Economy

Highlights Fed: We will use the monthly US employment data to track progress toward the first Fed rate hike. At present, our base case outlook calls liftoff in late-2022 or the first half of 2023. Investors should maintain below-benchmark portfolio duration. Corporate Bonds: The macro environment is supportive for spread product returns, but there are better opportunities than in investment grade corporate bonds. We prefer high-yield over investment grade within the US corporate space, particularly the Ba credit tier. Munis: Muni value has deteriorated markedly, but the sector still looks attractive compared to investment grade corporate bonds. EM Sovereigns: We recommend owning investment grade USD-denominated EM Sovereign bonds instead of investment grade US corporates. Within high-yield, US corporates still offer a better opportunity than EM Sovereigns. Using Employment Data To Time Fed Liftoff The current debate raging in fixed income circles revolves around whether large-scale fiscal stimulus will cause inflation to flare this year, possibly leading to a much earlier fed funds liftoff date than is currently priced into the yield curve (Chart 1). Chart 1Fed Liftoff Priced For July 2023 Last week’s report discussed our outlook for inflation in 2021.1 In short, our base case calls for 12-month PCE inflation to peak above the Fed’s 2% target in April but to then fall back below 2% by the end of the year. However, there is a compelling case to be made that inflation could rise more quickly. Table 1A Checklist For Liftoff Last week, our Global Investment Strategy service pointed out that the combined effect of December’s fiscal stimulus deal and President Biden’s newly proposed American Rescue Plan would inject an average of $300 billion per month into the economy through the end of September.2 The Congressional Budget Office estimates that the monthly output gap – the difference between what the economy is capable of producing and what it is actually producing – is currently $80 billion. In that environment, it’s not hard to see how excess demand could lead to price increases in certain sectors. Chart 2How Far From "Maximum Employment"? Of course, for bond investors what matters is not just the path of inflation but how the Fed responds. If rising inflation prompts the Fed to lift rates before July 2023 – the liftoff date currently priced into the market – then bonds will sell off. If liftoff occurs later, then yields will fall. This makes timing the liftoff date critical, and fortunately, the Fed has given us three explicit criteria that must be met before liftoff will occur (Table 1). This week’s report focuses, not on inflation, but on the condition related to “maximum employment.” Our sense is that if the Fed does not think the economy is at “maximum employment” it will ignore modest overshoots of its 2% inflation target on the view that the large amount of labor market slack will eventually cause inflationary pressures to wane. We define “maximum employment” as an unemployment rate of 4.5%, consistent with the upper-bound of the Fed’s most recent range of NAIRU estimates (Chart 2). Using that assumption, and an assumption for the path of the labor force participation rate (Chart 2, bottom panel), we can calculate the average monthly payroll gains that must occur for the unemployment rate to hit the 4.5% target by specific future dates. Our results are shown in Table 2. We use four different scenarios for the labor force participation rate. The lowest estimate assumes that the participation rate remains at its current level. The highest estimate assumes that it re-converges to its pre-COVID level at the same time as the unemployment rate hits 4.5%. The two middle estimates assume smaller increases of 1% and 0.5%, respectively. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% Over The Given Horizon We expect the participation rate to rise as the economy recovers and people are drawn back into the labor force, but some workers have likely been permanently displaced by the pandemic and a full convergence back to pre-COVID levels may not occur until well after the unemployment rate reaches 4.5%, if at all. With that in mind, the “Convergence To Pre-COVID” scenario probably overstates the monthly payroll gains necessary to hit full employment and the “Stays At 61.5%” scenario almost certainly understates them. If we focus on the two middle scenarios, we see that average monthly payroll gains of between 472k and 572k are required for the unemployment rate to hit 4.5% by the end of this year. This range falls to 346k - 413k if we push the liftoff date out until mid-2022 and to 283k – 334k if we move out until the end of 2022. At first blush, these numbers look unattainable. Between 2010 and 2019, average monthly payroll growth averaged a mere +97k. But, given the downturn that just occurred, employment growth will likely be much stronger going forward. Our research into past economic cycles has found that the two main determinants of average monthly employment growth during the first year following a recession are: The drawdown in employment that occurred during the recession (a larger drawdown correlates with greater payroll growth in the first 12 months of recovery) Real GDP growth during the first 12 months of recovery Chart 3 shows the correlation between the peak-to-trough decline in nonfarm payrolls during the past eight US recessions and the average monthly payroll gains seen during the first 12 months of economic recovery. The correlation is quite linear except for the 2008 recession where the peak-to-trough decline in payrolls was 8.7 million but the bounce-back was incredibly weak. Chart 4 explains why the 2008 recession looks like such an outlier in Chart 3. Real GDP growth during the first 12 months of recovery coming out of the 2008 recession was very low, only 2.6%. Chart 3Large Payroll Drawdowns Tend To Be Followed By Strong Gains… Chart 4…And Occur Alongside Strong Economic Recovery Thinking about the current recovery from the COVID recession. Nonfarm payrolls fell by about 22 million from peak to trough in 2020. This is literally off the charts (looking at Chart 3), about 2.5 times the job loss seen in 2008. Then, the Fed’s most recent median estimate for real GDP growth in 2021 is a robust 4.2%, and this estimate was made before Democrats took control of the Senate and proposed a massive new stimulus bill. Considering both the large drawdown in employment and the outlook for rapid GDP growth in 2021, average monthly payroll gains should be quite strong this year. A return to a 4.5% unemployment rate by the end of 2021 is probably a long shot, but we can easily envision average monthly payroll gains on the order of 300k to 400k per month, enough to prompt Fed tightening by late-2022 or the first half of 2023. Whatever transpires, we will monitor monthly payroll growth in the coming months and use this analysis to continuously reassess our liftoff expectations. For the time being, investors should keep portfolio duration low. Alternatives To Investment Grade Corporates Another conclusion that falls out of the above analysis is that the runway for spread product outperformance remains long. With Fed tightening unlikely until late-2022 or the first half of 2023, monetary conditions will remain accommodative for some time. This will drive a continued search for yield, supporting the outperformance of spread product relative to Treasuries. But despite the supportive macro environment, bond investors face a problem that the most popular US spread sector – investment grade corporate bonds – looks very expensive. The average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is only 2 bps above its pre-COVID low, and the spread on Baa-rated bonds is exactly equal to its pre-COVID low. Aa- and A-rated bonds appear somewhat cheaper (Chart 5). The valuation picture is even bleaker after adjusting the index to ensure a constant average credit rating and average duration over time. The 12-month breakeven spread for the credit rating-adjusted corporate index has only been tighter 3% of the time since 1995 (Chart 6). Chart 5IG Spreads Are Tight... Chart 6...Especially After Adjusting For Risk The remainder of this report discusses potential alternatives to investment grade corporate bonds. Specifically, we’re looking for spread products that will benefit from the same macro environment as investment grade corporates, but where investors can pick up some additional risk-adjusted value. Candidate #1: Junk Bonds Chart 7Ba-Rated Corporates Are Cheap One obvious thing investors might consider is a move down the quality spectrum into high-yield bonds. This move comes with greater credit risk, but we believe the incremental spread pick-up provides more than fair additional compensation. The Bloomberg Barclays High-Yield index’s average option-adjusted spread is still 33 bps above its pre-COVID low, and the spread pick-up in the Ba credit tier relative to the Baa credit tier looks particularly compelling (Chart 7). The supportive macro environment makes us less worried about taking additional credit risk in a portfolio, and we recommend that investors pick up the additional spread offered in the high-yield space. The elevated incremental spread pick-up in Ba bonds makes that credit tier look like the best risk-adjusted opportunity. Candidate #2: Tax-Exempt Municipal Bonds Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 8). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (Chart 9), the same goes for Revenue bonds with 8-12 year maturities. Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate of 10% or higher. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 14% and 26%, respectively. Chart 8Muni / Treasury Yield Ratios Chart 9Munis Still Attractive Versus Corporates All in all, municipal bond value has deteriorated markedly in recent months and we therefore downgrade our recommended allocation slightly from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). Investors should still prefer tax-exempt municipal bonds relative to investment grade corporate bonds with the same credit rating and duration. Candidate #3: USD-Denominated Emerging Market Sovereigns For all of last year we advised investors to favor investment grade corporate bonds over USD-denominated EM Sovereigns of equivalent credit rating and duration. This positioning worked out well. Since the March 23rd peak in credit spreads, the A3/Baa1-rated EM Sovereign index has only outperformed the duration-matched A-rated US Credit index by 159 bps while it has underperformed the Baa-rated US Credit index by 571 bps (Chart 10). In the high-yield space, the B1/B2-rated EM Sovereign index has significantly underperformed both the Ba and B-rated US junk bond indexes. Chart 10EM Sovereigns Underperformed US Corporates In 2020 But now, after nine months of poor relative performance, value is starting to look more compelling in the EM Sovereign space. Chart 11 shows that EM Sovereigns offer a yield pick-up versus duration-matched US corporate bonds for all credit tiers except Ba. At the country level, the yield advantage in the A and Aa credit tiers is attributable to opportunities in Qatar, UAE and Saudi Arabia (Chart 12). In the Baa credit tier, investors should look for opportunities in Mexico, Russia and Colombia, while avoiding the Philippines. Chart 11USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Credit Rating Chart 12USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Country All in all, investors should shift some allocation away from investment grade corporates and into USD-denominated EM Sovereigns with equivalent duration and credit rating, focusing on the countries that offer a yield pick-up. Turning to high-yield, we would rather own junk-rated US corporate bonds than junk-rated EM Sovereigns. US corporates offer a yield pick-up over EM Sovereigns in the Ba credit tier, and the sky-high spreads offered by B and Caa-rated EMs are due to overly risky opportunities in Turkey and Argentina. We don’t see these countries benefiting from the supportive US macro environment in the same way as US corporate credit, and therefore recommend overweighting US corporate junk bonds over EM Sovereign junk bonds. Bottom Line: Investors should continue to overweight spread product versus Treasuries in US fixed income portfolios but should look for opportunities outside of investment grade corporate bonds. We recommend owning municipal bonds and USD-denominated EM Sovereign bonds in place of investment grade US corporate bonds with the same credit rating and duration. We also recommend taking additional credit risk in US junk bonds, particularly in the Ba credit tier. Investors should prefer US junk bonds over junk-rated EM Sovereigns.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Trust The Fed’s Forward Guidance”, dated January 19, 2021, available at usbs.bcaresearch.com 2  Please see Global Investment Strategy Weekly Report, “Stagflation In A Few Months?”, dated January 22, 2021, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Yields: The fall in global bond yields over the past two weeks represents a corrective pullback from an overly rapid rise in inflation expectations, especially in the US. The underlying reflationary themes that drove yields higher, however, remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Duration Strategy: We maintain our broad core recommendations on global government bonds: stay below-benchmark on overall duration exposure, overweighting non-US markets versus US Treasuries, while favoring inflation-linked debt over nominal bonds. Australia vs. US: Following from the conclusions of our Special Report on Australia published last week, we are initiating a new cross-country spread trade in our Tactical Overlay portfolio: long 10-year Australian government bond futures versus short 10-year US Treasury futures. Feature Chart of the WeekCentral Banks Will Stay Very Dovish The benchmark 10-year US Treasury yield fell to 1.04% yesterday as this report went to press, after reaching a high of 1.18% on January 12th. 10-year government bond yields have also fallen over the same period, but by lesser amounts ranging between 5-10bps, in Germany, France, the UK and Australia. We view these moves as a consolidation before the next upleg in global yields, and not the start of a new bullish cyclical phase for government bond markets. Our Central Bank Monitors for the major developed economies are all showing diminished pressure for easier monetary policies, but are not yet signaling a need for tightening to slow overheating economies (Chart of the Week). Realized inflation and breakevens from inflation-linked bond markets remain below levels consistent with central bank policy targets, even in the US after the big run-up in TIPS breakevens. Reflationary, pro-growth monetary (and fiscal) policies are still necessary. Policymakers can talk all they want about optimism on future global growth with COVID-19 vaccines now being rolled out in more countries, but it is far too soon to expect any shift away from a maximum dovish monetary policy stance that is bearish for bonds and bullish for risk assets. We continue to recommend a below-benchmark overall stance on global cyclical duration exposure, with a country allocation focused most intensely on underweighting US Treasuries. The Global Backdrop Remains Bond Bearish Optimism over a potential boom in global economic growth in the second half of 2021 - fueled by the rollout of COVID-19 vaccines, massive pandemic income support programs and other increased government spending measures, and ongoing easy monetary policies – has become an increasingly consensus view among investors. As evidence of this, the latest edition of the widely-followed Bank of America Fund Managers’ Survey highlighted that the biggest tail risks for financial markets all relate to that bullish narrative: a disappointing vaccine rollout, a “Tantrum” in bond markets, a bursting of the US equity bubble and rising inflation expectations.1 We can understand why investors would be most worried about the success of the COVID-19 vaccine distribution which has started with mixed results. According to the Oxford University COVID-19 database, the UK has now delivered 10.38 vaccinations per 100 people, while the US has given out 6.6 shots per 100 people (Chart 2). By comparison, the pace of the vaccine rollout has been far slower in Germany, France, Italy and China. Note that this data shows total vaccine shots administered and does not represent a count of the total number of inoculated citizens, as a full dose requires two shots. Chart 2Vaccine Rollout So Far: Operation Impulse Power Success on the vaccine front is what is needed for investors to envision an eventual end to the pandemic … or at least an end to the growth-damaging lockdowns related to the pandemic. So a slower-than-expected rollout does justify somewhat lower bond yields, all else equal. However, the news on the spread of the virus itself has turned more encouraging during this “dark winter” of COVID-19. The latest data on new cases of the virus shows that the severe surge in the US and UK appears to have peaked (Chart 3). In the euro area, the overall number of new cases is at best stabilizing with more divergence between countries: cases are continuing to explode higher in Italy and Spain but slowing in large economies like Germany and the Netherlands (and stabilizing in France). The growth in new virus-related hospitalizations, however, has clearly slowed across those major economies, including in places with surging new case numbers like Italy. Chart 3Lockdowns Will Not Last Forever Chart 4European Lockdowns Taking A Bite Out Of Growth A reduction in the strain on hospital bed capacity gives hope that the current severe economic restrictions seen in Europe and parts of the US can soon begin to be lifted. This can help sustain the cyclical upturn in global economic growth, especially in countries where lockdowns have been most onerous like the UK, which saw a sharp plunge in the preliminary Markit PMI data for January (Chart 4). So on the COVID-19 front, we interpret the overall backdrop as more positive for global growth expectations, and hence more supportive of higher global bond yields. Chart 5Reflationary Expectations Remain Well Entrenched Expectations are still tilted towards rising yields, judging by the ZEW survey of global financial market professionals (Chart 5). The survey shows that the bias continues to lean towards expectations of both higher long-term interest rates and inflation, but without any expected increase in short-term interest rates. This fits with the overall yield curve steepening theme that has driven global bond markets since last summer, which has been consistent with the dovish messaging from central banks. The Fed, ECB and other major central banks continue to project a very slow recovery of labor markets from the COVID-19 shock, with no return to pre-pandemic levels until at least 2024 (Chart 6). This is forcing central banks to maintain as dovish a policy mix as possible, including projecting stable policy rates over the next several years supported by ongoing quantitative easing (QE). These policies have helped support the rise in global inflation expectations and helped fuel the “Everything Rally” that has stretched the valuations of risk assets worldwide. So it is also not surprising that worries about a bond “Tantrum”, rising inflation expectations and a bursting of equity bubbles would also top the tail risks highlighted in that Bank of America investor survey. All are connected to the next moves of the major global central banks. Chart 6Central Banks Must Stay Easy For A Long Time On that front, we are not worried about any premature shift to a less dovish stance, given the lingering uncertainties over COVID-19 and with actual inflation – and inflation expectations - remaining below central bank targets. Several officials from the world’s most important central bank, the US Federal Reserve, have made comments in recent weeks discussing the outlook for US monetary policy. A few FOMC members raised the possibility of a potential discussion of slower bond purchases by year-end, if the US economy grows faster than expected and the vaccine rollout goes smoothly. Although the majority of FOMC members, including Fed Chair Jerome Powell and Vice-Chairman Richard Clarida, noted that any such discussion was premature and would not take place until 2022 at the earliest. In our view, the Fed will not begin to signal any shift to a less dovish policy stance before US inflation and inflation expectations have all sustainably returned to levels consistent with the Fed’s 2% target (Chart 7). That means seeing TIPS breakevens rise to the 2.3-2.5% range that has prevailed during previous periods when headline PCE inflation as at or above 2%. Chart 7US Inflation Still Justifies Maximum Fed Dovishness Chart 8The Fed Is Not Yet Worried About Overly Easy Financial Conditions Such a shift by the Fed could happen by year-end, but only if there was also concern within the FOMC that financial conditions in the US had become overly stimulative and risked future instability of overvalued asset prices (Chart 8). At the present time, however, the Fed will continue to focus on policy reflation and worry about any negative spillover effects on financial markets at a later date. Financial conditions are also a potential issue for other central banks, but from a different perspective – currencies. Financial conditions in more export-focused economies like the euro area and Australia are more heavily influenced by the impact on competitiveness from currency values (Chart 9). Chart 9Currencies Dictate Financial Conditions Outside The US Chart 10Projected Relative QE Favors UST Underperformance The combination of the Fed’s lingering dovish policy bias and the improving global growth backdrop should keep the US dollar under cyclical downward pressure. The weaker greenback means that non-US central banks must try to maintain an even more dovish bias than the Fed to limit the upward pressure on their own currencies. A desire to fight unwanted currency appreciation via a more rapid pace of QE relative to the Fed – at a time when US Treasury yields are likely to remain under upward pressure from rising inflation expectations – should support a narrowing of non-US vs US bond spreads over the next 6-12 months (Chart 10). Bottom Line: The underlying reflationary themes that drove global bond yields higher over the past several months remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Stay below-benchmark on overall global duration exposure, overweighting non-US government bond markets versus US Treasuries, while also favoring global inflation-linked debt over nominal bonds. A New Cross-Country Spread Trade: Long Australian Government Bonds Vs. US Treasuries In last week’s Special Report on Australia, which we co-authored jointly with BCA Research Foreign Exchange Strategy, we concluded that a neutral exposure to Australian government debt within global bond portfolios was still warranted.2 Uncertainty over the Reserve Bank of Australia (RBA) reaction function and the future path of Australia’s yield beta, which measures the sensitivity of Australian yields to global yields and remains elevated, justified a neutral stance. We do, however, have a higher conviction view that Australian government debt will outperform US Treasuries – especially given our expectation that US yields have more cyclical upside – given that the yield beta of the former to the latter has declined (Chart 11). Chart 11Australian Government Bonds Are "Defensive" When US Yields Are Rising This week, we translate that view into a new tactical trade—going long 10-year Australian government bonds versus shorting 10-year US Treasuries. This trade will be implemented through bond futures (details of the trade can be seen in our trade table on page 15). In addition to the yield beta argument, the Australia-US 10-year spread looks attractive on a fair value basis. Chart 12 presents our new Australia-US 10-year spread valuation model, based on fundamental factors such as relative policy interest rates, inflation and unemployment. The model also accounts for the impact from the massive bond buying by the Fed and Reserve Bank of Australia (RBA); we include as an independent variable the relative central bank balance sheets as a share of respective nominal GDP. Although the Australia-US spread has converged somewhat towards fair value since the blow out in March 2020, it is still at attractive levels at 13bps or 0.8 standard deviations above fair value. The model-implied fair value of the Australia-US spread could also fall further, thereby creating a lower anchor point for spreads to gravitate towards. While the policy rate differential will likely remain unchanged until 2023, other factors will move to drag down the spread fair value (Chart 13). The gap in relative headline inflation should, much to the RBA’s chagrin, move further into negative territory given the relatively weaker domestic and foreign price pressures in Australia. On the QE front, the RBA also has much more room to expand its balance sheet relative to developed market peers, and will feel pressured to do so if the Australian dollar continues to rally. Finally, the RBA expects a much slower recovery in Australian unemployment than the Fed does for the US. This should further push down fair value if the central bank forecasts play out as expected. Chart 12The Australia-US 10-Year Spread Is Undervalued Technical considerations also seem to be in favor of our trade (Chart 14). While the deviation of the Australia-US 10-year spread from its 200-day moving average, and its 26-week change, are both slightly negative, the 2008 period is instructive. Chart 13Relative Fundamentals Point Towards A Lower Australia-US Spread Chart 14Technicals Favor Further Reduction In The Australia-US Spread For both measures, after blowing up to around the +75-150bps zone, they likewise fell by a commensurate amount, attributable to a strong “base effect”. A similar dynamic should play out now after the dramatic 2020 spike in spread momentum. Meanwhile, duration positioning in the US, while it is short on net, is still far from levels where it has troughed. Lastly and most importantly, forward curves are pricing in an Australia-US spread close to zero, which provides us a golden opportunity to “beat the forwards” as the spread tightens without incurring negative carry. As a reference, we are initiating this trade with the cash 10-year Australia-US bond spread at 4bps, with a target range of -30bps to -80bps over the usual 0-6 month horizon that we maintain for our Tactical Overlay positions. Bottom Line: We seek to capitalize on our view that Australian yields will be slower to rise relative to US yields by introducing a new spread trade: buy Australian government bond 10-year futures and sell US 10-year Treasury futures. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1https://www.bloombergquint.com/markets/record-number-of-fund-managers-overweight-on-emerging-markets-says-bofa-survey 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021, available at gfis.bcaresearch.com.   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns