Fixed Income

Highlights Several factors point to both an improvement and a deterioration in economic and financial market conditions, underscoring that the 6- to 12-month investment outlook is unavoidably uncertain. On the one hand, the US will likely avoid a recession over the coming year, slowing headline inflation will boost real wages and lower the equity risk premium, bond yields will not move much higher this year, and US services spending will support consumption as the pandemic continues to recede in importance. These are positive factors that will work to support economic activity and risky asset prices. On the other hand, the US will likely experience a recession scare focused on the housing market, the European economy may contract, Omicron’s spread in China threatens a further rise in shipping costs and a trade shock for Europe, and US inflation expectations may unanchor despite a falling inflation rate. For now, investors should remain minimally-overweight stocks over a 6- to 12-month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. Within a global equity allocation, we recommend that investors maintain a neutral regional stance. The larger risk of a recession in Europe than in the US would normally imply that investors should be overweight US stocks, but euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine. Within a fixed-income portfolio, we recommend that investors maintain a modestly short duration stance despite our forecast that long-maturity bond yields will not increase much this year. More nimble investors should be neutral duration, and should test a long stance if US data releases begin to exhibit meaningfully negative surprises. The US dollar is likely to strengthen over the near term, but we expect it to be lower a year from today. The Scourge Of Harry Truman US President Truman famously lamented the need for “one-handed” economists. His complaint reflected how essential it is for economic policymakers to receive clear advice about the best path forward. Investors understandably have even less tolerance for ambiguity than Truman did about the macro landscape and the attendant investment implications. However, there are times when the economic and financial market outlook is unavoidably uncertain. The current economic and geopolitical environment easily qualifies as one of those instances. Several factors point to both an improvement and a deterioration in economic and financial market conditions, which we review in detail below. The likely avoidance of a recession in the US over the coming year suggests that investors should remain minimally-overweight stocks over a 6- to 12-month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. What Could Go Right The US Will Likely Avoid A Recession Over The Coming Year Chart I-1The Odds Of A US Recession Are Currently Low We downgraded our odds of an above-trend 2022 growth scenario in last month’s report,1 but noted that a stagflation-lite environment of below-trend growth and above-target inflation was a more likely outcome than recession. We based this assessment on our view that the US neutral rate of interest is likely higher than the Fed and investors expect, which we discussed at length in past reports.2 Chart I-1 highlights that our recession probability indicator also supports this view, as it does not yet signal that a recession is on the horizon.3 Table I-1 highlights the components of the model (which is significantly influenced by the Conference Board’s LEI), and shows that the model is not providing a meaningful warning signal. The Fed funds rate component of the model will likely flash red next month following the FOMC meeting, and we have listed it as providing a warning signal in Table I-1. But rising rates themselves have not proven to be a particularly timely indicator of a recession; this is similarly true with rising inflation expectations and oil prices. We noted in last month’s report that a surge in oil prices has not been an especially consistent indicator of a recession since 2000. Table I-1The Components Of Our Recession Model Are Not Yet Flashing A Warning Sign The yield curve component of the model is based on the spread between the 10-year Treasury yield and the 3-month T-bill yield in order to minimize false recession signals, and we agree that the 10-year / 2-year spread has better leading properties. But even the latter curve measure has recently moved back into positive territory (Chart I-2), which will certainly qualify as a false yield curve signal if a recession is avoided over the coming 18 months. Within the components of the Conference Board’s LEI, Table I-1 highlights that there have been signs of weakness from the manufacturing sector, consumer expectations, and the credit market. Chart I-3 aggregates the deviation of six of these components from their trend, and shows that they have indeed been consistent with a significant slowdown in economic activity. Chart I-2The 2/10 Yield Curve Is No Longer Inverted Chart I-3The Weakest Components Of The Conference Board's LEI Are Not Yet Signaling A Recession However, two caveats are warranted. First, part of this weakness reflects the ongoing shift from goods to services spending, unraveling the massive surge in goods spending that occurred during the pandemic (Chart I-4). Second, Chart I-3 highlights that similar weaknesses occurred in the past outside of the context of a recession, most notably in 1995/1996, in the aftermath of the 1994 bond market crisis; in 1998/1999, following the Long-Term Capital Management (LTCM) crisis; in 2015, following the collapse in oil prices; and, finally, in 2018/2019, in response to the Trump administration’s trade war. None of these instances resulted in a contraction in output. Headline Inflation Is Likely To Come Down Headline consumer price inflation is currently extremely high in the US. Rising prices do not just reflect energy, food, or pandemic-related effects. Chart I-5 highlights that trimmed mean CPI and PCE inflation rates have accelerated significantly since last summer, and are currently running at 6% and 3.6% year-over-year rates, respectively. Chart I-4Part Of The Weakness In Manufacturing Activity Indicators Reflects A Shift In Spending From Goods To Services Chart I-5There Is More To High Inflation Than Food, Energy, And Pandemic-Related Effects... However, it seems likely that inflation has peaked in the US (or is about to do so), even abstracting from base effects.Chart I-6 highlights that the one-month rate of change in trimmed mean measures seemingly peaked in October and January, and shows that the level of used car prices also appears to be trending lower (panel 2). The ongoing shift away from goods to services spending noted above will also push core ex-COVID-related consumer prices lower. Finally, BCA’s Commodity & Energy strategy service is forecasting that Brent crude oil prices will average roughly $90/bbl for the remainder of the year, which would likely bring US gasoline prices back toward $3.50/gallon and will lower both headline inflation and energy passthrough effects to core prices (Chart I-7). Chart I-6... But The Rate Of Headline Inflation Has Likely Peaked Chart I-7Our Forecast For Oil Implies US Gasoline Prices Will Fall     A meaningful deceleration in inflation will help reverse some of the recent decline in real wage growth that has occurred, and will likely lower the equity risk premium (see Section 2 of this month’s report).   Long-Maturity Bond Yields Will Not Move Much Higher This Year Chart I-8Our Inflation Probability Model Is Signaling Core Inflation That Is Roughly In Line With The Fed's Latest Forecast Chart I-8 highlights that our inflation probability model is currently signaling core PCE inflation of roughly 4.3% over the coming year. This is only moderately above the Fed’s forecast for this year, suggesting that a moderation in the rate of inflation makes it more likely that the Fed will raise rates in line with, or only moderately above, what was projected in the March Summary of Economic Projections (1.9% by the end of this year, and 2.8% by the end of 2023). By contrast, Chart I-9 highlights that the OIS curve is pricing the Fed funds rate at 80 basis points higher by the end of this year than what the Fed projected in March, suggesting that the bar for further hawkish surprises is quite high. We agree that the Fed will likely front-load a good portion of its planned tightening this year, and we agree that a 50 basis point hike is likely next month and also possibly in June. However, it is quite possible that the Fed will ultimately raise rates over the coming year at a slower pace than investors currently anticipate, which would lower yields at the front end of the curve. Chart I-9The Bar For Further Hawkish Surprises From The Fed Is Quite High If short-maturity yields are flat or trend modestly lower over the coming year, then a significant further rise in long-maturity yields would likely necessitate a major shift in neutral rate expectations on the part of investors or the Fed. We believe that such a shift will eventually occur, as the economic justification for long-maturity bond yields well below trend rates of economic growth disappeared in the latter half of the last economic expansion. However, we noted in last month’s Special Report that a low neutral rate outlook has become entrenched in the minds of investors and the Fed, and is only likely to change once the Fed funds rate rises meaningfully and a recession does not materialize.4 BCA’s fixed-income team currently recommends that investors maintain a neutral duration stance; the Bank Credit Analyst service is more inclined to recommend a modestly short stance. However, the key point for investors is that another significant rise in long-maturity bond yields is unlikely over the coming year, which is positive for economic activity and investor sentiment. The Pandemic Will Recede In Importance, Supporting Services Spending Chart I-10COVID Hospitalizations And Deaths Remain Low In The DM World While the pandemic is clearly not over in China (discussed below), it is likely to continue to recede in importance in the US and other highly vaccinated, and relatively highly exposed DM economies. Despite the fact that confirmed cases of COVID-19 have risen in the DM world in March and April, Chart I-10 highlights that there has been very little increase in ICU patients or deaths. A recent study from the US CDC suggests that 58% of the US population overall and more than 75% of younger children have been infected with the SARS-COV-2 virus since the start of the pandemic.5 When combined with a vaccination rate close to 70%, that signals an extraordinarily high national immunity to severe illness from the disease. Chart I-11 also highlights that deliveries of Pfizer’s Paxlovid continue to climb in the US, a drug that seemingly works against all known variants and has been found to reduce hospitalizations from COVID significantly if taken within the first five days of symptoms. Given that the decline in services spending that we showed in Chart I-4 has been clearly linked to the pandemic, we expect that a slowing pandemic will continue to support services spending. Goods spending is normally a more forceful driver of economic activity than is the case for services spending, but the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-World War II economic environment (Chart I-12). This underscores that a continued recovery in services spending relative to its pre-pandemic trend will provide a ballast to overall consumer spending as goods spending continues to normalize. Chart I-11Paxlovid To The Rescue! Chart I-12Real Services Spending Will Continue To Be A Forceful Driver Of US Economic Activity What Could Go Wrong The US Will Likely Experience A Recession Scare Chart I-13US Housing Affordability Has Cratered, In Large Part Due To Surging House Prices Despite our view that the US economy will avoid a recession over the coming year, it seems likely that investors will experience a recession scare at some point over the coming 6 to 12 months. Even though it has recently moved back into positive territory, the inversion of the 2-10 yield curve has set the scene for a recessionary overtone to any visible weakness in the US macro data over the coming months. We noted above that the manufacturing and goods-producing sectors of the US economy are likely to slow as spending returns to services. More importantly, the extremely sharp increase in mortgage rates will likely cause at least a temporary slowdown in US housing activity, even if that slowdown does not ultimately prove to be contractionary.Chart I-13 highlights that the recent increase in mortgage rates will cause US housing affordability to deteriorate back to 2007 levels. While rising mortgage rates will be the proximate cause of this deterioration in affordability, panel 2 highlights that the real culprit has been a significant increase in house prices relative to income. There is strong evidence pointing to the fact that US real residential investment has been too weak since the global financial crisis (GFC).6 We agree that high prices will likely spur additional housing construction (which will support growth). But over the nearer-term, the sharp deterioration in affordability may imply that house price appreciation will have to fall below the rate of income growth, which would represent a very sharp correction in house price gains that would almost assuredly appear recessionary for a time. The European Economy May Contract We have discussed the risk of a European recession in past reports, and noted that it would be almost certain to occur in a scenario in which Russia’s energy exports to Europe were to be completely cut off. We continue to see this as an unlikely scenario, although the odds have increased significantly of late in light of Russia’s halt of gas supplies to Bulgaria and Poland and Germany’s apparent acceptance of an oil embargo against Russia. However, Chart I-14 highlights that a recession, at least a technical one, may occur in Germany even if its imports of Russian natural gas are not interrupted. The chart shows that the German IFO business climate indicator for manufacturing has deteriorated more than the Markit PMI has, and panel 2 highlights that IFO-reported service sector sentiment is considerably worse than what was suggested by the Markit services PMI. Chart I-15 highlights that European stocks are not fully priced for a European recession, either in relative or absolute terms. This underscores the risk to global equities if real euro area growth falls meaningfully below current consensus expectations of 1.9% this year. Chart I-14German Business Sentiment Suggests A Possible Recession Chart I-15Euro Area Stocks Are Not Fully Priced For A European Recession Omicron Will Continue To Spread In China Table I-2The Ports Of Shanghai and Ningbo Are Quite Important To Chinese Trade Flows Confirmed cases of COVID-19 have surged in China over the past two months, and it is now clear that the country’s zero-tolerance policy will fail to contain the spread of the disease. We initially downgraded the odds of our above-trend growth scenario in our January report specifically in response to the risk that the Omicron variant of the virus posed to China.7 That risk that is now manifesting itself most acutely in Shanghai, but also increasingly in other coastal and northeastern provinces. Chart I-16COVID Restrictions In China Are Causing Significant Delays In Suppliers' Delivery Times China’s COVID surge has two implications for the global economic and financial market outlook. The first is that the surge has led to increased port congestion and shipping delays, which clearly threaten to cause a further rise in global shipping costs. We have noted in past reports that shipping costs from China to the West Coast of the US surged following the one month shutdown of the port of Yantian last year. Table I-2 highlights that the ports of Shanghai and nearby Ningbo handle nearly 30% of China’s total ocean shipping volume. Chart I-16 highlights that road traffic restrictions in the Yangtze River Delta have caused significant delays in suppliers’ delivery times, further raising the risk of bottlenecks that may take months to clear. Chart I-17China's Battle With Omicron Further Raises The Risk Of A Euro Area Recession The second implication of China’s COVID surge is that China’s contribution to global growth is at risk of declining significantly further, at least for a time. If Chinese economic activity slows sharply in response to the lockdowns and a further spread of the disease, we fully expect Chinese policymakers to provide further stimulus to support household income in line with what occurred in DM countries two years ago. In addition, some investors have argued that reduced commodity demand from China is actually desirable in the current environment, as it would further reduce inflationary pressure in the US and other developed economies. However, Chart I-17 highlights that Chinese import growth has already slowed very significantly, which has clearly impacted euro area exports. European exports to China are not predominantly commodity-based, and it is yet unclear whether the form of stimulus that Chinese policymakers will introduce will be particularly import-intensive. As such, China’s failure to contain Omicron further adds to the risk of the European recession we noted above, and threatens our view that US headline inflation will trend lower this year. Inflation Expectations May Unanchor Despite Slowing Inflation We discussed above that US inflation will decelerate this year and that this may allow the Fed to raise interest rates at a slower pace than currently expected by market participants. One risk to this view is the possibility that inflation expectations may unanchor to the upside, despite an easing in inflation. Even though inflation expectations have not trended in a different direction than actual inflation since the GFC, Chart I-18 highlights that this has occurred in the past (from 2001-2006). In our view, the level of inflation that is likely to prevail over the coming two years will be an extremely important determinant of whether inflation expectations break above their post-2000 range. For now, Chart I-18 highlights that the Fed’s expectation for core inflation this year is reasonable, but it remains an open question whether core inflation will decelerate below 3% next year as the Fed is forecasting. This is notable, because US core PCE inflation peaked at a rate of 2.6% during the 2002-2007 economic expansion, which is the period when stable long-dated inflation expectations were prevalent. Chart I-19 highlights that market-based inflation expectations are currently challenging or have risen above their 2004-2014 average. We noted in last month’s report that long-dated household inflation expectations will be historically low, even if inflation decelerates in line with what near-dated CPI swaps are forecasting. Chart I-18Inflation Expectations May Still Unanchor Even If The Inflation Rate Comes Down Chart I-19Market-Based Inflation Expectations May Soon Rise Above Pre-GFC Range   The bottom line for investors is that a slowing of inflation over the coming several months may not be enough to prevent long-term inflation expectations from rising. That raises the risk of an even more aggressive pace of interest rates than currently expected by investors, because the Fed is determined to avoid repeating the mistakes of the 1970s when rising inflation expectations led to a wage-price spiral that required years of comparatively tight monetary policy to correct. By contrast, the Fed will view a temporary income-statement recession stemming from a sharp rise in interest rates as the lesser of two evils. A recession to prevent a long-lasting wage-price spiral would also probably be better for investors over the longer run, but a recession would clearly imply a significant decline in risky asset prices at some point over the coming two years were it to occur. Investment Conclusions Chart I-20Despite The Risks Facing Europe, Euro Area Stocks Are Not A Clear Underweight Candidate From the perspective of allocating to risky assets, the most important question for investors to answer is whether the US is likely to experience a recession over the coming year. As we noted above, in our view the answer is “no”, which implies that US earnings growth will remain positive and that investors should not be underweight stocks within a global multi-asset portfolio. It is true that earnings can decline outside of the context of a recession, but we discuss in Section 2 of our report that this has almost always been associated with a significant contraction in profit margins. The factors that have historically been associated with a nonrecessionary decline in profit margins may occur later this year, but our indicators so far point more to flat margins rather than a significant decline. For now, investors should remain minimally-overweight stocks over a 6 to 12 month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. Within a global equity allocation, we recommend that investors maintain a neutral regional allocation. The larger risk of a recession in Europe than in the US would normally imply that investors should be overweight US stocks, but euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine. Chart I-15 highlighted that they will underperform further if euro area growth turns negative. It is not clear, however, if that risk warrants an underweight stance today, especially considering the enormous valuation advantage offered by euro area stocks versus their US counterparts and the fact that the euro has already fallen to a five-year low (Chart I-20). Chart I-21Favor A Neutral Stance Towards Cyclical Stocks Versus Defensives Within the dimensions of the equity market, Chart I-21 highlights that the outperformance of cyclicals versus defensives was already late at the onset of Russia’s invasion of Ukraine, and that the uptrend in relative performance has seemingly ended. Still, a moderately overweight stance toward stocks overall does not especially support an underweight stance toward cyclicals; therefore, we recommend a neutral stance over the coming year. We continue to recommend that investors (modestly) favor value stocks over growth stocks on the basis of better value and as a hedge against potentially higher long-maturity yields, although we acknowledge that most of the outsized outperformance of growth stocks during the pandemic has already reversed. Despite their recent underperformance, we continue to favor global small-cap stocks over their large-cap peers, as they are now unequivocally inexpensive and have seemingly already priced in a likely recession scare in the US later this year (Chart I-22). Within a fixed-income portfolio, we recommend that investors maintain a modestly short duration stance despite our forecast that long-maturity bond yields will not increase much this year. We are wary of recommending a neutral duration stance given the possibility that investors or the Fed may upwardly revise their neutral rate expectations earlier than we anticipate; however, investors are also likely to see long-maturity yields come down for a time in response to a housing market slowdown over the coming several months. More nimble investors should be neutral duration, and should test a long stance if US data releases begin to exhibit meaningfully negative surprises. Finally, while we are bearish toward the dollar on a 6- to 12-month time horizon, it is likely to strengthen over the near term. Chart I-23 highlights that our composite technical indicator for the US dollar is now clearly in overbought territory. We expect that a downtrend will begin once the war in Ukraine reaches a durable conclusion and clarity about the economic impact of the spread of Omicron in China – and the likely policy response – emerges. Chart I-22The Selloff In Small Caps Seems Overdone Chart I-23US Dollar And Indicator The Dollar Is Ripe For A Major Pullback Beyond Likely Near-Term Strength   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 28, 2022 Next Report: May 26, 2022 II. The US Equity Market: A Fundamental, Technical, And Value-Based Review All four of our US Equity indicators are currently pointing in a bearish direction. Our Monetary Indicator has fallen to a three decade low, our Technical Indicator has broken into negative territory, our Valuation Indicator still signals extreme equity pricing, and our Speculation Indicator does not yet support a contrarian buy signal. Still, we do not expect a US recession over the coming year, which implies that S&P 500 revenue growth will stay positive. Nonrecessionary earnings contractions are rare, and are almost always associated with a significant contraction in profit margins. Our new profit margin warning indicator currently suggests the odds of falling margins are low, although the risks may rise later this year. Stocks are extremely expensive, but rich valuations are being driven by extremely low real bond yields, rather than investor exuberance. Valuation is unlikely to impact US stock market performance significantly over the coming year unless long-maturity bond yields rise substantially further. Technical analysis of stock prices has a long and successful history at boosting investment performance, which ostensibly suggests that investors should be paying more attention to technical conditions in the current environment. However, technical trading rules have been less helpful in expansionary environments when inflation is above average and when stock prices and bond yields are less likely to be positively correlated (as is currently the case). As such, the recent technical breakdown of the US equity market may simply reflect a reduced signal-to-noise ratio associated with these economic and financial market regimes. For now, we see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio over the coming 6 to 12 months. Rising odds of a recession, declining profit margins, and a large increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market, the risks of which should be monitored closely by investors. In Section 1 of our report, we reviewed why a recession in the US is unlikely over the coming 6 to 12 months. However, we also highlighted that the risks to the economic outlook are meaningful and that an aggressively overweight stance toward risky assets is currently unwarranted. During times of significant uncertainty, investors should pay relatively more attention to long-term economic and financial market indicators with a reliable track record. In this report we begin by briefly reviewing the message from our US Equity Indicators, and then turn to a deeper examination of the top-down outlook for earnings, the determinants of rich valuation in the US stock market, and whether investors should rely on technical indicators in the current environment. We conclude that, while an indicator-based approach is providing mixed signals about the US equity market, we generally see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. Aside from tracking the risk of a recession, investors should be closely attuned to signs of a contraction in profit margins or shifting neutral rate expectations as a basis to reduce equity exposure to below-benchmark levels. A Brief Review Of Our US Equity Indicators Chart II-1Our Equity Indicators Are Pointing In A Bearish Direction Chart II-1 presents our US Equity Indicators, which we update each month in Section 3 of our report. We highlight our observations below: Chart II-1 shows that our Monetary Indicator has fallen to its lowest level since 1995, when the Fed surprised investors and shifted rapidly in a hawkish direction. The indicator is most acutely impacted by the speed of the rise in 10-year Treasury yields and a massive surge in the BCA Short Rate Indicator to levels that have not prevailed since the late 1970s (Chart II-2). Our Technical Indicator has recently broken into negative territory, which we have traditionally interpreted as a sign to sell stocks. The indicator has been dragged lower by a deterioration in stock market breadth across several tracked measures and by weak sentiment (Chart II-3). The momentum component of the indicator is fractionally positive but is exhibiting clear weakness. Our Valuation Indicator continues to highlight that US equities are extremely overvalued relative to their history, despite the recent sell-off in stock prices. Our Speculation Indicator arguably provides the least negative signal of our four indicators, at least from a contrarian perspective. In Q1 2021, the indicator nearly reached the all-time high set in March 2000, but it has since retreated significantly and has exited extremely speculative territory. While this may eventually provide a positive signal for stocks, equity returns have historically been below average during months when the indicator declines. Thus, the downtrend in the Speculation Indicator still points to weakness in stock prices, at least over the nearer term. Chart II-2Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Chart II-3All Three Components Of Our Technical Indicator Are Falling In summary, all four of our US Equity indicators are currently pointing in a bearish direction, which clearly argues against an aggressively overweight stance favoring equities within a multi-asset portfolio. At the same time, we reviewed the odds of a US recession over the coming year in Section 1 of our report and argued that a recession is not likely over the coming 12 months. Thus, one key question for investors is whether a nonrecessionary contraction in earnings is likely over the coming year. We address this question in the next section of our report, before turning to a deeper examination of the relative importance of equity valuation and technical indicators. Gauging The Risk Of A Nonrecessionary Earnings Contraction Chart II-4Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Based on S&P data, there have been five cases since 1960 when 12-month trailing earnings per share fell year-over-year, while the economy continued to expand (Chart II-4). Sales per share growth remained positive in four of these cases (panel 2), underscoring that falling profit margins have been mostly responsible for these nonrecessionary earnings declines. We have noted our concern about how elevated US profit margins have become and have argued that a significant further expansion is not likely to occur over the coming 12-24 months.8 To gauge the risk of a sizeable decline in margins over the coming year, we construct a new indicator based on the seven instances when S&P 500 margins fell outside the context of a recession. This includes two cases when margins fell but earnings did not (because of buoyant revenue growth). We based the indicator on these five factors: Changes in unit labor cost growth to measure the impact of wage costs on firm profitability; Lagging changes in commodity prices as a proxy for material costs; The level of real short-term interest rates as a proxy for borrowing costs; Changes in a sales growth proxy to measure the impact of operating leverage on margins; And changes in the ISM manufacturing index to capture any residual impact on margins from the business cycle. Chart II-5The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low Chart II-5 presents the indicator, which is shaded both for recessionary periods and the seven nonrecessionary margin contraction episodes we identified. While the indicator does not perfectly predict margin contractions outside of recessions, it did signal 50% or greater odds of a margin contraction in four of the seven episodes we examined, and signals high odds of a contraction in margins during recessions. Among the three cases in which the indicator failed to indicate falling margins during an expansion, two of those failures were episodes when earnings growth did not ultimately contract. The inability to explain the 1997-1998 margin contraction is the most relevant failure of the indicator, in addition to two false signals in 1963 and 1988. Still, the approach provides a useful framework to gauge the risk of falling profit margins, and the results provide an interesting and somewhat surprising message about the relative importance of the factors we included. We would have expected that accelerating wages would have been the most significant factor explaining nonrecessionary profit margin declines. Wages were highly significant, but they were the second most important factor behind our sales growth proxy. Lagged commodity prices were the third most significant factor, followed by real short-term interest rates. Changes in the ISM manufacturing index were least significant, underscoring that our sales growth proxy already captures most of the effect of the business cycle on profit margins. This suggests that operating leverage is an important determinant of margins during economic expansions, and that investors should be most concerned about declining profit margins when both revenue growth is slowing significantly and wage growth is accelerating. The indicator currently points to low odds of a nonrecessionary margin contraction, but this is likely to change over the coming year. We expect that all five of the factors will evolve in a fashion that is negative for margins over the coming twelve months: While the pace of its increase is slowing, median wage growth continues to accelerate, even when adjusting for the fact that 1st quartile wage growth is growing at an above-average rate (Chart II-6). Combining the latter with higher odds of at or below-trend growth this year implies that unit labor costs may rise further over the coming twelve months. Analysts expect S&P 500 revenue growth to slow nontrivially over the coming year (Chart II-7). Current expectations point to growth slowing to a level that would still be quite strong relative to what has prevailed over the past decade; however, accelerating wage costs in lockstep with decelerating revenue growth is exactly the type of combination that has historically been associated with falling margins during economic expansions. Chart II-6Wage Growth Is Accelerating... Chart II-7...And Revenue Growth Is Set To Slow​​​​​​ Although these are less impactful factors, the lagged effect of the recent surge in commodity prices will also weigh on margins over the coming year, as will rising real interest rates and a likely slowdown in manufacturing activity in response to slower goods spending. In addition to our new indicator, we have two other tools at our disposal to track the odds of a decline in profit margins over the coming year. First, Chart II-8 illustrates that an industry operating margin diffusion index does a decent job at leading turning points in S&P 500 profit margins, despite its volatility. And second, Chart II-9 highlights that changes in the sales and profit margin diffusion indexes sourced from the Atlanta Fed’s Business Inflation Expectations Survey have predicted turning points in operating sales per share and margins over the past decade. Chart II-9 does suggest that profit margins may not rise further, but flat margins are not likely to be a threat to earnings growth over the coming year if a recession is avoided (as we expect). Chart II-8Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Chart II-9...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes     The conclusion for investors is that the odds of a decline in profit margins over the coming year are elevated and should be monitored, but are seemingly not yet imminent. In combination with expectations for slowing revenue growth, this implies, for now, that earnings growth over the coming year will be low but positive. Valuation, Interest Rates, And The Equity Risk Premium As noted above, our Valuation Indicator continues to highlight that US Equities are extremely overvalued relative to their history. Our Valuation Indicator is a composite of different valuation measures, and we sometimes receive questions from investors asking about the seemingly different messages provided by these different metrics. For example, Chart II-10 highlights that equity valuation has almost, but not fully, returned to late-1990 conditions based on the Price/Earnings (P/E) ratio, but is seemingly more expensive based on the Price/Book (P/B) and especially Price/Sales (P/S) ratios. In our view, this apparent discrepancy is easily resolved. Relative to the P/E ratio, both the P/B and especially P/S ratios are impacted by changes in aggregate profit margins, which have risen structurally over the past two decades because of the rising share of broadly-defined technology companies in the US equity index (Chart II-11). Barring a major shift in the profitability of US tech companies over the coming year, we do not see discrepancies between the P/E, P/B, or P/S ratios as being particularly informative for investors. As an additional point, we also do not see the Shiller P/E or other cyclically-adjusted P/E measures as providing any extra information about the richness or cheapness of US equities today, as these measures tend to move in line with the 12-month forward P/E ratio (Chart II-12). Chart II-10US Equities Are Extremely Overvalued, Based On Several Valuation Metrics Chart II-11Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis In our view, rather than focusing on different measures of valuation, it is important for investors to understand the root cause of extreme US equity prices, as well as what factors are likely to drive equity multiples over the coming year. As we have noted in previous reports, the reason that US stocks are extremely overvalued today is very different from the reason for similar overvaluation in the late 1990s. Charts II-13 and II-14 present two different versions of the equity risk premium (ERP), one based on trailing as reported earnings (dating back to 1872), and one based on twelve-month forward earnings (dating back to 1979). Chart II-12The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation Chart II-13The Equity Risk Premium Is In Line With Its Historical Average… The ERP accounts for the portion of equity market valuation that is unexplained by real interest rates, and the charts highlight that the US ERP is essentially in line with its historical average based on both measures, in sharp contrast to the stock market bubble of the late 1990s. This underscores that historically low interest rates well below the prevailing rate of economic growth are the root cause of extreme equity overvaluation in the US (Chart II-15), meaning that very rich pricing can be thought of as “rational exuberance.” Chart II-14…In Sharp Contrast To The Late 1990s Chart II-15US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low     Chart II-16The Equity Risk Premium Is Fairly Well Explained By The Misery Index Over the longer term, the risks to US equity valuation are clearly to the downside, as we detailed in our October 2021 report.9 But over the coming 6 to 12 months, US equity multiples are likely to be flat or modestly up in the US. As we noted in Section 1 of our report, a significant further rise in long-maturity bond yields will likely necessitate a major shift in neutral rate expectations on the part of investors and the Fed, which we think is more likely a story for next year than this year. And Chart II-16 highlights that the ERP has historically been well explained by the sum of unemployment and inflation (the Misery Index), which should come down over the coming several months as inflation moderates and the unemployment rate remains low. To conclude, it is absolutely the case that US equities are extremely expensive, but this fact is unlikely to impact US stock market performance significantly unless long-maturity bond yields rise substantially further. Technical Analysis Amid A Shifting Economic Regime Technical analysis of financial markets, and especially stocks, has a long history. It has also provided disciplined investors with significant excess returns over time. A simple stock / bond switching rule based on whether stock prices were above their nine-month moving average at the end of the previous month has significantly outperformed since the 1960s, earning an average excess annual return of 1.3% relative to a 60/40 stock/bond benchmark portfolio (Chart II-17). This outsized performance has come at the cost of only a minor increase in portfolio volatility. Ostensibly, then, investors should be paying more attention to equity technical conditions in the current environment, which we noted above are not positive. Our Technical Indicator has recently broken into negative territory, and the S&P 500 has clearly fallen back below its 200-day moving average. However, Chart II-17 presented generalized results over long periods of time. Over the past two decades, investors have been able to rely on a durably negative correlation between stock prices and bond yields to help boost portfolio returns from technically-driven switching rule strategies. Chart II-18 highlights that this correlation has been much lower over the past two years than has been the case since the early 2000s, raising the question of whether similar switching strategies are viable today. In addition, there is the added question of whether technical analysis is helpful to investors during certain types of economic and financial market regimes, such as high inflation environments. Chart II-17Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Chart II-18Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated To test whether the message from technical indicators may be relied upon today, we examine the historical returns from a technically-driven portfolio switching strategy during nonrecessionary months under four conditions that reflect the economic and political realities currently facing investors: months when both stock and bond returns are negative; months of above-average inflation; months of above-average geopolitical risk; and the 1970s, when the Misery Index was very elevated. In all the cases we consider, the switching rule is simple: whether the S&P 500 index was above its nine-month moving average at the end of the previous month. If so, the rule overweights equities for the subsequent months; if not, the rule overweights a comparatively risk-free asset. We consider portfolios with either 10-year Treasurys or 3-month Treasury bills as the risk-free asset, as well as a counterfactual scenario in which cash always earns a 1% annual rate of return (to mimic the cash returns currently available to investors). Table II-1 presents the success and whipsaw rate of the trading rule. Table II-2 presents the annualized cumulative returns from the strategy. The tables provide three key observations: As reflected in Chart II-17, both Tables II-1 and II-2 highlight that simple technical trading rules have historically performed well, and that outperformance has occurred in both recessionary and nonrecessionary periods. Relative to nonrecessionary periods overall, technical trading rules have underperformed during the particular nonrecessionary regimes that we examined. It is the case not only that these strategies have performed in inferior ways during these regimes, but also that they were less consistent signals in that they generated significantly more “whipsaws” for investors. Among the four nonrecessionary regimes that we tested, technical indicators underperformed the least during periods of above-average geopolitical risk, and performed abysmally during nonrecessionary (but generally stagflationary) months in the 1970s. Table II-1During Expansions, Technically-Driven Switching Rules Underperform… Table II-2…When Inflation Is High And When Stocks And Bonds Lose Money The key takeaway for investors is that technical analysis is likely to be helpful for investors to improve portfolio performance as we approach a recession but may be less helpful in an expansionary environment in which inflation is above average and when stock prices and bond yields are less likely to be positively correlated. Investment Conclusions Echoing the murky economic outlook that we detailed in Section 1 of our report, our analysis highlights that an indicator-based approach is providing mixed signals about the US equity market. On the one hand, all four of our main equity indicators are currently providing a bearish signal, and the risk of a nonrecessionary contraction in S&P 500 profit margins over the coming year is elevated – albeit seemingly not imminent. On the other hand, our expectation that the US will not slip into recession over the coming year implies that revenue growth will stay positive, which has historically been associated with expanding earnings. In addition, US equity multiples are likely to be flat or modestly up, and the recent technical breakdown in the S&P 500 may simply reflect a reduced signal-to-noise ratio that appears to exist in expansionary environments in which inflation is high and the stock price / bond yield correlation is near-zero or negative. Netting these signals out, we see our equity indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. The emergence of a recession, declining profit margins, and a significant increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market. We will continue to monitor these risks and adjust our investment recommendations as needed over the coming several months. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate III. Indicators And Reference Charts As discussed in this month’s Section 2, BCA’s equity indicators do not paint an optimistic picture for stock prices. Our monetary indicator is at its weakest point in almost three decades, our valuation indicator continues to highlight that stocks are overvalued, and both our sentiment and technical indicators have broken down. An eventual easing in the latter two measures will ultimately prove positive for equities, but this will likely happen only once they reach extremes. Investors should be at most modestly overweight stocks versus bonds over the coming year. Forward equity earnings are likely pricing in too much of an increase in earnings per share over the coming year. Net earnings revisions and net positive earnings surprises have rolled over considerably, although there is no meaningful sign yet of a decline in the level of forward earnings. Earnings growth is more likely than not to be positive over the coming year, but will be modest. Within a global equity portfolio, we recommend a neutral stance towards cyclicals versus defensives, as well as a neutral regional equity stance. Euro area stocks are not a clear underweight candidate despite the risk of a European recession. Within a fixed-income portfolio, the 10-Year Treasury Yield has very little further upside over the coming year, arguing for a modestly short duration stance. We do not believe that the Fed will end up raising rates to a level higher than investors are forecasting over the coming year. Commodity prices continue to rise in a broad-based fashion following Russia’s invasion of Ukraine, and our composite technical indicator highlights that they remain significantly overbought. We expect oil and food prices to come down over the coming year, but there is a risk to that assessment. Russia aggression has very likely sped up Europe’s decarbonization timeline, suggesting that investors should be tactically, cyclically, and structurally bullish on industrial metals prices. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries. Leading and coincident indicators remain decently strong, and we do not expect a recession in the US over the coming year. However, the odds of a stagflationary-lite outcome of above-target inflation and at-or-below-trend growth have increased because of the war. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Footnotes 1     Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 2     Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, and "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3  Please see US Investment Strategy/ US Bond Strategy Special Report "Gauging The Risk Of Recession: Slowdown Or Double-Dip?" dated August 16, 2010, available at usbs.bcaresearch.com 4    Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 5    Clarke, KE, JM Jones, Y Deng, et al. Seroprevalence of Infection-Induced SARS-CoV-2 Antibodies — United States. September 2021–February 2022. 6    Please see The Bank Credit Analyst "Global House Prices: A New Threat For Policymakers," dated May 27, 2021, available at bca.bcaresearch.com 7     Please see The Bank Credit Analyst "January 2022," dated December 23, 2021, available at bca.bcaresearch.com 8    Please see The Bank Credit Analyst “OUTLOOK 2022: Peak Inflation – Or Just Getting Started?” dated December 1, 2021, available at bca.bcaresearch.com 9    Please see The Bank Credit Analyst “The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms,” dated September 30, 2021, available at bca.bcaresearch.com

Executive Summary Using the real yield on inflation protected bonds as a gauge of the long-term real interest rate is possibly the biggest mistake in finance. The ultra-low real yield on inflation protected bonds captures nothing more than a stampede for inflation protection overwhelming a tiny supply of inflation protected bonds. The long-term real interest rate embedded in the US bond and US stock markets is likely to be significantly higher than the -0.2 percent real yield on US inflation protected bonds. Long-term investors should overweight conventional bonds and stocks versus inflation protected bonds. On a 6-12 month horizon, overweight both US bonds and US stocks. With core inflation on the cusp of rolling over and global growth decelerating, the end is in sight for the sell-offs both in long duration bonds and in the stock market. Fractal trading watchlist: High dividend stocks, and MSCI Hong Kong versus MSCI China. The Low ‘Real Bond Yield’ Just Reflects A Massive Demand For Inflation Protection Bottom Line: The end is in sight for the sell-offs both in long duration bonds and in the stock market. Feature “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so” One of my favourite quotes, ostensibly attributed to Mark Twain, warns us that trouble doesn’t come from what you don’t know. Rather, trouble comes from what you think you know for certain but turns out to be wrong. In economics and finance the “what you know for sure that just ain’t so” is the long-term real interest rate. In economics and finance the “what you know for sure that just ain’t so” is the long-term real interest rate. The long-term real interest rate is arguably the most fundamental concept in economics and finance. It encapsulates the risk-free real return on savings, and it is embedded in the returns offered by all assets such as bonds and equities. The trouble is, the way that most people quantify the long-term real interest rate turns out to be wrong. Specifically, most people define the long-term real interest rate as the real yield on (10-year) inflation protected bonds, which now stands at -0.2 percent in the US and -2.3 percent in the UK. US and UK inflation protected bonds will of course deliver the negative long-term real returns that their yields offer. So, most people believe that the long-term real interest rate is still depressed, permitting many rate hikes from the Federal Reserve and Bank of England before monetary policy becomes ‘restrictive’, and providing a massive cushion to asset valuations before they become expensive.This commonly held belief is arguably the biggest mistake in finance. The Long-Term Real Interest Rate Is Not What You Think The biggest mistake in finance stems from the confluence of two factors: first, the inflation protected bond market is the only true hedge against inflation; and second, it is tiny. Compared with the $45 trillion US equity market and the $25 trillion T-bond market, the Treasury Inflation Protected Securities (TIPS) market is worth just $1.5 trillion. Many other economies do not even have an inflation protected bond market! The ultra-low real yield on inflation protected bonds captures nothing more than the massive imbalance between huge demand for inflation hedges and tiny supply. When the price level surges, as it has recently, stock and bond investors have a fiduciary duty to seek an inflation hedge, even if they are shutting the stable door after the horse has bolted (Chart I-1). With at least $70 trillion worth of investors all wanting a piece of the $1.5 trillion TIPS market, the demand for TIPS surges, meaning that their real yield collapses. Therefore, the ultra-low real yield on inflation protected bonds captures nothing more than the massive imbalance between huge demand for inflation hedges and tiny supply. Chart I-1When The Price Level Surges, Investors Flood Into Inflation Protected Bonds The proof comes from the perfect positive correlation between the oil price and so-called ‘inflation expectations.’ As a surging oil price drives down the 10-year TIPS yield relative to the 10-year T-bond yield, this difference in yields – which is the commonly accepted definition of expected inflation through 2022-32 – also surges (Chart I-2and Chart I-3). This perfect positive correlation also applies to the so-called ‘5-year, 5-year forward’ inflation rate, the expected inflation rate through 2027-32 (Chart I-4). Chart I-2Inflation Expectations Just Track The Oil Price Chart I-3Inflation Expectations Are Just A Mathematical Function Of The Oil Price Chart I-4Even The ‘5-Year, 5-Year Forward’ Inflation Expectation Just Tracks The Oil Price Yet this observed positive correlation between the oil price and inflation expectations is nonsensical, because the reality is the exact opposite! The higher the price level at a given moment, the lower will be the subsequent inflation rate. This is just basic maths. The subsequent inflation rate is the future price divided by the current price, so dividing by a higher price results in a lower number. The empirical evidence over the last 50 years confirms this. The higher the oil price, the lower the subsequent inflation rate (Chart I-5). Chart I-5But A Higher Oil Price Means Lower Subsequent Inflation As the price level surges, subsequent inflation declines, both in theory and in practice. Hence, we should subtract a smaller number from the nominal bond yield to get a higher long-term real interest rate. In other words, all else being equal, the impact of a higher price level is to lift the long-term real interest rate. To repeat, the very low real yield on inflation protected bonds just captures the stampede of inflation hedging demand overwhelming a tiny supply (Chart I-6). Given this distortion, the real yield on inflation protected bonds is likely not the long-term real interest rate embedded in the much larger bond and stock markets. Right now, the long-term real interest rate embedded in the bond and stock markets is likely to be significantly higher than the -0.2 percent real yield on TIPS. Chart I-6The Low ‘Real Bond Yield’ Just Reflects A Massive Demand For Inflation Protection To which the obvious rejoinder is: if the real yield embedded in conventional bonds and stocks is much higher than in inflation protected bonds, why does the market not arbitrage it away? The simple answer is that the market will arbitrage it away, but in slow motion. This is because the mispricing between expected and realised inflation will crystallise in real time, and not ahead of it. Nevertheless, this slow motion arbitrage provides a compelling opportunity for patient long-term investors. Overweight conventional bonds and stocks versus inflation protected bonds. The Best Way To Value The Stock Market Given that we cannot use the yield on inflation protected bonds as a reliable measure of the long-term real interest rate embedded in stock prices, it is also a big mistake to value equities versus the real bond yield. In The Case Against A ‘Super Bubble’ (And The Case For) we explained the much better way to value equities. The basic idea is that the cashflows of any investment can be condensed into one future ‘lump sum payment’. So, we just need to know the size of this lump sum payment, and then to calculate its present value. The US stock market tracks (the 30-year T-bond price) multiplied by (profits expected in the year ahead). For a stock market, the size of the payment just tracks current profits multiplied by ‘a structural growth constant’, and the present value just tracks the value of an equal duration bond. For example, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years.1  It follows that the US stock market price should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a structural growth constant) To the extent that the structural growth outlook for profits does not change, we can simplify the expression to: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) This approach might seem simplistic, yet it perfectly explains the US stock market’s evolution both over the past 40 years (Chart I-7) and over the past year (Chart I-8). Specifically, in 2022 to date, the major drag on the US stock market has been the sell-off in the 30-year T-bond. Chart I-7The US Stock Market = The 30-Year T-Bond Price Times Profits (40 Year Chart) Chart I-8The US Stock Market = The 30-Year T-Bond Price Times Profits (1 Year Chart) For the foreseeable future, we expect profit growth to be lacklustre, keeping the 30-year T-bond price as the dominant driver of the US stock market. With core inflation on the cusp of rolling over and global growth decelerating, the end is in sight for the sell-off in long duration bonds and therefore for the sell-off in the stock market. On a 6-12 month horizon, overweight both US bonds and US stocks. Fractal Trading Watchlist This week, we note that the MSCI index outperformance of Hong Kong versus Chinese has reached a point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2015, 2016, 2018, 2019, and 2020. Therefore, we have added this to our watchlist of investments that are at or approaching turning points, which is available in full on our website: cpt.bcaresearch.com We also highlight that the strong rally in high dividend stocks (the ETF is HDV) is vulnerable to correction if, as we expect, bond yields stabilise or reverse (Chart I-9). Accordingly, the recommended trade is to short high dividend stocks (HDV) versus the 10-year T-bond, setting the profit target and symmetrical stop-loss at 6 percent. Chart I-9The Outperformance Of High Dividend Stocks Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile   Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Has Reached A Potential Turning Point Chart 19Switzerland's Outperformance Vs. Germany Has Started To End Chart 20The Rally In USD/EUR Could End Chart 21The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. Defined mathematically, it is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Summarizing Our Main Investment Themes In One Chart Our current strategic recommendations are centered around four key themes: global inflation will slow over the rest of 2022, Europe remains too weak to handle significantly higher interest rates, corporate default risk in the US and Europe is relatively low, and the fundamental backdrop for emerging markets is poor. If we are going to be proven wrong on any of those themes, it will most likely be because global inflation remains high for longer due to resilient commodity prices and lingering supply chain disruptions. A sluggish economy will handcuff the ECB’s ability to raise rates as fast as markets are discounting over the next year. The state of corporate balance sheet health in the developed world is not problematic, on average, even with some sectors taking on more leverage in response to the 2020 COVID downturn. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. Bottom Line: We remain comfortable with our main fixed income investment recommendations: maintaining neutral global portfolio duration, overweighting core European bonds versus US Treasuries, favoring high-yield corporates over investment grade (both in the US and Europe), and underweighting EM hard currency debt. Feature One of the foundations of a sound medium-term investment process is to allocate capital towards highest conviction views, while constantly assessing - and reassessing - if those views are unfolding as expected. Trades that are not going according to plan may need to be reconstructed, if not exited entirely, to avoid losses. We feel the same way about the investment recommendations highlighted in the pages of our reports, which represent our portfolio, as it were. With this in mind, in this report we identify the four most critical themes underpinning our current main investment recommendations and evaluate the potential risks that our views will not turn out as expected. Theme #1: Global Inflation Will Decline In The Latter Half Of 2022 Our biggest theme for the rest of this year is that global inflation will cool off after the massive acceleration over the past year. Many of our current fixed income investment recommendations across the developed markets – maintaining neutral overall global duration exposure, underweighting global inflation-linked bonds versus nominal government debt, betting against additional yield curve flattening (especially in the US) – are predicated on reduced inflationary pressure on interest rates. Related Report  Global Fixed Income StrategyA Crude Awakening For Bond Investors The expectation of lower inflation is based on some easing of the forces that first caused the current inflationary overshoot – booming commodity prices and rapidly accelerating goods prices due to supply-chain disruptions. Already, the commodity price factor is starting to fade, on an annual rate-of-change basis that matters for overall inflation, thanks to more favorable comparisons to the commodity surge in 2021 (Chart 1). The year-over-year growth rate of the CRB index has decelerated from a peak of 54.4% in June 2021 to 19.3% today, even with many commodity prices seeing big increases in response to the Russia/Ukraine war. This is because the increases in commodity prices were even larger one year ago when much of the global economy reopened from COVID-related economic restrictions. Favorable base effect comparisons are not the only reason why commodity inflation has slowed. Commodities are priced in US dollars, and the steady appreciation of the greenback, with the trade-weighted dollar up 5% on an year-over-year basis, has also helped to slow commodity price momentum (Chart 2). Slower global growth, coming off the overheated pace of 2021, has also acted as a drag on overall commodity price inflation (middle panel). Beyond the commodity space, some easing of global supply chain tensions has resulted in indicators of shipping costs seeing meaningful declines even with supplier delivery times still elevated (bottom panel). Chart 1Our Main Strategic Theme: Decelerating Global Inflation​​​​​​ Chart 2Disinflationary Momentum From Commodities Already Underway​​​​​ A more fundamental factor that should help moderate global inflation momentum this year beyond the commodity/supply chain effects relates to a lack of broad-based global "excess demand", even as the world economy continues to recover from the massive pandemic shock in 2020. The IMF’s latest projections on output gaps – estimates of the amount of spare economic capacity – show that few major developed or emerging market economies are expected to have positive output gaps over 2022 and 2023 (Chart 3). The US is the most notable exception, with an output gap projected to average +1.6% this year and next. Most other developed market countries are projected to have an output gap close to zero. This suggests that the US is facing the most inflationary pressure from an overheating economy, which is why we continue to see the Fed as being the most hawkish major developed market central bank over the next couple of years. Chart 3Few Countries Expected To Have Inflationary Output Gaps In 2022/23 Yet even with so much of the macro backdrop supporting our call for slower global inflation in the coming months, there are several potential risks to that view. Chart 4A Risk To Our Lower Inflation View: Resilient Oil Prices Another war-related upleg in global oil prices Our commodity strategists continue to see oil prices settling down to the low $90s by year-end. Yet oil has seen tremendous volatility since the Ukraine war began as prices had to factor in the potential loss of Russian oil supplies in an already tight crude market. The benchmark Brent oil price briefly hit $140 in the immediate aftermath of the Russian invasion. A similar move sustained over the latter half of 2022 would trigger a reacceleration of oil momentum, putting upward pressure on overall global inflation rates. A renewed bout of energy-induced inflation would push global interest rate expectations, and bond yields, even higher from current levels – a challenge to both our neutral duration stance and underweight bias on global inflation-linked bonds (Chart 4). More supply-chain disruption from China Chinese authorities are clamping down hard on the current COVID wave sweeping across China. The current lockdowns in major cities like Shanghai could shave as much as one percentage point off Chinese real GDP growth for 2022, according to our China strategists. Those same lockdowns in a major transportation and shipping hub like Shanghai are already causing supply chain disruption within China. Supplier delivery times saw big increases in the March PMI data (Chart 5), while the number of cargo ships stuck outside Shanghai has soared. The longer this lasts, the greater the risk that supply chains beyond China would be disrupted, erasing the improvements in global supplier delivery times seen over the past few months. That could keep goods price inflation elevated for longer. Stubbornly resilient services inflation A big part of our lower inflation view is related to a rebalancing of consumer demand in the developed world away from goods towards services as economies move away from COVID restrictions. This implies an easing of the excess demand pressures that have triggered supply shortages for cars and other big-ticket consumer goods. The result would be a sharp slowing of goods price inflation, with the result that overall inflation rates in the major economies would gravitate towards the slower rate of services inflation. The latter, however, is accelerating in the US, UK and Europe (Chart 6) – largely because of soaring housing costs – which raises the risk that overall inflation will fall to a higher floor in 2022 as goods inflation slows. Chart 5Another Risk To Our Lower Inflation View: China Lockdowns​​​​​ Chart 6One More Risk To Our Lower Inflation View: Sticky Service Prices In the end, we see the balance of risks still tilted towards much slower global inflation this year. However, if we are going to be proven wrong on any of our major investment themes in 2022, it will most likely be because global inflation remains resilient for longer. Theme #2: Europe’s Economy Is Too Fragile To Handle Higher Interest Rates Beyond the global inflation call, our next highest conviction view right now is that markets are overestimating the ECB’s ability to tighten euro area monetary policy. Markets are now pricing in 85bps of ECB rate hikes by the end of 2022, according to the euro area overnight index swap (OIS) curve, which would take policy rates back to levels last seen before the 2008 financial crisis. The war has put the ECB in a difficult spot vis-à-vis its next policy move. High euro area inflation, with annual headline HICP inflation climbing to 7.4% in March and core HICP inflation reaching 2.9%, the highest level of the ECB era dating back to 1996, would justify a move to begin hiking policy interest rates as soon as possible.   However, European growth momentum has slowed significantly so far in 2022. Initially this was due to the spread of the Omicron COVID variant that resulted in a wave of economic restrictions. That was followed by the shock of the Russian invasion of Ukraine, that has hit European economic confidence and raised fears that Europe would lose access to Russian energy supplies. Our diffusion indices of individual country leading economic indicators and inflation rates within the euro area highlight the pickle the ECB finds itself in (Chart 7). All countries have headline and core inflation rates above the ECB’s 2% target, yet only 60% of euro area countries have an OECD leading economic indicator that is higher than year ago levels. In the three previous tightening cycles of the “ECB era” since the inception of the euro in 1998, the diffusion indices for both growth and inflation reached 100% - in other words, every euro area economy was seeing faster growth and above-target inflation. Chart 7The ECB Will Have Difficulty Hiking As Much As Expected Chart 8Warning Signs On European Growth Other economic data are also sending worrying messages. The euro area manufacturing PMI fell to the lowest level since January 2021 in March, while the European Commission consumer confidence index and the ZEW expectations index have plunged to levels last seen during the depths of the 2020 COVID recession (Chart 8). Euro area export growth has also decelerated sharply, with exports to China contracting on a year-over-year basis. Simply put, these are not the kind of growth data consistent with a central bank that needs to begin tightening policy aggressively. The inflation data also does not paint a clean picture for the ECB. ECB President Christine Lagarde has repeatedly noted that the central bank is on the lookout for any “second round effects” from the current commodity-fueled surge in European inflation on more lasting inflationary measures like wages. On that front, European wage growth remains stunningly subdued. European annual wage growth was only 1.6% in Q4/2021, despite the unemployment rate for the whole euro area falling below the OECD’s full employment NAIRU estimate of 7.7% (Chart 9). Unit labor costs only grew at an 1.5% annual rate at the end of 2021, suggesting little underlying pressure on European inflation from wages. Chart 9No Inflationary Pressures From Wages In Europe​​​​​ Chart 10European Bond Yields Discount Too Much ECB Hawkishness Without a bigger inflation boost from labor costs, the ECB will feel less pressured to begin tightening monetary policy as rapidly and aggressively as markets are discounting – especially if global goods/commodity inflation slows as we expect. We remain comfortable with our overweight recommendation on core European government bonds (Germany and France), both within a global bond portfolio but especially versus the US. The Fed is far more likely to deliver the aggressive rate hikes discounted in money markets compared to the ECB (Chart 10). Theme #3: Corporate Default Risk In The US And Europe Is Relatively Low Another of our main investment themes relates to corporate credit risk. Specifically, we see high-yield debt in the US and Europe as being relatively more attractive than investment grade credit, even in a typically credit-unfriendly environment of tightening global monetary policy and slowing global growth momentum. Our Corporate Health Monitors are highlighting that corporate finances are in relatively good shape on either side of the Atlantic (Chart 11). This is primarily related to strong readings on interest coverage, free cash flow generation and profit margins, all of which are helping to service higher levels of corporate leverage. Defaults are expected to rise over the next year in response to slowing growth momentum, but the increase is projected to be moderate. Moody’s is forecasting the US and European high-yield default rates to be virtually identical, climbing to 3.1% and 2.6%, respectively, by February 2023. Those relatively low default rates, however, are for the aggregate of all high-yield borrowers. Default risks may be higher for some companies and industries that were more severely impacted by the pandemic. Chart 11US/Europe Default Risk Remains Relatively Modest​​​​​ Chart 12The IMF Sees Fewer Financially Vulnerable Firms​​​​​​ Chart 13Default-Adjusted HY Spreads Still Offer Some Value An analysis of global private sector debt included in the latest IMF World Economic Report highlighted that companies that suffered the most significant declines in revenues in 2020 also took on greater amounts of debt than companies whose businesses were least impacted by the 2020 growth shock (Chart 12). Industries that were “worst-hit” by COVID also saw significant worsening of debt servicing capability, described by the IMF analysts as the percentage of firms among the “worst-hit” that had interest coverage ratios less than one (middle panel). Importantly, the IMF report noted that the “worst-hit” industries have seen significant improvements in interest coverage since 2020, reducing the number of financially vulnerable firms (those with high debt-to-assets ratios and interest coverage less than one). The IMF analysis uses corporate data from a whopping 71 countries, but the conclusions are like those from our Corporate Health Monitors for the US and Europe – corporate credit quality has improved, on the margin, since the dark days of the 2020 COVID recession for an increasing number of borrowers. Default-adjusted spreads for high-yield bonds in the US and Europe, which subtract expected default losses from high-yield index spread levels, show that high-yield bonds currently offer decent compensation for expected credit losses (Chart 13). This is especially true for European high-yield, where the default-adjusted spread is just below the average level since 2000. This fits with our current recommendation to maintain neutral allocations to both US and European high-yield. We have a bias to favor the latter, however, due to better valuation metrics and a more dovish outlook on ECB monetary policy compared to the Fed. Theme #4: The Fundamental Backdrop For Emerging Markets Is Poor Chart 14The Backdrop Remains Challenging For EM We have been negative on emerging market (EM) credit dating back to the latter months of 2021. Specifically, we are now underweight EM USD-denominated debt, both sovereigns and corporates. This is a high-conviction view and one that remains fundamentally supported. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China policy stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. While we expect the latter to occur in the coming months, there are meaningful risks to that view, as described earlier. Meanwhile, the situation in Ukraine appears to be worsening with Russia pushing the offensive and showing no desire for reengaging talks with Ukraine. Chinese policymakers are starting to respond to slowing Chinese growth, made worse by the COVID lockdowns, with some easing measures on monetary policy. Credit growth has also started to pick up, but the credit impulse remains too weak to warrant a more positive view on Chinese growth and import demand from EM countries (Chart 14). Finally, the US dollar remains well supported by a hawkish Fed and widening US/non-US interest rate differentials. This may be the most critical variable to watch before turning more positive on EM credit, given the strong historical correlation between the US dollar and EM hard currency spreads (bottom panel). For now, the trend of the US dollar remains EM-negative. Concluding Thoughts Chart 15Summarizing Our Main Investment Themes In One Chart Our four main investment themes, and associated recommendations, are summarized in Chart 15. The credit-related themes – underweighting high-yield bonds in the US and Europe versus investment grade equivalents, and underweighting EM USD-denominated debt – are already performing as expected. The interest rate related themes – slower global inflation and fading European rate hike expectations – should unfold in favor of our recommendations over the balance of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Executive Summary A housing slowdown has begun and it will proceed in three stages. First, rising mortgage rates will lead to slowing demand. Second, weak demand will push inventories higher and cause home prices to decelerate. Finally, construction activity will trend down signaling a peak in the fed funds rate. We are at least one year away from housing signaling a peak in interest rates. Agency MBS returns will improve going forward, but the sector is still not sufficiently attractive to increase exposure. Housing Starts Are A Useful Fed Indicator Bottom Line: Maintain an underweight allocation to agency MBS within US bond portfolios and favor low coupons (1.5%-2.5%) over high coupons (3%-4.5%). Feature Chart 1The Highest Mortgage Rate Since 2011 The biggest question for investors continues to be how the economy and financial markets will react to the Federal Reserve’s hawkish pivot, a pivot that has led to sharply higher bond yields and a much flatter yield curve. However, it’s not just this re-shaping of the Treasury curve that has changed the economic landscape. The Fed’s hawkish pivot has also sent the mortgage rate back above 5% for the first time since 2011 (Chart 1). This week’s report considers what an elevated mortgage rate means for the future path of Fed rate hikes. It also updates our view on Agency MBS.   Housing Is Critical For Fed Policy Housing is probably the most important channel through which monetary policy impacts the economy. This is simply the result of the fact that monetary policy directly influences mortgage rates and mortgage rates are a major determinant of housing demand. Not only that, but empirical research has shown residential investment to be an excellent leading indicator of recession.1 Related Report  Global Fixed Income StrategyGlobal Bond Yields Take A Breather From these facts we can draw two conclusions. First, monetary policy works in large part through its influence on housing activity. Second, trends in housing activity can send important signals about the stance of monetary policy. For example, we observe that periods of Fed tightening tend to occur when the 12-month moving average of housing starts is above the 24-month moving average. Meanwhile, periods of Fed rate cuts tend to occur when the 12-month moving average of housing starts is below the 24-month moving average (Chart 2). This is a fairly reliable relationship going back to the early 1970s, the sole exception being the late-1980s when the Fed delivered a series of rate hikes as housing activity trended down. Chart 2Housing Starts Are A Useful Fed Indicator Chart 2 shows us that housing starts are currently trending higher, consistent with a period of Fed tightening. However, it also tells us that we should start to anticipate the end of the tightening cycle when the 12-month moving average of housing starts falls below the 24-month moving average. While the elevated mortgage rate will certainly slow housing activity going forward, we expect that we are still at least one year away from receiving that signal from the housing starts data. A Housing Slowdown In Three Steps We see the coming housing slowdown proceeding in three steps. First, higher mortgage rates will crimp demand. This is already starting to occur. New and existing home sales have both dipped in recent months, and mortgage purchase applications are down off their highs (Chart 3). Chart 3Phase 1: Weaker Demand Demand weakness will continue until the housing slowdown reaches its second phase. The second phase will be characterized by rising home inventories and decelerating home prices. This has still not occurred. The total inventory of new and existing homes is near its all-time low and home prices were up 18% during the 12-month period ending in January (Chart 4). The second phase of the housing slowdown is critical because builders will be incentivized to add supply as long as inventories remain low and prices remain elevated. That is, the housing slowdown will not reach its third phase – declining housing starts – until weak demand pushes inventories up and prices down, making new construction less attractive. Presently, while homebuilder equities have sold off as mortgage rates have risen, homebuilder confidence is still extremely high (Chart 5). This tells us that we are still quite far away from seeing a trend reversal in housing starts. Chart 4Phase 2: Falling Prices Chart 5Phase 3: Less Construction Bottom Line: A trend reversal in housing starts, as indicated by the 12-month moving average dipping below the 24-month moving average, will send a strong signal that the Fed is near the peak of its tightening cycle. Given that the housing slowdown is still in its early stages, we view this development as at least one year away. Agency MBS: The Rout Is Over, But It’s Still Too Soon To Buy Chart 6Poor MBS Performance Agency Mortgage-Backed Securities (MBS) have performed terribly during the past year (Chart 6). Not only have the securities drastically underperformed duration-matched Treasuries, but they have also performed worse than investment grade corporate bonds and Agency-backed Commercial Mortgage-Backed Securities. The chief reason for the poor performance has been the surge in bond yields and the resulting increase in Agency MBS duration. It became less attractive for homeowners to prepay their mortgages as mortgage rates rose. This caused MBS duration to extend, meaning that every further increase in yields led to a more severe drop in price. Chart 7 shows that the average duration of the conventional 30-year Agency MBS index was around 3.0 at the beginning of 2021. It is now above 6.0! The good news is that this is probably about as high as the index duration will get. The refi option on most mortgages is already out-of-the-money. That is, close to 0% of the amount outstanding of the conventional 30-year MBS index can profitably refinance with the mortgage rate at its current level (Chart 7, panel 2). We also observe that the average price of the index has fallen to well below par (Chart 7, panel 3) and the average convexity of the index is close to zero (Chart 7, bottom panel). The key point is that there is now very little convexity risk in the MBS index, so further movements in bond yields will lead to much smaller changes in index duration. Low convexity risk means that the worst of the MBS duration extension has already passed. MBS returns should be somewhat better going forward, though we still don’t recommend increasing exposure to the sector. At this juncture, the main reason to stay defensive on Agency MBS is that spreads simply don’t offer sufficient value. The average index spread versus Treasuries is close to its lowest level since 2000 (Chart 8). Interestingly, dramatic MBS underperformance didn’t lead to spread widening during the past year because MBS yields kept getting compared to longer and longer duration Treasuries as the MBS index duration extended. Chart 7The Extension Trade Is Over Chart 8MBS Spreads Are Too Tight MBS value is also relatively poor compared to investment grade rated corporate bonds. The option-adjusted spread differential between Agency MBS and investment grade corporates is close to its median since 2000 (Chart 8, panel 2). MBS value looks slightly more expensive if we adjust for index duration by using the 12-month breakeven spread (Chart 8, bottom panel). With value relative to investment grade corporates either at its historical median or slightly more expensive, we don’t see a compelling case for favoring Agency MBS over investment grade corporates. Bottom Line: MBS index duration extension has likely run its course. We therefore expect MBS returns to improve somewhat during the next 6-12 months. That said, we continue to recommend an underweight allocation to the sector as current spreads don’t justify favoring MBS over Treasuries or investment grade corporates. Take A Look At Low Coupons We think investors should consider favoring low coupons (1.5%-2.5%) within an overall underweight allocation to agency MBS. We view this recommendation as a way to position for a drop in Treasury yields between now and the end of the year. In prior reports we noted that long-dated forward Treasury yields are elevated relative to survey estimates of the long-run neutral fed funds rate, and also that we expect inflation to trend down in the coming months.2 While we continue to recommend keeping portfolio duration close to benchmark on a 6-12 month horizon, a low-coupon bias within Agency MBS is a good way to position for the possibility that falling inflation will push bond yields down. To see why, we need to simply consider that low coupon mortgages are the least likely to refinance and thus low-coupon MBS have the highest durations (Chart 9). With convexity currently close to zero for the entire coupon stack (Chart 10), MBS relative coupon positioning can really be boiled down to a play on rates and duration risk. Chart 9Agency MBS 30-Year Conventional Coupon Stack: OAS vs. Duration Chart 10Agency MBS 30-Year Conventional Coupon Stack: OAS vs. Convexity A further rise in bond yields will cause higher coupon MBS (3%-4.5%) to outperform lower coupon MBS (1.5%-2.5%), while a drop in bond yields will lead to low-coupon outperformance. Given our current macro outlook, we think it makes sense to bet on the latter. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.nber.org/papers/w13428 2 Please see US Bond Strategy Weekly Report, “Peak Inflation”, dated April 19, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Chart 20Fractal Trading Watch List   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary A Good Time For A Pause In The Bond Bear Market The global government bond selloff looks stretched from a technical perspective, and a consolidation phase is likely over the next few months as global growth and inflation momentum both roll over. Central banks are starting to turn more aggressive on the pace of rate hikes in the face of elevated inflation expectations, as evidenced by the 50bp rate hikes in Canada and New Zealand last week (and the likely similar move the Fed next month). However, forward pricing of policy rates over the next 12-18 months is already at or above policymaker estimates of neutral in most developed countries. Global bond yields will be capped until central banks and markets revise higher their estimates of neutral policy rates. This is more a 2023/24 story than a 2022 story. Interest rate expectations are too high in Canada. High household debt will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Bottom Line: Maintain a neutral stance on overall global duration exposure. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. How To Interpret Rising Real Bond Yields Chart 1Bonds Under Pressure From Both Inflation & Real Yields The sharp rise in global government bond yields seen so far in 2022 has been driven by both rising inflation expectations and higher real yields (Chart 1). The former is a function of the war-fueled surge in oil prices at a time of high realized inflation, while the latter is a consequence of expectations for tighter monetary policy to fight that inflation. The magnitude of the yield increases seen year-to-date is surprising given the downgrades to global growth expectations. Just this week, the IMF downgraded its growth forecasts for the second time this year. It now expects global growth to reach 3.6% in both 2022 and 2023, shaving 0.8 and 0.2 percentage points, respectively, from the last set of yearly forecasts made back in January. The World Bank similarly chopped its growth forecast for 2022 to 3.2% from 4.1%. Spillovers from the Russia/Ukraine war were the main factor behind the downgrades, including more aggressive monetary tightening by global central banks in response to commodity-fueled inflation. We’re already seeing a faster pace of rate hikes from developed market central banks. The Bank of Canada (BoC) and Reserve Bank of New Zealand (RBNZ) lifted policy rates by 50bps last week and the Fed is signaling a similar move in May. Not all policymakers are sending hawkish signals, however. The ECB last week opted to not commit to the timing and pace of any future moves on rates, while the Bank of Japan has pledged to maintain monetary stimulus measures even in the face of a collapsing yen. Related Report  Global Fixed Income StrategyPolicymakers Face The No-Win Scenario While government bond yields have risen across the developed world so far in 2022, the drivers of the yield increase have not been the same in all countries when looking at moves in benchmark 10-year nominal and inflation-linked bonds (Chart 2). About three-quarters of the nominal yield moves seen year-to-date in the US (+134bps), Canada (+136bps) and Australia (+130bps) have come from higher real yields, while the increase in the Gilt yield (+92bps) was more of an equal split between real yields and inflation breakevens. In Germany (+102bps) and Japan (+17bps), the upward move in 10-year yields this year has all been from higher breakevens, as real yields have fallen in both countries. Chart 2Real Yields (ex-Europe/Japan) Driving Nominal Yields Higher In 2022 In the US, Canada and UK – three countries where central banks have delivered rate hikes this year and are promising to do more – real yields have been highly correlated to rising interest rate expectations for the next two years taken from overnight index swap (OIS) curves (Chart 3). Meanwhile, in Germany, Japan and Australia - where central banks have kept rates steady and not sending strong messages on when that will change – the correlation between real yields and OIS-derived interest rate expectations has not been as strong (Chart 4). Chart 3Rising Real Yields Where Central Banks Have Been Hiking​​​​​ Chart 4More Stable Real Yields Where CBs Are More Dovish​​​​​ Chart 5Real Rate Expectations Have Risen Much Faster In The US The link between interest rate expectations and real yields is intuitive after factoring in inflation expectations. In Chart 5, we show actual real interest rates (policy rates minus headline CPI inflation) in the US, euro area and UK, as well as a “market-based” measure of real interest rate expectations derived as the difference between forward rates from the nominal OIS and CPI swap curves (the dotted lines). The current path for real rates is the black dotted line, while the path as of the start of 2022 is the green dotted line. In all three countries, the market-derived path for real rates over the next decade has shifted upward since the start of the year, which is consistent with a rising path for real bond yields. Yet the largest move has been in the US where real rates are expected to average around zero over the next ten years. This lines up logically with the more hawkish messaging on rates from the Fed, leading to a repricing of the 10-year TIPS yield from -1% at the start of the year to a mere -0.04% today. By contrast, real rate expectations and real yields remain negative in the euro area and UK, as both the ECB and Bank of England have been much less hawkish compared to the Fed in terms of signaling the timing and magnitude of future rate hikes. We have long flagged deeply negative real bond yields, especially in the US, as the greatest source of vulnerability for global bond markets. Such yield levels can only be sustained in a rising inflation environment if central banks deliberately keep policy rates below inflation for a long time. The Fed was not going to allow that to happen with inflation reaching levels not seen since the early 1980s, leaving US Treasuries vulnerable to a sharp repricing of fed funds rate expectations that would drive real bond yields higher. Looking ahead, we do not expect to see much additional bearish repricing of global rate expectations and real yields over the rest of 2022, for the following reasons: Global growth momentum is slowing The combined shock of geopolitical uncertainty from the Ukraine war, high oil prices and tightening global monetary policy – in addition to the expected slump in Chinese growth due to the latest wave of COVID lockdowns – has damaged economic confidence. The April reading from global ZEW survey of professional forecasters and investors showed another modest decline in US and euro area growth expectations after the huge drop in March (Chart 6). Interestingly, the ZEW survey also showed a big decline in the net number of respondents expecting higher inflation and a small dip in the number of respondents expecting higher bond yields – both potential signals that the increase in global bond yields is ready to pause. Medium-term US inflation expectations have remained relatively contained The sharp run-up in US inflation has boosted survey-based measures of inflation expectations, although the increase has been much higher for shorter-term expectations (Chart 7). One-year-ahead inflation expectations from the University of Michigan and New York Fed consumer surveys have doubled over the past year and now sit at 6.6% and 5.4%, respectively. Yet the 5-10 year ahead inflation expectation from the Michigan survey has seen a much smaller increase and is holding stable around 3%. The 5-year/5-year forward TIPS breakeven is at even less worrisome levels and now sits at a trendline resistance level of 2.4% (bottom panel). Chart 6ZEW Survey Shows Weaker Growth & Inflation Expectations​​​​​ Chart 7Medium-Term US Inflation Expectations Have Not Broken Out​​​​​ US inflation is showing early signs of peaking Year-over-year headline US CPI inflation reached another cyclical high of 8.6% in March. However, core CPI inflation rose by a less-than-expected +0.3% on the month and the year-over-year rate of 6.5% was essentially unchanged versus the February level (Chart 8). Used car prices, a huge driver of the surge in US goods inflation in 2021, fell by a sizeable -3.8% in March, the second consecutive monthly decrease. Chart 8A Peak In US Core Inflation?​​​​​ Chart 9Housing Cost Inflation Is A Global Problem We expect US consumer spending to shift more towards services from goods over the next 6-12 months, which should lead to overall US inflation rates converging more towards lower services inflation. Services inflation is still well above the Fed’s inflation target, however, particularly with shelter inflation – one-third of the overall US CPI index – now at 5.0% and showing no signs of slowing. Chart 10A Good Time For A Pause In The Bond Bear Market Rising housing costs are not only a problem in the US, and house prices and valuations have soared across the developed world (Chart 9). This suggests that housing and rental costs will remain an important driver of underlying inflation in many countries, not just the US. Summing it all up, we continue to see conditions conducive to a period of relative global bond market stability, with government bond yields remaining rangebound over the next several months. The stimulus for higher yields – from even more hawkish repricing of central bank expectations, even higher real bond yields or additional increases in inflation expectations – is not evident. Bond yields look stretched from a technical perspective, and our Global Duration Indicator continues to signal that global yield momentum should soon peak (Chart 10). Bottom Line: Maintain a neutral stance on overall global bond portfolio duration. Upgrade Canadian Government Bonds To Neutral The Bank of Canada (BoC) hiked its policy interest rate by 50bps last week to 1%, the first rate increase of that size since 2000. The BoC also announced that it will begin quantitative tightening of its balance sheet at the end of April when it stops buying Canadian government bonds to replace maturing debt it currently owns. In the press conference explaining the move, BoC Governor Tiff Macklem noted that the central bank now saw the Canadian economy in a state of “excess demand” with inflation that was “expected to be elevated for longer than we previously thought” and that “the economy could handle higher interest rates, and they are needed.” Chart 11Canadian Growth Momentum Peaking? This is a very clear hawkish message from Macklem, who hinted that the BoC may have to lift rates above neutral for a period to bring Canadian inflation back down to the central bank’s target. We have our doubts that the BoC will be able to raise rates that far, and keep them there for long, before inflation pressures ease. The BoC Business Outlook Survey plays an important role in the central bank’s policy decisions. The survey for Q1/2022 showed dips in the overall survey, and the individual components related to sales growth expectations, investment intentions and hiring plans (Chart 11). There were even small drops in the net number of survey respondents seeing intense labor shortages and expecting faster wage growth (bottom panel). The moves in these survey components were modest, but they are important coming after the relentless upward rise since the trough in mid-2020. Importantly, this survey was conducted before the Russian invasion of Ukraine, which likely provided an additional drag on business confidence. The components of the Business Outlook Survey related to prices and costs continued to show that Canadian firms are facing lingering capacity constraints and intense cost pressures from both labor and supply chain disruption. A net 80% of respondents – a survey record – report they would have some or significant difficulty meeting an unexpected increase in demand. A net 35% of respondents in the Q1/2022 survey cited “labor cost pass through” as a source of upward pressure on their output prices, a huge jump from the Q4/2022 reading of 19% (Chart 12). Also, a net 33% of respondents noted “non labor cost pass through”, i.e. higher prices due to supply chain disruption, as a source of pressure on output prices. Only a net 12% of respondents cited strong demand as a source of pressure on prices, and the net balance of respondents noting that the competitive environment was inflationary was effectively zero. Chart 12Canadian Businesses See More Cost-Push Inflation Pressures The two main messages from the Business Outlook Survey are: a) Canadian growth momentum likely cooled in Q1, and b) Canadian inflation pressures remain significant, but are more supply driven than demand driven. Overall Canadian inflation is still accelerating rapidly, with headline CPI hitting an 31-year high of 5.7% in February. Underlying measures of inflation are more subdued, but still elevated: the BoC’s CPI-trim and CPI-median measures are at 4.3% and 3.5%, respectively, both above the BoC’s 1-3% target band (Chart 13). Chart 13Mixed Messages On Canadian Inflation Expectations There are more mixed messages coming out of Canadian inflation surveys. The 1-year-ahead inflation expectation from the BoC’s Survey of Consumer Expectations climbed to 5.1% in Q1/2022 from 4.9% in Q4, while the 5-year-ahead expectation dropped to 3.2% from 3.5%. The 10-year breakeven inflation rate on Canadian inflation linked bonds is even lower, now sitting near at 2.2%. There are also very mixed signals on wage expectations, even with the Canadian unemployment rate dropping to a record low of 5.3% in March. Canadian consumers expect wage growth to reach 2.2% over the next year, below the latest reading on actual wage growth of 2.5% and far below the 5.2% growth expected by Canadian businesses (bottom panel). If medium-term consumer inflation expectations are not rising in the current high inflation environment, and consumer wage expectations are not increasing with a record-low unemployment rate, then the BoC can potentially move slower than markets expect on rate hikes over the next year if realized inflation peaks. On that front there are tentative signs of optimism. When breaking down Canadian inflation into goods and services components, both are still accelerating rapidly (Chart 14). Goods inflation reached 7.6% in February, while services inflation hit 3.8%. However, the pace of year-over-year inflation for some key durable goods components like new cars, household appliances and furniture – items that saw demand and prices increase during the worst of the pandemic – appears to have peaked (middle panel). This may be a sign that overall goods inflation is set to roll over, similarly to what we expect in the US in the coming months. Also like the US, services inflation is less likely to decelerate, as rent inflation is accelerating and the housing cost component of Canadian inflation (home replacement costs) is still expanding at a 13.2% annual rate. On that note, housing remains the key component to watch to determine the BoC’s next move, given highly levered household balance sheets exposed to house prices and higher mortgage rates. The robust strength of the Canadian housing market has driven house prices to some of the most overvalued levels among the developed economies. There is a speculative aspect to the housing boom, with Canadian households expecting house prices to appreciate by 7.1% over the next year according to the BoC consumer survey (Chart 15). Canadian housing demand has also become more sensitive to rate increases by the choice of mortgages. 30% of outstanding mortgages are now variable rate, up from 18% at the start of the pandemic in 2020 after the BoC cut rates to near-0%. Chart 14The Goods-Driven Canadian Inflation Surge May Be Peaking​​​​​​ Chart 15BoC Rate Hikes Will Cool Off Canadian Housing​​​​​​ During the BoC’s last rate hiking cycle in 2017-19, national house price inflation slowed from 15% to 0%. Policy rates had to only reach 1.75% to engineer that outcome. With household balance sheets even more levered today, and with greater exposure to variable rate mortgages, it is unlikely that a policy rate higher than the previous cycle peak will be needed to cool off house price growth – an outcome that should also dampen Canadian services inflation with its large housing related component. In addition to the rate hike at last week’s policy meeting, the BoC also announced the results of its annual revision to its estimated range for the neutral policy rate. The range is now 2-3%, up slightly from 1.75%-2.75%. The current pricing of interest rate expectations from the Canadian OIS curve has the BoC lifting rates to the high-end of that new neutral range by the first quarter of 2023, then keeping rates near those levels over at least the next five years (Chart 16). Chart 16Markets Expect The BoC To Keep Rates Elevated For Longer Chart 17Upgrade Canadian Government Bonds To Neutral We doubt the BoC will be able to raise rates all the way to 3% without inducing instability in the housing market. More importantly, the current surge in inflation is not becoming embedded in medium-term inflation and wage expectations – outcomes that would require the BoC to keep policy rates at the high end of its neutral range or even move them into restrictive territory. Turning to bond strategy, we have had Canada on “upgrade watch” in recent weeks, with rate hike expectations looking a bit too aggressive. We now see it as a good time to pull the trigger on that upgrade. Thus, this week, we are moving our recommended exposure to Canadian government bonds to neutral (3 out of 5) from underweight (Chart 17). We are “funding” that move in our model bond portfolio by reducing exposure to US Treasuries (see the tables on pages 15-16), as we see the Fed as being more likely than the BoC to deliver on the rate hike expectations discounted in OIS curves. A move to an outright overweight stance, versus all countries and not just the US, will be appropriate once Canadian inflation clearly peaks and interest rate expectations begin to decline. It is too soon to make that move now, but we will revisit that call later this year. Bottom Line: Interest rate expectations are too high in Canada with medium-term inflation expectations relatively subdued. High household debt in Canada will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Executive Summary Above Fair Value March’s CPI report will mark peak inflation for 2022. We recommend several ideas to profit from peak inflation. First, investors should keep portfolio duration close to benchmark. The bond market is fairly priced for the likely near-term pace of rate hikes, and long-dated forward yields are now above fair value. Second, investors should underweight TIPS versus nominal Treasuries. They should also favor inflation curve steepeners, real yield curve flatteners and outright short positions in 2-year TIPS. Third, investors should favor the 5-year nominal Treasury note relative to a duration-matched barbell consisting of the 2-year and 10-year notes. The Fed published its plan for shrinking its balance in the minutes from the last FOMC meeting. We estimate that the Fed will be able to shrink its balance sheet at its intended pace for at least the next two years before it is forced to stop. Bottom Line: Investors should position for peak inflation by keeping portfolio duration close to benchmark, by underweighting TIPS versus nominal Treasuries and by favoring the 5-year nominal Treasury note versus the 2-year and 10-year. Feature Chart 1Base Effects Kick In Next Month Last week’s March CPI report showed that 12-month core consumer price inflation came in at 6.44%, a level that will almost certainly mark the peak for the year. Several reasons justify our peak inflation call. First, base effects will send year-over-year core CPI sharply lower during the next three months (Chart 1). Monthly core CPI growth rates were 0.86%, 0.75% and 0.80% in April, May and June 2021 (Chart 1, bottom panel). These exceptionally high prints will roll out of the 12-month average during the next three months. Second, monthly core CPI grew 0.32% in March, a significant step down from the 0.5%-0.6% range that had been the norm since October. If monthly core CPI growth rates remain between 0.3% and 0.4% from now until the end of the year, then 12-month core CPI will fall to a range of 4.19% to 5.13%. We think that trends in the major components of core inflation make this outcome likely, and we could even see inflation falling to below that range. Chart 2 shows the contributions of shelter, goods and services (ex. shelter) to overall core CPI. Chart 2Monthly Core Inflation By Major Component Starting with core goods, we see that prices fell in March for the first time since February 2021. This represents an important inflection point. Core goods, particularly autos, have been the principal driver of current extremely high inflation rates (Chart 3), and these prices will continue to fall in the coming months as supply chain issues are resolved and as goods spending reverts to its pre-pandemic trend (Chart 3, bottom panel). Few dispute that core goods inflation will be weaker going forward. However, one critical question is whether the impact from falling goods prices will simply be offset by the rising cost of services. There was indeed some evidence for this in March. Core services (ex. shelter) prices rose 0.71% in March, up from 0.55% in February. While this is a strong print, it was not sufficient to prevent a drop in overall core inflation from 0.51% to 0.32%. What’s more, March’s core services print was heavily influenced by a surge in airfares that represents a rebound from steep declines seen near the end of last year. With airfares excluded, core services inflation would have only come in at 0.50% in March (Chart 4). Chart 3Goods Inflation Chart 4Services & Shelter Inflation Finally, we turn to the outlook for shelter inflation. Monthly shelter inflation has rebounded to above its pre-COVID levels, but its acceleration has abated during the past few months (Chart 4, bottom panel). Trends in home prices and some indicators of market rents suggest that shelter inflation has some further near-term upside.1 However, shelter inflation is also very sensitive to the economic cycle and the unemployment rate. With that in mind, rapid shelter inflation during the past 12 months is mostly explained by the fact that the unemployment rate fell by almost 2.5%! With the labor market already close to full employment, this sort of cyclical economic improvement will not be repeated during the next 12 months. All in all, we think monthly shelter inflation will average close to its current level during the next nine months. Bottom Line: March’s CPI report marked an inflection point for inflation. Year-over-year inflation will fall sharply during the next few months and will settle close to 4% by the end of the year. Profiting From Peak Inflation Portfolio Duration We have been recommending an “at benchmark” portfolio duration stance in US bond portfolios since mid-February, yet Treasury yields have continued their upward march during the past two months. Our sense is that bond yields now look somewhat too high, and some pullback is likely as inflation moves lower during the next few months. First, let’s consider that the bond market is priced for 262 bps of tightening during the next 12 months (Chart 5), the equivalent of more than ten 25 basis point rate hikes at the next eight FOMC meetings. Our view is that this pricing is close to fair. Chart 5Rate Expectations A 50 basis point rate hike at the May FOMC meeting is now a near certainty. The minutes from the last meeting revealed that “many” participants would have preferred a 50 bps increase in March, but uncertainty surrounding the war in Ukraine prevented that view from becoming consensus. The Treasury curve has also re-steepened significantly during the past few weeks, a development that will ease any concerns about near-term over-tightening. It’s also worth noting that the precedent for a 50 bps hike has now been set by the Reserve Bank of New Zealand and the Bank of Canada. Both central banks lifted their policy rates by 50 bps at their most recent meetings. Chart 6Above Fair Value Beyond May, we expect to see more 25 basis point rate hikes than 50 basis point hikes. Falling inflation will ease some of the Fed’s urgency and the Fed will continue to tighten policy with the goal of getting the fed funds rate close to estimates of the long-run neutral rate by the end of the year. A 25 basis point rate increase at every meeting after May would bring the fed funds rate to a range of 2.0% - 2.25% by the end of the year, just below the Fed’s median estimate of the long-run neutral rate (2.4%). One additional 50 bps hike would bring the funds rate right up to neutral, and such a path would still be consistent with what is currently priced in the curve. Meanwhile, bond pricing at the long end of the yield curve now looks a touch cheap. The 5-year/5-year forward Treasury yield – a market proxy for the long-run neutral rate – has moved up to 2.87%, significantly above survey estimates of the long-run neutral rate (Chart 6). Some pullback closer to survey levels is likely as inflation trends lower. Bottom Line: Keep portfolio duration close to benchmark. Front-end pricing looks fair and long-dated forward yields are somewhat too high. TIPS Perhaps the most obvious way to profit from peak inflation in 2022 is by shorting TIPS versus nominal Treasuries. The 10-year TIPS breakeven inflation rate has risen to 2.91%, well above the Fed’s target range of 2.3%-2.5% (Chart 7). The combination of Fed tightening and falling inflation will send this rate back toward the Fed’s target between now and the end of the year. However, the potential downside in the 10-year TIPS breakeven inflation rate is nothing compared to the 2-year rate. The 2-year TIPS breakeven inflation rate is 4.4% (Chart 7, panel 2) and this short-maturity rate is much more sensitive to the incoming inflation data. Finally, long-maturity TIPS breakeven inflation rates look elevated compared to survey estimates of long run inflation. The 5-year/5-year forward TIPS breakeven inflation rate is currently 2.46%, above the range of estimates from the New York Fed’s Survey of Primary Dealers (Chart 7, bottom panel). In addition to underweight positions in TIPS versus nominal Treasuries, we continue to see the opportunity for an outright short position in 2-year TIPS. The 2-year TIPS yield has risen significantly since the end of last year, but this has been driven by a rising 2-year nominal yield (Chart 8). Going forward, the 2-year TIPS yield still has room to rise but it’s increase will be driven less by a rising nominal yield and more by a falling 2-year TIPS breakeven inflation rate. Chart 7Inflation Expectations Chart 8Sell 2-Year TIPS Consistent with our view that the cost of short-maturity inflation compensation has more downside than the cost of long-maturity inflation compensation, we view positions in 2-year/10-year inflation curve steepeners and 2-year/10-year TIPS curve flatteners as likely to profit during the next nine months (Chart 8, bottom panel). Bottom Line: Investors should underweight TIPS versus nominal Treasuries. They should also position in inflation curve steepeners and real yield curve flatteners and hold outright short positions in 2-year TIPS. Nominal Treasury Curve Chart 9Go Long 5yr Versus 2/10 One final idea is for investors to take a long position in the 5-year Treasury note versus a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. This 5 over 2/10 trade currently offers an attractive 18 bps of yield pick-up, which is much higher than we normally see when the 2-year/10-year Treasury slope is this flat (Chart 9). In fact, a simple model of the 2/5/10 butterfly spread versus the 2-year/10-year slope shows the 5-year bullet to be very cheap relative to history (Chart 9, panel 2). This position will profit from continued 2-year/10-year curve steepening, or more likely, it will profit if the 2-year/10-year slope remains near its current level but the 2-year/5-year slope flattens as the Fed tightening cycle progresses (Chart 9, panel 3). Bottom Line: The recent steepening trend in the 2-year/10-year Treasury slope is likely exhausted, but the 5-year Treasury yield is too high relative to the current 2-year/10-year slope. Investors should go long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The Fed’s Balance Sheet Plan The minutes from the March FOMC meeting revealed the Fed’s plan for shrinking its balance sheet. This plan will likely be put into action at either the May or June FOMC meeting. Specifically, the Fed intends to allow a maximum of $60 billion of Treasuries and $35 billion of MBS to passively run off its portfolio each month. The Fed also hinted that it may decide to start with lower caps and raise them up to the $60 billion and $35 billion targets over a period of three months. However, with the market already well positioned for Quantitative Tightening (QT), this phase-in period will probably not be deemed necessary. For its Treasury securities, the Fed intends to allow a maximum of $60 billion of coupon securities to run off its portfolio each month. If fewer than $60 billion of coupon securities are maturing that month, then the Fed will redeem T-bills to reach the $60 billion target. For MBS, the Fed’s $35 billion per month cap will probably not be binding. Given the slow pace of mortgage refinancings, which will only slow further as interest rates rise, it is unlikely that there will be many months with more than $35 billion of maturing MBS. In fact, some recent Fed research estimated that average MBS runoff will be closer to $25 billion per month going forward.2 Assuming the Fed’s plan starts in June and that MBS runoff averages $25 billion per month, we calculate that the Fed’s Treasury holdings and total assets will still be above pre-COVID levels in 2026 (Chart 10). More important than the Fed’s total assets, however, are the total reserves supplied to the banking system. It is the amount of reserves, after all, that determine whether the Fed can maintain adequate control over interest rates. If too few reserves are supplied, then the fed funds rate will threaten to break above the upper end of the Fed’s target band and the Fed will be forced to increase reserves by either re-starting purchases or engaging in repo transactions. This is exactly what happened when the Fed was forced to abandon its last QT effort in September 2019 (Chart 11). Chart 10Fed Asset Projections Chart 11Reserve Projections Making a few additional assumptions about the growth rate of currency-in-circulation and the size of the Treasury’s General Account, we are able to forecast the path for reserves going forward (Chart 11, top panel). We estimate that reserves will fall to roughly $2 trillion by the end of 2025, still slightly above the levels that caused problems in fall 2019. Ultimately, neither us nor the Fed knows exactly what level of reserves will be adequate to maintain control of interest rates going forward. The Fed will track usage of its new Standing Repo Facility as it shrinks its balance sheet. If usage of the repo facility increases, that will be the sign that the Fed has done enough QT and it is time to start slowly increasing the balance sheet once again. Given the recently published pace of runoff, we think this won’t be story for at least another two years.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 https://www.newyorkfed.org/newsevents/speeches/2022/log220302 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns