Fixed Income

Highlights Many investors remain overweight equities; BCA recommends a neutral stance. Investors should position portfolios for rising rates. Fed Chair Powell weighed in last week on yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. More evidence of trade policy-related uncertainty, rising labor costs and deteriorating margins in the latest Beige Book. Feature The S&P 500 finished the week little changed, as investors braced for a wave of Q2 earnings reports this week and next. The S&P financials sector, which tends to lead the overall market, rose more than 1% last week, as the banks reported healthy Q2 results. The dollar sold off late last week after President Trump grumbled about the Fed's rate policy. BCA's view is that Fed Chair Powell will ignore Trump's comments on monetary policy and adhere to the central bank's mandate of low and stable inflation and full employment. Gold fell 1% on the week. BCA recommends monitoring the price of gold for clues about the neutral rate of interest. Fed Chair Powell's semiannual policy testimony to Congress dominated the headlines last week. Powell discussed trade policy, the yield curve, the neutral rate and financial stability. The week's economic data was robust, suggesting that Q2 GDP will be well above the Fed's view of potential GDP. Housing starts were soft in June, but the weakness was due to supply issues, not tepid demand. Widespread supply constraints were prevalent in the Fed's latest Beige Book. The strong economic data, along with a 23-year high in the number of inflation words in the Beige Book pushed the 10-year Treasury yield up 6 bps to 2.88%. BCA's U.S. Bond Strategy team notes that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%. In late June, BCA downgraded its 12-month recommendation on global equities and credit from overweight to neutral. We still expect that the U.S. stock-to-bond ratio will grind higher in the next year, as U.S. stocks move sideways and Treasury yields climb. We recommend that investors put proceeds from the sale of equity positions into cash. Not all investors are being risk averse. The National Association of Active Investment Managers (NAAIM) says that active managers have increased their equity risk tolerance since the start of the year (Chart 1). At 89%, the average exposure of institutional investors is close to the cycle high reached in March 2017, which was the greatest since the S&P 500 zenith in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated (Chart 2). Moreover, the asset allocation survey from AAII shows that investors' allocation to equites (at 69% in June) are in line with the 2007 market top (Chart 3). However, equity holdings based on this survey were higher before the peak in equity prices in 2000. Moreover, consumers' expectations for stock price returns in the next 12 months remain close to cycle highs (U of Michigan) and near 24-year extremes based on the Conference Board surveys (Chart 4). Despite the optimism, individual sentiment toward equities remains muted in some surveys (Chart 4, panel 3). Chart 1Active Managers Have Increased Equity Exposure This Year Active Managers Have Increased Equity Exposure This Year Active Managers Have Increased Equity Exposure This Year Chart 2Equity Speculation##BR##Is Elevated Equity Speculation Is Elevated Equity Speculation Is Elevated Chart 3Equity Allocations##BR##On The Rise... Equity Allocations On The Rise... Equity Allocations On The Rise... Chart 4Households Expect Higher Stock##BR##Prices In The Next 12 Months Households Expect Higher Stock Prices In The Next 12 Months Households Expect Higher Stock Prices In The Next 12 Months Individuals, banks and other financial institutions hold more equities today than at the height in 2007. However, insurance companies and pension funds' holdings of equites are not as elevated as they were in 2007 (Table 1). Somewhat surprisingly, households' cash positions are below the 2007 level and at a cycle low. However, the cash positions of financial institutions are four times as large as in 2007, partly due to the Fed's vigilance on financial stability. Pension funds and insurance companies have roughly the same allocation to cash today as earlier in the cycle (2012) and in 2007, just before the financial crisis. Table 1Asset Allocation: Comparison With Early 1990s Powell Tells All Powell Tells All Bottom Line: BCA's view is that the risk/reward balance for holding equities is much less attractive than it was at the start of the bull market in 2009. The economy is in the late stages of an expansion and is running beyond full employment. The Fed is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (not shown). The good news is already priced into the equity market. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early in 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily moving our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months. This shift would also be favored if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. 10-Year Treasuries: An Update BCA's U.S. Bond Strategy service recommends that investors remain below benchmark in duration. However, at 2.84%, the 10-year Treasury yield is 27 bps below its 2018 zenith of 3.11%, which was reached in mid-May. Chart 5 shows that the drop in yields since that time reflects both slower economic growth prospects and weaker inflation. Investors are concerned about the impact of Trump's trade policies on global growth and those fears have been stoked by the recent run of poor economic data in the U.S. Oil prices and inflation breakevens moved up in tandem earlier this year, and both are currently rolling over (not shown). U.S. inflation is back to the Fed's 2% target and the central bank remains on course to raise rates two more times in 2018 and another four times next year. The market is pricing in only three more hikes in the next 18 months. The economy is at full employment. Moreover, at 3.6%, the average of the New York Fed and Atlanta Fed's Nowcasts for Q2 GDP growth implies that the GDP expanded well above the Fed's projection of potential GDP (1.8%) in the first half of the year (Chart 6). Moreover, the lagged effect of easier financial conditions suggests that GDP growth in the second half of the year will also be far above potential (Chart 7). Chart 5Inflation Breakevens##BR##Rolling Over Again Inflation Breakevens Rolling Over Again Inflation Breakevens Rolling Over Again Chart 6U.S. Economy Poised For Above##BR##Potential Growth in 2018 U.S. Economy Poised For Above Potential Growth in 2018 U.S. Economy Poised For Above Potential Growth in 2018 Inflation breakevens (Chart 5) are falling again despite mounting inflation pressures. The New York Fed's Underlying Inflation Gauge (Chart 8, panel 4) climbed to 3.33% in June, its highest point since 2005. Moreover, wage inflation is trending up and the economy is beset with shortages and constraints.1 Chart 7Lagged Effect Of Easier Financial##BR##Conditions Will Boost Growth Lagged Effect Of Easier Financial Conditions Will Boost Growth Lagged Effect Of Easier Financial Conditions Will Boost Growth Chart 8Inflation Is##BR##Accelerating Inflation Is Accelerating Inflation Is Accelerating Bottom Line: Investors should position their portfolios for escalating rates. Global growth should bottom in the second half of the year and the U.S. economic activity reports will begin to outpace lower expectations. Moreover, with inflation at the Fed's target and mounting, inflation breakevens will adjust upward. BCA's position is that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current forward rates.2 Leading The Way S&P Financials provide a long lead time for market peaks. Table 2 shows that since the mid-1970s, a peak in the Financials sector relative to the S&P 500 occurs an average of 16 months before a peak in the overall index. The Bank (Industry Group) sector provides a similar warning (18 months), while the Investment Banking index's relative performance peaks 20 months before the S&P 500 tops out (Chart 9). Note that the leads times are slightly shorter in the last 15 years than in the 1976-2000 period (Table 2). Table 2Financial Stocks' Relative Performance Provides Early Warning Of Market Tops Powell Tells All Powell Tells All Chart 9Financials Lead The Broad Market Financials Lead The Broad Market Financials Lead The Broad Market In a recent report,3 BCA's U.S. Equity Strategy service noted that cyclicals and interest rate-sensitive sectors, including financials, perform well when U.S. fiscal policy is loose and monetary policy is tight. Furthermore, our equity strategists found that rising rates boost top-line growth for banks, while the impact of fiscal stimulus via lower taxes should support business and consumer demand for capital. Moreover, our U.S. Equity Strategy team examined sector performance in late cycles, defined as the period between the peak in the ISM Manufacturing Index and the next recession.4 Financials outperform the S&P 500 in late-cycle environments; in the early stages (peak in the ISM's index to peak in the S&P 500) financials underperform the broad market, but they outperform after the peak in the S&P 500 and the next recession. Bottom Line: Our equity strategists recommend that investors remain overweight financials relative to the S&P 500. The late-cycle environment, along with the favorable regulatory climate, suggest that financials still have some room to run. The implication is that the peak in the overall U.S. equity market is still over a year away. Until then, the Fed will continue to remain vigilant on the financial sector and financial stability. Staying The Course At his semiannual Congressional testimony last week, Fed Chair Powell reaffirmed that the Fed will maintain its gradual pace of rate hikes. Following his presentation, Powell met with legislators and discussed the yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. Powell repeated his June statement that the yield curve can be considered an indicator of monetary stance. Like Powell, BCA's position is that a steep curve signals that policy is stimulative and short-term rates will need to climb. The opposite holds if the yield curve inverts. A flat yield curve indicates that the policy stance is neutral. The 2/10-year curve has flattened to about 25 bps. Our view is that if the curve inverts with a few more Fed rate hikes, it would suggest that the neutral rate is lower than what the Fed believes and policy is becoming restrictive. Furthermore, BCA's U.S. Bond Strategy team anticipates that curve flattening will occur as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations at a higher level. On tariffs, Powell stated that "in general, countries that have remained open to trade, that haven't erected barriers including tariffs, have grown faster. They've had higher incomes, higher productivity." He added that more and broader tariffs are bad for the economy. Furthermore, Powell said that the FOMC has not yet seen evidence that the trade uncertainty has affected wages, but he noted that the central bank is concerned that capital spending plans may be at risk. The latest Beige Book (see next section of this report) finds that the business community is increasingly apprehensive about trade policy. BCA's Geopolitical Strategy service anticipates that trade-related uncertainty will remain in place at least until the U.S. mid-term elections in November.5 BCA views financial stability as a third mandate for the central bank,6 along with low and stable inflation, and full employment. Powell stated last week that financial stability vulnerabilities were "moderate right now," but he remarked that "we keep our eye on that very carefully after our recent experience." Chart 10 presents several indicators that the FOMC uses to assess financial vulnerabilities. Powell acknowledged the prominent status of financial stability when asked about the Fed's role. The central bank's Monetary Policy Report,7 released on July 13, has an entire section dedicated to financial stability. Powell spoke about the shape of the yield curve, saying it can relay a message about longer run neutral interest rates. BCA also recommends monitoring the price of gold for clues about the neutral rate of interest. Chart 11 shows that when the Fed funds rate is above its neutral or equilibrium rate, the 2/10 curve is flat (panel 3). Moreover, gold tends to appreciate when the stance of monetary policy is more accommodative and then the metal depreciates when the stance becomes more restrictive (panel 4). The steep decline in the gold price between 2013 and 2016 preceded downward revisions to the Fed's estimate of the neutral rate. An upside price breakout would signal that we should bump up our estimate of the neutral rate. Conversely, a large decline in gold prices would imply that monetary policy is turning restrictive. Gold prices recently headed lower. Chart 10FOMC Is Closely Monitoring##BR##Financial Stability FOMC Is Closely Monitoring Financial Stability FOMC Is Closely Monitoring Financial Stability Chart 11The 2/10 Curve,##BR##Gold And The Neutral Rate The 2/10 Curve, Gold And The Neutral Rate The 2/10 Curve, Gold And The Neutral Rate Bottom Line: The Fed will continue with gradual rate hikes until it believes policy has returned to near neutral. The yield curve and gold will help to indicate when that point is reached. Widespread Chart 12Inflation Words At A 23 Year High Inflation Words At A 23 Year High Inflation Words At A 23 Year High The Beige Book released last week ahead of the FOMC's Jul 31-August 1 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in June and July. The Fed's business and banking contacts mentioned either tariffs (31) or trade policy (20) a total of 51 times, an increase from 34 in May and 44 in April. In March, as President Trump announced the first round of proposed tariffs, there were only three mentions of trade or tariff-related uncertainty. Moreover, uncertainty arose nine times in July (Chart 12, panel 4); all were related to trade policy. A recent study by the Federal Reserve Bank of St. Louis8 found that GDP per capita, wages and the investment-to-GDP ratio, all decline after tariffs are implemented (Chart 13). The study covered tariffs in 14 countries from 1980 through 2016. Importantly, the researchers noted that while the data showed that past tariff increases are followed by persistent decreases in economic activity, this evidence does not necessarily mean that higher tariffs triggered these changes. It is possible that other economic events may have driven tariff increases and ensuing recessions. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book, despite the recent rise in the greenback. The report also finds widespread concern about profit margins. Chart 12, panel 2 shows that at 81% in July, BCA's Beige Book Monitor ticked up from May's 67% reading. The July reading was the highest since early 2016. The recent low in November 2017 at 53% was when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book hit an 18 -year low in July. On the other hand, the number of strong words climbed in July to a 30-month high. The 2017 Tax Cut and Jobs Act was noted 5 times in the latest Beige Book, up from 3 in May, but still far below 15 mentions in March and 12 in April. The legislation was cast in a positive light in three of the five mentions. The implication is that most of the good news related to the tax bill has already been discounted by businesses. BCA's stance is that the dollar will move up modestly in 2018. The trade-weighted dollar has climbed by 6% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the handful of references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be a meaningful issue for corporate profits in Q2 2018. We will provide an update on Q2 S&P 500 earnings in next week's report. The dearth of recent dollar references is in sharp contrast with a flood of comments during 2015 and early 2016 (Chart 12, panel 3). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The disagreement on inflation between the Beige Book and the Fed's preferred price metric widened in July as the number of inflation words surged (Chart 12, panel 1). Mentions of inflation in July's Beige Book were the greatest since at least 1995. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that core PCE may still rise. Chart 13The Economic Consequences Of Trade Wars Powell Tells All Powell Tells All Moreover, July's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. Furthermore, several districts stated that a lack of workers was impeding growth. In addition, "widespread", which is part of BCA's inflation word count, was used 14 times in July to describe both labor shortages and swelling input costs, up from 11 times in May. We discussed the impact of escalating labor and input costs on margins in last week's report.9 The Beige Books released this year suggest that concerns about deteriorating margins is more prevalent in 2018 versus 2017. Only 57% of comments about margins in the first five Beige Books of 2017 noted deteriorating margins. In the 2018 Beige Books, 85% of references to margins indicated concern about higher labor, interest and raw materials costs. Bottom Line: July's Beige Book supports our stance that rising inflation pressures will result in at least two more Fed rate hikes by year-end and four next year. Moreover, the Beige Book confirms that labor shortages are restraining output of goods and services in some economic sectors. Furthermore, rising input costs are pervasive and will continue to pressure corporate profit margins. BCA expects both corporate profit growth and margins to peak later this year. The nation's tax policy still gets high marks from the business community, but the impact is fading. Ongoing uncertainty over trade policy will restrain growth. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Aailable at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Bond Bear Still Intact", published June 5, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Special Report "Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening", published April 16, 2018. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Special Report "Portfolio Positioning For A Late Cycle Surge", published May 22, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," published July 24, 2017. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf 8 https://research.stlouisfed.org/publications/economic-synopses/2018/04/18/what-happens-when-countries-increase-tariffs 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Available at usis.bcaresearch.com.

Highlights Chart 1Corporate Health: Improving Everywhere, ##br##Down In The U.S. Corporate Health: Improving Everywhere, Down In The U.S. Corporate Health: Improving Everywhere, Down In The U.S. Dollar bull markets are often accompanied by positive returns for the S&P 500. While a strong dollar hurts the earnings outlook for the S&P 500, it supports an expansion of multiples by putting downward pressure on rates and elongating the U.S. business cycle. The dollar and stocks are most positively correlated when the U.S. yield curve slope is between zero and 50-basis points, and flattening. Today's environment fits this bill. BCA is neutral on U.S. in a balanced portfolio. While the USD's strength should be associated with rising U.S. equity prices, the quality of U.S. stock returns is deteriorating. This warrants a certain degree of de-risking relative to our former overweight stance. Feature For the past two weeks, we have warned investors that the dollar rally was over-extended, and that a correction was likely to ensue. However, we also argued that this correction was likely to prove a countertrend move, and that the dollar was likely to end the year at higher levels. BCA has a neutral stance on equities on both a cyclical and tactical horizon. BCA is also neutral on U.S. equities within a global equity portfolio. For investors, it becomes important to understand whether a stronger dollar constitutes an additional downside risk for stocks. This is especially relevant in the U.S., where equity valuations are comparatively elevated, and where corporate health is deteriorating relative to the rest of the world (Chart 1). In this report, we built on the research of our colleague Anastasios Avgeriou, who spearheads BCA's U.S. Equity Sector Strategy service, who has shown that the dollar and the S&P often do rise in unison.1 Ultimately, while the dollar can have an impact on the relative performance of the U.S., it is generally not a strong determinant of the trend in the S&P 500. Strong Dollar And The S&P: Good Friends Indeed A picture is worth a thousand words. As Chart 2 illustrates, a strong dollar has never really been enough to slay a bull run in the S&P 500. Between late 1978 and early 1985, the real trade-weighted dollar rallied by 45%, yet the S&P 500 was able to advance by 102%. Between 1995 and 2002, the real trade-weighted dollar increased by 33% but rallied by nearly 92%. If one were to confine their observations to 1995 to August 2000 window, the dollar would have been up 16.5% and the S&P an outstanding 223%. Finally, from its most recent cyclical bottom in 2011 to the end of 2016, the trade-weighted dollar rallied by 22%, but the S&P 500 managed to rise by another impressive 68%. It is true that the magnitude of the strength of U.S. equities in the face of a strong dollar has decreased over time. This essentially reflects the fact that in the early 1980s, 20% of S&P 500 revenues were garnered outside the U.S. versus roughly 40% today, which in turn has increased the drag on earnings created by a stronger dollar. This problem is illustrated by the negative relationship present between the dollar and U.S. earnings revisions (Chart 3). Chart 2Strong Dollar, No Problem Strong Dollar, No Problem Strong Dollar, No Problem Chart 3Dollar Is Dangerous For The Earnings Outlook Dollar Is Dangerous For The Earnings Outlook Dollar Is Dangerous For The Earnings Outlook Yet, despite this negative link between earnings revisions and the dollar, the S&P can still rise when the dollar increases. What explains this seeming paradox? The answer is almost tautological: It is multiples. A strong dollar tends to be associated with a rising P/E ratio. This is because a strong dollar has a dampening impact on inflation. As a result, when the dollar rises, the Federal Reserve can keep interest rates lower than would otherwise be the case, fomenting periods of declining bond yields (Chart 4). Thanks to lower bond yields, not only do multiples get a boost, but additionally the domestically driven U.S. economic cycle also gets elongated. This further helps stocks in the process. Another more international dimension helps explain the positive correlation between stocks and the dollar. The dollar tends to experience its strongest rallies when U.S. growth is superior to that of the rest of the G-10. As Chart 5 illustrates, the bulk of the early 1980s dollar rally, of the late 1990s rally, and of the 2011 to early 2017 rally materialized when U.S. economic activity was outperforming. In all these instances, the relative strength of the U.S. economy attracted funds from abroad. This also meant that foreign funds flowing into the U.S. economy bolstered liquidity in the U.S. economy. Not only did this liquidity support economic activity, thereby counterbalancing the drag created by a stronger dollar, these funds also found their way into asset markets, generating higher multiples in the U.S. in the process. Chart 4Strong Dollar Hurts Yields Strong Dollar Hurts Yields Strong Dollar Hurts Yields Chart 5Growth Differentials Matter For The Dollar Growth Differentials Matter For The Dollar Growth Differentials Matter For The Dollar Bottom Line: A strong dollar in and of itself has never been enough to derail a bull market in the S&P 500. While a strong dollar creates a hurdle for foreign earnings accruing to U.S. firms, higher multiples often compensate for this negative. Essentially, a higher dollar causes downside to bond yields, warranting lower hurdle rates and higher valuations. Moreover, a stronger dollar diminishes inflationary pressures in the U.S., warranting easier Fed policy than would otherwise be the case. Since the U.S. economy is domestically driven, this elongates the business cycle, helping stocks in the process. Correlation And The Yield Curve Slope While a strong dollar does not seem to be a death threat for the equity market, are there environments when the dollar and the S&P 500 are more correlated than others? Table 1Dollar Versus S&P 500 Correlation: ##br##A Function Of The Yield Curve The S&P Doesn't Abhor A Strong Dollar The S&P Doesn't Abhor A Strong Dollar The answer to this question is yes. As Table 1 illustrates, the correlation between the dollar and the S&P 500 fluctuates significantly based on both the slope of the yield curve and whether the yield curve is flattening or not. Interestingly, when the yield curve is steep (defined as greater than a 50-basis-point spread between 10-year and 2-year Treasury yields), the dollar and U.S. stock prices tend to move in opposite directions. However, when the yield curve is flatter but before it has yet to invert (a yield curve slope of between zero and 50 basis points), the correlation between the dollar and the S&P 500 changes: it becomes positive. In fact, the time at which the correlation between stocks and the dollar is the highest is when the yield curve slope is in that zone and is also flattening. This is surprising, but at the same time it makes sense. We know that when the yield curve is flat but not inverted, the stock market tends to still rally (Chart 6). However, this flattening yield curve indicates that monetary conditions are not as accommodative as they once were. Interestingly, while the dollar performs poorly in the early innings of a monetary tightening campaign, it performs much better when monetary conditions are not so easy anymore that they juice up global growth, but they are not yet tight enough to cause an imminent recession in the U.S.2 This corresponds to a an environment with a flatter yield curve that has yet to invert, such as the one in place today. In light of these observations, the close correlation between the S&P 500 and the dollar in this environment should not be very surprising. Chart 6Flat And Flattening: No Problem For Stocks Flat And Flattening: No Problem For Stocks Flat And Flattening: No Problem For Stocks Bottom Line: The dollar and the stock market are not always positively correlated. However, when the U.S. yield curve slope stands between zero and 50 basis points and is flattening, the positive correlation between the S&P 500 and the dollar is at its strongest. This defines today's environment. Investment Implications BCA thinks the U.S. dollar has ample downside on a long-term basis. After all, the U.S. dollar trades at a significant premium to its PPP fair value, and this kind of overvaluation historically indicates significant downside for the greenback on a multi-year time horizon (Chart 7). Moreover, the Trump administration's fiscal policy is likely to result in a widening of both the fiscal and current account deficits. While a twin deficit rarely impacts the dollar negatively, so long as U.S. real rates rise relative to the rest of the world, it nonetheless often ends up being a harbinger of long-term weakness in the greenback.3 It is hard to make any inference for the S&P 500 based on a bearish long-term dollar view as historically, during a structural dollar bear market, the relationship between the greenback and the S&P has been rather ambiguous. However, BCA also thinks the 2018 dollar rally is not over. As Chart 8 shows, when U.S. rates are in the top of the distribution of interest rates among G-10 economies, the dollar tends to perform well. The U.S.'s status as the global high-yielder is currently unchallenged. This suggests the dollar has a natural advantage over other currencies through the remainder of the year. Chart 7Long-Term Downside For The Dollar... Long-Term Downside For The Dollar... Long-Term Downside For The Dollar... Chart 8...But 2018 Rally Is Not Over ...But 2018 Rally Is Not Over ...But 2018 Rally Is Not Over Moreover, as the U.S. economy is less exposed to the global industrial cycle than the rest of the world is, the U.S. dollar will benefit from the softening global economic environment. This is even truer, given that the U.S. economy was already set to outperform other G-10 economies even before the soft patch in global trade began. As a result, long-term flows into the U.S. are strong, which is generating a basic balance-of-payments surplus (Chart 9). American investors are not blind to this reality; the higher expected rate of returns on U.S. projects along with U.S. corporations bringing earnings back home to take advantage of the Trump tax cuts is generating outsized repatriation flows into the country, historically a good correlate of a strong dollar (Chart 10). This phenomenon is likely to remain alive through the remainder of the year. Chart 9Money Is Making Its Way Into The U.S. Money Is Making Its Way Into The U.S. Money Is Making Its Way Into The U.S. Chart 10Americans Like Their Dollar Americans Like Their Dollar Americans Like Their Dollar Since the U.S. yield curve slope currently stands between zero and 50 basis points while it is flattening in response to the Fed's interest rate hikes, we are in the part of the cycle where the dollar and stocks are positively correlated, and where they in fact often rise together. This suggests the S&P 500 has more upside ahead for the rest of the year as well. It is important to note that the tech sector is now the most at risk from the dollar strength as it has the largest percentage of foreign sales (Chart 11). However, BCA is neutral on stocks on a cyclical horizon. This is not because stocks will not be able to eke out some positive returns; it is because we are acutely aware that we stand close to the end of the bull market. Moreover, the end of an equity bull market is often marked by a pick-up in volatility. Accordingly, risk-adjusted returns for U.S. equities are declining. Hence, while an underweight stance on stocks is not yet warranted, a neutral stance is appropriate as we believe that it is better to be early and leave some money on the table than to be late.4 There remains a big risk that could cause the dollar to rally and stocks to fall, despite where we stand in the cycle: trade disputes. As Chart 12 illustrates, since May, tariff announcements and protectionist pronouncements have buoyed the dollar. However, the same announcements ultimately represent a real risk to profits as they create a real danger for global supply chains and imply higher cost of goods sold by U.S. corporations. Investors should monitor these risks closely. Chart 11S&P 500: Aggregate Sector International Revenue Exposure (%) The S&P Doesn't Abhor A Strong Dollar The S&P Doesn't Abhor A Strong Dollar Chart 12While Tariffs Can Help The Dollar, ##br##They Will Not Help Stocks While Tariffs Can Help The Dollar, They Will Not Help Stocks While Tariffs Can Help The Dollar, They Will Not Help Stocks Bottom Line: BCA anticipates the dollar to be able to rise over the course of the next six to nine months, as U.S. rates are in favor of the greenback and domestic growth outperformance will continue to favor inflows into the U.S. This bullish view on the U.S. dollar currently does not constitute a reason to downgrade stocks to underweight. In fact, at this stage of the cycle, U.S. stocks and the dollar tend to rise in unison. However, since the quality of the equity gains is likely to deteriorate as equity volatility is on an uptrend, BCA prefers to maintain a neutral cyclical stance on equities within a balanced portfolio rather than an overweight stance. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Sector Strategy Insight Report, titled "Can the S&P 500 Continue Rising Alongside the U.S. Dollar?", dated October 13, 2016, available at uses.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different," dated May 25 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card," dated February 23 2018, available at fes.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report, titled "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated June 28, 2018 available at bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low Term Premia Across Developed Markets Are Low Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Bond Yields Now Tend To Rise When Equity Prices Go Up Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Long-Term Inflation Expectations Have Remained Subdued For Over Two Decades Long-Term Inflation Expectations Have Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening From Quantitative Easing To Quantitative Tightening From Quantitative Easing To Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Developed Markets: Inflation Has Remained Low Despite Shrinking Output Gaps Developed Markets: Inflation Has Remained Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Inflation In The 1960s Took Off Once The Economy Began To Overheat Inflation In The 1960s Took Off Once The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets Chart 11Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets Chart 13Upside Risks To U.S. Inflation Upside Risks To U.S. Inflation Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Investors Are Too Complacent Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The real culprit for the mushrooming U.S./euro area trade imbalance is the ECB, and specifically its post-2014 experiment with ultra-loose monetary policy. There could be a major sea-change in ECB policy after November 2019 when Draghi's Presidency ends - just as there was after the last two changes in the ECB Presidency in November 2003 and November 2011. The yield spread between 30-year U.S. T-bonds and German bunds has much more scope to tighten than to widen. The euro's undervaluation - as calculated by the ECB itself - will ultimately correct. European exporters and equity markets heavily exposed to exporters - such as Sweden's OMX - will find the going tough, one way or another. If a stronger currency doesn't hit them, then President Trump surely will. Feature Chart of the WeekThe U.S./Euro Area Trade Imbalance Is A Near-Perfect Function Of Relative Monetary Policy The U.S./Euro Area Trade Imbalance Is A Near-Perfect Function Of Relative Monetary Policy The U.S./Euro Area Trade Imbalance Is A Near-Perfect Function Of Relative Monetary Policy Here in London last week President Trump trumpeted one of his biggest gripes: "The European Union treats the United States horribly. And that's going to change. And if it doesn't change, they're going to have to pay a very big price... Last year, we lost $151 billion with the European Union. We can't have that. We're not going to have that any longer, okay?" 1 President Trump is absolutely right about the size of the U.S. trade imbalance with Europe. But he is wrong to place the blame entirely on "trade barriers that are beyond belief". At least half of the imbalance - including with Germany - has appeared since 2014 (Chart I-2). Therefore, by definition, this part of the bilateral deficit is neither a structural issue, nor about trade barriers. Chart I-2Half of Germany's Export Surplus Appeared After 2014 ECB Policy Has Driven Up Germany's Export Surplus ECB Policy Has Driven Up Germany's Export Surplus The Real Culprit For The Mushrooming U.S/Euro Area Trade Imbalance As we have identified on these pages many times, the real culprit for the mushrooming U.S./euro area trade imbalance is the ECB, and specifically its post-2014 experiment with ultra-loose monetary policy. This experiment has resulted in a significantly undervalued euro, which has made the euro area grossly over-competitive vis-à-vis the United States, as calculated by the ECB itself. The Chart of the Week provides the damning and incontrovertible evidence: the U.S./euro area bilateral deficit is a near-perfect function of relative monetary policy. Of course, the ECB is targeting neither the euro nor the trade imbalance; the ECB is targeting its definition of price stability. The trouble is that the ECB definition of price stability omits owner-occupied housing costs, and thereby understates true euro area inflation by 0.5 per cent. To the extent that the ECB thinks in terms of real interest rates based on its own (faulty) definition of inflation, this means that the ECB is setting real interest rates that are far too low for the euro area's true economic fundamentals, resulting in the significantly undervalued euro and the associated trade imbalance (Chart I-3 and Chart I-4). Chart I-3Relative Monetary Policy Has Driven The Euro's Undervaluation... Relative Monetary Policy Has Driven The Euro's Undervaluation... Relative Monetary Policy Has Driven The Euro's Undervaluation... Chart I-4...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance ...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance ...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance The bilateral deficit, by definition, is based on a true cross-border comparison, so it is tracking the 'apples for apples' real interest rate differential almost tick for tick, as our charts compellingly show. This true real interest rate differential is stretched relative to the fundamentals. In effect, while incorrectly measured inflation is deceiving the ECB, the mushrooming trade imbalance tells us that something is seriously awry. That something is not trade barriers that are too high; that something is ECB monetary policy that is too loose. The Target2 Imbalance Reaches €1.5 Trillion The ECB's ultra-loose policy has spawned another huge distortion: the euro area Target2 banking imbalance, which now amounts to an unprecedented €1.5 trillion (Chart I-5). What is the Target2 imbalance (Box 1), and why should we care about it anyway? Chart I-5ECB Policy Has Lifted The Target2 Banking Imbalance To Euro 1.5 Trillion The EU's 'Horrible Treatment Of The U.S.' The EU's 'Horrible Treatment Of The U.S.' BOX 1 What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability vis-à-vis the ECB. Target2 balances therefore show the cumulative net payment flows within the euro area. The ECB has delegated its QE sovereign bond purchases to the respective national central banks within the Eurosystem. In the case of Italian bonds, Italian investors have offloaded their BTPs to the Bank of Italy and deposited the received cash cross-border in countries with healthier banking systems - like Germany. Strictly speaking, this flow of Italian investor cash to German banks is not the same as the deposit flight during the depths of the euro debt crisis in 2012. Rather, we might call it precautionary cash management. Nevertheless, in Eurosystem accounting terms it still means that the Bundesbank has a new liability to German banks denominated in 'German' euros, while the Bank of Italy has a new asset - the BTP - denominated in 'Italian' euros (Chart I-6 and Chart I-7). The Target2 imbalance is the aggregate of such mismatches between Eurosystem liabilities denominated in 'German and other core' euros and assets denominated in 'Italian and other periphery' euros. Chart I-6The Target2 Imbalance Reflects The##br## Cross-Border Flow Of Italian Investor Cash... The Target2 Imbalance Reflects The Cross-Border Flow Of Italian Investor Cash... The Target2 Imbalance Reflects The Cross-Border Flow Of Italian Investor Cash... Chart I-7...To German Banks ...To German Banks ...To German Banks Does any of this Target2 accounting gymnastics really matter? No, so long as a 'German' euro equals an 'Italian' euro, the imbalance is just an accounting identity within the Eurosystem. But if Germany and Italy started using different currencies, then suddenly all hell would break loose. The Bundesbank liability to German banks would be redenominated into deutschemarks, while the Bank of Italy asset would be redenominated into lira. Thereby the ECB would end up with much greater liabilities than assets, and a solvency shortfall potentially equivalent to hundreds of billions of euros would end up on the shoulders of the ECB's shareholders - largely, German taxpayers. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in recent election and referendum outcomes, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do a detailed cost benefit analysis. A Sea-Change For The ECB In 2019? Although the ECB is unlikely to broadcast the undesired side-effects of its ultra-loose policy, it must by now be acutely aware that it is spawning huge imbalances. The costs are rising while the benefits are becoming questionable. The irony is that the one euro area economy that arguably does need stimulus - Italy - has a dysfunctional banking system which makes ultra-loose monetary policy largely ineffective anyway. Despite record low interest rates through the past four years, Italian bank credit growth has been virtually non-existent (Chart I-8). As we pointed out last week in Monetarists Vs Keynesians: The 21st Century Battle, the M5S/Lega coalition government is right to say: Italy would be better off with fiscal stimulus, not monetary stimulus.2 Chart I-8Italian Banks Have Not Been Lending Italian Banks Have Not Been Lending Italian Banks Have Not Been Lending The ECB will end its QE purchases at the end of this year, though the central bank has promised to maintain its current constellation of negative and zero interest rates "at least through the summer of 2019". However, it might be problematic to extend this forward guidance much beyond that. This is because Mario Draghi's eight year term as ECB President ends on October 31 2019, and it would be difficult both politically and operationally to tie the steering hands of his successor, especially if he/she comes from outside the current Governing Council. Interestingly, the last two changes in the ECB Presidency marked major sea-changes in policy direction: in 2003, Jean-Claude Trichet immediately stopped the rate cutting of his predecessor, Wim Duisenberg; and in 2011, Mario Draghi immediately reversed the rate hikes of his predecessor, Trichet. We would not bet against another major sea-change at the end of 2019 (Chart I-9). Chart I-9A Sea-Change For The ECB In 2019? A Sea-Change For The ECB In 2019? A Sea-Change For The ECB In 2019? If the end of 2019 does mark a turning point in relative monetary policy, investors should plan for three medium-term repercussions: The yield spread between 30-year U.S. T-bonds and German bunds has much more scope to tighten than to widen. The euro's undervaluation - as calculated by the ECB itself - will ultimately correct. European exporters and European equity markets heavily exposed to exporters - such as Sweden's OMX - will find the going tough, one way or another. If a stronger currency doesn't hit them, then President Trump's vow that "they're going to have to pay a very big price" surely will (Chart I-10). Chart I-10If A Stronger Currency Doesn't Hit European Exporters, Then President Trump Surely Will! If A Stronger Currency Doesn't Hit European Exporters, Then President Trump Surely Will! If A Stronger Currency Doesn't Hit European Exporters, Then President Trump Surely Will! 1 At the joint press conference with Theresa May. 2 Please see the European Investment Strategy Special Report 'Monetarists Vs Keynesians: The 21st Century Battle' July 12 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to go long gold, whose 65-day fractal dimension is close to the lower bound that has reliably signaled previous tradeable trend reversals. Set a profit target of 3% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long Gold Long Gold * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate 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 Duration Checklist: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A below-benchmark overall portfolio duration stance is still warranted - even after our recent move to downgrade spread product exposure. Canada: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Feature Chart of the WeekStagflation Keeping Yields Afloat Stagflation Keeping Yields Afloat Stagflation Keeping Yields Afloat Developed market bond yields are lacking direction at the moment, pulled by competing forces. Overall global economic activity has lost some momentum and is now less synchronized. Yet the majority of major countries in the developed world are still growing at an above-potential pace that is keeping unemployment low and slowly boosting wages. This is helping underpin inflation, both realized and expected, while keeping government bond yields elevated despite increasing concerns about the future path of the global economy (Chart of the Week). The growing worries about a potential "U.S. versus the world" trade war are weighing on growth expectations, although not yet by enough to cause a meaningful pullback in global equity markets which remain supported by current solid earnings growth. Credit spreads have increased for both developed market corporate debt, but are still at historically narrow levels suggesting that investors are not overly concerned about default/downgrade risk. Emerging market (EM) debt has seen more significant spread widening in recent months, with a stronger U.S. dollar playing a large role there, but there has been little spillover from weaker EM markets into developed market credit valuations. We recently downgraded our recommended allocation to global corporate debt to neutral, while also upgrading our weighting on government bonds to neutral. Yet we maintained our below-benchmark overall duration stance, given our view that bond markets were still underpricing the potential for faster global inflation and tighter monetary policies given the persistent underlying strength of economic growth (especially in the U.S.). In light of that change in our view, an update of one of more reliable tools over the past eighteen months - our Duration Checklist - is timely. The Duration Checklist Is Still Bearish We have maintained our strategic below-benchmark stance on duration exposure for some time now, dating back to January 2017. Shortly afterward, we introduced a list of indicators to monitor going forward to determine if that defensive duration posture on U.S. Treasuries and German Bunds was still justified.1 We called that list our "Duration Checklist", and it contains elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The Checklist is meant to be a purely objective read on the data and how it relates to the likely future path of bond yields. We last updated the Checklist back on January 30th of this year.2 The conclusion was that the underlying economic and inflation backdrop was still indicating more upside for yields on a 6-12 month horizon in both the U.S. and Europe. There was a risk, however, that the bond selloff could pause given heightened bullishness on risk assets and extremely oversold conditions in government bond markets. Since that last update of the Checklist, the 10-year U.S. Treasury yield is higher (2.86% vs. 2.72%) while the 10-year German Bund yield is lower (0.36% vs. 0.70%). Although yields in both markets did climb to even higher levels - 3.12% and 0.78%, respectively - in February and March before pulling back to current levels. As we update the Checklist once again this week, we see that the backdrop is still conducive to rising bond yields in the U.S. and Europe, but with differing risks compared to six months ago (Table 1). Note that the Checklist was designed to assess if we should maintain our duration tilt, thus we apply a checkmark ("check") to any indicator that points to potentially higher bond yields, and an "x" to any element that could signal a bond market rally. Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds The Trendless, Friendless Bond Market The Trendless, Friendless Bond Market Global growth momentum is decelerating. The OECD's global leading economic indicator (LEI) is in a clear downtrend, having fallen for five consecutive months (Chart 2). That weakening is broad based, as shown by the depressed level of our LEI diffusion index. The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has been falling sharply since March of this year and now sits at the lowest level since January 2012. The Citigroup Global Data Surprise index peaked at the beginning of 2018 and has fallen steadily to below zero, although it may be in the process of bottoming out. Meanwhile, our global credit impulse - a reliable leading indicator of global growth - has noticeably slowed. We are giving an "x" to all these elements of our Duration Checklist, indicating that the current "soft patch" of global growth represents a risk to the performance of our below-benchmark duration stance. U.S. growth remains solid, but Europe is cooling a bit. The U.S. economy is firing on all cylinders at the moment (Chart 3). The ISM manufacturing index is near 60, while both consumer and business confidence are above the mid-2000s peak of the previous business cycle. Corporate profits are growing around 20% and our models suggest that this trend can continue over the rest of 2018. All these indicators earn a "check" on the U.S. side of our Duration Checklist. Chart 2Global Growth Indicators Are##BR##No Longer Bond Bearish Global Growth Indicators Are No Longer Bond Bearish Global Growth Indicators Are No Longer Bond Bearish Chart 3U.S. Growth##BR##Remains Strong U.S. Growth Remains Strong U.S. Growth Remains Strong The growth story is mixed in the euro area, however (Chart 4). The manufacturing PMI has been steadily falling since February of this year, but still remains well above the 50 line indicating an expanding economy. Consumer and business confidence are both at cyclical highs, but the upward momentum has stalled. Corporate profits are growing at a robust pace, but our models suggest that earnings should slow over the remainder of this year. In our Duration Checklist, the momentum of the growth indicators is the relevant measure and not the level. So we are now placing an "x" on the manufacturing PMI, which is giving a clear signal on slowing growth, while maintaining a "check" next to confidence and profit growth but with a question mark given that both may be in the process of rolling over. Inflation pressures are strengthening on both sides of the Atlantic. Back in January, the inflation elements of the Checklist were providing the most mixed signals. That is no longer the case (Charts 5 & 6). Oil prices are accelerating in both U.S. dollar and euro terms, which suggests upside risks on headline inflation in the U.S. and euro area. Unemployment rates are now below the OECD estimates of full employment, and wage inflation is accelerating, in both regions. Thus, all the inflation components of our Duration Checklist earn a "check". Chart 4Is Euro Area Growth Peaking? Or Just Cooling? Is Euro Area Growth Peaking? Or Just Cooling? Is Euro Area Growth Peaking? Or Just Cooling? Chart 5U.S. Inflation Backdrop Is Bond Bearish U.S. Inflation Backdrop Is Bond Bearish U.S. Inflation Backdrop Is Bond Bearish Chart 6Euro Area Inflation Backdrop Is Bond Bearish Euro Area Inflation Backdrop Is Bond Bearish Euro Area Inflation Backdrop Is Bond Bearish Both the Fed and European Central Bank (ECB) are biased to tighten monetary policy. The Fed continues to signal that additional rate hikes are coming given the underlying strength of the U.S. economy and rising trend in U.S. inflation. The ECB has announced that it will taper its net new bond purchases to zero by year-end in its asset purchase program, and has provided forward guidance on the timing of a first rate hike in 2019. Both policies are credible given falling unemployment and rising core inflation rates in both the U.S. and euro area. Thus, we are keeping the "check" on both sides of the policy portion of the Checklist. Investor risk appetite has grown more cautious. This element of our Checklist was a potential headwind to our below-benchmark duration stance back in January, but is much less of an impediment to higher yields now (Charts 7 & 8). Chart 7U.S. Investor Risk Appetite##BR##Has Cooled Off A Bit U.S. Investor Risk Appetite Has Cooled Off A Bit U.S. Investor Risk Appetite Has Cooled Off A Bit Chart 8European Investor Risk Appetite##BR##Has Also Cooled Off European Investor Risk Appetite Has Also Cooled Off European Investor Risk Appetite Has Also Cooled Off The cyclical advances of both the S&P 500 and EuroStoxx 600 have stalled, and both indices are now back close to their 200-day moving averages, suggesting that equity markets are not overstretched (and, therefore, ripe for a correction that could drive down bond yields in a risk-off move). The VIX and VStoxx volatility indices remain at low levels, even after the spike that occurred in early February and the more modest volatility shock in the aftermath of the Italian election in May. This implies that investors still prefer owning risky assets over risk-free government bonds. These elements warrant a "check" on both sides of our Duration Checklist. Corporate bond spreads, however, have widened over the past few months, suggesting that investors are pricing in some increased uncertainty over future creditworthiness. While the overall level of spreads is still historically low, the rising trend justifies an "x" in our Checklist as a possible headwind to rising Treasury and Bund yields from waning investor risk appetite. Treasuries and Bunds are not as oversold compared to January, but large short positions remain an issue. The 10-year U.S. Treasury yield is now trading just above its 200-day moving average, while the deeply oversold price momentum seen earlier in the year has eased up a bit but remains negative (Chart 9). The combined signal is a neutral one but, in our Checklist framework, neither of these measures is stretched enough to suggest that yields cannot move higher. Thus, we are giving a weak "check" to both momentum elements on the U.S. side. There is still a large short position in 10-year Treasury futures according to the CFTC data, however, and this remains an impediment to higher Treasury yields - we are keeping the "x" for this piece of the Checklist. For Bunds, yields are now trading just below the 200-day moving average while price momentum has turned slightly positive (Chart 10). While neither indicator is stretched from an historical perspective, they are not sending a message that Bunds are oversold. Thus, we are giving a weak "check" to both technical elements on the European side of our Checklist (note that due to a lack of available data, we exclude investor positioning when evaluating the technical backdrop for Bunds). Chart 9USTs Not Oversold,##BR##But Large Short Positions Remain USTs Not Oversold, But Large Short Positions Remain USTs Not Oversold, But Large Short Positions Remain Chart 10Bund Technicals##BR##Are Neutral Bund Technicals Are Neutral Bund Technicals Are Neutral The majority of indicators in our Duration Checklist continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, we conclude that a continued below-benchmark duration stance is warranted for both markets. Not all of the news is bond bearish, however. The cooling of global growth indicators, the euro area manufacturing PMI, the widening of corporate credit spreads and the persistent short position in the Treasury market remain potential headwinds to a renewed period of rising bond yields. Yet without evidence that U.S. or European capacity constraints are loosening up, triggering a dovish shift from the Fed and ECB, the upward trend in inflation will prevent any meaningful decline in yields from current levels. Bottom Line: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A continued below-benchmark overall portfolio duration stance is warranted - even after our recent move to downgrade spread product exposure. Canada Delivers Another Rate Hike, With More To Follow Chart 11The BoC & The Fed: Follow The Leader The BoC & The Fed: Follow The Leader The BoC & The Fed: Follow The Leader The Bank of Canada (BoC) hiked its policy rate last week by 25bps to 1.5%, once again delivering a tightening in lagged response to U.S. rate increases over the past year. The hike was not a surprise, as the Canadian economy is operating at full capacity and core inflation is at the midpoint of the BoC's 1-3% target band. Overnight Index Swap (OIS) markets are now pricing that both the BoC and the Fed will raise rates by another 75bps over the next twelve months, and we see the potential for even more increases than that - even with the Canadian economy cooling from the very rapid growth seen last year (Chart 11). The current spread between 2-year government bond yields in the U.S. and Canada is the widest since 2008, which is weighing on the level of the Canadian dollar versus the greenback (3rd panel). The latter is helping to ease financial conditions in Canada (bottom panel), especially at a time when the country is benefitting from the positive terms of trade impact of strong oil prices. The loonie is also being impacted by worries about future U.S. trade policy. The Trump administration has already imposed tariffs on Canadian steel and aluminum exports and is demanding serious concessions in the renegotiation of the North American Free Trade Agreement (NAFTA). In their latest Monetary Policy Review (MPR) that was released after the BoC policy meeting last week, the central bank provided an estimate of the impact of the steel and aluminum tariffs that went into effect on June 1st. The conclusion was that the 25% tariff on U.S. imports of Canadian steel, and 10% levy on U.S. aluminum imports, would have little net impact on the Canadian economy once the Canadian response was factored in. The BoC concluded that the level of total real Canadian exports would be reduced by -0.6% by year-end, but that Canadian real imports would also decline by a similar amount as the Canadian government slapped its own tariffs on U.S. exports of steel, aluminum and various consumer products. This neutral view on U.S.-Canada trade tensions appeared throughout the BoC's updated economic forecasts, as its projections on the growth of Canadian exports, imports and U.S. real GDP growth (the critical driver of Canadian trade) were all increased from the previous MPR published in April. That may be an overly optimistic assessment of the potential impact of a trade dispute with the U.S. Yet the BoC did admit that it can only estimate the impact of tariffs once the precise details are known, thus it cannot adjust its forecasts based on what might happen in the NAFTA negotiations. The BoC can only base its forecasts on what they can observe now, which is that Canada's overall economy remains in decent shape, even though the composition of growth is shifting. The BoC's latest Business Outlook Survey indicates that Canadian firms continue to see robust demand and are facing increasing capacity constraints. This is boosting hiring plans and keeping capital spending intentions reasonably firm even with the uncertainties over NAFTA that is causing some firms to delay investment (Chart 12). The BoC is projecting that overall Canadian real GDP will only grow by 2% in 2018, even with a smaller contribution to growth from consumer spending and housing. The year-over-year rate of change in retail sales volumes has already dipped into negative territory and is now at the lowest since the end of 2009 (Chart 13). The BoC has attributed this to some slowing in interest-sensitive spending in response to tighter BoC monetary policy. At the same time, household debt growth has been slowing and house price inflation has plunged over the past year (although most of this decline occurred in the overheated Toronto market). The BoC is not concerned about the impact of its rate hikes on the interest burden for households, despite the high level of household debt, given the accelerating pace of wages and income growth. The BoC is likely happy to see a shift away from overheating consumption fueled by speculative increases in house prices, but there is a risk that additional rate hikes could finally trigger the long-awaited bursting of the Canadian housing bubble. Chart 12Canadian Businesses Are Optimistic,##BR##Even With Trade Worries Canadian Businesses Are Optimistic, Even With Trade Worries Canadian Businesses Are Optimistic, Even With Trade Worries Chart 13Higher BoC Rates##BR##Do Have An Impact Higher BoC Rates Do Have An Impact Higher BoC Rates Do Have An Impact (On a related note - the topic of housing bubbles will be discussed at the upcoming BCA Investment Conference in Toronto on September 23-25 by Hilliard Macbeth of Richardson GMP, who has written several books on the topic of global asset bubbles and has some particularly strong views to share on Canadian housing.) Yet the BoC will have to take the risk that additional rate increases could cause a bigger shakeout in the Canadian housing market, given that Canadian inflation is trending higher. Headline CPI inflation is now above the midpoint of the BoC's 1-3% target band, while all the various measures of core inflation that the BoC monitors are hovering around 2% (Chart 14). The BoC estimates that the output gap in Canada is now closed, and that the tight labor market will continue to boost inflation. Chart 14Inflation On The Rise In Canada Inflation On The Rise In Canada Inflation On The Rise In Canada Chart 15Market Is Underpricing The BoC Market Is Underpricing The BoC Market Is Underpricing The BoC Already, the average hourly earnings measure of wage inflation is growing close to 4% on a year-over-year basis, although the BoC has noted in recent research that other measures of labor costs are not growing as fast.3 Nonetheless, with 10-year inflation expectations in the Canadian inflation-linked government bond market now trading just below the BoC's 2% target (bottom panel), and with a high number of Canadian businesses reporting increasing difficulties in sourcing quality labor, the inflationary message sent by the surging rate of average hourly earnings growth will likely prove to be correct. Even though the Canadian OIS curve is now discounting another 75bps of rate hikes over the next year, that would only take the BoC policy rate to 2.25% - still below the central bank's estimate of the neutral policy rate, which is between 2.5-3% (Chart 15). Given the likely need for the BoC to eventually move to a restrictive stance to cool off an overheating economy and keep inflation around the 2% target, we see more potential upside for Canadian bond yields, especially with very little increase currently priced in the forwards. Stay underweight Canada in hedged global bond portfolios. Bottom Line: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th, 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Some Thoughts On The Treasury-Bund Spread", dated January 30th, 2018, available at gfis.bcaresearch.com. 3 https://www.bankofcanada.ca/wp-content/uploads/2018/01/san2018-2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Trendless, Friendless Bond Market The Trendless, Friendless Bond Market Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Weakening global growth is unlikely to derail the Fed, which must also contend with mounting domestic inflationary pressures. Maintain below-benchmark portfolio duration and only a neutral allocation to spread product versus Treasuries. MBS & CMBS: Non-Agency CMBS offer attractive return potential, but remain too risky for the current environment. Agency MBS are unattractively valued but should remain insulated from negative shocks. Agency CMBS offer an alluring combination of risk and potential reward. Monetary Policy: The effective fed funds rate has been creeping toward the upper-end of the Fed's target band, signaling that bank reserves are becoming scarce. If the situation persists the Fed will be forced to cease the shrinking of its balance sheet. Feature Crosscurrents Two opposing forces are acting on financial markets at the moment and U.S. Treasury yields are caught in the middle. One the one hand, rising U.S. inflation and the gradual tightening of monetary policy are pressuring yields higher. But on the other hand, cyclical indicators point to a slowdown in global economic growth at a time when protectionist trade policies already have investors on edge. The end result is that U.S. Treasury yields are aimless, awaiting a catalyst that will push the prevailing winds in one direction or the other. On the domestic front, inflationary pressures are clearly mounting. The year-over-year core consumer price index rose to 2.23% in June while the New York Fed's Underlying Inflation Gauge moved up to 3.33%, its highest level since 2005 (Chart 1). The Fed's preferred core PCE deflator grew 1.96% during the 12 months ending in May, only a hair below the 2% target. Meanwhile, our Boom/Bust Indicator - a composite of global metals equities, commodity prices and U.S. unemployment insurance claims - has rolled over and investor expectations as measured by the Global ZEW survey have collapsed. Both indicators correlate strongly with long-maturity bond yields (Chart 2). Chart 1Inflation Picking Up Steam Inflation Picking Up Steam Inflation Picking Up Steam Chart 2Global Growth Slowdown Global Growth Slowdown Global Growth Slowdown The plunge in Global ZEW investor expectations is particularly interesting because the same survey shows that investors continue to describe current economic conditions as incredibly strong (Chart 3). Clearly, investors view the current state of global demand as constructive but are worried about threats to the global economy from trade barriers and the persistent removal of monetary accommodation. Oftentimes, negative readings from the Global ZEW expectations survey precede similar drops in the current conditions survey, such as prior to the 2008 and 2001 recessions. But other times, such as in 1998, the drop in expectations sends a false signal that is quickly unwound. Chart 3ZEW Expectations Vs. Current Conditions ZEW Expectations Vs. Current Conditions ZEW Expectations Vs. Current Conditions Only time will tell which outcome will occur, but we think global growth will slow further before finding a floor.1 The implication for U.S. bond portfolios is that investors should maintain only a neutral allocation to spread product versus Treasuries. Weakening foreign growth and the resultant upward pressure on the U.S. dollar will negatively impact corporate bond spreads, as will persistent Fed tightening. Investors should also maintain below-benchmark overall portfolio duration, as rising inflation will make it difficult for the Fed to pause its rate hike cycle for any significant length of time. Picking Up Yield In MBS And CMBS? The combination of weakening global growth and rising domestic inflation makes finding attractive U.S. fixed income plays difficult. This week we consider the risk/reward proposition in residential mortgage-backed securities (Agency only) and commercial mortgage-backed securities (both Agency and non-Agency). We conclude that non-Agency CMBS offer attractive return potential, but remain too risky for the current environment. Agency MBS are unattractively valued but should remain insulated from negative shocks. Agency CMBS offer an alluring combination of risk and potential reward. Chart 4 shows our excess return Bond Map, a good place to start when considering the risk/reward trade-off between the different spread sectors of the U.S. fixed income universe. The horizontal axis shows the number of months of average spread widening required for each sector to lose 100 bps versus an equivalent-duration position in Treasury securities. The vertical axis shows the number of months of average spread tightening required to earn 100 bps. Sectors plotting closer to the bottom-left are less likely to lose 100 bps, but are also less likely to gain 100 bps. Sectors plotting closer to the top-right are more likely to gain 100 bps, but are also more likely to lose 100 bps. In Chart 4 we use an interval from 2000-present to estimate monthly spread volatility. Since the Agency CMBS index only begins in 2014, it is excluded from this chart. Chart 4Excess Return Bond Map (Spread Volatility Estimated From 2000 - Present) The Fed's Balance Sheet Problem The Fed's Balance Sheet Problem The Bond Map shows that neither Agency MBS nor non-Agency CMBS offer an attractive risk/reward proposition. Non-Agency CMBS carry a similar risk of losses as the riskiest corporate bonds while offering less return potential. Agency MBS offer only slightly greater return potential than Consumer ABS, but with considerably more risk. Chart 5 shows the same Bond Map but using a post-2014 time interval to estimate monthly spread volatility. This allows us to include Agency CMBS. Chart 5 shows that Agency CMBS clearly dominate Agency MBS, offering similar reward with less risk. It also makes non-Agency CMBS look much more attractive, since spread volatility in the CMBS sector has been much lower in the post-2014 period. Chart 5Excess Return Bond Map (Spread Volatility Estimated From May 2014 - Present) The Fed's Balance Sheet Problem The Fed's Balance Sheet Problem Macro Environment Favors Residential MBS Despite the poor valuation picture painted by the Bond Map, the macro environment casts Agency MBS in a more favorable light. The two main factors that influence MBS spreads are residential mortgage lending standards and mortgage refinancing activity. Neither factor is likely to send MBS spreads wider during the next 6-12 months. Extension risk can also influence MBS spreads from time to time, but we have shown in prior research that the required yield increase is massive and unlikely to occur.2 The shaded regions in Chart 6 correspond to periods when banks are tightening lending standards on residential mortgage loans. We can see that lending standards tightened sharply during the financial crisis and have generally been easing since then. More important, however, is that the post-crisis easing in lending standards has been extremely modest. The median FICO score for new mortgage borrowers has barely come down, and remains well above pre-crisis levels (Chart 6, panel 3). The Urban Institute's Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is also extremely low (Chart 6, panel 4). In addition, the household debt-service ratio remains incredibly healthy (Chart 6, bottom panel). With such high borrower quality, banks are much more likely to ease lending standards going forward. Mortgage refinancing activity has also been very low, and this should continue to be the case for some time. A good predictor of refinancing activity is the percentage of the MBS index (by par value) that carries a coupon above the current mortgage rate (Chart 7). At present, only 5% of the index carries a coupon above the current 30-year mortgage rate of 4.53%. We calculate that even if the mortgage rate fell to below 4% the percentage of the MBS index with the incentive to refinance would only rise to 38%, still consistent with muted refi activity. Only a drop in the mortgage rate to below 3.5% would cause the refinanceable percentage to spike significantly, reaching 73%. Chart 6MBS: The Macro Environment MBS: The Macro Environment MBS: The Macro Environment Chart 7Refi Risk Is Non-Existant The Fed's Balance Sheet Problem The Fed's Balance Sheet Problem Or course, mortgage rates are much more likely to rise during the next 6-12 months as the Fed continues to tighten monetary policy. In other words, the risk that an increase in refi activity will drive MBS spreads wider is very low. All in all, valuation is not attractive in the Agency MBS sector, but the macro environment is favorable and should ensure that spreads remain tight on a 6-12 month horizon. We recommend a neutral allocation to Agency MBS, and could upgrade the sector further at the expense of corporate bonds as we approach the turn in the credit/default cycle. Fading Headwinds In CMBS? Chart 8CMBS: The Macro Environment CMBS: The Macro Environment CMBS: The Macro Environment Non-Agency Aaa-rated CMBS appear relatively unattractive in Chart 4 and somewhat attractive in Chart 5. The latter chart uses a post-2014 time interval to estimate monthly spread volatility and this period flatters the CMBS sector. The macro picture for the sector is also decidedly mixed. A typical negative environment for CMBS spreads is characterized by tightening bank lending standards on commercial real estate (CRE) loans, falling demand for CRE loans and decelerating CRE prices (Chart 8). CRE lending standards were tightening throughout 2016 and 2017, while demand remained reasonably strong and CRE prices decelerated. But CMBS spreads performed quite well during this period, taking cues from the rally in corporate bonds rather than the slightly negative message from CRE fundamentals. More recently, we are receiving very mixed signals from our CRE indicators. Lending standards are no longer tightening, but CRE prices continue to decelerate and demand is close to unchanged. It is possible that a renewed easing in lending standards will cause CRE prices to accelerate, but that is far from certain. Our U.S. Equity Strategy service recently flagged numerous risks in the CRE space, including the fact that occupancy rates have already begun to contract.3 A possible signal that demand is waning. While the return of CRE lending standards to "net easing" territory is a positive development, it remains to be seen whether the easing will help spur a rebound in CRE prices in the face of weakening demand. The uncertain macro picture and the unattractive valuation shown in Chart 4 cause us to maintain an underweight allocation to non-Agency CMBS. In contrast, we remain overweight Agency-backed CMBS based on the attractive risk/reward profile presented in Chart 5. A Note On Monetary Policy Operations While we maintain that the expected pace of Fed rate hikes is by far the most important monetary policy question for investors, some technical issues related to the implementation of monetary policy have come to light during the past few months that merit a mention. These issues will likely gain even more attention later this summer when they are discussed at the Jackson Hole Monetary Policy Symposium where the chosen theme is "Changing Market Structure and Implications for Monetary Policy". The main problem that has emerged during the past few months is that the effective fed funds rate has begun to creep toward the upper-end of the Fed's target channel (Chart 9). While the Fed currently targets a range of 1.75% to 2% for the effective fed funds rate, the rate itself currently sits at 1.91%, dangerously close to the top. Chart 9Is The Fed Losing Control? Is The Fed Losing Control? Is The Fed Losing Control? IOER Is A Treatment, Not A Cure The Fed tried to push the effective fed funds rate back toward the middle of its target range following the June FOMC meeting when it lifted the interest rate on excess reserves (IOER) by only 20 bps instead of 25 bps. Previously, the IOER had been set at the upper-bound of the Fed's target range, now it is 5 bps below. At best, this manipulation of IOER is a stop-gap measure that will not permanently solve the Fed's problem. This is because the Fed's problem is that the effective fed funds rate is rising because bank reserves are once again becoming scarce. The Fed currently controls interest rates using a "floor system". In order for such a system to work the Fed must ensure that the banking system is supplied with more bank reserves than it wants. The excess supply of bank reserves then pressures the effective funds rate lower, toward a "floor" interest rate set by the Fed. The Fed currently uses two different interest rates to act as the "floor", the IOER and the overnight reverse repo rate (ON RRP).4 The problem is that if banks are not over-supplied with reserves then the floor is not binding and the fed funds rate could break above the Fed's target range. Several factors have conspired to drain reserves from the banking sector during the past few months. First and foremost is that the Fed is allowing the securities to run off its balance sheet. Table 1 shows a simplified version of the Fed's balance sheet as of July 5 and as of September 28 of last year, just before the Fed started to shrink its bond portfolio. The change in each balance sheet item between the two dates is also shown. Table 1A Simplified Federal Reserve Balance Sheet The Fed's Balance Sheet Problem The Fed's Balance Sheet Problem Changes in the Fed's securities holdings are the main driver of bank reserves, and Table 1 shows that the Fed has reduced its portfolio holdings by $156 billion since last September. This has drained $156 billion of reserves from the banking system. Reserves appear as a liability on the Fed's balance sheet, but as an asset on the banking sector's consolidated balance sheet. But Table 1 also shows that the U.S. Treasury's General Account at the Fed has increased by $170 billion since last September, draining bank reserves by the same amount. This occurred because the Treasury department has been rebuilding its cash holdings which had become very low due to repeated encounters with the debt ceiling. But this process is largely complete. The Treasury department was targeting a cash balance of $360 billion by the end of June and that target has essentially been met. Table 1 also shows that reverse repos declined significantly since September, offsetting some of the reserve drain from the run-off of the Fed's securities holdings and the increase in the Treasury's cash balance. As reserves become scarcer it becomes less necessary for banks to engage in reverse repos with the Fed, so reverse repo balances should continue to decline as long as the Fed is shrinking its securities holdings. There Is Only One Cure The key point is that if the Fed continues to shrink its balance sheet and drain reserves from the banking system, then at some point bank reserves will no longer be over-supplied and the Fed will lose control of interest rates if the situation is not rectified. What makes things particularly confusing is that nobody (including the Fed) is quite sure what level of bank reserves constitutes "scarcity" in the new post-crisis environment. Chart 10 shows that if the Fed's planned shrinking of its balance sheet continues un-interrupted then bank reserves will reach zero by March 2022. But under the stricter post-crisis regulatory regime, banks will desire reserve balances that far exceed what they demanded before the financial crisis. Unfortunately, the only way to find out at what point bank reserves become scarce is for the Fed to drain reserves from the system and wait for signs that interest rates are starting to rise above its target range. At that point, the Fed will be forced to stop shrinking its balance sheet in order to maintain control over interest rates. Based on the current behavior of the fed funds rate, we cannot rule out this situation arising within the next year. Some Notes On Treasury Operations Many have blamed sizeable T-bill issuance for the creep higher in the fed funds rate, and this is somewhat true. The Treasury department has been issuing T-bills in large amounts and parking the proceeds in its cash account at the Fed. As explained above, this has drained reserves from the banking system and put upward pressure on the effective fed funds rate. But the focus should be on the Treasury's cash balance and not T-bill issuance itself. This is important because going forward T-bill issuance will remain elevated. The Treasury must finance the increasing deficits mandated by Congress and has pledged to concentrate a large portion of this financing in bills. Specifically, the Treasury is targeting a range of 25% to 30% for the proportion of bills in the outstanding funding mix. At present, bills make up only 15% of the mix (Chart 11). But while bill issuance will stay strong, as long as the Treasury maintains its cash balance near current levels, then there will be no impact on bank reserves or the effective fed funds rate. Chart 10The Pace Of Balance Sheet Reduction The Pace Of Balance Sheet Reduction The Pace Of Balance Sheet Reduction Chart 11Gross T-Bill Issuance Gross T-Bill Issuance Gross T-Bill Issuance The Treasury department will also increase coupon issuance to finance the rising fiscal deficit (Chart 12), and has decided to do so by increasing issuance for every coupon but with a focus on the 2-year, 3-year and 5-year notes. Gross issuance in the 2-year and 3-year notes has already started to increase, and it will soon exceed 5-year and 7-year note issuance (Chart 13). Because so much of the Treasury's new issuance will be concentrated at the front-end of the curve (and in bills), it has dropped its prior stated goal of increasing the weighted-average maturity (WAM) of the funding mix. Its current policy states that "the WAM is just an outcome of an issuance strategy and not a goal in and of itself." Chart 12Gross Coupon Issuance Gross Coupon Issuance Gross Coupon Issuance Chart 13Gross Coupon Issuance By Maturity Gross Coupon Issuance By Maturity Gross Coupon Issuance By Maturity Bottom Line: The effective fed funds rate has been creeping toward the upper-end of the Fed's target band, signaling that bank reserves are becoming scarce. If the situation persists the Fed will be forced to cease the shrinking of its balance sheet. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "On The Move", dated February 13, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Equity Strategy Special Report, "UnReal Estate Opportunity", dated July 9, 2018, available at uses.bcaresearch.com 4 A detailed explanation of the floor system and its alternative "corridor system" can be found in U.S. Bond Strategy Special Report, "Cleaning Up After The 100-Year Flood", dated June 10, 2014, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Investors are too complacent about the risks of a trade war. Standard economic models understate the potential economic damage that a trade war could cause. Global equities would suffer mightily from a trade war. Deep cyclical sectors would be hardest hit. Financial equities would also fare poorly. Regionally, European and EM stock markets would underperform. A trade war would benefit Treasurys and other safe-haven government bonds. A contained trade war would likely be somewhat dollar-bearish. In contrast, a full-out war could send the greenback soaring. Feature From Phony War To Real War? After months of posturing, Trump's trade war is starting to heat up. The U.S. imposed tariffs of 25% on $34 billion of Chinese goods last Friday. Tariffs on another $16 billion of goods are set to go in effect on July 20th. China has stated that it will retaliate in kind. On Tuesday, Trump further upped the ante, announcing that he will levy a 10% tariff on an additional $200 billion of Chinese imports by August 31. He also threatened tariffs on another $300 billion on top of that if China still refuses to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than what China exported to the U.S. last year! China is not the only country in Trump's crosshairs. The Trump administration levied tariffs of up to 25% on steel and aluminum from the EU, Canada, Mexico, and other U.S. allies on June 1, 2018. The affected regions have retaliated with their own tariffs. As Marko Papic, BCA's chief geopolitical strategist, has repeatedly stressed, there is little reason to think that trade tensions will ease over the coming months. Protectionism is popular with the American public (Chart 1). Trump ran on a protectionist platform and now he is trying to fulfill his campaign promises. It does not help that Trump is accusing foreign governments of doing things they are not doing. Chart 2 shows that U.S. tariffs are actually higher than in most other G7 economies. As we have argued in the past, the U.S. runs a persistent current account deficit because it has a higher neutral real rate of interest - otherwise known as r-star - than most other countries.1 Standard interest rate parity equations imply that a country with a relatively high neutral rate will have an "overvalued" currency that is expected to weaken over time, whereas a country with a low neutral rate will have an "undervalued" currency that is expected to strengthen over time. Intuitively, this must happen because investors will only hold low-yielding bonds if they expect a currency to strengthen. The result is a current account deficit for countries with overvalued currencies such as the U.S., and a current account surplus for regions with undervalued currencies such as the euro area (Chart 3). Chart 1Free Trade Is Not In Vogue In The U.S. How To Trade A Trade War How To Trade A Trade War Chart 2Tariffs: Who Is Robbing The U.S.? How To Trade A Trade War How To Trade A Trade War Chart 3Interest Rates And Current Account Balances How To Trade A Trade War How To Trade A Trade War The Economic Costs Of A Trade War How much damage could a trade war do to the global economy? As it turns out, this is a surprisingly difficult question to answer. Standard economic theory offers little guidance on the matter. By definition, global exports are always equal to imports. In a conventional Keynesian model, countries with trade deficits would gain some demand from a trade war, while countries with surpluses would lose some demand. However, the contribution of net exports to global demand would always be zero. Granted, there would be some efficiency losses, but in the standard Ricardian model of comparative advantage, they would not be that large. As Box 1 explains, the deadweight loss from a tariff can be computed as one-half times the change in the tariff rate multiplied by the percentage-point decline in imports that results from the tariff. Suppose, for example, that a trade war leads to a 10% across-the-board increase in U.S. tariffs, which causes U.S. imports to fall by 30%.2 Given that imports are 15% of U.S. GDP, the resulting deadweight loss would be 0.5*0.1*0.3*15=0.225% of GDP. That's obviously not a lot. The True Cost Of A Trade War Is Likely To Be High Our sense is that the true cost of a trade war would be much greater than these simple models suggest. There are at least six reasons for this: Most simple models assume that labor and capital are completely fungible and that the economy is always at full employment. In practice, it is doubtful that workers could easily move to companies that would benefit from tariff protection from those that would suffer from retaliatory measures. Workers have specialized skills. Likewise, a piece of machinery that is useful in one sector of the economy may be completely useless in another. Industries are often concentrated in particular regions. As such, a trade war could severely degrade the value of the existing stock of human and physical capital. This would result in lower potential GDP. It would also result in temporarily higher unemployment as workers, laid off from firms which have been adversely affected by tariffs, are forced to scramble for a new job elsewhere. Comparative advantage is not the only source of trade gains. Arguably more important are economies of scope and scale. A firm that has access to a global market can spread fixed costs over a larger quantity of output, thus lowering average costs (and ultimately prices). The existence of large global markets also allows companies to offer niche products that might not be worthwhile to develop for smaller markets. Modern trade is dominated by the exchange of intermediate goods within complex supply chains (Chart 4). This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. U.S. firms are particularly vulnerable to supply-chain disruptions because the Trump administration has dotardly chosen to levy tariffs mainly on intermediate and capital goods (Chart 5). This stands in contrast to China and the EU, which have raised tariffs mainly on final goods in a politically strategic manner (agricultural products in Trump-supporting rural areas and Harley Davidson bikes, which are manufactured in Paul Ryan's home district in Wisconsin). Chart 4Trade In Intermediate Goods Dominates How To Trade A Trade War How To Trade A Trade War Chart 5The U.S. Is Not Very Smart In ##br## Implementing A Protectionist Agenda How To Trade A Trade War How To Trade A Trade War Uncertainty over the magnitude and duration of a trade war could cause companies to postpone new investment spending. A vast economic literature pioneered by Avinash Dixit and Robert Pindyck has shown that firms tend to defer capital expenditure decisions when faced with rising uncertainty.3 Furthermore, as I discussed in an academic paper which was published early on in my career, business investment is typically higher when firms have access to larger markets.4 Higher tariffs could lead to an implicit tightening in fiscal policy. If the U.S. raises tariffs by an average of ten percentage points across all imports, a reasonable estimate is that this would imply a tightening in fiscal policy by around 1% of GDP - enough to wipe out the entire stimulus from Trump's tax cuts. Of course, the tariff revenue could be injected back into the economy through more tax cuts or increased spending. However, given the possibility that gridlock will increase in Washington if the Republicans lose the House of Representatives in November, it is far from obvious that this would happen. A trade war would lead to lower equity prices and higher credit spreads. This would translate into tighter financial conditions. Historically, changes in financial conditions have been highly correlated with changes in real GDP growth (Chart 6). Changes in financial conditions have, in turn, led the stock market. The S&P 500 index has risen at an annualized pace of 10% since 1970 when BCA's Financial Conditions Index (FCI) was above its 250-day moving average, while gaining only 1.5% when the FCI was below its 250-day average (Chart 7). Given today's elevated valuations across many asset markets, the risk is that a trade war triggers a sizable correction in asset prices. Chart 6Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Chart 7The Link Between Financial Conditions ##br##And The Stock Market The Link Between Financial Conditions And The Stock Market The Link Between Financial Conditions And The Stock Market Protecting Your Equity Portfolio From A Trade War We think investors are understating the risks of a trade war. This, along with a host of other reasons, prompted us to downgrade global risk assets from overweight to neutral on June 20.5 As bad as a trade war would be for Main Street, it would be even worse for Wall Street. The mega- cap companies that comprise the S&P 500 have a lot more exposure to foreign markets and global supply chains than the broader U.S. economy. The "beta" of corporate profits to changes in GDP growth is also quite high (Chart 8). Chart 9 shows how U.S. equity sectors performed during days when the S&P 500 suffered notable losses due to heightened fears of protectionism. We identified seven separate days, including Wednesday's selloff, which was spurred by Trump's threat to impose tariffs on another $200 billion of Chinese imports. Chart 8Profits Are Much More Volatile Than GDP Profits Are Much More Volatile Than GDP Profits Are Much More Volatile Than GDP Chart 9This Is How Markets Trade When They Are Worrying About Trade Wars How To Trade A Trade War How To Trade A Trade War The chart shows that deep cyclical sectors such as industrials, materials, and energy fared badly during days of protectionist angst. Financials also underperformed, largely because such days saw a flattening of the yield curve. Tech, health care, and telecom performed broadly in line with the S&P 500. Consumer stocks outperformed the market, but still declined in absolute terms. Utilities and real estate were the only two sectors that saw absolute price gains. Considering that the sector composition of European and EM bourses tends to be more tilted towards cyclicals than the U.S., it is not surprising that the former have underperformed during days of increased protectionist worries. Bonds: Yields Likely To Rise, But A Trade War Is A Risk To That View In contrast to equities, a trade war would benefit Treasurys and other safe-haven government bonds. Admittedly, the imposition of tariffs would push up import prices. However, the effect on inflation would be temporary. Just as the Fed tends to disregard one-off increases in commodity prices, it will play down any transient boost to inflation stemming from a trade war. Instead, the Fed will focus on the growth impact, which is likely to be negative. To be clear, trade jitters are not the only thing affecting bond yields. Judging by numerous business surveys, the U.S. economy is starting to overheat (Chart 10). Last week's employment report does not alter this conclusion. While the unemployment rate rose by 0.2 percentage points, this was mainly because of a jump in the participation rate. Considering that the number of workers outside the labor force who want a job is near a record low, the ability of the economy to draw in additional workers is limited (Chart 11). Chart 10The U.S. Economy Is Overheating The U.S. Economy Is Overheating The U.S. Economy Is Overheating Chart 11A Small Pool Of People Want ##br##To Jump Into The Labor Market A Small Pool Of People Want To Jump Into The Labor Market A Small Pool Of People Want To Jump Into The Labor Market Historically, continuing unemployment claims have closely tracked the unemployment rate over time (Chart 12). The fact that continuing claims have dropped by 9% since the end of January, while the unemployment rate has dipped by only 0.1 percentage points, suggests that the unemployment rate will fall further over the coming months. On balance, we continue to maintain our bearish recommendation on Treasurys, but acknowledge that a trade war is a risk to that view. Trade Wars And Currencies Unlike safe-haven bonds, whose yields are likely to decline in proportion to the magnitude of the trade war, the impact on the dollar is more difficult to predict. On the one hand, a modest trade dispute is likely to be somewhat dollar bearish, inasmuch as it hurts U.S. growth and forces the Fed to slow the pace of rate hikes. Since most other major central banks are not in a position to cut rates, expected rate differentials between the U.S. and its trading partners would narrow. On the other hand, a severe trade war would probably be dollar bullish. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. still tend to attract capital inflows into the safe-haven Treasury market. The U.S. is a fairly closed economy, and hence would be relatively less affected by a breakdown in global trade. Commodities are also likely to suffer if trade flows decline (Chart 13). Lower commodity prices tend to be bullish for the greenback. Moreover, as we discussed in our latest Strategy Outlook, a tit-for-tat trade war with China could force the Chinese government to devalue the yuan. That would have a knock-on effect on other emerging market currencies. Chart 12Unemployment Can Fall Further Unemployment Can Fall Further Unemployment Can Fall Further Chart 13Commodities Are A Potential Victim Of Trade War Commodities Are A Potential Victim Of Trade War Commodities Are A Potential Victim Of Trade War Notably, the greenback has fared better recently than it did earlier this year during days when protectionist rhetoric intensified. On Wednesday, the broad trade-weighted dollar gained 0.3% while the DXY picked up 0.6%. This supports our view that the dollar will strengthen over the remainder of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 2 This assumes an elasticity of import demand of 3, which is broadly consistent with most academic estimates. 3 Avinash K. Dixit, and Robert S. Pindyck, "Investment Under Uncertainty," Princeton University Press, (1994). 4 Peter Berezin, "Border Effects Within A Dynamic Equilibrium Trade Model," The International Trade Journal, 14:3 (2000), 235-282. 5 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. BOX 1 The Deadweight Loss From A Trade War Box Chart 1Tariffs Increase Budget Revenues, But Lead To A Bigger Loss In Consumer Surplus How To Trade A Trade War How To Trade A Trade War In the simplest models of international trade, an increase in tariffs leads to higher prices, resulting in a loss of consumer surplus. This is depicted by the blue region (ABCE) in Box Chart 1. The government collects revenue from the tariff shown by the red-colored rectangle (ABDE). The difference between the loss in consumer surplus and the gain in revenue - often referred to as the "deadweight loss" from a tariff - is depicted by the green-colored triangle (BCD). Arithmetically, the area of the triangle can be calculated as: Deadweight loss = 0.5 x Tariff x (Pre-tariff level of imports - Post-tariff level of imports) If one divides both sides by GDP, the formula reduces to: Deadweight loss/GDP = 0.5 x Tariff x Percentage Point Change In Import Share of GDP Resulting From Tariff There are many things in the real world that are not captured by this equation. For example, if the country that imposes the tariff is sufficiently large, this could push down the international price of the goods that it imports. The country would then benefit from an improvement in its terms of trade. As Robert Torrens showed back in the 19th century, if a country has any degree of market power (i.e., it is not a complete price-taker on international markets), there will always be a level of tariffs that makes it better off. The caveat is that this "optimal tariff" only exists if other countries do not retaliate. If everyone retaliates against everyone else, everyone will be worse off from a trade war. Moreover, as discussed in the main text, there are many factors that this simple model does not capture which could result in significant economic damage from raising tariffs even when retaliation does not take place, especially in cases where the tariffs are imposed on intermediate and capital goods. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Ryan Swift, Vice President U.S. Bond Strategy Highlights Chart 1Inflations Expectations Hard To Shake Inflations Expectations Hard To Shake Inflations Expectations Hard To Shake Low inflation expectations are proving difficult to shake. Year-over-year core PCE inflation moved to within 5 bps of the Fed's 2% target in May, but long-maturity TIPS breakeven inflation rates barely budged (Chart 1). Instead, breakevens are taking cues from commodity prices which are being held down by flagging global growth (bottom panel). The minutes from the June FOMC meeting revealed that "one participant" advocated postponing rate hikes in an attempt to re-anchor inflation expectations, but we do not expect the Fed to pursue this course. Instead, the Fed will continue to lift rates at a pace of 25 bps per quarter until a risk-off episode in financial markets prompts a delay, hoping that the incoming inflation data are strong enough to send TIPS breakevens higher in the meantime. Ultimately we think that strategy will be successful, but Fed hawkishness in the face of weakening global growth threatens the near-term performance of corporate credit. We recommend only a neutral allocation to spread product versus Treasuries, while maintaining a below-benchmark duration bias. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 60 basis points in June, dragging year-to-date excess returns down to -181 bps. Value is no longer stretched in the investment grade corporate bond market, though it is not attractive enough to compensate for being in the late stages of the credit cycle or for the looming collision between a hawkish Fed and decelerating global growth. These factors led us to reduce exposure to corporate bonds two weeks ago.1 With inflation running close to the Fed's 2% target and the 2/10 Treasury slope between 0 bps and 50 bps, our research shows that small positive excess returns are the best case scenario for corporate bonds. The likelihood that leverage will rise in the second half of this year is also a concern (Chart 2). Profit growth is only just keeping pace with debt growth and will soon have to contend with rising wage costs and the drag from recent dollar strength. The Fed's staunch hawkishness in the face of decelerating global growth is reminiscent of 2015. Then, the end result was a period of spread widening that culminated in the Fed pausing its rate hike cycle. In recent weeks we also explored how to position within the investment grade corporate bond sector, considering both the maturity spectrum and the different credit tiers.2 We concluded that in the current environment investors should favor long maturities and maintain a balanced or slightly up-in-quality bias (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Deflationary Mindset The Deflationary Mindset Table 3BCorporate Sector Risk Vs. Reward* The Deflationary Mindset The Deflationary Mindset High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 40 basis points in June, bringing year-to-date excess returns up to +76 bps. The average index option-adjusted spread widened 1 bp on the month, and currently sits at 365 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses has widened to 262 bps, just above its long-run mean (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 262 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in last week's report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.03% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than they are today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks to that forecast are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which remain low relative to history but have perked up in recent months (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to -24 bps. The conventional 30-year zero-volatility MBS spread widened 1 bp on the month, driven entirely by a 1 bp widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The MBS option-adjusted spread has widened since the beginning of the year (Chart 4), though by much less than the investment grade corporate bond spread (panel 3). The year-to-date OAS widening has been offset by a contraction in the option cost component of spreads, and this has kept the overall nominal MBS spread flat at very tight levels (bottom panel). Going forward, rising interest rates will limit mortgage refinancing activity and this will ensure that MBS spreads remain low. In other words, while MBS valuation is not attractive, the downside is limited. Our Bond Maps show an unfavorable risk/reward trade-off in the MBS sector. This analysis, based on volatility-adjusted breakeven spreads, shows that only 7 days of average spread widening are required for the MBS sector to lose 100 bps versus duration-matched Treasuries. While this speaks to the low spread buffer built into current MBS valuations, the message from the Bond Map must be weighed against the macro outlook which suggests that the odds of significant spread widening are quite low. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to -35 bps. Sovereign debt outperformed the Treasury benchmark by 33 bps on the month, bringing year-to-date excess returns up to -210 bps. Foreign Agencies outperformed by 10 bps on the month, bringing year-to-date excess returns up to -46 bps. Local Authorities underperformed by 9 bps on the month, dragging year-to-date excess returns down to +28 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to zero. The escalating tit-for-tat trade war and increasing divergence between U.S. and non-U.S. growth is a clear negative for USD-denominated Sovereign debt. Relative valuation also shows that U.S. corporate bonds are more attractive than similarly rated Sovereigns (Chart 5). Maintain an underweight allocation to Sovereign debt. Within the universe of Emerging Market Sovereign debt, we showed in a recent report that only Russian debt offers an attractive spread relative to the U.S. corporate sector.4 In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps). Maintain overweight allocations to these two sectors. The Bond Maps also show that the Supranational and Domestic Agency sectors are very low risk, but offer feeble return potential compared to other sectors. The Supranational and Domestic Agency sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 10 basis points in June, bringing year-to-date excess returns up to +120 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio fell 1% in June to reach 85%, close to one standard deviation below its post-crisis mean. It is also only slightly higher than the average 81% level that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The technical picture remains favorable for Muni / Treasury yield ratios. Fund inflows increased in recent weeks, and visible supply has contracted substantially compared to this time last year (Chart 6). State & local government credit fundamentals are also fairly robust. Net borrowing is on the decline and this should ensure that municipal ratings upgrades continue to outpace downgrades (bottom panel). Despite relatively tight valuation compared to history, the Total Return Bond Map on page 16 shows that municipal bonds offer a fairly attractive risk/reward trade-off compared to other U.S. fixed income sectors, particularly for investors exposed to the top marginal tax rate. Given the favorable reading from our Bond Map and the steadily improving credit fundamentals, we recommend an overweight allocation to Municipal bonds. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2/10 Treasury slope flattened 10 bps and the 5/30 slope flattened 7 bps. At present, the 2/10 slope sits at 29 bps, its flattest level of the cycle. The yield curve has flattened relentlessly in recent months as the impact of Fed rate hikes at the short-end of the curve have not been offset by higher inflation expectations at the long end. As explained in a recent report, we think it is unlikely that curve flattening can maintain this rapid pace.5 At 2.34%, the 1-year Treasury yield is already priced for 100 bps of Fed rate hikes during the next 12 months, assuming no term premium. Meanwhile, long-maturity TIPS breakeven inflation rates remain below levels that are consistent with the Fed's 2% inflation target. While curve flattening will proceed as the Fed lifts rates, higher breakeven inflation rates at the long-end of the curve will offset some flattening pressure during the next few months. With that in mind, we continue to recommend a position long the 7-year bullet and short the duration-matched 1/20 barbell. According to our models, this butterfly spread currently discounts 41 bps of 1/20 curve flattening during the next six months (Chart 7). This is considerably more than what is likely to occur. Table 4 of this report shows the output from our valuation models for each butterfly combination across the entire yield curve, as explained in a recent Special Report.6 Table 4Butterfly Strategy Valuation (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 35 basis points in June, bringing year-to-date excess returns up to +129 bps. The 10-year TIPS breakeven inflation rate increased 4 bps on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 5 bps and currently sits at 2.16% (Chart 8). Both the 10-year and 5-year/5-year TIPS breakeven inflation rates remain below the range of 2.3% to 2.5% that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, the current outlook is promising. Core PCE inflation has printed above the 0.17% month-over-month level that is consistent with 2% annual inflation in four of the past five months (panel 4). Year-over-year trimmed mean PCE inflation is at 1.84% and should continue to rise based on the 2.03% reading from the 6-month trimmed mean PCE (bottom panel). Finally, our Pipeline Inflation Indicator continues to point toward mounting inflationary pressures in the economy (panel 3). Maintain an overweight allocation to TIPS relative to nominal Treasury securities. We will reduce exposure to TIPS once long-maturity TIPS breakeven inflation rates return to our 2.3% to 2.5% target range. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in June, bringing year-to-date excess returns up to -2 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and now stands at 43 bps, 16 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends are moving against the sector. The household debt service ratio on consumer credit ticked down slightly in the first quarter, but its multi-year uptrend remains intact (Chart 9). Consumer credit delinquency rates follow the household debt service ratio with a lag. Meanwhile, banks are noticing the decline in credit quality and have begun tightening lending standards (bottom panel). Tighter lending standards tend to coincide with upward pressure on delinquencies and spreads. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +61 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month and currently sits at 74 bps (Chart 10). The gap between decelerating commercial real estate prices and tight CMBS spreads continues to send a worrying signal for CMBS (panel 3). However, delinquencies continue to decline and banks recently started to ease lending standards on nonfarm nonresidential loans (bottom panel). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in June, dragging year-to-date excess returns down to +6 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 51 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset Chart 12Total Return Bond Map (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, for further details on positioning across different credit tiers. Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, for further details on positioning across the maturity spectrum. Both reports available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Threats & Opportunities In Emerging Markets", dated June 12, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Robert Robis, Chief Fixed Income Strategist Highlights Q2 Performance Breakdown: The return for the Global Fixed Income Strategy (GFIS) recommended model bond portfolio was flat (hedged into U.S. dollars) in the second quarter of 2018, outperforming the custom benchmark index by +13bps. This pushed the 2018 year-to-date performance back into positive territory. Winners & Losers: Nearly the entire outperformance came from our overweight stance on U.S. high-yield corporates versus our underweight tilt on emerging market corporates. Successful government bond country allocation (overweight U.K. & Australia, underweight Italy) helped offset the drag on performance from our overweight stance on U.S. investment grade corporates. Scenario Analysis: Our recent decision to downgrade overall spread product exposure, even as we maintain a below-benchmark duration stance, should help boost the expected alpha of the model portfolio over the next year. Feature This week, we present the performance numbers for the BCA Global Fixed Income Strategy (GFIS) model bond portfolio in the second quarter of 2018. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is meant to complement the usual macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. In this report, we update our estimates of future portfolio performance, using the scenario analysis framework that we introduced three months ago.1 After our recent decision to downgrade global spread product exposure, our model portfolio is now expected to outperform the custom benchmark index over the next year in both our base case and plausible stress test scenarios. Q2/2018 Model Portfolio Performance Breakdown: Country & Credit Selection Pays Off The total return of the GFIS model bond portfolio was flat (hedged into U.S. dollars) in the second quarter of the year, which outperformed our custom benchmark index by +13bps.2 The first half of the quarter was driven by gains from our below-benchmark duration tilt, as the 10-year U.S. Treasury yield hit a peak of 3.13%. As yields drifted a bit lower in the latter half of Q2 in response to some cooling of global economic growth amid rising concerns on U.S. trade policy, the gains from duration reversed. At the same time, the outperformance from the spread product portion of our model portfolio started to kick in (Chart of the Week), even as credit spreads in all markets widened. Chart of the WeekSpecific Country & Credit Allocations##BR##Boosted Q2 Performance Specific Country & Credit Allocations Boosted Q2 Performance Specific Country & Credit Allocations Boosted Q2 Performance Table 1GFIS Model Bond Portfolio##BR##Q2-2018 Overall Return Attribution GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +5bps of outperformance versus our custom benchmark index while the latter outperformed by +8bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio##BR##Q2/2018 Government Bond Performance Attribution By Country GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Chart 3GFIS Model Bond Portfolio##BR##Q2/2018 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. high-yield B-rated corporates (+5bps) Overweight U.S. high-yield Caa-rated corporates (+2bps) Overweight Japanese government bonds (JGBs) with maturities up to ten years (+3bps) Underweight emerging market U.S. dollar-denominated corporate debt (+5bps) Underweight Italian government bonds (+4bps) Overweight U.K. Gilts (+1bp) Overweight Australian government bonds (+1bp) Biggest underperformers Overweight U.S. investment grade Financials (-2bps) Overweight U.S. investment grade Industrials (-2bps) Underweight JGBs with maturities beyond ten years (-5bps) Underweight French government bonds with maturities beyond ten years (-2bps) Two unusual trends stand out in the Q2 performance numbers: First, our overweight stance on U.S. high-yield debt was able to deliver positive alpha but a similar tilt on U.S. investment grade did not, even as U.S. corporate credit spreads widened during the quarter. It is odd for an asset class (high-yield) that is typically more volatile to outperform during a period of credit spread widening. Although that outcome did justify our view that U.S. investment grade corporates have been offering far less cushion to a period of spread volatility than U.S. junk bonds. Second, the flattening pressures on global government bond yield curves resulted in underperformance from the very long ends of curves in core Europe and Japan, even though the latter regions were the best performing bond markets in our model bond portfolio universe. This can be seen in Chart 4, which presents the benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during the second quarter.3 Chart 4Ranking The Winners & Losers From The Model Portfolio In Q2/2018 GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound As can be seen in the chart, the best performers were government bonds in Germany, France and Japan. The fact that our excess return from those countries was only a combined +2bps, even with an aggregate overweight exposure to all three, suggests that our duration allocation within the maturity buckets of those countries was a meaningful drag on performance. Yet in terms of the overall success rate of our individual country and sector calls, the news was positive in Q2. We've been overweight U.K. Gilts and Australian government bonds, which were some of the top performers in Q2. On the other side, we have been underweight emerging market corporate debt and Italian sovereign debt, which were the worst performers in the quarter. Bottom Line: The GFIS model bond portfolio outperforming the custom benchmark index by +13bps. This pushed the 2018 year-to-date performance back into positive territory. Nearly the entire outperformance came from our overweight stance on U.S. high-yield corporates versus our underweight tilt on emerging market corporates. Future Drivers Of Portfolio Returns After Our Recent Changes Looking ahead, the performance of the model bond portfolio will have different drivers in the third quarter and beyond after the recent changes to BCA's recommended strategic asset allocations.4 We downgraded global equity and spread product exposure to neutral, based on our concern that the backdrop for global growth, inflation and monetary policy was turning less supportive for risk assets, particularly given the potential new economic shock from the "U.S. versus the world" trade tensions. In terms of the specific weightings in the GFIS model bond portfolio, we still prefer owning U.S. corporate debt versus equivalents in Europe and emerging markets. Thus, while we downgraded our recommended allocation to U.S. and investment grade corporates to neutral from overweight, we also cut our weightings to euro area corporates, as well as to all emerging market hard currency debt (see the table on page 12, which shows the model bond portfolio changes that were made back on June 26th). The latter changes were necessary to maintain the relatively higher exposure to U.S. corporate debt versus non-U.S. corporates, although it does leave the model portfolio with a small overall underweight stance to global spread product (Chart 5). Importantly, we are maintaining a below-benchmark stance on overall portfolio duration, even as we grow more cautious on credit exposure. This is because we still see potential medium-term upward pressure on bond yields coming from tightening monetary policies (Fed rate hikes, ECB tapering of bond purchases) and increasing inflation expectations. The majority of global central bankers are dealing with tight labor markets and slowly rising inflation rates. While global growth has cooled a bit from the rapid pace seen in 2017, it has not been by enough to have policymakers shift to a more dovish bias. Throughout the first half of 2018, we have been deliberately targeting a modest tracking error for our model portfolio, given the historical richness (low yields, tight spreads) of so many parts of the global bond universe. Our estimate of the tracking error is now below the 40-60bp range that we have been targeting (Chart 6), but we are willing to live with this given the higher degree of uncertainty at the moment.5 Chart 5New Spread Product Allocation:##BR##Neutral U.S., Underweight Non-U.S. GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Chart 6Staying Defensive With##BR##The Risk Budget Staying Defensive With The Risk Budget Staying Defensive With The Risk Budget Importantly, the changes to our asset allocation recommendations should help boost the expected return of the model portfolio over the next year. In our Q1/2018 portfolio review published in April, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors. For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using recent historical yield betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis based on projected returns of each asset class in the model bond portfolio universe by making assumptions on those individual risk factors. Table 2AFactor Regressions Used To Estimate##BR##Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Table 2BEstimated Government Bond Yield##BR##Betas To U.S. Treasuries GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound With these tools, we can forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios, but with our current relative allocations. In Tables 3A & 3B. we show three differing scenarios, with all the following changes occurring over a one-year horizon. Table 3AScenario Analysis For The GFIS Model Portfolio GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Our Base Case: the Fed delivers another 100bps of rate hikes, the U.S. dollar rises +5%, oil prices rise by +10%, the VIX index increases by five points from current levels, and U.S. Treasury yields rise by 20-40bps across the curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by +10%, oil prices rise by +10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve. A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by -5%, oil prices fall by -20%, the VIX index increases by fifteen points from current levels and there is a modest bull steepening of the U.S. Treasury curve (in this scenario, the Fed puts the rate hiking cycle on hold because of a sharp selloff in U.S. financial markets). The top half of Table 3A shows the expected returns for all three scenarios under our more bullish asset allocation prior to the changes made on June 26th, while the bottom half shows the expected performance of the model portfolio after our downgrade to global spread product. Importantly, the model bond portfolio is now expected to outperform the custom benchmark index in not only the base case scenario (+25bps of outperformance) but also in the two alternative scenarios of a very hawkish Fed (+46bps) and a very dovish Fed (+6bps). Those positive outcomes are not surprising, given that all three scenarios have some degree of risk aversion (higher VIX) that would play into our now-reduced exposure to credit risk in the portfolio. Our negative view on duration risk (Chart 7) also helps boost excess returns versus the benchmark in two of the three scenarios. Interestingly, these outcomes all occur despite the fact that the portfolio is now running with a negative carry (i.e. a lower total yield versus the benchmark index) after the reduction in spread product exposure (Chart 8). Although given our views that market volatility, bond yields and credit spreads are more likely to move higher in the next 6-12 months, we think that carry considerations now play a secondary role in portfolio construction. The time to try and earn carry is during stable markets, not volatile markets. Chart 7The Model Portfolio Is Not Chasing Yield The Model Portfolio Is Not Chasing Yield The Model Portfolio Is Not Chasing Yield Chart 8Staying Below-Benchmark On Overall Duration Staying Below-Benchmark On Overall Duration Staying Below-Benchmark On Overall Duration Bottom Line: Our recent decision to downgrade overall spread product exposure, even as we maintain a below-benchmark duration stance, should help boost the expected alpha of the model portfolio over the next year. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start", dated April 10th 2018, available at gfis.bcareseach.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 For Italy, Germany & France, the bars have two colors since the portfolio weights were changed in mid-May, when we cut the recommended stance on Italy to underweight and raised the allocations to Germany & France as an offset. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Spread Product Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. 5 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Global Growth: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Credit Curve: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Feature Chart 1Growth Divergence Redux Growth Divergence Redux Growth Divergence Redux Two factors influenced our recent decision to reduce the recommended exposure to credit risk in our U.S. bond portfolio.1 First, our indicators show that we are in the late stages of the credit cycle, meaning that small positive excess returns are the best case scenario for corporate bonds. Second, a large divergence in growth has emerged between the United States and the rest of the world, much like in 2014/15 (Chart 1). As was the case in 2014/15, such a divergence will put upward pressure on the U.S. dollar and eventually lead to a period of turmoil in U.S. risk assets - i.e. wider credit spreads and lower equity prices. Whether this turmoil translates into a playable rally in U.S. Treasuries will depend on how the Fed responds. First Spreads, Then (Maybe) Yields Chart 2The 2015 Template The 2015 Template The 2015 Template Using the 2015 episode as a template, we see that credit spreads widened sharply beginning in mid-2015. But despite the risk-off sentiment in credit markets, Treasury yields stayed roughly flat (Chart 2). This should not be too surprising. Since the weakness in global growth was concentrated outside the United States and a significant proportion of corporate profits are driven by foreign demand, a non-U.S. growth shock will have a more immediate impact on the U.S. corporate sector than it will on overall U.S. aggregate demand. Most of the latter is driven by the U.S. consumer who actually stands to benefit from a stronger dollar. Treasury yields and the Federal Reserve take their cues from overall GDP growth, not corporate profits. In fact, we contend that the 2015 widening in credit spreads was exacerbated by the fact that the Fed maintained its focus on overall U.S. growth and continued to signal a relatively steady pace of rate hikes. Spreads widened even further as the notion that the Fed would not bail out corporate bond investors took hold. Eventually, credit spreads widened enough by early 2016 that the Fed was forced to conclude that tighter financial conditions weighed significantly on the growth outlook. It then signaled a slower pace for rate hikes (Chart 2, panel 2), and only then did Treasury yields fall (Chart 2, bottom panel). The Fed's retreat also marked the peak in corporate bond spreads. We envision a similar pattern playing out this time around. Weaker foreign growth will first impact corporate credit, and eventually financial conditions may tighten so much that the Fed is forced to back away from its "gradual" 25 bps per quarter rate hike pace. However, with inflation much closer to target than in 2015, the Fed will be more reluctant to respond. A Less Responsive Fed Our Fed Monitor shows why this is the case (Chart 3). The Monitor is composed of indicators related to economic growth, inflation and financial conditions. It is designed so that a reading above zero signals that the Fed should be hiking rates and a reading below zero signals that it should be cutting. If we consider the three components of the Fed Monitor individually, it is clear that we have recently seen a fairly substantial tightening of financial conditions (Chart 3, bottom panel), but this has barely made a dent in the overall Monitor. The reason is that the components related to economic growth and inflation are on solid footing, and they are offsetting the message from the financial conditions component. In other words, with the output gap much narrower and inflation much closer to target than in 2015, the Fed will need to see more market pain before putting rate hikes on hold. Even if financial conditions tighten so much that a pause in rate hikes is justified, it is highly unlikely that such a delay will last for more than a quarter or two. The end result could be that Treasury yields see only limited downside, even as credit spreads widen. Chart 3Fed Can Tolerate More Market Pain Fed Can Tolerate More Market Pain Fed Can Tolerate More Market Pain China To The Rescue? Another possibility is that we never even reach the point of significant market turmoil and much tighter financial conditions. Non-U.S. growth might recover in the months ahead, ushering in a renewed synchronized global recovery that prevents corporate bond spreads from widening. The most likely driver of such a revival would be significant policy easing from China that puts a floor under global growth before U.S. financial markets feel much pain. Chart 4 shows that China did ease monetary conditions dramatically in 2015 as U.S. credit spreads widened. That easing was achieved through a combination of lower real interest rates, stronger credit growth and a weaker exchange rate. The evidence also suggests that Chinese authorities have started to devalue the renminbi in recent weeks, but so far the weakness is limited and overall monetary conditions have not eased at all. If China is attempting to spur a rebound in global growth, a lot more easing will be required in the coming months and it is not at all obvious that policymakers are willing to go down that path.2 If China does engage in a significant currency devaluation, it will obviously increase the foreign demand for U.S. Treasuries. However, in general, we think that foreign demand will exert less downward pressure on U.S. Treasury yields than it did during the 2014/15 period. This has less to do with Chinese official demand than with the simple fact that U.S. government bonds are now a much less attractive investment vehicle for conventional non-U.S. fixed income investors. After we account for the cost of currency hedging on a 3-month horizon, a typical European investor who wants to gain exposure to the U.S. bond market without taking currency risk is faced with a lower realized yield from a 10-year U.S. Treasury note than from a 10-year German bund (Chart 5). This was not the case at all in 2014/15 when hedged U.S. yields offered a huge advantage over bunds. Japanese investors are faced with a similar quandary. The 10-year U.S. Treasury yield hedged into yen still looks attractive relative to a 10-year JGB, but the yield advantage is nowhere near the levels seen in 2014/15 (Chart 5, panel 3). Chart 4Policy Easing In China? Policy Easing In China? Policy Easing In China? Chart 5Less Foreign Demand For USTs Less Foreign Demand For USTs Less Foreign Demand For USTs U.S. bonds are much less enticing for foreign investors on a currency hedged basis because the Fed has raised rates seven times since 2015, while European and Japanese interest rates are still at the floor. This large rate divergence means that investors must pay a lot more to swap foreign currency for dollars. Essentially, foreign investors are faced with an unpalatable choice. They can gain access to elevated un-hedged U.S. Treasury yields only if they are willing to take on the substantial currency risk. If not, then they are better off keeping their money at home. The end result should be less foreign demand for U.S. bonds. Bottom Line: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: The Good News Is Priced In Our measure of the excess spread available in the High-Yield index after accounting for default losses has recently widened to 260 bps, slightly above its long-run historical average (Chart 6). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 260 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. While the default-adjusted spread suggests that junk bonds are fairly valued relative to history, it's important to also consider the balance of risks surrounding our default loss assumptions. To calculate the default-adjusted spread we start with the Moody's baseline default rate projection for the next 12 months. It is currently 1.99% (Chart 6, panel 2). Then, we project the recovery rate based on its historical relationship with the default rate. This gives us a forecasted recovery rate of 48% (Chart 6, panel 3). Combined, the forecasted default rate and recovery rate give us expected high-yield default losses of 1.03% for the next 12 months (Chart 6, bottom panel). The only historical period to show significantly lower default losses was 2007, a time when non-financial corporate balance sheets were in much better shape than they are today. This is not to suggest that our default forecasts are unrealistically low. The economic and corporate landscape is consistent with a relatively low default rate. But that outlook can change quickly, and the historical record shows that the risk that we are underestimating future default losses is far greater than the risk that we are overestimating them. Gross non-financial corporate leverage is highly correlated with the default rate over time (Chart 7, top panel). It has flattened off during the past few quarters, but is likely to rise modestly in the second half of the year. As we have discussed in prior reports, corporate revenue growth is elevated but close to peaking, and labor costs are just now starting to ramp up. Even a small moderation in profit growth will be enough for leverage to start moving higher.3 Chart 6High-Yield Expected Returns High-Yield Expected Returns High-Yield Expected Returns Chart 7Macro Drivers Of The Default Rate Macro Drivers Of The Default Rate Macro Drivers Of The Default Rate Interest coverage is also still consistent with a low default rate (Chart 7, panel 2). But the combination of peaking profit growth and rising interest rates clearly biases it lower going forward. Other indicators that correlate strongly with corporate defaults, such as layoff announcements and C&I lending standards, also remain supportive for the time being (Chart 7, bottom 2 panels). Bottom Line: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Considering The Credit Curve Two weeks ago we examined the risk/reward proposition of moving down in quality within an allocation to investment grade corporate bonds.4 We concluded that a move down the rating scale has a greater positive impact on risk-adjusted portfolio performance when excess return volatility and index duration-times-spread (DTS) are low. With index DTS currently elevated, now is not the best time to move down-in-quality. This week we perform a similar analysis using the maturity buckets of the investment grade corporate bond index. Charts 8-11 show four excess return Bond Maps. The horizontal axes of these maps show the number of months of average spread widening required for each maturity bucket to underperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting further to the left require more months of spread widening, and are thus less risky. Chart 8Investment Grade Corporate Excess Return ##br##Bond Map: +/- 50 BPs Threshold Out Of Sync Out Of Sync Chart 9Investment Grade Corporate Excess Return ##br##Bond Map: +/- 100 BPs Threshold Out Of Sync Out Of Sync Chart 10Investment Grade Corporate Excess Return##br## Bond Map: +/- 200 BPs Threshold Out Of Sync Out Of Sync Chart 11Investment Grade Corporate Excess Return ##br##Bond Map: +/- 300 BPs Threshold Out Of Sync Out Of Sync The vertical axes of the maps show the number of months of average spread tightening required for each maturity bucket to outperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting closer to the top require fewer months of spread tightening, and thus provide greater potential reward. Much like what we found with the different credit tiers, the maturity buckets tend to cluster together when we set a low return threshold. The risk/reward trade-off becomes more linear as the return threshold increases. We can therefore conclude that shorter maturities offer similar return potential to longer maturities when return volatility is low, along with less risk. The risk-adjusted advantage in low maturity buckets disappears as we transition into higher volatility environments. At the moment, average index DTS is elevated compared to other non-recession periods. There is no obvious advantage to maintaining a bias toward the short maturity buckets. Fundamental Drivers In addition to the risk/reward trade-offs shown in our Bond Maps, we also identify two fundamental drivers of relative performance across the corporate maturity spectrum. First, we notice that while long maturities offer a substantial spread advantage over short maturities, the advantage is entirely driven by differences in duration (Chart 12). Logically, if the duration difference between the short and long ends of the curve were to decline, then the option-adjusted spread term structure would flatten. In fact, this is exactly what should transpire as Treasury yields rise (Chart 12, bottom panel). The second factor that can influence the credit spread curve is the outlook for default losses. Short-maturity spreads widen more than long-maturity spreads when default losses increase. This is because only the highest quality firms are able to issue long maturity debt. Chart 13 shows that, after controlling for differences in duration, the credit spread curve is inversely correlated with default losses. Higher default losses coincide with a flatter spread curve, and vice-versa. A model of the credit spread curve (duration-adjusted) versus expected default losses shows that the curve is currently fairly valued relative to our optimistic default loss assumptions (Chart 13, bottom panel). In other words, if default losses were to surprise to the upside, then the credit spread curve would appear too steep. Chart 12IG Term Structure Is Steep IG Term Structure Is Steep IG Term Structure Is Steep Chart 13Rising Defaults Flatten The Spread Curve Rising Defaults Flatten The Spread Curve Rising Defaults Flatten The Spread Curve All in all, our outlook for higher Treasury yields and the negative balance of risks surrounding our default loss forecast both suggest that investors should favor the long-end of the maturity spectrum within an allocation to investment grade corporate bonds. Bottom Line: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification