Europe

Highlights Global Duration: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Country Allocation: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. Treasury-Bund Spread: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures. Feature In a Special Report jointly published last week with our colleagues at BCA Research US Bond Strategy, we laid out the case for why US Treasury yields have bottomed and should now begin to drift higher.1 We reached that conclusion for two reasons: 1) there will be a major US fiscal stimulus after the upcoming US election, especially so if Joe Biden becomes president and the Democrats take the Senate; and 2) the Fed’s shift to Average Inflation Targeting in late August represented the point of maximum Fed dovishness. The investment conclusions were to reduce duration exposure, while also downgrading our recommended allocation to US government bonds to underweight. We also advised cutting exposure to non-US government bond markets with relatively higher sensitivity to changes in US bond yields, while increasing allocations to countries with a lower “yield beta” to US Treasuries (Table 1). Table 1Updated GFIS Model Bond Portfolio Recommended Positioning In this follow-up report, we will further discuss the implications of our changed view on US yields for non-US developed market government bonds. This includes specific adjustments to the recommended country allocations in our model bond portfolio, as well as a new tactical trade to profit from a move higher in US yields that will not to be matched in Europe. Our Recommended Overall Duration Stance: Now Below-Benchmark The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound at very low levels across the developed economies. Our Global Duration Indicator, comprised of economic sentiment measures and leading economic indicators, bottomed back in March and has soared sharply since then (Chart of the Week). Given the usual lead time between peaks and troughs of the Indicator and global bond yields - around nine months, on average – that suggests yields should bottom out sometime before year-end. Chart of the WeekA Cyclical, US-Led Bottoming Of Global Bond Yields Chart 2UST Yields About To Break Out? In the US, we now think we are past that point, as we discussed last week. The 10-year US Treasury yield has been drifting higher during the month of October and is now bumping up against its 200-day moving average of 0.83% (Chart 2). This is only the first such attempt at a trend breakout in yields, and such a move is unlikely prior to US Election Day - or, more accurately, “US Election Is Decided Day” which may not be November 3! The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound. Outside the US, however, momentum of bond yields and potential trend breakouts paint a more mixed picture. German and French bond yields remain stable and generally trendless, with Italian and Spanish yields continuing to grind lower. At the same time, yields in the UK, Canada and Australia have started to perk up but remain just below their 200-day moving averages. Bond yields have not responded to the sharp cyclical rebound across the developed world, with large gaps between elevated manufacturing PMIs and stagnant bond yields (Chart 3). Low inflation, ample spare economic capacity and dovish monetary policies are all playing a role, with bond markets not expecting an imminent inflation surge that could drive up yields and fuel expectations of tighter monetary policy. By way of contrast, China - where domestic services sectors have improved at a rapid pace from the COVID-19 recession and where the central bank is not running an overly accommodative monetary policy – has seen a more typical positive correlation between government bond yields and the rising manufacturing PMI over the past several months (Chart 4). This suggests that developed market bond yields can begin to normalize if the domestic services side of those economies emerges more forcefully from the lockdown-induced downturn. Chart 3A Wide Gap Between Growth & Yields Chart 4Are Chinese Yields Sending A Message? The news on that front is more optimistic in the US compared in Europe. The Markit services PMIs for the euro area and UK have all weakened over the past few months, with headline inflation rates flirting with deflation (Chart 5). Similar data in the US has trended in the opposite direction, with stronger US services activity with rising inflation. Chart 5Deflation Risks In Europe, Not The US The pickup in new COVID-19 cases, and the degree of the response by governments to contain it, has been far stronger in Europe and the UK than in the US on a population-adjusted basis (Chart 6). Lockdowns have become more widespread across Europe to contain the second larger wave of the virus. The recent softer services PMI data in the euro area and UK are a reflection of those greater economic restrictions and weaker confidence. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates.  In the US, governments have been far less willing to implement politically unpopular restrictions in an election year, while lockdown-weary consumers have been more willing to go about their lives rather than stay sheltered at home. The result is a healthier tone to the US data compared to other countries, even with the number of new US cases on the rise again. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates. As we discussed in last week’s Special Report, both the Biden and Trump platforms are calling for major fiscal stimulus – between $5-6 trillion over the next decade, including tax changes – although the Biden plan has much more front-loaded direct government spending, only partially offset by tax increases, if fully implemented. This is the “Blue Sweep” scenario, with a Biden victory and Democratic Party control of the US Congress, that is most bearish for US Treasuries, as the outcome would eventually help reduce the expected 2021 US fiscal drag of -7.2% of GDP as estimated by the latest IMF Fiscal Monitor (Chart 7). Even a re-elected Trump, however, would also mean more US fiscal stimulus, although with a mix of tax cuts and spending increases. Chart 6The Latest COVID-19 Wave Is Hitting Europe Harder Combined with an improving services sector and rising inflation, this puts the US in a much different economic position than the major economies of Europe. Chart 7Post-Election US Stimulus Will Offset Fiscal Drag There, the IMF is also projecting some fiscal drag in 2021, but now with a much less healthy domestic economy due to the COVID-19 surge and where inflation is already near 0%. Our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. There will likely be another round of fiscal measures to help combat virus-stricken economies in Europe and elsewhere, but the US election is bringing the issue to the forefront more quickly. In other words, the US will get a more bond-bearish fiscal stimulus before Europe does. Bottom Line: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Our Recommended Country Allocation: Downgrade US, Upgrade Lower-Beta Countries Net-net, our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. This also has implications for our recommend country allocation in our model bond portfolio. First, are downgrading our recommended US Treasury allocation to underweight. We are also increasing our desired weighting in countries where government bond yields are less sensitive to changes in US Treasury yields – especially during periods when the latter are rising. We call this “upside yield beta”. The countries that have the highest such beta to US Treasuries are Canada, Australia and New Zealand, making them downgrade candidates (Chart 8). Similarly, lower upside beta countries like Germany, France, Japan and the UK are upgrade possibilities. Chart 8Favor Countries With Lower Yield Betas To USTs Already, we are seeing the widening of yield spreads between US Treasuries and non-US government markets – with more to come as US Treasuries grind higher over the next 6-12 months. We see the greatest upside for spreads between the US and the low upside yield beta countries – that means wider spreads for US-Germany, US-France, US-Japan and US-UK (Chart 9). Chart 9Expect More Underperformance From USTs Chart 10Fed QE Momentum Peaking, Unlike Other CBs Thus, this week are making significant changes to our strategic government bond country allocations (see page 15), as well as the country weightings in our model bond portfolio (see pages 13-14), based on our new view on US bond yields and non-US yield betas. Specifically, we are not only cutting our recommended US weighting to underweight, but we are also downgrading Canada and Australia from overweight to neutral. On the other side, we are upgrading UK Gilts to overweight from neutral, while also upgrading Germany, France and Japan to overweight. Importantly, we are maintaining our overweight stance on Italian and Spanish sovereign debt, as those markets are supported by greater European fiscal policy integration in the world of COVID-19 and, just as importantly, large-scale ECB asset purchases. More generally, the relative “aggressiveness” of central bank quantitative easing (QE) does play a role in our recommended country allocation. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. This means less expected QE buying of Treasuries by the Fed. Conversely, given how aggressive the Reserve Bank of Australia and Bank of Canada have been with expanding their balance sheet via QE (Chart 10), this makes us reluctant to shift to the underweight stance on those countries implied by their high beta to rising US Treasury yields. Therefore, we are only downgrading those two countries to neutral. Bottom Line: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. A New Tactical Trade: A UST-Bund Spread Widener Using Futures This week, we are also introducing a new recommended trade in our Tactical Overlay portfolio on page 16 to take advantage of our view on US bond yields: a 10-year US-Germany spread widening trade using government bond futures. Chart 11A Tactical Opportunity For A Wider UST-Bund Spread This trade makes sense for several reasons: Germany has one of the lowest yield betas to US Treasuries during periods when the latter is rising, as shown earlier. Our US Treasury-German Bund fundamental fair value spread model – which uses relative policy interest rates, unemployment and inflation between the US and the euro area as inputs - suggests that the spread is now far too tight after the massive rally in US Treasuries in 2020 (Chart 11). The main reason why the spread looks so “expensive” is that the underlying fair value has risen with US inflation rising and euro area inflation falling (Chart 12, bottom panel). The UST-Bund yield differential is not stretched from a technical perspective, when looking at deviations of the spread from its 200-day moving average or the 26-week change in the spread; both measures suggest room for additional spread widening before reaching historical extremes (Chart 13). Also, duration positioning by US fixed income investors is only around neutral, according to the JP Morgan duration survey, suggesting scope to push yields higher if bond investors become more defensive. Chart 12Inflation Differentials Justify A Wider UST-Bund Spread Chart 13Technical Trends Favor A Wider UST-Bund Spread As a reference, we are initiating this trade with the cash bond 10-year US-Germany spread at +138bps, with a target range of +170-190bps over the 0-6 month horizon we maintain for our Tactical Overlay positions. Bottom Line: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "Beware The Bond-Bearish Blue Sweep", dated October 20, 2020, available at usbs.bcaresearch.com and 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

Special Report

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights Long-term investors should seek companies and sectors that facilitate and support a new way of doing things: specifically, a way of life and business that is more de-centralised and de-urbanised… …and a way of life in which we live, work, and interact more online, remotely, and digitally. The long-term winners will be technology, biotechnology, healthcare, and communications: the growth defensives. The long-term losers will be banks, oil and gas, and resources: the value cyclicals. The European stock market’s substantial underweighting to the growth defensives will weigh on its relative performance, both in the short term and in the long term. Fractal trade: Overweight the US 30-year T-bond versus the French 30-year OAT. Also, we have closed our tactical underweight to equities versus bonds. Feature Chart of the WeekYield Chasers Get A Rude Awakening As Dividends Collapse For the world’s yield chasers, 2020 has been a rude awakening. What seemed to be safe and attractive dividend yields have vanished into smoke, as blue-chip company after blue-chip company has slashed its dividend. To name just a few, HSBC has cut its dividend to zero for the first time ever; Barclays has cut its dividend to zero for the first time since 2009; and Royal Dutch Shell has slashed its dividend by 34 percent, taking it back to where it was in 2009. More generally, the high-yielding sectors have slashed their dividends: the world oil and gas sector by 60 percent (Chart of the Week) and the world bank sector by 33 percent (Chart I-2). The basic resources sector has cut its dividend by a more modest 15 percent, but the dividend now stands at the same level as it was in 2009 (Chart I-3). Chart I-2Dividend Cuts From High-Yielding Banks... Chart I-3...And High-Yielding Resource Companies In contrast, the low-yielding technology and healthcare sectors have managed to grow their dividends consistently over the past decades, and then maintain the dividends during the current crisis (Chart I-4 and Chart I-5). Chart I-4Dividend Growth And Continuity From ##br##Low-Yielding Healthcare... Chart I-5…And Low-Yielding ##br##Tech The world’s yield chasers have had a rude awakening because they often confuse yield with return. One reason for this confusion is that for cash and for high-quality government bonds held to redemption, yield and return are broadly the same.1  But for an equity, yield and return are not the same. As we have seen with the oil and gas sector and banks, an equity could start with a seemingly safe and attractive dividend yield yet end up generating a deeply negative return.2 The lesson is that long-term investors should never search for yield, they should always search for return. Mental Accounting Bias, And The Irrational Search For Yield The confusion between yield and return is not just an issue of semantics. It is a well-known phenomenon in behavioural finance known as mental accounting bias.3 This psychological bias describes the tendency to group financial gains and losses into separate mental accounts or buckets. This causes people to treat money differently according to the bucket that the money occupies. One version of this bias is a distinction between the return that an investment provides from yield and that which it provides from capital appreciation. The distinction between yield and capital appreciation is irrational. Assuming an equal tax treatment, the money that comes from yield and the money that comes from capital appreciation is perfectly fungible. Yet psychologically, the distinction is very stark. Behavioural finance postulates that because of fears about self-control, some people tend to categorize an investment’s yield as spending money, and its capital as saving money. Long-term investors should never search for yield, they should always search for return. Hence, those people who want their assets to generate spending money – say, retirees – have an irrational bias towards investments that generate yield. Whereas those people that are saving for the long term have a bias towards investments that generate capital growth. To reiterate, these biases are completely irrational.  Under normal circumstances, the irrational biases are not a problem because there are enough investments available for both buckets. But in today’s world of zero and negative interest rates, the assets that would normally generate the safe income for the spending bucket – cash and government bonds – are no longer doing so (Chart I-6). In the ensuing ‘search for yield’, income focussed investors have flocked to the dwindling number of investments that appear to generate the required income, such as high-yielding equities. But in irrationally focussing on yield rather than on expected return, the world’s yield chasers have lost a lot of money. Chart I-6Equities Are The Only Yield-Generating Mainstream Asset-Class The Halo Effect, And The Shattered Halo The matter is made worse by a second phenomenon in behavioural finance known as the halo effect. This is the tendency to worship – place a halo – on someone or something based on some narrow criteria. For a company, the narrow criteria can mean its dividend history. The dividend is one of the few financial metrics over which the company has substantial control, giving it totemic significance with the company’s investors. Investors place a halo on companies with dividend continuity, a lengthy absence of a dividend cut. The distinction between yield and capital appreciation is irrational. However, if the company cuts its dividend, even slightly, then the halo shatters. Given this stigma, companies try very hard not to cut the dividend until it is unavoidable. But when they do cut, they usually cut big, and for an extended period – because the halo is shattered anyway (Chart I-7 and Chart I-8). Chart I-7When Firms Cut Their Dividends, They Usually Cut Big... Chart I-8...And For An Extended ##br##Period Realising this, investors flip the company from saint to sinner, meaning that they demand a higher cost of capital. The upshot is that even after the dividend cut, the stock can suffer a prolonged period of underperformance. Low Yield To Deliver High Return To repeat, long-term investors should never search for yield, they should always search for return. Today, this search for return boils down to two questions: Which companies will be able to grow or, at the very least, maintain their dividends in the post-pandemic world? What is the likely direction of bond yields, and specifically the long-duration T-bond yield, given its pivotal role in setting the discount rate on all investments? To the first question, the winning companies will be the ones that facilitate and support a new way of doing things: specifically, a way of life and business that is more de-centralised and de-urbanised. And one in which the way we live, work, and interact – both socially and economically – is more remote, online, and digital. The pandemic is the accelerant, and not the cause, of the structural shift in our way of life. Crucially, this means that when a credible treatment for Covid-19 eventually arrives, it will not reverse the major changes that our way of life is now undergoing. To the second question, the Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric, especially to the labour market. The central bank has told us that it will be thick-skinned to reflationary shocks or lower unemployment, but trigger-happy to the slightest further deflationary shock or higher unemployment. The pandemic is the accelerant, and not the cause, of the structural shift in our way of life. Hence, when the slightest further deflationary shock comes – and sooner or later it will – the Fed will either follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or more likely, the Fed will follow the Bank of Japan in formally implementing yield curve control. Either way, US long-duration bond yields will eventually converge with those in the UK and Japan at zero. The result of our two answers is that long-term investors should seek companies that can thrive off the major changes in the way we live, work, and interact; and investors should seek companies with long-duration cashflows that benefit most from a further compression in the long-duration T-bond yield. In combination, the long-term winners will be technology, biotechnology, healthcare, and communications: the growth defensives (Chart I-9). And the long-term losers will be banks, oil and gas, and resources: the value cyclicals (Chart I-10). Chart I-9Growth Defensives Are The Long-Term Winners Chart I-10Value Cyclicals Are The Long-Term##br## Losers For the European stock market, the unfortunate consequence is that its substantial underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* This week’s recommended trade is to go long the US 30-year T-bond versus the French 30-year OAT. Set the profit target and symmetrical stop-loss at 3.2 percent. The tactical underweight to equities versus bonds (short DAX versus 10-year T-bond) reached the end of its holding period. Although it closed in slight loss, the fractal signal correctly identified that the majority of the strong rally in the DAX was over by mid-July after which the DAX has traded broadly sideways. The countertrend move in the Italian BTP’s rally versus the German bund did not materialise, so this trade was closed at its stop-loss. The rolling 1-year win ratio now stands at 57 percent. Chart I-1130-Year Govt. Bonds: US Vs. France When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Assuming no reinvestment risk on the bond’s income. 2 This is because unlike the government bond, the equity does not generate a predetermined stream of cash flows. 3 See Rational Choice and the Framing of Decisions by Amos Tversky and Daniel Kahneman. 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