the Fed will also fight off the growing risk of stablecoins, which could pose a threat to the use-case of fiat money in everyday life. Other Central Banks On The March The authority to issue money is an important element of economic power. History is replete with examples of currency competition both within countries and between them. CBDC research and development are picking up speed across central banks (Charts 4A and 4B). China is the world leader with its digital yuan, as we discuss below. Design and implementation of CBDCs will follow in coming years just like in the case of the digital yuan. If the theoretical payoffs to adopting a CBDC are met by real-world green shoots, then foreign CBDCs could pose a threat to continued dollar dominance in the global monetary and economic system, namely if countries can draw down their dependence on dollar reserves. Chart 4ACentral Banks Paying More Attention To CBDCs Chart 4BCentral Banks Paying More Attention To CBDCs Central Bank Competition Treasury Secretary Janet Yellen has noted this challenge in recent remarks explaining that any implementation of a “US central bank digital currency must support the prominent role the dollar plays in the global financial system.”4 The Fed is on the same page as the Treasury noting that any CBDC should be used to preserve the dominant international role of the dollar. The dollar is the world’s most widely used currency for payments and investments and serves as the world’s premier reserve currency. The dollar’s international role allows the US to influence the practices and standards of the global monetary and economic system. Basically, when the US constricts the supply of dollars in response to domestic conditions, the rest of the world suffers tighter monetary conditions, and when the US expands the supply, the rest of the world enjoys looser conditions, almost regardless of what other nations want or need. Central banks have made their policy goals clear in respect to developing a CBDC. Some central banks look to expand financial inclusion, market access, and their payments system while others are looking to compete with one another (Table 2). Canada, China, and Sweden want to gain a local and international market advantage for their currencies by introducing CBDCs. Table 2CBDC Policy Goals Of Central Banks China Leading CBDC Race, But… At this early stage, China’s digital yuan poses the largest threat to a digital dollar on the international stage. It is the most prominent CBDC project at this current juncture. The digital yuan entered beta testing at the end of 2020 in parts of the country. Wider testing across provinces is being phased in. China’s monetary endeavors began with the Cross-Border Inter-Bank Payment Service in 2015. The digital yuan will be positioned as an extension of this system to promote the national currency and fight global dollar dominance. But how big of a challenge could a digital yuan mount? The answer is not much, not now. China is the world’s largest trading partner but the renminbi accounts for less than 3% of the world’s reserve currency (Chart 5). The disparity between trade and currency status in the global economy reflects a lack of global trust in the renminbi and is a cause for concern for China. China is structurally invested in the dollar-dominated financial system and hence vulnerable to American influence by means of that system. Chart 5Global Renminbi Reserves Are Low The digital yuan would support more debt issuance based on cost and payment incentives to debt holders when financing BRI projects. This will help drive the use of the digital yuan going forward. For example, China can assert its influence over countries with Chinese debt by having them accumulate digital yuan reserves to pay back loans. China can even provide countries with concessions on loans to promote its digital yuan. Concessions on Chinese debt may lead to easier uptake, therefore promoting issuance. If the cost of switching to the digital yuan is low, countries will see no benefit in continuing their trade transactions with China in US dollars. Using the digital yuan as the currency of invoice to disburse loans can make these transactions more transparent and manageable. This could also allow for more state control over funds, an attractive scenario for China. However, China’s monetary ambitions face serious constraints. Lack of trust in the currency is the most critical challenge for internationalization of the yuan, digital or otherwise. Even if the digital yuan project is five to ten years ahead of the curve, countries still opt to hold the dollar over the yuan in any type of crisis, as has been amply demonstrated in history, and over a range of global shocks since 2019. Hence digital yuan adoption will require guarantees from Chinese institutions. But these same institutions have struggled to internationalize the paper renminbi. Lack of openness, transparency, and convertibility are persistent problems. Bottom Line: Central banks around the world are gearing up to introduce CBDCs in coming years. Some are looking to promote financial inclusivity. Others like China’s digital yuan want to chip away at the dollar’s global dominance. Digital versions of fiat currencies will have to demonstrate substantial economic and trade efficiencies in order to encourage diversification away from the US dollar, since there is no inherent reason a digital version of a nation’s currency would increase trust beyond what is already established. But those efficiencies could take shape, which would put pressure on the US to respond. The US faces significant monetary challenges over the long run, including from CBDCs. But the US is a technological power and will eventually respond by developing its own CBDC. Pushback Against A Digital Dollar The Fed has stated that it would only pursue a digital dollar in the context of broad public and cross-governmental support. However, neither the public nor congress broadly support one at present. Public opinion is uneducated on the issue and therefore highly malleable depending on leadership and events. Public Opinion Is Non-Supportive Across age groups, people do not know enough about digital currencies and think it is a bad idea to introduce a digital dollar (Chart 6). A 2020 poll found that only 13% of respondents approved of a digital dollar.5 Low approval is becoming a trend. However, the same poll showed that 38% of respondents think the US dollar is backed by gold, bonds, or oil. Addressing poor monetary literacy among the public would help to improve public support of a digital dollar. US households say they are more likely to trust traditional financial institutions than government agencies to safeguard their personal data (Chart 7). A digital dollar will grant the Fed and federal government far-reaching information regarding the everyday financial transactions of households. Trust in government has been declining and a digital dollar underpinned by a central ledger system would provoke consumer privacy lobby groups and government activists to fight and protest adoption (Chart 8). Chart 6Popular Support For A Digital Dollar Is Lacking Chart 7Households Trust Government Less Than Financial Institutions Chart 8Trust In Government Has Been Waning Chart 9Inflation Outbreak Will Limit Big Government About half of the US public already view the government as “doing too much” (Chart 9). The explosive inflation of 2020-22 will slow the underlying ideological shift to the political left, potentially limiting support for a digital dollar. Public opinion has been shifting for decades in favor of more government involvement in people’s day-to-day lives (Chart 10), but that trend may well stall now that excess of government creates tangible negatives for household pocketbooks (inflation). The bigger of a problem the Fed has in taming inflation in 2022-23, the bigger the political backlash will be. Federal solutions will suffer as a result. This is our theme of “Limited Big Government,” since the role of the state will increase relative to the past 40 years but still within an American context of checks and balances. Chart 10People Have Favored Government Involvement Bottom Line: There is no clear public demand for the digitization of the dollar at present. A major financial or economic disruption stemming from the monetary system or digital assets may be necessary to call public attention to the question. Meanwhile the private sector will drive innovation and the federal government will react to try to maintain domestic stability and international competitiveness. These data support the Fed taking an intermediated approach to cbdc when forced to take action. Policymakers Will Resist Policymakers are divided over the idea of a digital dollar. Senator Ted Cruz introduced a bill in March 2022 to “prohibit the Federal Reserve from offering products or services directly to individuals, maintaining accounts on behalf of individuals, or issuing a central bank digital currency directly to an individual.”6 Cruz has yet to receive widespread party support on the bill but he could get the backing from more GOP members if Republicans take over Congress, as expected, this November. Some Republicans and Democrats have favored cryptocurrencies while others have not, advocating for crypto-mining and crypto start-ups in progressive-left and libertarian right states. But the center-left and center-right might lean more toward cryptocurrency regulation and digital dollar adoption. Coalitions may need to be formed on the topic of a digital dollar, in parties and between parties. A digital dollar will cause a level of disruption, which will affect both the Democrats and Republicans. Government gridlock will create challenges to digital dollar adoption too. The upcoming mid-term elections favor the GOP. Both the House and the Senate are expected to flip in favor of the GOP in 2023. The “Blue Sweep” policy setting will end and only the White House will remain in Democrat control. Republicans have a shot at flipping the White House in 2024, which could see a “Red Sweep.” This scenario may slow adoption of a digital dollar but it will only preclude the unilateral cbdc model, not the intermediated model. The period of 2023-24 is too soon for adoption of a digital dollar anyway but the fact is that gridlock will delay the process until external factors force US action. Bottom Line: Public and political pushback will slow the adoption of a digital dollar. Politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation but this will be difficult in a highly polarized country and will likely depend on foreign competition. Investment Takeaways We avoided cryptocurrencies during the irrational exuberance over the past two years. We expect governments to regulate the sector in order to preserve a monopoly over money supply and hence geopolitical interests. With monetary conditions tightening, we expect continued volatility in the crypto space. The US dollar remains strong tactically but is nearing its peak cyclically. We remain long but have put the currency on downgrade watch as the market more fully prices a range of bad news this year. On the global stage, the US dollar will remain the premier reserve currency despite cyclical ups and downs. The current macroeconomic backdrop is negative for the US financial sector (Chart 11). Mergers and acquisitions are drying up while regulatory risks loom. Initial public offerings are also slowing, while trading volume is low. Consumers had already accumulated debt earlier in the cycle and with rising interest rates amid a more challenging job environment, growth in loans and ultimately bank profits will slow. The commercial banking sector faces challenges during the upcoming transitional period of disruptive innovation and regulatory uncertainty. We believe the Fed and policymakers in general will want to cause as little disruption as possible, by integrating any digital dollar with the traditional finance sector as seamlessly as possible. However, transitions, especially those digital in nature, bring with them high uncertainty in the financial sector and elsewhere. Chart 11Financial Sector Facing Macro Headwinds     Guy Russell Senior Analyst guyr@bcaresearch.com     Footnotes 1     Stablecoins are backed by various assets and means. Fiat money, commodities, other cryptocurrencies and by algorithmic means are some examples. 2     See The Bank For International Settlements, Central Bank Digital Currencies: Executive Summary, September 2021, bis.org. 3    See The Board of Governors of the Federal Reserve System, Money and Payments: The U.S.Dollar in the Age of Digital Transformation, January 2022, federalreserve.gov. 4    See U.S. Department Of The Treasury, Remarks from Secretary of the Treasury Janet L. Yellen on Digital Assets, April 2022, treasury.gov. 5    See Cointelegraph, Most Americans are against a digital dollar CBDC, survey reveals,september 25, 2020, cointelegraph.com 6    See Ted Cruz’s Proposed Bill to amend the Federal Reserve Act to prohibit the Federal reserve banks from offering certain products or services directly to an individual, and for other purposes, March 2022, cruz.senate.gov.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets

Executive Summary Peak Fed Funds? The bond market is priced for a fed funds rate that will peak in February 2023 at 3.44% before trending down. We survey several interest rate cycle indicators and conclude that the market’s expected peak is too low and occurs too early. These indicators include: the unemployment rate, financial conditions, PMIs, the yield curve and housing starts. We also update our default rate forecast and are now looking for the default rate to rise to between 4.7% and 5.9% during the next 12 months. While our default rate forecasts imply a reasonably attractive 12-month junk bond valuation, we hesitate to turn too bullish on high-yield given that the next peak in the default rate is still not in sight. Bottom Line: We recommend keeping portfolio duration close to benchmark for the time being, though we will be looking for opportunities to reduce duration in the second half of this year. Similarly, we recommend a neutral (3 out of 5) allocation to junk bonds but will recommend reducing exposure if spreads rally back to average 2017-19 levels. Feature Last week’s report presented three conjectures about the US economy.1 One of those was that a recession will be required to get inflation back to 2%. But when will that recession occur? The question of timing is a vital one for bond investors. Are we on the cusp of recession right now? If so, then bond investors should extend portfolio duration in anticipation of Fed rate cuts and a return to 2% inflation. Conversely, if the recession is delayed, interest rates probably move higher before the cycle ends and investors should consider reducing portfolio duration. This week’s report addresses the topic of timing the next recession and discusses the implications for bond portfolio construction. Timing The Interest Rate Cycle From a bond market perspective, the question of whether the economy is in recession is less important than whether the Fed is hiking or cutting rates. Therefore, for the purposes of this report we will define a “recession” as an economic slowdown that is significant enough for the Fed to start cutting interest rates. Chart 1Peak Fed Funds? Now, let’s start by looking at what sort of interest rate cycle is priced in the market. The overnight index swap curve is currently discounting a peak fed funds rate of 3.44% (Chart 1). It is also priced for that peak to occur in 7 months, or by February 2023 (Chart 1, bottom panel). As bond investors, the question we must ask is whether this pricing seems reasonable. To do so, we will perform a survey of different indicators that have strong track records of sending signals near the peaks of interest rate cycles. Unemployment The first indicator we’ll look at is the unemployment rate. Economist Claudia Sahm has shown that a recession always occurs when the 3-month moving average of the unemployment rate rises to 0.5% above its trailing 12-month minimum.2 Table 1 dispenses with the moving average and simply shows the deviation of the unemployment rate from its trailing 12-month minimum on the dates of first Fed rate cuts since 1990. We see that the Fed has typically started to cut rates once the unemployment rate is 0.3-0.4 percentage points off its low. The exception is 2019 when the unemployment rate was only 0.1% off its low, but when inflation was below the Fed’s 2% target. Table 1Unemployment And Inflation When The Fed Starts Easing At 3.6%, the unemployment rate is currently at its cycle low. Based on the numbers shown in Table 1, this means that we should only expect the Fed to cut interest rates if the unemployment rises to at least 3.9% or 4.0%. We say “at least” because it’s also important to note that the inflation picture is a lot different today than it was during the periods shown in Table 1. With inflation so much higher, it is reasonable to think that the Fed will tolerate a greater increase in the unemployment rate before pivoting to rate cuts. Looking ahead, initial unemployment claims appear to have bottomed for the cycle and changes in initial claims are highly correlated with changes in the unemployment rate (Chart 2). That said, the trend in claims is currently consistent with a leveling-off of the unemployment rate, not a large increase. Financial Conditions Second, we turn to financial conditions. Fed officials often assert that monetary policy works through its impact on broad financial conditions. Therefore, it’s not too surprising that rate cuts tend to occur only after the Goldman Sachs Financial Conditions Index has moved into restrictive territory. Currently, despite the Fed’s dramatic hawkish shift, the index still shows financial conditions to be accommodative (Chart 3). Chart 2Jobless Claims Moving Higher Chart 3Financial Conditions   The same caveat we applied to the unemployment rate applies to financial conditions. As long as inflation is above the Fed’s target, it’s highly likely that the Fed will be comfortable with financial conditions that are somewhat restrictive. Therefore, the Fed may not pivot as soon as the Goldman Sachs index moves above 100, as has been the pattern in the recent past. Yield Curve Third, we note that an inverted Treasury curve almost always precedes the start of a Fed rate cut cycle, and the Treasury curve is certainly inverted today (Chart 4). The logic behind this indicator is somewhat circular in the sense that an inverted Treasury curve simply tells us that the market anticipates Fed rate cuts. If data emerge to suggest that Fed rate cuts will be postponed, then the Treasury curve could re-steepen. It’s for this reason that the Treasury curve often inverts well in advance of an economic recession and Fed rate cuts. We explored the relationship in more detail in a recent Special Report.3 Chart 4Interest Rate Cycle Indicators Chart 5Manufacturing PMIs PMIs Typically, the ISM Manufacturing PMI is below 50 by the time of the first Fed rate cut (Chart 4, panel 3). Currently, the ISM Manufacturing PMI is a healthy 53.0, but it has been falling quickly and trends in regional PMI surveys suggest that it will dip below 50 within the next few months (Chart 5). Interestingly, both the ISM and regional PMI surveys show that manufacturing supplier delivery times have come down a lot (Chart 5, panel 2). This gives some hope that goods inflation will trend lower during the next few months, as is our expectation. Recently, there’s also been an unusual divergence between the employment components of the ISM and regional Fed surveys. The New York and Philadelphia Fed surveys are showing strength in their employment components. Meanwhile, the ISM employment figure is below 50 (Chart 5, bottom panel). This divergence likely boils down to labor shortages that complicate how firms are responding to the employment question in the surveys. For example, despite the sub-50 employment figure, the latest ISM release noted that “an overwhelming majority of panelists […] indicate that their companies are hiring.”4 Housing In a recent report, we developed a rule of thumb that says that Fed rate cuts typically don’t occur until after the 12-month moving average of housing starts falls below the 24-month moving average.5 That indicator is coming down, but it still has a lot of breathing room before it dips into negative territory (Chart 4, bottom panel). That same report also outlined that we see the housing market slowdown proceeding in three stages. First, higher mortgage rates will suppress housing demand. This is already happening at a rapid pace as indicated by trends in mortgage purchase applications and existing home sales (Chart 6A). Second, lower housing demand will push up inventories and send prices lower. This has not yet shown up in the data (Chart 6B). Finally, once lower prices and higher inventories sufficiently disincentivize construction, we will see a marked deterioration in housing starts. Currently we see that housing starts have dipped, and homebuilder confidence has plummeted, but starts still haven’t decisively broken their uptrend (Chart 6C). Chart 6AHousing Demand Chart 6BPrices & Inventories Chart 6CBuilding Activity Putting It All Together To make sense of all the different indicators that could signal a Fed pivot toward rate cuts, we turn to our Fed Monitor. The Fed Monitor is a composite indicator that includes many of the individual indicators we have already examined in this report, as well as some others. The Fed Monitor is constructed so that a positive reading suggests that the Fed should be hiking rates and a negative reading suggests the Fed should be cutting rates. As can be seen in Chart 7, the Monitor is currently deep in positive territory. Chart 7Fed Monitor Calls For Tighter Money The Fed Monitor consists of three main sub-components, an economic growth component, an inflation component and a financial conditions component (Chart 7, bottom 3 panels). We see that the economic growth component of the Monitor is consistent with a neutral Fed policy stance – neither hikes nor cuts - and financial conditions point to a mildly restrictive stance. However, unsurprisingly, the inflation component is the highest it has been since the early-1980s and this is applying a ton of upward pressure to the Monitor. While our Fed Monitor is not a perfect indicator, it does speak to the tradeoff between inflation and economic growth that we have already hinted at in this report. Specifically, the Monitor illustrates that as long as inflation remains elevated it will take a significant deterioration in economic growth and financial conditions before the overall Monitor recommends a dovish Fed pivot. To us, this argues for a higher and later peak in the fed funds rate than is currently priced in the curve. Bottom Line: The peak fed funds rate that is currently priced in the market for 2023 is too low, and the funds rate will also likely peak later than what is priced in the curve. That said, falling inflation and economic growth concerns will probably keep a lid on bond yields during the next few months. We advise investors to keep portfolio duration close to benchmark for the time being, but to look for opportunities to reduce exposure. We will consider reducing our recommended portfolio duration stance to ‘below-benchmark’ if the 10-year Treasury yield falls to 2.5% or if core inflation reverts to our estimate of its 4%-5% underlying trend. Timing The Default Rate Cycle The interest rate cycle is not the only important one for bond investors. The default rate cycle is also crucial for spread product allocations because default trends are responsible for a significant amount of the volatility in corporate bond spreads. In this section we consider the outlook for corporate defaults and high-yield bond performance. We model the trailing 12-month speculative grade default rate using gross leverage (total debt over pre-tax profits) and C&I lending standards (Chart 8). Conservatively, if we assume 5% corporate debt growth for the next 12 months and corporate profit growth of between -10% and -20%, our model projects that the default rate will rise to between 4.7% and 5.9% (Chart 8, top panel). It’s notable that, like us, banks are also preparing for an increase in corporate defaults by raising their loan loss provisions (Chart 8, panel 2). Meanwhile, job cut announcements – another reliable indicator of corporate defaults – still don’t point to a higher default rate (Chart 8, bottom panel). Chart 8The Default Rate Has Troughed Interestingly, our model’s conservative projections suggest that in 12 months the default rate will be lower than its typical recession peak. Given today’s cheap junk valuations, this sort of analysis is encouraging a lot of people to turn bullish on high-yield bonds. Chart 9Default-Adjusted Spread This line of reasoning is not totally unfounded. Using the same forecasted default rate scenarios from Chart 8 along with an assumed 40% recovery rate on defaulted debt, we calculate that the excess spread available in the junk index after subtracting 12-month default losses is between 136 bps and 208 bps. This is below the historical average (Chart 9), but still above the 100 bps threshold that often delineates between junk bond outperformance and underperformance versus duration-matched Treasuries.6 More specifically, Chart 10 shows the relationship between our default-adjusted spread and high-yield excess returns versus Treasuries for each calendar year going back to 1995. We see that, in general, there is a positive relationship between spread and returns and that excess returns are more often positive than negative whenever the default-adjusted spread is above 100 bps. However, Chart 10 also shows periods when a pure analysis of junk bond performance based on the 12-month default-adjusted spread didn’t pan out. The year 2008 is a prime example. The default-adjusted spread came in at 249 bps for 2008, above the historical average. However, junk spreads widened dramatically in 2008 and excess returns were dismal. Chart 10The Default-Adjusted Spread And High-Yield Returns The reason the default-adjusted spread valuation framework failed in 2008 is that while the default rate only moved up to 4.9% in 2008, it wasn’t done increasing for the cycle. In fact, the rise in the default rate accelerated in 2009 until it hit 14.6% in November of that year. So, while default losses were low compared to the starting index spread in 2008, junk index spreads widened sharply in 2008 as the market prepared for worse default losses in 2009. The lesson we draw from the 2008 example is that even if the junk bond market is attractively priced relative to expected default losses on a 12-month horizon, unless we can forecast a peak in the default rate it is unwise to be overly bullish on high-yield bonds. Even if a recession doesn’t occur within the next 6-12 months, it will likely occur within the next 12-24 months. In that environment, investors are unlikely to realize the full potential of today’s attractive 12-month junk bond valuations. Chart 11Junk Spreads The bottom line is that we maintain a neutral (3 out of 5) allocation to high-yield within US fixed income portfolios for now. Junk spreads are elevated compared to past rate hike cycles and could tighten during the next few months as inflation converges to its underlying 4%-5% trend. That said, we will not turn outright bullish on junk bonds until we can reasonably forecast a peak in the default rate. In the meantime, a sell on strength strategy is more appropriate. We will reduce our recommended allocation to high-yield bonds if the average index spread tightens to its average 2017-19 level (Chart 11) or once inflation converges with its underlying 4%-5% trend. Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1     Please see US Bond Strategy Weekly Report, “Three Conjectures About The US Economy”, dated July 19, 2022. 2     https://www.hamiltonproject.org/assets/files/Sahm_web_20190506.pdf 3    Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 4    https://www.ismworld.org/supply-management-news-and-reports/reports/ism… 5    Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 6    For a more complete analysis of the link between the default-adjusted spread and excess high-yield returns please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds,” dated April 12, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns