Fixed Income

Highlights The US is only one deflationary shock away from a European level of bond yields. On a multi-year horizon, a deflationary shock is a near-certainty. The shock will be deflationary, because even if it starts inflationary, it will quickly morph into deflationary. The reason is that the sharp backup in bond yields resulting from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. Hence, the US 30-year bond will ultimately deliver an absolute return approaching 100 percent, in absolute terms… …and relative to core European and Japanese bonds. Fractal trade shortlist: Stocks to consolidate versus bonds; Commodities look dangerously frothy; Buy USD/CAD. Feature Chart of The WeekThe Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks The Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks The Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks Ten years ago, 30-year bond yields in the US, UK and Germany stood at near-identical levels, around 3 percent. Today though, those yields are widely dispersed: the US at 2.3 percent, the UK at 1.3 percent, and Germany at 0.3 percent. What happened? In 2012, the German bond yield decoupled from the UK and the US, because the deflationary shock from the euro debt crisis was focussed in the euro area. Then, in 2016, the UK bond yield decoupled from the US, because the deflationary shock from Brexit was focussed in the UK and EU27 (Chart Of The Week). The ‘Shock Theory’ Of Bond Yields Welcome to a new concept – the ‘shock theory’ of bond yields. According to this theory, the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that the economy has suffered. Each successive deflationary shock takes the bond yield to a lower structural level until it can go no lower (Chart I-2). Chart I-2Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Since 2011, US, UK and German bond yields have decoupled because the US has suffered the legacies of one fewer deflationary shock than the UK, and two fewer deflationary shocks than Germany. But the important corollary is that the US is only one deflationary shock away from a European level of bond yields. When that deflationary shock arrives and the US 30-year bond yield reaches the recent low achieved in the UK, it will equate to a price gain of over 50 percent. And if the yield reaches the recent low achieved in Germany, it will equate to a price gain of well over 100 percent. Many people say that such gains are impossible. Yet ten years ago these same people were saying that UK and German long-duration bonds could never reach near-zero yields, and look what happened! Our high-conviction view is that the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. The simple reason is that another deflationary shock is just a matter of time away. Long-Term Investors Must Always Plan For A Shock Most strategists and investors claim that shocks, such as the pandemic, are inherently unpredictable, and therefore that you cannot plan for them. We disagree. Yes, the timing and nature of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the statistical distribution of shocks is highly predictable. What constitutes a shock? There is no established definition, so our definition is any event that causes the long-duration bond price in a major economy to rally or slump by at least 25 percent.1 (Chart I-3) Using this definition through the last 50 years, we can say that the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the statistical distribution of the time between shocks is Exponential (3.33). Chart I-3A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years It follows that in any ten-year period, the likelihood of suffering a shock is a near-certain 96 percent (Chart I-4). And even in any five-year period, the likelihood of a shock is an extremely high 81 percent. Chart I-4On A Multi-Year Horizon, A Shock Is A Near-Certainty The 'Shock Theory' Of Bond Yields The 'Shock Theory' Of Bond Yields For many people, this creates a cognitive dissonance. Even though a shock is a near-certainty, they cannot visualise its exact nature or timing, so they resist planning for it. Yet long-term investors must always plan for shocks. Not to do so is unforgiveable. An Inflationary Shock Will Quickly Morph Into A Deflationary Shock The crucial question is, will the next shock be deflationary, or inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if the shock starts as inflationary, it will quickly morph into deflationary. The simple reason is that the sharp backup in bond yields that would come from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. The 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. As prices doubled almost everywhere, the value of global real estate surged by $150 trillion (Chart I-5), of which $75 trillion was due to the valuation uplift from lower bond yields (Chart I-6). To put this into context, lower bond yields have boosted the value of global real estate by the equivalent of world GDP! Chart I-5In The 2010s Housing Boom, The Value Of Global Real Estate Surged By $150 Trillion… In The 2010s Housing Boom, The Value Of Global Real Estate Has Surged By $150 Trillion... In The 2010s Housing Boom, The Value Of Global Real Estate Has Surged By $150 Trillion... Chart I-6…Of Which $75 Trillion Was Due To Lower Bond Yields ...Of Which $75 Trillion Is Due To Lower Bond Yields ...Of Which $75 Trillion Is Due To Lower Bond Yields Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. The starting valuation needed to generate a given real return during an inflationary shock is much lower than during price stability. For example, for equities in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But in the inflation shock of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to halve to 7 (Chart I-7). Chart I-7In The 1970s Inflationary Shock, Valuations Collapsed In The 1970s Inflationary Shock, Valuations Collapsed In The 1970s Inflationary Shock, Valuations Collapsed How much can bond yields rise before undermining the value of global real estate? Over the past decade the global rental yield has not been able to deviate from the global long-duration bond yield by more than 100 bps.2 Given that the bond yield is already around 25 bps above the rental yield, we deduce that the long-duration bond yield can rise by no more than 75 bps before global real estate prices start getting hurt (Chart I-8).  Chart I-8The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt To repeat our key structural recommendation, the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. Candidates For Countertrend Reversal This week we note that the rally in stocks versus bonds (MSCI All Country World versus 30-year T-bond) is likely to consolidate in the coming months – given the fragility in the 260-day fractal structure similar to previous turning points in 2008, 2010, 2013, and 2020 (Chart I-9). Chart I-9The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months We also repeat our warning to steer clear of commodities. The rally in all commodities is becoming dangerously frothy, displaying the extremes of fractal fragility seen in 2008. (Chart I-10and Chart I-11). Chart I-10The Rally In Commodities Is Becoming Dangerously Frothy... The Rally In Commodities Is Becoming Dangerously Frothy... The Rally In Commodities Is Becoming Dangerously Frothy... Chart I-11...Displaying The Extremes Of Fractal Fragility Seen In 2008 ...Displaying The Extremes Of Fractal Fragility Seen In 2008 ...Displaying The Extremes Of Fractal Fragility Seen In 2008 A good trade right now is to short the Canadian dollar. Based on the loonie’s composite fractal structure, a lot of good news is already priced in, including the dangerously frothy commodity markets and the Bank of Canada’s (hawkish) taper of asset purchases. As such we expect the Canadian dollar to reverse in the coming months (Chart I-12). Chart I-12Short The Canadian Dollar Short The Canadian Dollar Short The Canadian Dollar Go long USD/CAD, setting a profit-target and symmetrical stop-loss at 3.7 percent. Dhaval Joshi Chief Strategist Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 Here, the global long-duration bond yield is defined as the average of the 30-year yields in the US and China. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Feature Chinese stocks remain in limbo despite robust economic data in April and early May (Chart 1).  Onshore equities are pricing in policy tightening risks and a peak in the domestic economic cycle. Meanwhile, a regulatory clampdown on the tech sector continues to curb global investors’ enthusiasm towards Chinese investable stocks.  The PBoC has not changed its course of policy normalization. The falling 3-month SHIBOR since March likely reflects softening demand for interbank liquidity rather than monetary easing (Chart 2). Chart 1Stay Underweight Chinese Stocks Stay Underweight Chinese Stocks Stay Underweight Chinese Stocks Chart 2No Easing In Monetary Policy No Easing In Monetary Policy No Easing In Monetary Policy Fiscal policy has also been consolidating with a renewed focus on reducing local government debt load and financial risks. A delay in local government bond issuance in Q1 could potentially boost bond sales in the second half of the year. However, as we noted late last month, without a synchronized policy push for more bank loans and loosened regulations on provincial government spending, an increase in special-purpose bond issuance alone will not make a significant difference in infrastructure investment nor economic growth. We still expect China's economy, which lags the credit cycle by six to nine months, to start weakening by mid-2021 (Chart 3A & 3B). Chart 3ADomestic Economic Growth Set To Slow Domestic Economic Growth Set To Slow Domestic Economic Growth Set To Slow Chart 3BPolicy Tightening Will Weigh On Earnings Growth In 2H21 Policy Tightening Will Weigh On Earnings Growth In 2H21 Policy Tightening Will Weigh On Earnings Growth In 2H21   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Our BCA Li Keqiang Leading Indicator continues to fall despite a marginal improvement in the Monetary Conditions Index (MCI) component. The deceleration in both money supply and credit growth has more than offset a small uptick in the MCI (Chart 4). Furthermore, a rising RMB in trade-weighted and real terms will not help the profit outlook for China’s exporters (Chart 5). Overall, monetary conditions remain unfavorable for risk assets. This is consistent with the poor performance of Chinese stocks Chart 4Falling Credit And Money Growth More Than Offset A Minor Improvement In The MCI Falling Credit And Money Growth More Than Offset A Minor Improvement In The MCI Falling Credit And Money Growth More Than Offset A Minor Improvement In The MCI Chart 5Strengthening RMB Will Not Help The Profit Outlook For Chinese Exporters Strengthening RMB Will Not Help The Profit Outlook For Chinese Exporters Strengthening RMB Will Not Help The Profit Outlook For Chinese Exporters   A sharp jump in state-owned enterprise (SOE) defaults since late last year is due to deteriorating corporate balance sheets. The defaults have exposed the weakened fiscal positions of local governments (Chart 6 & 7). SOE bond defaults have surpassed the number of private bond defaults this year. The more restrictive policy on local government financing, together with an acceleration in SOE defaults, will weigh on spending by local governments, local government financing vehicles (LGFVs) and SOEs.  Chart 6Returns On SOE Assets Remain In Deep Contraction Returns On SOE Assets Remain In Deep Contraction Returns On SOE Assets Remain In Deep Contraction Chart 7SOE Bond Defaults Have Surpassed Private Bond Defaults China Macro And Market Review China Macro And Market Review The Politburo meeting on April 30 established new guidelines to reduce local government leverage, both on- and off-balance sheet debt. According to the new rules, local governments are strictly prohibited from obtaining “hidden debts” for new investment projects directly or through their affiliated SOEs, which include LGFVs. The directives also state that the assets of LGFVs with defaulted loans should be restructured or liquidated if companies are unable to repay their debts. In addition, financial institutions should not accept government guarantees when making decisions on lending to LGFVs or government related entities.  Moreover, stricter measures in the property market have further dampened local governments’ fiscal situations since land sales account for 53% of local government fiscal revenues. Growth in government expenditures decelerated in recent months along with slowing land auctions (Chart 8). Scaled down fiscal supports will lead to subdued infrastructure investment growth this year (Chart 9). Chart 8Fiscal Stance Has Tightened Fiscal Stance Has Tightened Fiscal Stance Has Tightened Chart 9Subdued Growth In Infrastructure Investments Subdued Growth In Infrastructure Investments Subdued Growth In Infrastructure Investments   In addition to policy tightening in the domestic economy, Chinese offshore stocks continue to face regulatory headwinds to root out monopolies in technology, media, and telecom (TMT) companies. The antitrust investigations and fines extending from Alibaba and Tencent to Meituan highlight China’s aim to curb platform oligopolies and monopolies. Meanwhile, Chinese tech firms listed on US exchanges are facing another regulatory threat on their accounting reporting standards, which could potentially result in their delisting from the US bourses.  Moreover, elevated valuations and a weakening in the earnings outlook will generate more downside risks for TMT stocks (Chart 10). Given that TMT stocks account for around 50% of the MSCI China Index’s market capitalization, Chinese investable stocks are disproportionally vulnerable to a selloff in TMT stocks (Chart 11). Chart 10ATMT Stocks: From Tailwind To Headwind TMT Stocks: From Tailwind To Headwind TMT Stocks: From Tailwind To Headwind Chart 10BTMT Stocks: From Tailwind To Headwind TMT Stocks: From Tailwind To Headwind TMT Stocks: From Tailwind To Headwind Chart 11MSCI China Is Highly Concentrated In TMT Stocks MSCI China Is Highly Concentrated In TMT Stocks MSCI China Is Highly Concentrated In TMT Stocks   China’s official PMI and the Caixin China PMI moved in opposite directions in April due to the nature of the two surveys. The Caixin PMI covers smaller, more export-oriented businesses while the NBS Manufacturing PMI includes larger, more domestically exposed companies. The divergence highlights that the domestic economy is losing speed while external demand remains robust (Chart 12). Given the dominance of domestic demand in China’s economy (investment expenditures, household spending and government spending), strong external demand will not fully offset the deceleration in domestic growth.  New orders and production subcomponents in the official PMI moderated in April from March, which indicates a slowing momentum in economic activity (Chart 13). Moreover, construction PMI fell to 57.4 from 62.3 in March, corresponding with weaker infrastructure spending and more policy tightening in the real estate sector (Chart 13, bottom panel). Chart 12Conflicting Messages From The NBS And Caixin PMIs Conflicting Messages From The NBS And Caixin PMIs Conflicting Messages From The NBS And Caixin PMIs Chart 13Slowing Momentum In China's Economic Activity Slowing Momentum In China's Economic Activity Slowing Momentum In China's Economic Activity   The moderating momentum in China’s economy is also reflected in April’s trade data, which showed a strengthening external sector and a slowing domestic demand. A few observations support our view: First, strong imports since early this year were partly due to robust re-exports. Solid external demand boosted processing imports, which in turn contributed to China’s overall import growth (Chart 14). Secondly, Chinese imports of commodities in volume, such as copper and steel products, have plunged recently. Chinese domestic demand for commodities will likely peak in the coming months, therefore, inventory destocking pressures and weakness in underlying consumption will threaten commodities prices (Chart 15). Finally, the strengthening of coal imports in volume terms may be related to China’s increasingly stringent environmental policies. A temporary cutback in domestic coal supply boosted the demand for imports. However, in the long run, China’s push for green energy will be bearish for Chinese coal imports (Chart 16). Chart 14Solid External Demand Boosted Processing Imports Solid External Demand Boosted Processing Imports Solid External Demand Boosted Processing Imports Chart 15Demand Of Commodities May Be Approaching A Cyclical Peak Demand Of Commodities May Be Approaching A Cyclical Peak Demand Of Commodities May Be Approaching A Cyclical Peak Chart 16China's Coal Imports Likely To Decline In The Long Run China's Coal Imports Likely To Decline In The Long Run China's Coal Imports Likely To Decline In The Long Run   Housing prices in tier-one cities continue to post major gains despite a slew of tightening regulations in the property sector introduced since the second half of last year (Chart 17). The Politburo meeting last month reiterated authorities’ concerns over a bubble in housing. We expect authorities to impose additional regulations to constrain both financing supply and demand in the property sector. In the meantime, the existing policies have successfully started to cool the real estate market.  Chart 17Skyrocketing Housing Prices In First-Tier Cities Skyrocketing Housing Prices In First-Tier Cities Skyrocketing Housing Prices In First-Tier Cities Chart 18Real Estate And Mortgage Loans Tumbled Under More Restrictive Borrowing Regulations Real Estate And Mortgage Loans Tumbled Under More Restrictive Borrowing Regulations Real Estate And Mortgage Loans Tumbled Under More Restrictive Borrowing Regulations Both mortgage loans and loans to real estate developers tumbled under more restrictive borrowing policies (Chart 18). Growth in home sales has also started to roll over (Chart 19). Housing completed has dropped significantly, which confirms that construction activity is decelerating. Looking forward, the reduced expansion rate of new projects due to shrinking land transfers and stricter borrowing regulations will further dampen construction activities in the second half of this year (Chart 20).   Chart 19Home Sales Growth Started To Ease Home Sales Growth Started To Ease Home Sales Growth Started To Ease Chart 20Real Estate Investments Are Set To Slow Further Real Estate Investments Are Set To Slow Further Real Estate Investments Are Set To Slow Further Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review ​​​​​​​   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Tapering: The Bank of England has joined the Bank of Canada as central banks tapering the pace of bond buying. Markets are now trying to sort out who is next and concluding that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. US Treasury Curve: We are adding a new recommended US butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell using US Treasury futures. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime. Feature Heading into 2021, one of our key investment themes for the year was that no major central bank would shift to a less dovish monetary policy stance before the Fed. Not even five months into the year, our theme has already been proven incorrect. Last week, the Bank of England (BoE) announced a slower pace of its asset purchases, following a similar tapering decision by the Bank of Canada (BoC) last month. Chart of the WeekUS Jobs Recovery Lagging, Despite Vaccine Success Who Tapers Next? Who Tapers Next? We had assumed that no central bank could tolerate the currency strength that would inevitably occur by tapering ahead of the Fed. That was clearly not the case in Canada, and the Canadian dollar has already appreciated 4.6% versus the greenback since the BoC taper announcement April 21. The British pound also rallied solidly against both the US dollar and euro immediately after the BoE taper announcement last week. Markets are beginning to speculate on future taper candidates, like the Reserve Bank of New Zealand (RBNZ), with the New Zealand dollar being one of the strongest currencies in the G10 versus the US dollar since the end of March (+4.4%). Investors had been debating the possibility that the Fed could begin tapering sometime in the second half of 2020, largely based on what has to date been a successful US vaccination campaign. Yet while that led to optimism that the US economy can quickly reopen and return to normal, the fact remains that the recovery in US employment from the COVID shock has lagged other major economies (Chart of the Week). The big downside miss on the April US payrolls report highlights how the Fed can be patient before joining the tapering club. US Treasury yields are likely to continue trading sideways, and the US dollar will trade soft, until markets can sort out the true state of US labor demand versus supply. Which Central Bank Could Follow The BoC And BoE? Back in March, we published a report that discussed what we called the “pecking order of global liftoff”.1 We looked at how interest rate markets were pricing in an increasingly diverse path out of the coordinated global monetary easing enacted last year during the COVID recession (Chart 2). We looked at both the timing of “liftoff” (the first rate hike) and the pace of hikes afterward to the end of 2024. We then ranked the countries by the market-implied timing of liftoff. Chart 2Sorting Out The Relative Hawks & Doves Among Global CBs Sorting Out The Relative Hawks & Doves Among Global CBs Sorting Out The Relative Hawks & Doves Among Global CBs At the time, overnight index swap (OIS) curves were discounting the earliest liftoff from the RBNZ (June 2022) and BoC (August 2022). The Fed was expected to hike in January 2023, followed by the BoE in June 2023 and Reserve Bank of Australia (RBA) in July 2023. The European Central Bank (ECB) and Bank of Japan (BoJ) were the laggards, with no rate hiked discounted until September 2023 and February 2025, respectively. In terms of the pace of rate hikes after liftoff through 2024, our list was broken into two groups. The more aggressive central banks were expected to be the BoC (+175bps), RBA (+156bps), RBNZ (+140bps) and the Fed (+139bps). Much smaller amounts of rate hikes were anticipated from the BoE (+63bps), ECB (+25bps) and BoJ (+9bps). In the two months since our March report, the market timing of liftoff, and the pace of subsequent hikes, has shifted for all those countries (Table 1). The BoC is now expected to move in September 2022, ahead of the RBNZ (October 2022). In 2023, the Fed is now priced for liftoff in March 2023, followed by the BoE and RBA (both in July 2023). The ECB liftoff date is little changed (now August 2023), while the market has dramatically pushed out the timing of any BoJ hike (now November 2025). The cumulative rate hikes through 2024 are moderately lower for all countries except Australia (a reduction in total tightening of 56bps). Table 1The Fed Is Sliding Down The “Pecking Order Of Liftoff” List Who Tapers Next? Who Tapers Next? What is interesting about these changes is that the market has pulled forward the timing of liftoff for the BoE and RBA, while pushing it out for the BoC, RBNZ, BoJ and, most importantly, the Fed. The Fed is now drifting down the “pecking order” for liftoff, expected to lift rates only a couple of months before the BoE or RBA. This is a major change from previous monetary policy cycles, when the Fed would typically be a first mover when it comes to tightening policy. Chart 3The Momentum Of Global QE Has Already Been Slowing The Momentum Of Global QE Has Already Been Slowing The Momentum Of Global QE Has Already Been Slowing While the BoC and BoE decisions to taper quantitative easing (QE) have garnered the headlines, the pace of global central bank balance sheet expansion had already peaked at the start of 2021 (Chart 3). The pace has slowed most dramatically in Canada and the US, but this was a result of certain emergency programs expiring – most notably the Fed’s corporate bond buying vehicles late last year and the BoC’s short-term repo facilities more recently. Greater financial market stability was the reason cited to end those programs, while still leaving government bond QE buying in place unchanged. The year-over-year pace of global QE was set to slow, simply from less favorable comparisons to 2020 after the surge in central bank balance sheet expansion last year. Yet now we are starting to see actual tapering of government bond purchases from some central banks. Is such “early tightening” warranted? Back in that same March report where we discussed the order of global liftoff, we gave our assessment of the most important factors that could drive central banks to consider a shift to a less dovish stance (like tapering). For the BoC, we cited booming house prices and robust business confidence as reasons the BoC could turn less dovish sooner (Chart 4). For the BoE, we noted a sharper-than-expected recovery in domestic investment and consumer spending, as the locked-down UK economy reopens, as reasons why the BoE could begin to tweak its policy settings. For both central banks, all those indicators were mentioned as factors leading to their decision to taper. For the Fed, we determined that rising inflation expectations and increasing labor market tightness would both be required for the Fed to turn less dovish. Only inflation expectations have reached that goal, with the US Employment/Population ratio still well below the pre-pandemic peak (Chart 5). For the RBA, we looked solely at realized inflation measures, as the RBA has explicitly noted that Australian wage growth must rise sustainably towards 3% - nearly double current levels - before realized CPI inflation could return to the 2-3% target range. For both the Fed and RBA, the necessary conditions for a change in current policy settings have not yet been met. Chart 4What The More Hawkish CBs Are Watching What The More Hawkish CBs Are Watching What The More Hawkish CBs Are Watching Chart 5What The More Dovish CBs Are Watching What The More Dovish CBs Are Watching What The More Dovish CBs Are Watching For the ECB, we noted that realized inflation (and the ECB’s inflation forecasts), along with the Italy-Germany government bond spread as a measure of financial conditions, were the most important indicators to watch before the ECB could consider any move to taper its QE programs (Chart 6). Italian spreads have widened a bit in recent months, while the latest set of ECB economic forecasts still call for headline euro area inflation to remain well south of the 2% target out to 2023. For the BoJ, we simply cited a rise in realized inflation as the only possible development that could lead to a BoJ taper. The BoJ now forecasts that Japanese inflation will not reach the 2% central bank target until at least 2024. So for both the ECB and BoJ, the conditions do not warrant any imminent tapering of bond buying. Chart 6What The Most Dovish CBs Are Watching What The Most Dovish CBs Are Watching What The Most Dovish CBs Are Watching As another way to determine who could taper next, we turn to our Central Bank Monitors, which are designed to measure the pressure on policymakers to ease or tighten monetary setting. All the Monitors have responded to the recovery in global growth and inflation, along with the easing of financial conditions implied by booming markets, over the past year. Yet only the RBA Monitor is calling for tightening (Chart 7), indicating that the RBA’s current focus on only wages and realized inflation is a departure from their behavior in the past. The Fed and BoE Monitors have risen to the zero line, suggesting no further pressure to ease policy but no tightening is needed either. The ECB, BoJ and RBNZ Monitors are all close, but just below, the zero line, suggesting diminishing need for more monetary stimulus (Chart 8). Chart 7Bond Yields Have Moved Ahead Of Our CB Monitors Bond Yields Have Moved Ahead Of Our CB Monitors Bond Yields Have Moved Ahead Of Our CB Monitors Chart 8Yields Overshooting Tightening Pressures Here Too Yields Overshooting Tightening Pressures Here Too Yields Overshooting Tightening Pressures Here Too Based on our assessment of the above indicators, we judge the RBNZ to be the next central bank most likely to taper, sometime in the 2nd half of 2021. We still see the Fed starting to signal tapering later this year, but with actual slowing of US Treasury (and Agency MBS) purchases not occurring until early 2022. The year-over-year momentum of bond yields correlates strongly with the Central Bank Monitors. The rise in global bond yields seen over the past year has exceeded the pace implied by the Monitors. This is unsurprising given how rapidly the global economy has recovered from pandemic-fueled recession in 2020. Supply chain disruptions and surging commodity prices have also given a lift to bond yields via rising inflation expectations, even as central banks have promised to keep rates on hold for at least the next couple of years. Yet purely from a monetary policy perspective, the surge in global bond yields looks to have gone a bit too far, too fast. Bottom Line: Markets are now trying to sort out who will taper next after the BoC and BoE, and have concluded that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. Bond yields in other developed markets appear to have overshot economic momentum, and a period of consolidation is needed before yields can begin moving higher again. US Treasury Curve: How Much Steepening Left? Chart 9A Pause In The UST Bear-Steepening Trend A Pause In The UST Bear-Steepening Trend A Pause In The UST Bear-Steepening Trend For most of the past year, the primary trend in the US Treasury curve has been one of bear steepening. Longer maturity yields have borne the brunt of the upward pressure stemming from the rapid recovery in US (and global) economic growth from the depths of the 2020 COVID-19 recession. In recent weeks, however, the surge in longer-maturity Treasury yields has stalled, as have the immediate steepening pressures (Chart 9). Purely from a fundamental economic perspective, a steepening Treasury curve is an expected result of the reflationary mix of growth, inflation and monetary policy currently at work in the US. For example, since the 2020 lows, 5-year/5-year forward inflation expectations from the TIPS market have risen 143bps while the ISM manufacturing index surged from a low of 41 to a high of 65 in March of this year (Chart 10). Combine that with the Fed cutting rates to 0% last year, while promising to keep rates unchanged through 2023 and reinforcing that commitment through QE, and it is no surprise to see a steeper US Treasury curve. Chart 10UST Curve Steepening Has Been Driven By Reflation UST Curve Steepening Has Been Driven By Reflation UST Curve Steepening Has Been Driven By Reflation Yet even despite these obvious steepening pressures, the pace of the Treasury curve steepening does seem to be a bit rapid compared to history. In Chart 11, we show a “cycle-on-cycle” analysis, comparing the slope of various US Treasury curve segments (2-year versus 5-year, 5-year versus 10-year, 10-year versus 30-year) to the average of the previous five US business cycles, dating back to the 1970s. The curves are lined up to the start date of the previous recession, with the vertical line in the chart representing that date. Thus, this chart allows us to see how the Treasury curve evolved heading into, and coming out of, economic downturns. Chart 11 shows that the current 2-year/5-year curve, with a steepness of 63bps, is in line with past steepening moves coming out of recession. For the curve segments at longer maturities, the pace of steepening has been much more rapid than in the past. In fact, the current 5-year/10-year slope of 82bps is already above the average past peak level, as is the 10-year/30-year curve of 72bps. If we do the same cycle-on-cycle analysis for the three previous US recessions dating back to 1990, the current curve slopes are more in line with levels seen one year into the economic expansion (Chart 12). During those previous cycles, the curve steepening trend ended around two years into the expansion. This suggests that the current curve steepening could continue into 2022, except for one major difference – the Fed cut rates to 0% very rapidly last year, far faster than in the previous easing cycles. This suggests that additional curve steepening from current levels can only occur through a surge in US inflation. Chart 11Current UST Steepening Has Moved Fast Compared To Past Cycles Current UST Steepening Has Moved Fast Compared To Past Cycles Current UST Steepening Has Moved Fast Compared To Past Cycles Chart 12Can More UST Curve Steepening Occur With A 0% Funds Rate? Can More UST Curve Steepening Occur With A 0% Funds Rate? Can More UST Curve Steepening Occur With A 0% Funds Rate? The slope of the Treasury curve is typically correlated to the level of the nominal fed funds rate, but is even more strongly correlated to the funds rate minus actual inflation, or the real fed funds rate. When the real funds rate is below the natural real rate of interest, a.k.a. r-star, the Treasury curve has historically exhibited its strongest steepening trend. That can be seen in Chart 13, where we show the real fed funds rate (adjusted by US core CPI inflation) compared to the New York Fed’s estimate of r-star. The gap between the two series is shown in the bottom panel, correlating very strongly to the 2-year/30-year Treasury curve slope. Chart 13Curve Steepening Results When Real Rates Are Below R* Curve Steepening Results When Real Rates Are Below R* Curve Steepening Results When Real Rates Are Below R* With the nominal funds rate at zero, that gap between r-star and the real fed funds rate can only widen in a fashion that would support more curve steepening if a) realized US inflation moves higher or b) r-star moves higher. Both outcomes are possible as the US economic recovery, fueled by expanding vaccinations and fiscal stimulus. Both real rates and r-star are much lower in the current cycle than in previous economic recoveries, although the r-star/real funds rate gap appears to be following a more typical path that suggests potential additional steepening pressure (Chart 14). The wild card in this analysis is the Fed itself. If US economic growth and inflation evolve in way that makes it more likely the Fed would have to begin tapering QE and, eventually, signal future rate hikes, the Treasury curve may shift to a more typical bear-flattening trend seen during tightening cycles. We saw an example of that after the release of the March US employment report, where over a million jobs were created in a single month, causing 5-year Treasury yields to jump higher than longer-maturity Treasuries (i.e. curve flattening). Looking ahead, it appears that the US yield curve is more likely to slowly transition to a bear-flattening/bull-steepening regime than continue the bear-steepening/bull-flattening: trend of the past twelve months. One way to position for this is to enter into butterfly curve trades that offer attractive carry or valuation. For that, we turn to our Treasury curve valuation models. We have been recommending a Treasury yield curve trade in our Tactical Overlay portfolio on page 19, going long a 7-year bullet versus going short a 5-year/10-year barbell (Chart 15). This barbell is now very cheap on our models, which measure value by regressing the butterfly spread on the underlying slope of the curve. In this case, the spread between the 5/7/10 butterfly is unusually wide compared to the slope of the 5/10 Treasury curve. According to our model, this butterfly spread discounts nearly 100bps of additional 5/10 steepening, an excessive amount compared to past cycles. Chart 14R* - Real Funds Rate Gap Below Previous Cyclical Peaks R* - Real Funds Rate Gap Below Previous Cyclical Peaks R* - Real Funds Rate Gap Below Previous Cyclical Peaks Chart 15Maintain Our Current 5/7/10 UST Butterfly Trade Maintain Our Current 5/7/10 UST Butterfly Trade Maintain Our Current 5/7/10 UST Butterfly Trade While the valuation is attractive on the 5/7/10 butterfly (Table 2), the carry on this position is a modest 12bps. A butterfly with more attractive carry is the 2/5/30 butterfly. Table 2US Butterfly Strategy Valuation: Standardized Residuals Who Tapers Next? Who Tapers Next? Table 3US Butterfly Strategies: Carry Who Tapers Next? Who Tapers Next? Chart 16Enter A New 2/5/30 UST Butterfly Trade Enter A New 2/5/30 UST Butterfly Trade Enter A New 2/5/30 UST Butterfly Trade This butterfly has a neutral valuation (Chart 16) on our model, but offers 35bps of carry - the most attractive among all butterflies involving a 5-year bullet (Table 3). With US Treasury yields, and the Treasury curve slope, likely to remain rangebound for the next few months, going for higher carry trades is an attractive strategy – particularly if used in conjunction with a below-benchmark duration stance, which we still advocate. The 2/5/30 butterfly represents an attractive near-term hedge to that more defensive duration posture. Bottom Line: We are adding a new recommended US Treasury butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Who Tapers Next? Who Tapers Next? ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Despite last month’s weak employment growth, we continue to expect the economy to reach maximum employment in time for the Fed to lift rates in 2022. Maintain below-benchmark portfolio duration. TIPS: Long-maturity TIPS breakeven inflation rates have returned to levels that are consistent with the Fed’s target. Breakevens are also discounting a very rapid increase in near-term inflation at the front-end of the curve. Investors should take this opportunity to reduce TIPS exposure from overweight to neutral and to close inflation curve flattener and real yield curve steepener positions. Yield Curve: The Treasury curve has transitioned into a bear-flattening/bull-steepening regime beyond the 5-year maturity point, and as such, our recommended yield curve positioning must be re-considered. We recommend that investors position for maximum carry across the yield curve by going long the 5-year bullet and short a duration-matched 2/30 barbell. April Payrolls Shock The Bond Market In the current environment, there is probably nothing more important for US bond investors than keeping a close eye on the monthly employment data. The Federal Reserve has made the first rate hike contingent on a return to “maximum employment”, and bond yield fluctuations reflect the market’s changing assessment of the timing and pace of future Fed rate hikes. Chart 1A Big Miss On Payrolls A Big Miss On Payrolls A Big Miss On Payrolls With that in mind, investors got a shock last Friday when April’s employment report disappointed expectations by one of the widest margins ever. The economy added only 266 thousand jobs to nonfarm payrolls in April while the Bloomberg consensus estimate was calling for 1 million! At present, the market is looking for Fed liftoff in February 2023 (Chart 2). We calculate that monthly employment growth must average at least 412 thousand for the Fed to reach its maximum employment goal by the end of 2022, in time to lift rates in early-2023 (Chart 1 on page 1). Average monthly employment growth of at least 698 thousand is required to hit the Fed’s maximum employment target by the end of this year.1   Chart 2Market Priced For Liftoff In February 2023 Market Priced For Liftoff In February 2023 Market Priced For Liftoff In February 2023 The last section of this report (titled “Evidence Of A Labor Shortage In The April Payrolls Report”) explores possible reasons for the weaker-than-expected employment data and concludes that payroll growth will be stronger in the second half of this year. We continue to expect that the economy will reach maximum employment in time for the Fed to lift rates in 2022, and as such, we advise bond investors to maintain below-benchmark portfolio duration. Peak Inflation Last week, we downgraded our allocation to TIPS from overweight to neutral and closed two yield curve positions – an inflation curve flattener and a real yield curve steepener – that had been in place since April 2020.2 We made these moves for two reasons: There is a good chance that realized inflation won’t match the aggressive expectations that are already discounted in the front-end of the inflation curve. Long-maturity TIPS breakeven inflation rates are now consistent with the Fed’s target. In other words, they can’t rise much further without the Fed acting to bring them back down. On the first point, we continue to expect that inflation will be relatively strong between now and the end of the year, but the market has already more than priced-in this outcome. The 1-year CPI swap rate is currently 3.18% and the 2-year CPI swap rate sits at 2.99% (Chart 3). Even if we assume that core CPI increases by a robust +0.2% per month going forward, that will only cause 12-month core CPI inflation to reach 2.29% by the end of this year (Chart 4). Chart 3An Inflation Snapback Is Priced In An Inflation Snapback Is Priced In An Inflation Snapback Is Priced In Chart 4Inflation In 2021 Inflation In 2021 Inflation In 2021 Chart 5TIPS Are Very Expensive TIPS Are Very Expensive TIPS Are Very Expensive To further that point, this week we unveil our new TIPS Breakeven Valuation Indicator (Chart 5). The indicator is based on the theory of adaptive expectations – the theory that inflation expectations are formed based on recent trends in the actual inflation data. In essence, the indicator compares the current 10-year TIPS breakeven inflation rate to different measures of inflation and determines whether 10-year TIPS are currently cheap or expensive relative to 10-year nominal bonds. A negative reading indicates that TIPS are expensive, while a positive reading suggests that TIPS are cheap. At present, the indicator sits at -0.88. Historically, when TIPS are this expensive on our indicator there are strong odds that the 10-year TIPS breakeven inflation rate will fall during the next 12 months (Table 1). Table 1TIPS Breakeven Valuation Indicator Track Record Entering A New Yield Curve Regime Entering A New Yield Curve Regime On the second point, we have often noted that a range of 2.3% to 2.5% on long-maturity TIPS breakevens (levels seen during the mid-2000s) is consistent with the Fed’s inflation target. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates haven’t spent much time near those levels during the past decade, but that is starting to change. The 10-year TIPS breakeven inflation rate recently shot up to 2.52%, above the top-end of our target band, while the 5-year/5-year forward TIPS breakeven inflation rate sits near the low-end of the range at 2.34% (Chart 6). Even Fed Chair Powell acknowledged that TIPS breakeven rates are “pretty close to mandate consistent” in the press conference that followed the April FOMC meeting.3 This is not to say that we expect the Fed to pivot quickly towards tightening. However, once the economy reaches maximum employment and the Fed starts to lift rates, the pace of rate hikes will be much quicker if long-maturity TIPS breakeven inflation rates are threatening to break above 2.5%. This puts a long-run ceiling on TIPS breakevens, one that we are quickly approaching. As for our inflation curve flattener and real yield curve steepener positions, neither makes sense unless TIPS breakeven rates continue to rise (Chart 7). Chart 6Long-Maturity Breakevens Are At Target Long-Maturity Breakevens Are At Target Long-Maturity Breakevens Are At Target Chart 7Exit Inflation Curve Flattener And Real Yield Curve Steepener Exit Inflation Curve Flattener And Real Yield Curve Steepener Exit Inflation Curve Flattener And Real Yield Curve Steepener   The cost of inflation compensation is much more volatile at the front-end of the curve than at the long end, which means that the inflation curve tends to flatten when breakevens rise and steepen when they fall. In other words, the inflation curve will not flatten further unless breakevens move higher. While we don’t see room for further inflation curve flattening, we also think that the curve will remain inverted. With the Fed targeting a temporary overshoot of its 2% inflation target, an inverted inflation curve is much more consistent with the Fed’s stated goals than a positively sloped one. As for the real yield curve, it’s easiest to think of a real yield curve steepener as the combination of a nominal curve steepener and an inflation curve flattener. If the inflation curve holds steady, then there is no difference between a real yield curve steepener and a nominal yield curve steepener. On that note, the next section of this report discusses why the case for a nominal yield curve steepener is also starting to break down. Bottom Line: Long-maturity TIPS breakeven inflation rates have returned to levels that are consistent with the Fed’s target. Breakevens are also discounting a very rapid increase in near-term inflation at the front-end of the curve. Investors should take this opportunity to reduce TIPS exposure from overweight to neutral and to close inflation curve flattener and real yield curve steepener positions. Nominal Treasury Curve: Pick Up Carry In Bullets The average yield on the Bloomberg Barclays Treasury Master Index troughed on August 4th 2020 and rose by 92 basis points until it peaked on April 2nd. The Treasury curve steepened dramatically during that period, with increases in the 10-year and 30-year yields far outpacing the rise in the 5-year yield (Table 2). Table 2Treasury Yield Changes Since The August 2020 Trough Entering A New Yield Curve Regime Entering A New Yield Curve Regime But the shape of the yield curve has behaved differently since yields peaked on April 2nd. The average index yield is down 11 bps since then, but the decline has been led by the 5-year while the 10-year and 30-year yields have been relatively sticky. We view this as evidence that, as we edge closer to an eventual rate hike cycle, the yield curve is entering a new regime. This is a natural progression. When rate hikes are only expected to occur far into the future, there will be very little volatility at the front-end of the curve and the yield curve will tend to steepen when yields rise and flatten when they fall. But over time, as we get closer to expected rate hikes, volatility will shift toward shorter and shorter maturities. This will eventually cause the yield curve to flatten when yields rise and steepen when they fall. Chart 8Buy 5-Year Versus 2/30 Buy 5-Year Versus 2/30 Buy 5-Year Versus 2/30 While there is still very little volatility in 1-3 year yields, it looks like the curve beyond the 5-year maturity point has transitioned into a bear-flattening/bull-steepening regime. That is, when yields rise we should expect the 5/30 slope to flatten and when yields fall we should expect the 5/30 slope to steepen. Indeed, we see that a gap has recently opened up between the trends in the 5/30 slope and the Treasury index yield, while the 2/5 slope remains tightly correlated with the level of yields (Chart 8). The big implication of this regime shift is that we should no longer expect our current recommended yield curve position, long the 5-year bullet and short a duration-matched 2/10 barbell, to perform well in a rising yield environment. To profit from rising yields, investors would be better off positioning for a flatter 5/30 curve by going short the 10-year bullet and long a duration-matched 5/30 barbell. However, this is not the strategy we’d recommend for investors who are already running below-benchmark portfolio duration and are thus already exposed to rising yields. The reason is that while we think the market’s current expected fed funds rate path is slightly too dovish, it is not that far from a reasonable forecast. Put differently, we see bond yields as biased higher but the near-term upside could be limited. For this reason, and since we are already exposed to higher yields through our portfolio duration call, we prefer to enter a yield curve position that will profit from an environment of stable yields. That is, a carry trade that offers a large amount of yield pick-up. The best trade in that regard is a position long the 5-year bullet and short a duration-matched 2/30 barbell (Chart 8, bottom panel). This position offers a positive yield pick-up of 31 bps, a nice cushion against the risk of capital losses from further 2/30 steepening. Bottom Line: The Treasury curve has transitioned into a bear-flattening/bull-steepening regime beyond the 5-year maturity point, and as such, our recommended yield curve positioning must be re-considered. We recommend that investors position for maximum carry across the yield curve by going long the 5-year bullet and short a duration-matched 2/30 barbell. Evidence Of A Labor Shortage In The April Payrolls Report Given the well-founded optimism about the pace of US economic recovery (real GDP grew 6.4% in the first quarter after all) it was very surprising that only 266 thousand jobs were added in April. One possible reason for the weak job growth is that a lack of labor supply is holding it back. We explored this issue in a recent report and concluded that there is a lot of evidence to support the claim.4 While it is a bad idea to read too much into any single datapoint, we think it’s likely that the labor shortage played a significant role in April’s poor employment number. At first blush, the industry breakdown of April’s employment report appears to refute the labor shortage narrative. For example, the Leisure & Hospitality sector added 331 thousand jobs on the month, by far the most of all the industry groups (Table 3). This is interesting because the Leisure & Hospitality sector – primarily restaurants and bars – is a close-contact service industry with low average wages, the exact sort of industry where we would expect to see evidence of a labor shortage. Table 3Employment By Industry Entering A New Yield Curve Regime Entering A New Yield Curve Regime But we don’t think strong Leisure & Hospitality job growth refutes the labor shortage narrative. For one thing, while +331k is a lot of new jobs in a single month, it could have been a lot more. The third column of Table 3 shows that the Leisure & Hospitality industry is still 2.8 million jobs short of where it was prior to COVID. Further, other indicators within the Leisure & Hospitality sector clearly point toward a lack of labor supply. The Job Openings Rate is much higher in the Leisure & Hospitality sector than in the economy as a whole (Chart 9) and Leisure & Hospitality wages have grown much more quickly during the past few months (Chart 9, bottom panel). It seems highly likely that Leisure & Hospitality job growth would be stronger if not for supply side constraints. More generally, economy-wide measures of labor demand have recovered much more quickly than the actual employment data (Chart 10). The job openings rate and the NFIB Jobs Hard To Fill survey have both surpassed their pre-COVID peaks, and more households describe jobs as “plentiful” than as “hard to get”. The one outlier is the unemployment rate which, after controlling for furloughed workers, has barely budged off its peak (Chart 10, bottom panel). This points strongly to labor supply being the limiting factor, not demand. Chart 9Leisure & Hospitality Wages Are Accelerating Leisure & Hospitality Wages Are Accelerating Leisure & Hospitality Wages Are Accelerating Chart 10Evidence Of A Labor Shortage Evidence Of A Labor Shortage Evidence Of A Labor Shortage   Bottom Line: There is a lot of evidence that a lack of labor supply is holding back job growth. However, we expect that supply constraints will be cleared up relatively soon as widespread vaccination makes people more comfortable re-entering the labor force, and as expanded unemployment benefits lapse. We expect that job growth will be much stronger in the second half of 2021 and into 2022.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 We define maximum employment as an unemployment rate of 4.5% and a labor force participation rate equal to its pre-COVID level of 63.3%. 2 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020. 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210428.p… 4 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis.  Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Climbing Swiss Peaks Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone A Good Sign For The Eurozone A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Sweden Leads The Eurozone Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Accelerating Vaccinations Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus A Surprising Dance A Surprising Dance Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Ample European Pent-up Demand Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount The Service Sector Recovery Is Paramount The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises Decomposing The Surprises Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns A Surprising Dance A Surprising Dance The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks A Surprising Dance A Surprising Dance Table 3A Bullish Backdrop For EUR/USD A Surprising Dance A Surprising Dance The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Rising German Yields? Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9).  Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February.  The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth Support For Household Net Worth Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More UK Consumption Will Rise More UK Consumption Will Rise More Chart 12Accelerating UK Inflation Accelerating UK Inflation Accelerating UK Inflation   Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains.  It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Cable Is Ripe For Some Near-Term Profit Taking Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable UK Small-Cap Stocks Are Technically Vulnerable UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Deteriorating Profit Performance Deteriorating Profit Performance Chart 16Quite The Valuation Premium Quite The Valuation Premium Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead Lower EUR/GBP Ahead Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Currency Performance A Surprising Dance A Surprising Dance Fixed Income Performance Government Bonds A Surprising Dance A Surprising Dance Corporate Bonds A Surprising Dance A Surprising Dance Equity Performance Major Stock Indices A Surprising Dance A Surprising Dance Geographic Performance A Surprising Dance A Surprising Dance Sector Performance A Surprising Dance A Surprising Dance ​​​​​​​ Closed Trades

Highlights Massive slack in the US labour market means that the current uplift in US inflation is highly likely to fade by the end of the year. On a long-term horizon, investors should own US T-bonds. Equity investors should fade the reflation trade… …and rotate into the unloved defensive sectors such as healthcare, consumer staples, and personal products. These sector preferences imply an overweight to developed markets (DM) versus emerging markets (EM). On a 6+ month horizon, overweight US T-bonds versus German bunds. Fractal trade shortlist: France versus Japan; corn versus wheat; timber; and building materials. Feature Chart of the WeekMillions Of People Have Dropped Out Of The US Labour Market Millions Of People Have Dropped Out Of The US Labour Market Millions Of People Have Dropped Out Of The US Labour Market The near 40 percent of Americans not in the labour market is the highest level in 50 years. Moreover, the exodus out of the labour market during the pandemic was on an unprecedented scale in the modern era. This means that we should treat the US unemployment rate with a huge dose of salt, because it does not include the millions of people that have dropped out of the labour market (Chart I-1). Even the headline 14 million plunge in the number of US unemployed is deceptive, because it is almost entirely due to the furloughed workers that have returned to their jobs (Chart I-2). Chart I-2Furloughed Workers Have Returned To Their Jobs... Furloughed Workers Have Returned To Their Jobs... Furloughed Workers Have Returned To Their Jobs... Worryingly, the additional 2 million ‘permanent unemployed’ has barely budged from its pandemic peak and the number of economically inactive stands 5.5 million higher (Chart I-3). Meanwhile, population growth is increasing the potential labour force. In combination, underemployment in the US labour market amounts to around 10 million people. Chart I-3...But The Numbers Of Permanent Unemployed And Inactive Remain Elevated ...But The Numbers Of Permanent Unemployed And Inactive Remain Elevated ...But The Numbers Of Permanent Unemployed And Inactive Remain Elevated To its credit, the Federal Reserve is acutely aware of this. Last week, Chair Jay Powell pointed out that: “We’re a long way from full employment, payroll jobs are 8.4 million below where they were in February of 2020…these were people who were working in February of 2020. They clearly want to work. So those people, they’re going to need help” Implicit is the Fed’s belief that the massive slack in the US labour market will keep structural inflation depressed. And that the coming increases in inflation will be short-lived. Travel And Hospitality Cannot Move The Inflation Needle Some people argue that pent-up demand for things that we couldn’t do under social restrictions – such as travel and eat out – will unleash a major inflation. The flaw in this argument is that these things account for a tiny part of the inflation basket. For example, airfares are weighted at a negligible 0.6 percent in the US consumer price index (CPI). Eating out at (full service) restaurants is weighted at just 3 percent. So, even if these prices were to surge, they would barely move the overall inflation needle. By far the biggest component in US inflation is rent of shelter, weighted at 33 percent in the CPI and 42 percent in the core CPI. By far the biggest component in US inflation is rent of shelter, weighted at 33 percent in the CPI and 42 percent in the core CPI. The lion’s share of rent of shelter is so-called ‘owner-equivalent rent’, weighted at 24 percent in the CPI and 30 percent in the core CPI.1  Owner-equivalent rent is the hypothetical cost that homeowners incur to consume their own home, obtained by surveying a sample of homeowners. In the US, this hypothetical cost tracks actual rents. So, we can say that the biggest driver of US inflation is rent inflation (Chart I-4). Chart I-4Owner-Equivalent Rent Inflation Tracks Actual Rent Inflation Owner-Equivalent Rent Inflation Tracks Actual Rent Inflation Owner-Equivalent Rent Inflation Tracks Actual Rent Inflation Rent inflation has consistently outperformed the rest of the inflation basket. Hence, to get overall inflation to a persistent 2 percent, rent inflation must get to 3 percent and stay there – meaning a persistent 1.5 percent higher than it is now (Chart I-5). Chart I-5Core Inflation At 2 Percent Requires Rent Inflation At 3 Percent Core Inflation At 2 Percent Requires Rent Inflation At 3 Percent Core Inflation At 2 Percent Requires Rent Inflation At 3 Percent What drives rent inflation? The answer is the permanent unemployment rate. This is because the ability to pay rent relies on the security of having a permanent job. Empirically, a one percent decline in the permanent unemployment rate lifts rent inflation by one percent (Chart I-6). Chart I-6A 1 Percent Decline In The Permanent Unemployment Rate Lifts Rent Inflation By 1 Percent A 1 Percent Decline In The Permanent Unemployment Rate Lifts Rent Inflation By 1 Percent A 1 Percent Decline In The Permanent Unemployment Rate Lifts Rent Inflation By 1 Percent Pulling this together, the US permanent unemployment rate needs to fall by about 1.5 percent for core inflation to reach the Fed’s target persistently. Put another way, most of the additional 2 million permanent unemployed need to find work. Yet history teaches us that this will take a long time. The Post-Pandemic Productivity Boom Will Be Disinflationary When an industry sheds millions of jobs in a recession, it tends to substitute that labour input permanently with a new productivity-boosting technology or strategy. For example, after the Great Depression the smaller craft-based auto producers shut down permanently, while those that had adopted labour-saving mass production survived. The result was a major restructuring of the auto productive structure. Another example was the ‘typing pool’, a ubiquitous feature of office life until the late 1990s. After the dot com bust, the wholesale roll-out of Microsoft Word wiped out these typing jobs. It takes years for excess labour to get fully absorbed into a post-recession economy. Hence, the flip side of a post-recession productivity boom is that displaced workers need to re-skill, or even change career – requiring a long time for the excess labour to get absorbed into the restructured economy. After the dot com bust, it took four years. After the global financial crisis, it took six years (Chart I-7). Chart I-7How Long Does It Take To Absorb The Permanent Unemployed? How Long Does It Take To Absorb The Permanent Unemployed? How Long Does It Take To Absorb The Permanent Unemployed? The post-pandemic experience will be no different. In fact, compared to a common-or-garden recession, the pandemic has accelerated wider-reaching changes to the way that we live, work, and interact. This means that it might take even longer for the economy to attain the central bank’s goal of ‘full employment.’ Again, to its credit, the Federal Reserve is acutely aware of this. As Jay Powell went on to say: “It’s going to be a different economy. We’ve been hearing a lot from companies looking at deploying better technology and perhaps fewer people, including in some of the services industries that have been employing a lot of people. It seems quite likely that a number of the people who had those service sector jobs will struggle to find the same job, and may need time to find work” In summary, elevated permanent unemployment will subdue rent inflation. And subdued rent inflation will constrain overall inflation once the current supply bottlenecks clear. On a long-term horizon, investors should own US T-bonds. Equity investors should fade the reflation trade, and rotate into the unloved defensive sectors such as healthcare, consumer staples, and personal products. These sector preferences imply an overweight to developed markets (DM) versus emerging markets (EM). US And European Inflation Will Converge US and European inflation rates are not measured on an apples-for-apples basis. European inflation excludes the largest component in the US inflation basket – owner-equivalent rent (OER). To repeat, OER is the hypothetical cost that homeowners incur to consume their own home. European statisticians do not like to include any hypothetical item in the inflation basket that does not have a market price. So, euro area inflation includes actual rents, but it excludes OER. On an apples-for-apples comparison, inflation rates in the US and the euro area have been near-identical for many years. This means that US core inflation has a 30 percent higher weighting to an item that has persistently inflated at well above 2 percent. If we strip out OER, then the core inflation rates in the US and the euro area have been near-identical for many years (Chart I-8).2 Chart I-8On An Apples-For-Apples Comparison, Inflation In The US And Euro Area Are Near-Identical On An Apples-For-Apples Comparison, Inflation In The US And Euro Area Are Near-Identical On An Apples-For-Apples Comparison, Inflation In The US And Euro Area Are Near-Identical Alternatively, what if we include OER in euro area inflation? Despite European rent controls, actual rents have persistently outperformed core inflation. Hence, OER would likely outperform by even more. We can infer that including OER would have lifted euro area inflation very close to US inflation (Chart I-9). Chart I-9Omitting Owner-Equivalent Rent Has Depressed Euro Area Inflation Omitting Owner-Equivalent Rent Has Depressed Euro Area Inflation Omitting Owner-Equivalent Rent Has Depressed Euro Area Inflation All of this may sound like a petty academic difference, but this petty academic difference has generated huge economic and political consequences. As OER has boosted inflation in the US versus Europe, US and euro area monetary policy have diverged much more than they should. Which means US and euro area bond yields have diverged much more than they should. Which has structurally weakened the euro. Which has spawned the near $200 billion trade surplus for the euro area versus the US. And all because of a petty academic difference! What happens next? If, as we expect, US shelter inflation remains depressed then the major difference between US and euro area inflation will vanish. Reinforcing this will be a catch-up in euro area growth as the delayed roll-out of vaccinations takes effect. On this basis, a stand-out opportunity on a 6+ month investment horizon is yield convergence between US T-bonds and German bunds. Overweight US T-bonds versus German bunds. Candidates For Countertrend Reversals Corn prices have surged on increased demand from China combined with supply shortages resulting from poor weather in Brazil. This has caused an odd divergence between corn and wheat prices, which is now susceptible to a sharp correction (Chart I-10). Chart I-10The Rally In Corn Versus Wheat Is Vulnerable To Reversal The Rally In Corn Versus Wheat Is Vulnerable To Reversal The Rally In Corn Versus Wheat Is Vulnerable To Reversal Likewise, timber prices have boomed on the back of increased housebuilding demand combined with supply bottlenecks. But as these bottlenecks clear and/or higher bond yields cool demand, the sector is vulnerable to an aggressive reversal given its fragile fractal structure (Chart I-11). Chart I-11Timber Prices Are Vulnerable To Reversal Timber Prices Are Vulnerable To Reversal Timber Prices Are Vulnerable To Reversal To play this, our first recommended trade is to short the Invesco Building and Construction ETF (PKB) versus the Healthcare SPDR (XLV), setting the profit target and symmetrical stop-loss at 15 percent (Chart I-12). Chart I-12Short Building And Construction (PKB) Versus Healthcare (XLV) Short Building And Construction (PKB) Versus Healthcare (XLV) Short Building And Construction (PKB) Versus Healthcare (XLV) Finally, within stock markets, the recent divergence of France versus Japan is highly unusual given that the two markets have near-identical sector compositions. This divergence has taken France versus Japan to the top of its multi-year trading range (Chart I-13). Chart I-13Short France Versus Japan Short France Versus Japan Short France Versus Japan Hence, our second recommended trade is to short France versus Japan (MSCI indexes), setting the profit target and symmetrical stop-loss at 4.8 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The PCE has broadly similar weights as the CPI. 2 We have approximated the removal of OER by removing the whole shelter component. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Global Reflation: Commodity prices have exploded higher of late, with surging global growth exacerbating demand/supply imbalances in important industrial commodities like copper and iron ore. These trends are likely to persist over the next 6-12 months, helping keep the inflation expectations component of global bond yields elevated. US Inflation Expectations: Longer-maturity US TIPS breakevens have climbed to the middle of the 2.3-2.5% range that we have long defined as consistent with the Fed’s 2% PCE inflation target. Additional increases in breakevens, fueled by further gains in commodity prices and a rapidly tightening US labor market, raise the risk that the Fed will be forced to shift to a less dovish policy stance sooner than expected. US TIPS: With the “easy money” having been made on US breakeven widening, we are booking profits on our long-held recommended overweight stance on US TIPS versus nominal US Treasuries. We now see a neutral allocation to TIPS as appropriate in the near term. Feature Chart of the WeekA True Global Reflation Trade A True Global Reflation Trade A True Global Reflation Trade Commodity prices have enjoyed a spectacular recovery from the COVID-induced lows of 2020. On a total return basis, the Goldman Sachs Commodity Indices (GSCI) for Industrial Metals, Energy and Agricultural are up a whopping 72%, 164% and 69%, respectively, from the 2020 lows. Surging commodities have been a major part of the global “reflation trade” over the past year, helping fuel spectacular bull markets in global risk assets like equities and corporate credit. The inflation expectations component of government bond yields has also climbed higher as part of the reflation trade. Our GDP-weighted average of major developed market 10-year breakeven rates from inflation-linked bonds now sits at 1.9%, a level last seen in 2014 (Chart of the Week). Nominal global bond yields have remained relatively subdued compared to the rapid increase in breakeven inflation rates, with markets discounting an extended period of negative real central bank policy rates in many countries. That fits with the current forward guidance of policymakers throughout the developed world, who continue to signal that policy rates will remain unchanged over at least the next two years. That guidance will begin to be challenged in the latter half of 2021, however, with policymakers forced to adjust their monetary settings as the COVID-19 pandemic approaches its end date. Already, the Bank of Canada has begun to taper the pace of its bond buying program, with economic growth, and house prices, surprising to upside in Canada. We expect the Fed to do the same by late 2021 or early 2022, as a US economy fueled by post-COVID reopening and big fiscal stimulus results in a smaller output gap and additional inflation pressures from more than just commodities. This shift will not represent a peak in US Treasury yields, but will mark a turning point where rising real yields, rather than higher inflation expectations, become the main driver of bond yields. Boom Times For Commodities Chart 2Commodities Boosting Headline Inflation Before Core Starts Catching UP Commodities Boosting Headline Inflation Before Core Starts Catching UP Commodities Boosting Headline Inflation Before Core Starts Catching UP Surging commodity prices over the past year have helped lift realized inflation rates in most countries, but have also widened the gap between headline and core inflation (Chart 2). This trend has been most visible in the US, where year-over-year headline consumer price index (CPI) inflation reached 2.6% in April but core (excluding food and energy) CPI inflation was only 1.6%. That gap was far more acute in the producer price index (PPI) data, with headline PPI inflation soaring to a 13-year high of 12.0% while core PPI inflation only reached 3.1%. That gap between headline and core inflation rates is a result of the nature of this particular commodity bull market, where the moves have been most extreme in the food and energy components excluded in the core inflation data. For the month of April alone (Chart 3), there were huge moves in food related commodities like corn (+24%), wheat (+18%) and sugar (+15%). Energy related commodities also had a big month, led by robust increases in oil (+10% for West Texas Intermediate) and gasoline (+6%). Chart 3Commodity Surge Accelerated Last Month From Reflation To Inflation From Reflation To Inflation Looking ahead, rapid above-trend economic growth over the next couple of years is likely to push core inflation rates higher. The IMF projects the output gap – which correlates most strongly with core inflation - for the advanced economies to be effectively closed by the end of 2022. This suggests that core inflation should drift higher over the next 12-18 months (Chart 2, bottom panel). This makes the outlook for commodity-driven inflation critical to the overall inflation outlook, as this could result in global headline inflation rates reaching levels not seen since before the 2008 financial crisis. To be sure, the current boom in commodities is different from anything seen over the past several years. Prices for key industrial commodities like copper and iron ore are close to the all-time highs reached during the “early Fed QE” days of 2010-2012 (Chart 4). Lumber prices have gone parabolic (up 5½ times from the 2020 low), as the pandemic-induced exodus to the suburbs has driven massive demand for new homes (and the wood needed to build them) at a time of limited lumber supply. Chart 4A Broad-Based Boom For Commodities A Broad-Based Boom For Commodities A Broad-Based Boom For Commodities Chart 5Demand Surge + Lean Inventories = Higher Prices Demand Surge + Lean Inventories = Higher Prices Demand Surge + Lean Inventories = Higher Prices That combination of surging demand and lean inventories is also evident in industrial metals like copper and aluminum. This has led to increasing levels of backwardation where spot prices rise much faster than futures prices – a sign of the tightness in physical commodity markets (Chart 5). Oil prices have also enjoyed a healthy rally, but still remain well south of the $100-120/bbl range seen during the 2010-2014 bull market. The oil market dynamics are different from some of the important industrial metals, as inventory levels remain relatively high (Chart 6). BCA Research’s Commodity & Energy Strategy service remains cyclically bullish on oil, forecasting a move to $76/bbl on the Brent oil price by the end of 2022. Given the historical strong correlation between oil prices and breakeven rates from global inflation-linked bond (ILB) markets, further increases in energy prices would imply more potential upside for breakevens. However, in many ILB markets - including US TIPS - breakevens already are trading above levels implied by oil prices (more on that later). Looking ahead, the broad-based commodity rally can continue over the latter half of 2021, as accelerating global growth leads to demand for commodities exceeding supply. Many commodity market commentators have even suggested that this move is the start of a new commodity “supercycle” or a multi-year period of rising prices. For that to happen, one of both of two things would need to take place: a) A steady surge of commodity demand that consistently exceeds supply China has been the dominant consumer of industrial commodities, accounting for nearly 60% of global consumption of copper and aluminum and 14% of global oil demand (Chart 7). Thus, it is nearly impossible to have a true commodities supercycle without robust Chinese demand. Chart 6As Oil Works Off Inventory Overhang, Prices Will Rise As Oil Works Off Inventory Overhang, Prices Will Rise As Oil Works Off Inventory Overhang, Prices Will Rise Chart 7China Remains Critical For Commodities China Remains Critical For Commodities China Remains Critical For Commodities Chart 8Diminished Chinese Stimulus A Potential Headwind For Commodities Diminished Chinese Stimulus A Potential Headwind For Commodities Diminished Chinese Stimulus A Potential Headwind For Commodities The IMF projects Chinese real GDP growth to expand from 2.3% in 2020 to 8.4% in 2021 before slowing back to 5.6% in 2022. That deceleration next year is in response to Chinese policymakers reining in the monetary and fiscal stimulus initiated in 2020 to fight the shock of the pandemic. Our measure of the combined credit and fiscal impulse in China – a reliable leading directional indicator of the growth in commodity indices like the CRB index – has already slowed sharply so far in 2021, suggesting reduced stimulus (Chart 8). It is possible that other sources of demand, like “green” investment or the global shift towards electric vehicles, could eventually increase to help offset the reduced pace of Chinese growth and commodity consumption for certain commodities like copper (electric cars use nearly four times as much copper as a car powered by a typical internal combustion engine). Given the sheer size of China’s footprint in global commodity markets, it is unlikely that other sources of commodity demand can accelerate fast enough to meaningfully offset slowing Chinese growth over at least the next 12-18 months. Chart 9Another Big Boost To Commodities From USD Weakness Is Unlikely Another Big Boost To Commodities From USD Weakness Is Unlikely Another Big Boost To Commodities From USD Weakness Is Unlikely b) A sustained depreciation of the US dollar Commodity prices are priced in US dollars, thus periods of commodity price strength often coincide with dollar bear markets. The greenback continues to be pulled in opposing directions by dollar-negative interest rate differentials and dollar-positive growth differentials versus other major developed economies (Chart 9). Those trends are starting to shift at the margin, but in a way that is unclear for the dollar’s future direction. Interest rate differentials have already turned more positive as US bond yields have increased since late 2020 at a faster pace than seen in other countries. This is positive for the dollar, on the margin. At the same time, the recent surge in non-US manufacturing PMIs relative to the US (bottom panel) suggests that growth is starting to catch up somewhat to the rapid pace of US growth as major economies like the UK and Germany begin to loosen pandemic economic restrictions. This is negative for the dollar, on the margin. Looking ahead, our expectation that the Fed will shift its forward guidance on future tapering of asset purchases and interest rate hikes in a less dovish direction later this year raises the risk that the dollar could find a cyclical bottom. As the Fed embarks on the slow path towards withdrawing its pandemic monetary stimulus measures over the next few years, it is highly unlikely that the dollar will weaken enough (if at all) and support a new commodity supercycle. Even without a new supercycle, the cyclical backdrop should remain supportive for more commodity price upside over at least the next six months. Beyond that, the impacts of China credit tightening and Fed tapering will likely lead to some slowing of the relentless upward march of commodity prices … and inflation expectations. Bottom Line: Commodity prices have exploded higher of late, with surging global growth exacerbating demand/supply imbalances in important industrial commodities like copper and iron ore. This is helping fuel a rise in realized inflation rates in many countries like the US, while also keeping global bond yields elevated through rising inflation expectations. These trends are likely to persist over the latter half of 2021, before running into policy headwinds from China and the US. Introducing Our New Comprehensive Breakeven Indicators Inflation breakevens on global ILBs have come a long way from the dark, depressed, disinflationary days during the 2020 COVID recession, fueled by accelerating economic growth and surging commodity prices. 10-year US TIPS breakevens have risen from a low of 0.6% in March 2020 to 2.4% today. German 10-year breakevens have seen a solid increase as well, from 0.2% in March 2020 to 1.4% today. How can we determine how much more upside exists for these moves? To help do this, we have constructed a new measure to assess the scope for future moves in ILB breakevens for the major developed economy ILB markets, which we have dubbed the Comprehensive Breakeven Indicator (CBI). For each country, the CBI consists of the following: The residual from our fair value model for 10-year inflation breakevens The gap between realized headline inflation and the central bank inflation target The gap between 10-year breakevens and survey-based inflation expectations We standardize all three of these variables and add them to form the CBI. The CBI should be interpreted as the “potential strength” of a trend in breakevens. For example, if breakevens are below the model-implied fair value or survey-based measures of inflation, of if actual inflation is below a central bank target, that suggests that there is room for inflation expectations to move higher. To the extent that any of those gaps become closed, this limits how much further breakevens can increase. The residuals from our fair value models are obviously a direct indication of the value of breakevens. The gap between breakevens and survey-based inflation expectations is an indication of the “inflation risk premium” embedded in breakevens and is, thus, also a measure of valuation (assuming survey-based measures represent something closer to the “true” level of inflation expectations among economic agents in any country). The third input into the CBI is not a valuation gauge, but a signal for future monetary policy changes that can impact breakevens. Once actual inflation rises to, or above, central bank targets, this raises the risk of tighter monetary policy that will act to slow economic growth and, eventually, lower inflation expectations. We present the CBIs for the eight countries where we have fair value breakeven models in Chart 10 and Chart 11. We show the CBIs in the top panel of the chart and the standardized inputs into the CBIs in the bottom three panels. We’ve grouped the countries such that those with the highest CBIs (the US, Canada, the UK and Australia) are in Chart 10 while those with the lower CBIs (Germany, France, Italy and Japan) are in Chart 11. Chart 10Less Upside Potential For Breakevens In This Group Less Upside Potential For Breakevens In This Group Less Upside Potential For Breakevens In This Group Chart 11More Upside Potential For Breakevens In This Group More Upside Potential For Breakevens In This Group More Upside Potential For Breakevens In This Group Chart 12European Breakevens Still Offer Some Value From Reflation To Inflation From Reflation To Inflation It is clear from the charts that the countries with the higher CBIs have seen a significant convergence of breakevens to survey-based inflation expectations. This can be interpreted as a reduction of the “disinflation risk premium” in ILB breakevens. Convergence of actual inflation to central bank targets has also boosted the CBI for the US, Canada, Germany and France.1 Looking purely at a snapshot of the latest CBIs, it is clear that euro area breakevens have more potential to rise compared to breakevens in the US, Australia and Canada (Chart 12). We find that the CBIs also correlate well with market expectations of future central bank interest rate moves. We plot the latest reading from the CBIs versus our 24-month central bank discounters, which measure the amount of interest rate hikes or cuts over the next two years priced in overnight index swap curves, in Chart 13. The correlation between the CBIs and discounters is robust, which is sensible as rising inflation – both realized and expected – will lead markets to expect tighter monetary policy in the future. Chart 13Our New Comprehensive Breakeven Indicator Correlates Well With Interest Rate Expectations From Reflation To Inflation From Reflation To Inflation The CBIs suggest that, from a country allocation perspective, bond investors should be reducing exposure to ILBs in the US, UK, Australia and Canada while increasing exposure to ILBs in the euro area and Japan. We already have those views reflected in our strategic investment recommendations, and our model bond portfolio, with two exceptions: Japan, where inflation remains too weak to expect any meaningful increase in breakevens; and the US, where we have had a long-standing overweight to US TIPS that now looks to have significantly less upside. US TIPS: Downgrade To Neutral With regards to our overweight recommendation on US TIPS versus nominal US Treasuries, we have always viewed the 2.3-2.5% range on longer-maturity breakevens as levels consistent with the Fed’s 2% inflation target on headline PCE inflation. With the 10-year TIPS breakeven now at 2.4%, and the 5-year/5-year forward breakeven at 2.3%, our target has been reached (Chart 14). Chart 14US TIPS Breakevens Are Now Consistent With The Fed's Inflation Target US TIPS Breakevens Are Now Consistent With The Fed's Inflation Target US TIPS Breakevens Are Now Consistent With The Fed's Inflation Target Chart 15Downgrade US TIPS To Neutral Downgrade US TIPS To Neutral Downgrade US TIPS To Neutral The Fed has actively been seeking to lift TIPS breakevens as part of its reflationary policies designed to combat the pandemic. Now, with US growth accelerating and realized inflation gaining significant upside momentum, any additional increases in breakevens are more likely to force the Fed to signal a policy shift in a less dovish direction. This is our expectation for the latter half of 2021, where we see the Fed beginning to signal a taper of its asset purchases starting in early 2022. Therefore, combining the signal from our new CBI for the US with actual inflation breakevens reaching our target range, we determine that an overweight stance on US TIPS is no longer appropriate. Thus, we are downgrading our formal strategic stance on TIPS to neutral (3 out of 5) from overweight. We are also removing our “non-benchmark” allocation to TIPS in our model bond portfolio on pages 14-15. The annual excess return for US TIPS appears to be peaking (Chart 15), further enhancing both the message from our US CBI and confirming that a move to a neutral allocation is appropriate. Bottom Line: With the “easy money” having been made on US breakeven widening, we are booking profits on our long-held recommended overweight stance on US TIPS versus nominal US Treasuries. We now see a neutral allocation to TIPS as appropriate in the near term. We are maintaining our overweight stance on euro area inflation-linked bonds, however, where breakevens are still undervalued and the ECB will stay dovish for longer.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Note that the series in the charts are standard deviations of the actual input series. So a positive reading does not mean that breakevens are above survey-based inflation expectations, for example, but that the gap between the two series is above its mean value. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index From Reflation To Inflation From Reflation To Inflation Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns