Fixed Income

Highlights Butterfly Trades: Duration-neutral butterfly trades are the best way to gain pure exposure to changes in the slope of the yield curve while remaining insulated from parallel shocks. Yield Curve Models: In this report we present models for each different butterfly spread combination across the entire Treasury curve. The models allow us to pinpoint the most attractively valued parts of the yield curve at any given point in time. We also demonstrate how trading rules based on our valuation models have delivered excellent investment results. Current Curve Valuation: Our models show that the most attractively valued butterfly spread at the moment is a position long the 7-year bullet and short the 1/20 barbell. We recommend closing our current position long the 5-year bullet and short the 2/10 barbell, and shifting into the 7-year over 1/20. Feature Last summer we published a Special Report that explained why duration-neutral butterfly trades are the best way to gain exposure to changes in the slope of the yield curve.1 That report focused on the 2/5/10 butterfly spread, which is defined as the spread between the 5-year Treasury note and a barbell consisting of the 2-year and 10-year notes. For this method to work the 2-year and 10-year notes must be weighted so that the dollar duration (DV01) of the 2/10 barbell matches the DV01 of the 5-year bullet.2 Chart 1Butterfly Strategy Valuation More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies The report demonstrated how, when using the above weighting scheme, a long position in the 5-year bullet versus a short position in the 2/10 barbell allows investors to profit from a steepening of the 2/10 Treasury slope while remaining insulated from small parallel yield curve shocks. Similarly, we showed that investors who want to gain exposure to 2/10 curve flattening should go long the 2/10 barbell and short the 5-year bullet. The report also presented a fair value model for the 2/5/10 butterfly spread based on the 2/10 slope. The model allows us to incorporate initial valuation into our yield curve trading framework. For example, while the 5-year bullet will tend to outperform the 2/10 barbell when the 2/10 slope is steepening, it will require very little 2/10 steepening for it to outperform when the 5-year appears cheap on our model. More 2/10 steepening is required when the 5-year is initially expensive. In this follow-up Special Report we extend the above modeling framework to all different segments of the yield curve. The results of our analysis, shown in Chart 1, allow us to quickly scan the entire Treasury curve and identify which butterfly combinations are most attractively valued. We can then consider the message from our valuation models alongside our macro view of how the slope of the yield curve will evolve. These two factors together will suggest appropriate butterfly trades to implement. This Special Report proceeds in three sections. The first section provides a quick re-cap of the theory of butterfly trades with a focus on the importance of valuing butterfly spreads relative to the slope. The second section explains the process we followed to extend our 2/5/10 butterfly model to the rest of the yield curve. The final section presents the results of two trading rules based on the read-out from our yield curve models. Butterfly Theory Revisited: The Importance Of Valuation In our report from last year we showed that, because both the bullet and barbell have the same DV01, a position long one and short the other is immune from small parallel yield curve shifts. However, because the longest maturity bond contributes more DV01 to the barbell than the short maturity bond, the barbell will underperform (outperform) the bullet when the curve steepens (flattens). This dynamic also means that the butterfly spread - defined as the bullet yield over the barbell yield - is positively correlated with the slope of the curve (Chart 2). The logic of this relationship depends on the fact that the yield curve tends to mean revert over time. A steep yield curve implies that it is more likely to flatten in the future. This means that when the curve is steep investors will demand greater compensation to enter trades that profit from further steepening. The bullet yield will therefore be bid up relative to the barbell. This is the relationship we exploit to create our yield curve models. Chart 2The Butterfly Spread And Slope Are Positively Correlated The Butterfly Spread And Slope Are Positively Correlated The Butterfly Spread And Slope Are Positively Correlated Trade Performance When The Butterfly Spread Is At Fair Value For example, let's consider the 2/5/10 butterfly spread once more. Our analysis shows that the butterfly spread is fairly valued when it is 0.14 times the slope of the 2/10 curve. The "first scenario" in Table 1 shows hypothetical returns to a position that is long the 5-year bullet and short the 2/10 barbell in four different yield curve scenarios. All four scenarios assume that the 2/5/10 butterfly spread is always fairly valued relative to the 2/10 slope (i.e. it is equal to 0.14 multiplied by the 2/10 slope). Table 1Hypothetical Butterfly Trade Performance More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies Notice that the bullet outperforms the barbell in both scenarios where the 2/10 slope steepens and underperforms in both scenarios where the 2/10 slope flattens. It does not matter whether yields move higher or lower, only changes to the slope of the curve impact returns. Trade Performance When The Butterfly Spread Deviates From Fair Value Next, let's consider the "second scenario" shown in Table 1. Here we assume that the butterfly spread is initially different from its model-implied fair value and then reverts to fair value by the end of the investment horizon. Now, in the bear-steepening scenario the 5-year bullet actually underperforms the 2/10 barbell even though the yield curve steepens. This is because the 5-year bullet is initially expensive relative to the barbell. Notice that the 2/5/10 butterfly spread is initially only 4 bps. A fairly valued butterfly spread would have been 7 bps (0.14 * 50 bps). The point of this analysis is to demonstrate the importance of initial valuation. When the butterfly spread is initially below fair value, more curve steepening is necessary for the bullet to outperform the barbell. Similarly, the bottom half of Table 1 shows that when the butterfly spread is initially above fair value, more curve flattening is required for the barbell to outperform. Modeling The Entire Curve With that in mind, we decided to extend our simple modeling framework to every segment of the yield curve. Using par-coupon bond yields from the Federal Reserve we considered all possible butterfly combinations consisting of 1-year, 2-year, 3-year, 5-year, 7-year, 10-year, 20-year and 30-year Treasury securities. We then estimated models of each possible butterfly spread (bullet over barbell) versus the slope between the two maturities used in the barbell. Chart 3 shows that the effectiveness of these models varies considerably between the different butterfly combinations. Chart 31-Factor Model Adjusted R2 More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies To understand why some butterfly combinations are more easily modeled than others we need to rely on an alternative theory for the positive correlation between the butterfly spread and the slope. This theory relates to the fact that implied interest rate volatility is also highly correlated with the slope of the yield curve (Chart 4). The reasoning is fairly straightforward. Investors demand more compensation to bear duration risk when the economic outlook is more uncertain and interest rate volatility is higher. Greater volatility therefore causes investors to bid up the term premium embedded in long-maturity Treasury securities, leading to a steeper curve. The strong relationship between implied volatility and the slope of the yield curve is important because another property of DV01-matched butterfly trades is that the barbell always has greater convexity than the bullet. Elevated convexity is a desirable property when interest rate volatility is high, meaning that the side of the trade with lower convexity (the bullet) will need to offer a higher yield to entice investors when rate volatility is elevated and the yield curve is steep. The key point is that while the barbell has greater convexity than the bullet in every butterfly combination, some butterfly combinations have a greater difference in convexity between the bullet and barbell than others. Chart 5 shows that those butterfly combinations with a larger convexity difference between the bullet and barbell are more sensitive to changes in the slope of the curve, and are thus easier to model using our framework. Chart 4The Yield Curve ##br##And Volatility The Yield Curve And Volatility The Yield Curve And Volatility Chart 5Models Work Better When The ##br## Convexity Mismatch Is Large More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies Finally, because there are strong theoretical arguments for why the butterfly spread should be positively correlated with both the slope of the yield curve and interest rate volatility, we tried adding the MOVE index of implied rate volatility as a second independent variable in each of our yield curve models. We found that this second variable only materially improved the accuracy of the models for a handful of butterfly combinations: the 5/7/10, 5/7/30, 1/20/30, 2/20/30, 3/20/30, 5/20/30, 7/20/30 and 10/20/30. We will rely on two-factor models (using both the curve slope and the MOVE index) for those combinations, while using one-factor models (with the slope only) for the others. One advantage of using a model based only on the slope is that we can reverse the model to ask the question: What change in the slope is necessary in order for the butterfly spread to be considered "fairly valued" at its current level? By framing the valuation question in this context it is easier to link the message from our valuation models to our macro view on the yield curve. For example, our 2/5/10 butterfly spread model shows that the 5-year bullet is currently 6 bps cheap. Alternatively, we can also state that the 2/5/10 butterfly spread is priced for 32 bps of 2/10 flattening during the next six months (Chart 6).3 If we expect the 2/10 slope to flatten by more than what is discounted we should enter the barbell over the bullet. Conversely, if we think the slope will flatten by less than what is discounted we should favor the bullet. Chart 62/5/10 Butterfly Spread Fair Value Model 2/5/10 Butterfly Spread Fair Value Model 2/5/10 Butterfly Spread Fair Value Model Chart 7 shows the current valuation for every butterfly combination in this manner. Rather than showing whether the bullet is cheap/expensive relative to the barbell (as in shown in Chart 1), it shows what change in the slope between the two components of the barbell is currently being discounted by the butterfly spread. We omit the butterfly combinations that are modeled using both the slope and volatility from this exercise. Chart 7Discounted Slope Change During Next Six Months (BPs) More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies Performance Tests We performed two tests to see whether our suite of yield curve models adds value to the investment process. Test #1 First, we considered each butterfly combination individually and tested the following trading rule: When the bullet is more than 0.5 standard deviations cheap on our model, we go long the bullet and short the barbell. When the barbell is more than 0.5 standard deviations cheap on our model, we go long the barbell and short the bullet. If nether the bullet nor the barbell is more than 0.5 standard deviations cheap we take no position. The trades are re-balanced daily and tested on a horizon from 1988 to the present. The results of this first test are shown in Chart 8. Here we see the annualized excess returns earned from each butterfly combination over the course of the testing horizon. In Chart 9 we also show the average number of times per year that the above trading rule would have recommended switching between the bullet, barbell and taking no position. Chart 10 shows the average annualized excess return divided by the average number of annual position changes. Chart 8Trading Rule Annualized Excess Returns Since April 1988 (BPs) More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies Chart 9Average Number Of Trades Per Year More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies Chart 10Excess Return Per Trade (BPs) More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies While the test results are encouraging insofar as every combination delivers positive excess returns, we note that due to limits in the amount of historical data at our disposal, most of the back-test is performed in sample. Although our robustness checks suggest that the regression coefficients are fairly stable through time, so we expect the results to be replicable going forward. Chart 11Excess Returns Versus Model Fit More Bullets, Barbells And Butterflies More Bullets, Barbells And Butterflies We also observe that the performance is not equally distributed amongst the different curve models. In fact, we notice that the models with the best fit - and hence largest convexity mismatches between the bullet and barbell - deliver better results than models with worse fit (Chart 11). This is not very surprising, but it does reinforce that we should put more weight on the message from the valuation models with greater convexity mismatches than on those with smaller mismatches. Test #2 In practice, we would not recommend trying to implement every butterfly trade that appears cheap according to our models. Rather, the real power of our modeling framework is that we can choose the most attractive segment of the yield curve and implement that trade only - assuming it synchs up with our macro view of the yield curve. In our second performance test we did just that. Each month we chose the most attractively valued yield curve trade based on our models and implemented only that trade. Chart 12 shows that not only does that method deliver excellent excess returns over time, it also outperforms a benchmark where we take the average of all yield curve trades recommended by our models. Chart 12Test #2 Results Test #2 Results Test #2 Results At present, the most attractive butterfly trade according to our models is the 7-year bullet over the 1/20 barbell. This trade is directionally similar to our currently recommended position long the 5-year bullet over the 2/10 barbell, in that both will benefit from curve steepening (or less curve flattening than is currently priced). Given the more attractive value in the 7-year over 1/20 combination, we recommended investors shift their yield curve allocation away from the 2/5/10 butterfly to favor the 7-year bullet over the 1/20 barbell. Alex Wang, CFA, Senior Analyst alexw@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 2 The dollar duration (DV01) is the dollar value of a basis point. It measures the dollar change in the price of a given bond assuming a one basis point change in yield. It is calculated as the bond's duration times its price, divided by 104. 3 We assume an investment horizon of 6 months, a length of time that approximates the average length of time it takes for the butterfly spread to revert to our model's fair value.

Highlights Tinbergen's rule says that the successful implementation of economic policy requires there to be at least as many "instruments" as "objectives." Policymakers today are increasingly discovering that they have too many of the latter but not enough of the former. By turning fiscal policy into a political tool rather than one for macroeconomic stabilization, the U.S. has found itself in a position where it can either meet President Trump's goal of having a smaller trade deficit or the Fed's goal of keeping the economy from overheating, but not both. In the near term, we expect the Fed's priorities to prevail. This will keep the dollar rally intact, which could spell bad news for some emerging markets. Longer term, the Fed, like most other central banks, must confront the vexing problem that the interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Getting inflation up a bit may be one way to mitigate this problem, as it would allow nominal interest rates to rise without pushing real rates into punitive territory. This suggests that the structural path for bond yields is up, consistent with our thesis that the 35-year bond bull market is over. Feature Constraints And Preferences The late Jan Tinbergen was one of the great economists of the twentieth century. Often referred to as the father of econometrics, Tinbergen and Ragnar Frisch were the first people to be awarded the Nobel Prize in Economics in 1969. One of Tinbergen's most enduring contributions was his demonstration that the successful implementation of economic policy requires there to be at least as many "instruments" (i.e., policy tools) as "objectives" (i.e., policy goals). Just like any system of equations can be "overdetermined" or "underdetermined," any set of "policy functions" may have a unique solution, many solutions, or no solution at all. The first outcome corresponds to a situation where there are as many instruments as objectives, the second where there are more instruments than objectives, and the third where there are fewer instruments than objectives. In essence, the Tinbergen rule is a mathematical formulation of the idea that it is hard to hit two birds with one stone. The Tinbergen rule often comes up in macroeconomics. Consider a country that wants to have a low and stable unemployment rate (what economists call "internal balance") and a current account position that is neither too big nor too small ("external balance"). This amounts to two objectives, which can be realized with the right mix of two instruments: Monetary and fiscal policy. As discussed in greater detail in Appendix A, the classic Swan Diagram, named after Australian economist Trevor Swan, shows how this is done. Chart 1Spain: The Cost Of The Crisis Spain: The Cost Of The Crisis Spain: The Cost Of The Crisis If the country wants to add a third objective to its list of policy goals, it has to either give up one of its existing objectives or find an additional policy instrument. Suppose, for example, that a country wants to move to a pegged exchange rate. It can either forego monetary independence, or introduce capital controls in order to allow domestic interest rates to deviate from the interest rates of the economy to which it is pegging its currency. This is the logic behind Robert Mundell's "Impossible Trinity," which states that an economy cannot simultaneously have all three of the following: A fixed exchange rate, free capital mobility, and an independent central bank. It can only choose two items from the list. Peripheral Europe learned this lesson the hard way in 2011. Not only did euro membership deny Greece, Italy, Spain, Portugal, and Ireland access to an independent monetary policy and a flexible currency, but the ECB's failure under the bumbling leadership of Jean-Claude Trichet to backstop sovereign debt markets necessitated fiscal austerity at a time when these economies needed stimulus. These countries were left with no effective macro policy instruments whatsoever, thus putting them at the complete mercy of the bond vigilantes, German politicians, and the multilateral lending agencies. The only thing they could do was incur a brutal internal devaluation to make themselves more competitive. Even for "success stories" such as Spain, the cost in terms of lost output was over one-third of GDP (Chart 1) - and probably much more if one includes the deleterious effect on potential GDP growth from the crisis. Trump Versus Tinbergen One might think that the U.S. is largely immune from Tinbergen's rule. It is not. President Trump and the Republicans in Congress have rammed through massive tax cuts and spending increases (Chart 2). By doing so, they have turned fiscal policy into a political tool rather than one for macroeconomic stabilization. In and of itself, that is not an insuperable constraint since monetary policy can still be used to achieve internal balance. The problem is that Trump has also declared that he wants external balance, meaning a much smaller trade deficit. Now we have two policy objectives (full employment and more net exports) and only one available instrument: Monetary policy. Chart 2The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline This puts the Fed in a bind. If the Fed hikes rates aggressively, this will keep the economy from overheating, thus achieving internal balance. But higher rates are likely to bid up the value of the dollar, leading to a larger trade deficit. On the flipside, if the Fed drags its feet in raising rates, the dollar could weaken, resulting in a smaller trade deficit and moving the economy closer to external balance. However, the combination of low real interest rates, a weaker dollar, and dollops of fiscal stimulus will cause the unemployment rate to fall further, leading to higher inflation. Investor uncertainty about which path the Fed will choose may be partly responsible for the gyrations in the dollar of late. At least for the next year or so, our guess is that the Fed's independence will keep it on course to raise rates more than the market is currently pricing in, which will result in a stronger dollar. Beyond then, the picture is less clear. This is partly because the increasing politicization of society may begin to affect the Fed's behavior. History suggests that inflation tends to be higher in countries with less independent central banks (Chart 3). But it is also because Tinbergen's ghost is likely to make another appearance, this time in a wholly different way. Chart 3Inflation Tends To Be Higher In Countries Lacking Independent Central Banks Tinbergen's Ghost Tinbergen's Ghost The Fed's "Other" Mandate Officially, the Fed has two mandates: ensuring maximum employment and stable prices. In practice, this "dual mandate" can be boiled down to a single policy objective: Keeping the unemployment rate near NAIRU, the so-called Non-Accelerating Inflation Rate of Unemployment. The Fed has sought to meet this objective through the use of countercyclical monetary policy: Easing monetary policy when output falls below potential and tightening it when the economy is at risk of overheating. So far, so good. The problem is that the Fed, like most other central banks, is being asked to take on another policy objective: ensuring financial stability. Here's the rub though: The interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Excessively low rates are a threat to financial stability. A decline in interest rates pushes up the present value of expected cash flows; the lower the discount rate, the more of an asset's value will depend on cash flows that may not be realized for many years. This tends to increase asset market volatility. In addition, borrowers need to devote a smaller share of their incomes towards servicing their debt obligations when interest rates are low. This tends to increase debt levels. From The Great Moderation To The Great Intemperance Starting in the 1990s, far from entering an era which policymakers once naively referred to as the "Great Moderation," it is possible that the world entered a precarious period where the only way to generate enough spending was to push down interest rates so much that asset bubbles became commonplace. In a world where central bankers have to choose between insufficient demand and recurrent asset bubbles, the idea of a "neutral rate" loses much of its meaning. By definition, the neutral rate is a steady-state concept. However, if the interest rate that produces full employment and stable inflation is so low that it also generates financial instability, how can one possibly describe this interest rate as "neutral"? Faced with the increasingly irreconcilable twin objectives of keeping the unemployment rate near NAIRU and putting the financial system on the straight and narrow, central bankers have reached out for a second policy instrument: macroprudential regulations. So far, however, the jury is still out on whether this tool is sufficiently powerful to prevent future financial crises. Politics has a bad habit of getting in the way of effective regulation. President Trump and the Republicans have been looking for ways to water down the Dodd-Frank Act. The Democrats are complaining that banks and other financial institutions are not doing enough to channel credit to various allegedly "underserved" groups. Faced with such political pressure, it is not clear that regulators can do their jobs. If You Can't Raise r-Star, Raise i-Star What is the Fed to do? One possibility may be to aim for somewhat more inflation. A higher inflation target would allow the Fed to raise nominal policy rates while still keeping real rates low enough to maintain full employment. Higher nominal rates would impose more discipline on borrowers and discourage excessive debt accumulation. Higher inflation would also reduce the likelihood of reaching the zero bound again, while also limiting the economic fallout of asset busts. The Case-Shiller 20-City Composite Index declined by 34% in nominal terms and 41% in real terms between April 2006 and March 2012. Had inflation averaged 4% over this period rather than 2.2%, a 41% decline in real home prices would have corresponded to a less severe 26% decrease in nominal prices, resulting in fewer underwater mortgages. Finally, higher inflation would allow countries to increase nominal income growth. In fact, higher inflation may be the only viable way to reduce debt-to-GDP ratios in a high-debt, low-productivity growth world. Investment Conclusions We advised clients on July 5, 2016 that we had reached "The End Of The 35-Year Bond Bull Market." As fate would have it, this was the exact same day that the 10-year yield reached an all-time closing low of 1.37%. Bond positioning is very short now (Chart 4), so a partial retracement in yields is probable. Cyclically and structurally, however, the path for yields is up. Much like what transpired between the mid-1960s and the early 1980s, investors should expect global bond yields to reach a series of "higher highs" and "higher lows" with each passing business cycle (Chart 5). Chart 4Traders Are Short Treasurys Traders Are Short Treasurys Traders Are Short Treasurys Chart 5A Template For The Next Decade? A Template For The Next Decade? A Template For The Next Decade? Just as was the case back then, the Fed is now behind the curve in raising rates. The three-month and six-month annualized change in core PCE has reached 2.6% and 2.3%, respectively. Yesterday's CPI report was softer than expected, but the miss was almost entirely due to a deceleration in used car prices and airfares, both of which are likely to be temporary. Meanwhile, the labor market remains strong. The unemployment rate is down to 3.9%, just slightly above the 2000 low of 3.8%. According to the latest JOLTS survey released earlier this week, there are now more job openings than unemployed workers, the first time this has happened in the 17-year history of the survey (Chart 6). Faced with this reality, the Fed will keep begrudgingly raising rates until the economy slows. Right now, the real economy is not showing much strain from higher rates. The cyclical component of our MacroQuant model, which draws on a variety of forward-looking economic indicators, moved back into positive territory this week. Both the housing market and capital spending are in reasonably good shape (Chart 7). Chart 6There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 7Higher Rates Have Not (Yet) Slowed The Economy Higher Rates Have Not (Yet) Slowed The Economy Higher Rates Have Not (Yet) Slowed The Economy The U.S. financial sector should also be able to weather further monetary tightening. Corporate debt has risen, but overall U.S. private-sector debt as a percent of GDP is still 18 percentage points lower than in 2008 (Chart 8). Lenders are also more circumspect than they were before the Great Recession. For example, banks have been tightening lending standards on credit and automobile loans, which should reverse the increase in delinquency rates seen in those categories (Chart 9). Chart 8U.S. Private Debt Still Below Pre-Recession Levels U.S. Private Debt Still Below Pre-Recession Levels U.S. Private Debt Still Below Pre-Recession Levels Chart 9Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Resilience to Fed tightening may not extend to the rest of the world, however. Following the script of the late 1990s, it is likely that the combination of higher U.S. rates and a stronger dollar will cause some emerging markets to fall out of bed before U.S. financial conditions have tightened by enough to slow U.S. growth (Chart 10). This week's turbulence in Turkey and Argentina may be a sign of things to come. For now, investors should underweight EM assets relative to their developed market peers. Chart 10Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com APPENDIX A The Swan Diagram The Swan Diagram depicts four "zones of economic unhappiness," each one representing the different ways in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). A rightward movement along the horizontal axis represents an easing of fiscal policy, whereas an upward movement along the vertical axis represents an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order keep the unemployment rate stable. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. To bring imports back down, the currency must weaken. Any point to right of the internal balance schedule represents overheating; any point to the left represents rising unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Appendix Chart 1Four Zones Of Unhappiness Tinbergen's Ghost Tinbergen's Ghost Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The U.S. dollar still has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. Fixed-income investors should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Argentine financial markets are rioting. We elaborate on our investment strategy below. Downgrade Indonesian stocks from neutral to underweight within an EM equity portfolio. Feature The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. Rüdiger Dornbusch Emerging markets (EM) currencies have come under substantial selling pressure. Various indexes of EM currencies versus the U.S. dollar have broken below their 200-day moving averages (Chart I-1). EM sovereign spreads are widening, and local bonds yields are moving higher from very low levels. Chart I-1EM Currencies: A Breakdown? EM Currencies: A Breakdown? EM Currencies: A Breakdown? Our view is that we are witnessing the beginning of a major down leg in EM currencies and a major up leg in the U.S. dollar. This constitutes a negative environment for all EM risk assets. As the above quote from professor Rüdiger Dornbusch eloquently states, a meltdown in financial markets could take much longer to develop, but once it commences it is likely to play out much faster than investors expect. This does not mean we are certain that a full-blown EM crisis is bound to happen. Neither can we predict the speed of financial market moves. Nevertheless, based on our macro themes, we maintain that this down leg in EM currencies and EM risk assets will likely be large enough to qualify as a bear market rather than a correction. Consistently, we continue to recommend that investors adopt defensive strategies or play EM risk assets on the short side. This bear market in EM could be comparable to the EM selloff episodes of 2013 (Taper Tantrum) or 2015 (China's slowdown). In this report, we first discuss the outlook for the broad U.S. dollar, then examine the factors that typically drive EM currencies, and those that do not. The Dollar: A Major Bottom In Place The U.S. dollar has recently rebounded sharply, and we believe this marks the beginning of a major rally. The following factors will support the greenback in the months ahead: The U.S. dollar does well in periods of a slowdown in global trade (Chart I-2). The average manufacturing PMI index of export-oriented Asia economies such as Korea, Taiwan and Singapore points to a peak in global export volumes (Chart I-3). Further, China's Container Freight index signifies an impending deceleration in Asian export shipments (Chart I-4, top panel). Chart I-2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Chart I-3A Peak In Global Export Growth A Peak In Global Export Growth A Peak In Global Export Growth Chart I-4A Leading Indicator For Asian Exports ##br##And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies Notably, this freight index - the price to ship containers - also correlates with emerging Asia currencies, and suggests that the latter stands to depreciate (Chart I-4, bottom panel). Chart I-5U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate The dollar should do particularly well if the epicenter of the global growth slowdown is centred in China - and if U.S. domestic demand remains robust due to fiscal stimulus, as we expect. Within advanced economies, the U.S. is the least vulnerable to a China and EM slowdown. Delta of relative growth will be shifting in favor of the U.S. versus the rest of the world. This will propel the dollar higher. Amid weakness in the world trade, growth will be priced at a premium. This will favor financial markets with stronger growth. The greenback will be the winner in the coming months. The U.S. twin deficits - the current account and budget deficits - would have acted as a drag on the dollar if global growth was robust/recovering. However, amid weakening global growth, the U.S. twin deficits are not a malignant phenomenon for the dollar; they will in fact support it as they instigate and reflect strong U.S. growth. As the Federal Reserve continues to reduce its balance sheet, the banking system's excess reserves will decline. Our U.S. dollar liquidity measure has petered out, which has historically been consistent with a bottom in the dollar; the latter is shown inverted on Chart I-5. As we have argued for some time, and to the contrary of widespread investor consensus, the U.S. dollar is not expensive. According to the real effective exchange rate based on unit labor costs, the greenback is fairly valued, as is the euro (Chart I-6). The yen is cheap but the Korean won is expensive (Chart I-6, bottom two panels). In our opinion, a real effective exchange rate based on unit labor costs is the most pertinent measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component in many companies and unit labor costs are critical to competitiveness. Chart I-7 demonstrates that commodities-related currencies including those of Australia, New Zealand and Norway are on the expensive side, while the Canadian dollar is fairly valued. Chart I-6The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive Chart I-7Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap There are no measures of real effective exchange rate based on unit labor costs for many EM currencies. If DM commodities currencies are not cheap, then it is fair to assume that EM commodities currencies are not cheap either. We are not suggesting that exchange rates of commodity producing EM nations are expensive, but we do believe their valuations are probably closer to neutral. When valuations are neutral, they are not a constraint for the underlying asset price. The latter can go either up or down. In short, the dollar is not expensive, and valuations will not deter its appreciation in the coming months. Finally, from the perspective of market technicals, the dollar's exchange rates versus many currencies appear to have encountered resistance at their long-term moving averages, as illustrated in Chart I-8A and Chart I-8B. Usually, when a market finds support (or resistance) at its long-term moving average, it often makes new highs (or lows). Chart I-8ATechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Chart I-8BTechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies We are not certain if the broad trade-weighted U.S. dollar will make a new high. However, some EM currencies will drop close to or retest their early 2016 lows. Such potential downside is substantial enough to short the most vulnerable EM currencies. Bottom Line: The U.S. dollar has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. What Really Drives EM Currencies A common narrative is that EM balance of payments and fiscal balances have already improved, making many EMs less vulnerable than they were during the 2013 Taper Tantrum. What's more, the interest rate differential between EM and the U.S. is still positive, heralding upward pressure on EM currencies. We do not subscribe to this analysis. First, current account balances do not always drive EM exchange rates. Chart I-9A and Chart I-9B illustrates that there is no meaningful positive correlation between EM currencies and both the level and changes in their current account balances. The same holds for the correlation between fiscal balances and exchange rates. Chart I-9ACurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Chart I-9BCurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Second, neither nominal nor real interest rate differentials over U.S. rates explain the trend in EM currencies, as shown in Chart I-10. Further, neither the level nor changes in interest rate differentials explain trends in EM exchange rates. On the contrary, it is the trend in EM currencies that drives local interest rates in EM. That is why getting the currencies right is of paramount importance to investors in various EM asset classes. So which factors do drive EM exchange rates? The key variables that define trends in EM currencies are U.S. bond yields, global trade cycles and commodities prices. The changes in U.S. bond yields and TIPS (inflation-adjusted) yields - not their difference with EM yields - have explained EM currency moves in recent years (Chart I-11). Chart I-10Interest Rate Differential Does Not ##br##Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Chart I-11EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields Chart I-4 on page 3 demonstrates that China's Container Freight index leads regional exports and strongly correlates with emerging Asian currencies. Non-Asian EM currencies are mostly leveraged to commodities prices, as these countries (all nations in Latin America, Russia and South Africa) produce commodities. Not surprisingly, the EM exchange rate composed primarily of EM non-Asian currencies correlates well with commodities prices (Chart I-12). Finally, EM currencies are substantially more exposed to China than to DM economies. Chart I-13 shows that when Chinese imports are underperforming DM imports, EM currencies tend to depreciate. Chart I-12EM Currencies And Commodities Prices EM Currencies And Commodities Prices EM Currencies And Commodities Prices Chart I-13EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM As such, what has caused EM currencies to riot in recent weeks? In short, it is the combination of the rise in U.S. bond yields and budding signs of slowdown in global trade. Chart I-14EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low Commodities prices have so far been firm with oil prices skyrocketing. We expect the combination of China's slowdown and a stronger U.S. dollar to eventually suppress commodities prices in the months ahead. That will produce another down leg in EM currencies. Finally, the volatility measure for EM currencies is still very low, albeit rising (Chart I-14). This suggests that investors remain somewhat complacent on EM exchange rates. Bottom Line: Our negative view on EM currencies has been anchored on two pillars: the U.S. dollar rally driven by higher U.S. interest rate expectations and weaker Chinese growth/lower commodities prices. We are now witnessing the first down leg in EM currency bear market propelled by the first pillar. It is not over yet. The second down leg will come when China's growth slows and commodities prices relapse in the coming months. All in all, there is still material downside in EM exchange rates. EM Local Bond And Credit Markets EM local bond yields typically rise when EM currencies drop meaningfully (Chart I-15). Foreign investors hold a large share of EM local currency bonds (Table I-1). Chart I-15EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies Table I-1Foreign Ownership Of EM Local Bonds EM: A Correction Or Bear Market? EM: A Correction Or Bear Market? As EM currency depreciation erodes foreign investors' returns on EM local currency bonds, there could be a rush to exit their positions. Chart I-16 portrays that the total return on J.P. Morgan GBI EM local currency bonds in U.S. dollar terms has broken below its 200-day moving average. Fluctuations in total return on local bonds is primary driven by currency moves. If our negative EM currency view is correct, there will be more downside in this EM domestic bonds total return index. EM sovereign and corporate credit spreads often widen when EM currencies depreciate (Chart I-17). As EM currencies lose value, U.S. dollar debt becomes more expensive to service, and credit spreads should widen to reflect higher credit risks. Chart I-16EM Local Bonds Total ##br##Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars Chart I-17EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies Finally, the ratios of U.S. dollar debt-to-exports and U.S. dollar debt-to-international reserves for EM ex-China are very elevated (Chart I-18). If these nations' exports stumble in the months ahead, the inflows of foreign currency will diminish, and credit spreads could widen to price this in. Chart I-18EM Ex-China: U.S. Dollar Debt ##br##Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective To be sure, this does not mean there will be widespread defaults. Simply, credit spreads are too low and investor sentiment is too upbeat. As EM growth deteriorates, asset prices will have to re-price. Bottom Line: Asset allocators should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Argentina Is Under Fire 10 May 2018 Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Chart II-1Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Chart II-2Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Chart II-3Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Chart II-4Argentina: Are Interest ##br##Rates High Enough? Argentina: Are Interest Rates High Enough? Argentina: Are Interest Rates High Enough? Chart II-5Argentina: Highest Real Interest ##br##Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Chart II-6Argentina: High Borrowing Costs ##br##Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Chart II-7Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Indonesia: Facing Major Headwinds 10 May 2018 Indonesian stocks appear to be in freefall in absolute terms and relative to the EM benchmark (Chart III-1). Meanwhile, the currency has been selling off and local currency as well as sovereign (U.S. dollar) bonds spreads are widening versus U.S. Treasurys from low levels (Chart III-2). Chart III-1Indonesian Equities: Absolute ##br##And Relative Performance Indonesian Equities: Absolute And Relative Performance Indonesian Equities: Absolute And Relative Performance Chart III-2Indonesian Local Bonds ##br##And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads These developments have been occurring due to vulnerabilities relating to Indonesia's balance of payments (BoP) dynamics. We believe Indonesia's BoP dynamics will deteriorate further and as such there is more downside for both the rupiah and its financial markets from here: Stronger U.S. growth and higher inflation prints will likely lead to higher interest rate expectations in the U.S. and lift the U.S. dollar further. This will likely lead to Indonesia's underperformance. Chart III-3 shows that Indonesia's relative equity performance versus the EM benchmark has been extremely sensitive to moves in U.S. Treasury yields. Hence, the cost of funding has been a critical variable for Indonesia. Indonesia is also a large commodities exporting nation and the latter account for around 30% of its exports. Specifically, coal, palm oil and copper make up about 9%, 8% and 2% of its exports, respectively. Coal exports are facing major headwinds. The Chinese government has moved to restrict coal imports in several Chinese ports in order to protect its domestic coal producers as we argued in our Special Report titled Revisiting China's De-Capacity Reforms.1 This development will be devastating for Indonesia's coal industry. Chart III-4 shows that the Adaro Energy's stock price - a large Indonesian coal mining company - is falling sharply. This stock price has already fallen by 40% in U.S. dollar terms since its peak on January 30. Chart III-3Indonesia Is Very Sensitive ##br##To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Chart III-4Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Further, palm oil prices have been weak while copper prices might be on edge of breaking down. Meanwhile, there are others negatives related to shipments of these commodities. Palm oil exports are at risk because India has imposed import duties on palm oil, while the European Parliament voted in favor of a ban on the use of palm oil in bio fuel by 2021. Offsetting these, however, China has just agreed to purchase more palm oil from Indonesia. In regard to copper, the ongoing dispute on environmental regulation between Freeport-McMoRan - a U.S. mining company that operates a large copper mine in Indonesia - and the Indonesian government, risks disrupting Freeport's copper production in Indonesia, hurting the country's export revenues. On the whole, export revenues are at risk of plummeting at a time when Indonesian imports are already too strong. This will worsen BoP dynamics further. Chart III-5 shows that a deteriorating trade balance in Indonesia is usually bearish for its equity market. It seems that the current account deficit will be widening when foreign funding is drying up. This requires either a major depreciation in the currency or much higher interest rates. As such, Bank Indonesia (BI) - Indonesia's central bank - might be forced to raise interest rates to cool down domestic demand and attract foreign funding to stabilize the rupiah. Even if the BI does not raise rates, it might opt to defend the rupiah by selling its international reserves. This would still bid up local interbank rates as defending the currency entails drawing down banking system liquidity, i.e., banks' reserves at the central bank. Chart III-6 shows that Indonesian interbank rates are starting to rise in response to falling international reserves. Chart III-5Indonesia: Swings In Trade ##br##Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Chart III-6Indonesia: Currency Defense By Selling ##br##FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Higher rates will weaken domestic demand and are bearish for share prices. Importantly, foreign ownership of local bonds is still high at 39% and a weaker rupiah could cause selling by foreign investors, pushing yields even higher. Chart III-7Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk Finally, a word on Indonesian banks is warranted. Financials account for 42% of Indonesia's MSCI market cap and 47% of its total earnings. Thus their performance is also very crucial for the outlook of the overall stock market. In our March 1st Weekly Report,2 we argued that Indonesian banks have been lowering their provisions to artificially boost earnings. This is not sustainable as these provisions are insufficient and will have to rise. As they ultimately rise, bank profits and share prices will hurt (Chart III-7). Bottom Line: We recommend investors to downgrade Indonesia's stocks from neutral to underweight within an EM equity portfolio. We also reiterate our short IDR / long USD trade and the short position in local bonds. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Revisiting China's De-Capacity Reforms," dated April 26, 2018, the link available on page 23. 2 Please see Emerging Markets Strategy Weekly Report "EM Equity Valuations (Part II)," dated March 1, 2018, the link available on page 23. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The big danger of higher bond yields is to the $380 trillion edifice of global risk-assets, rather than to the global economy per se. Buy a small portfolio of 30-year government bonds, given that higher bond yields are now hurting equities and 30-year yields are close to resistance levels. The ongoing drama of Italian politics is an irritation, rather than an existential risk to the euro area, as long as Italian populists correctly focus their fire on EU fiscal rules rather than the single currency. Nevertheless, we prefer France's CAC over Italy's MIB and Spain's IBEX, given the latter markets' outsize exposure to banks, a sector in which we remain underweight. Feature When travellers from the U.K. find themselves in Continental Europe or the U.S. they frequently make a potentially fatal error. Trying to cross a busy street, they look right instead of left... Your author has made this error several times and lived to tell the tale, but there is an important moral to the story. However carefully you look, you won't spot the oncoming truck if you are looking in the wrong direction! Chart of the WeekEquities And Bonds Are Both Offering A Paltry 2% Equities And Bonds Are Both Offering A Paltry 2% Equities And Bonds Are Both Offering A Paltry 2% Look At the Markets, Not The Economy The global long bond yield is up around 60bps from the lows of last September, and it would be natural to ask if this poses a danger to the economy. Credit sensitive economic sectors are understandably feeling a headwind, and global growth has indisputably decelerated (Chart I-2). Yet there is no sense of an oncoming truck. Chart I-2Credit Sensitive Sectors Are Feeling A Headwind Credit Sensitive Sectors Are Feeling A Headwind Credit Sensitive Sectors Are Feeling A Headwind But are we looking in the wrong direction? While higher bond yields do not yet threaten the global economy, the big danger is to the $380 trillion edifice of global risk-assets.1 In the space of a few weeks, the correlation between bond yields and equities has suddenly and viciously reversed. When the 10-year T-bond yield was below 2.65%, the correlation was a near perfect positive, r = +0.9 (Chart I-3) but above 2.85%, it has flipped to a near perfect negative, r = -0.8 (Chart I-4). Chart I-3Below A 2.65% T-Bond Yield, Equities And##br## Bond Yields Were Positively Correlated The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Chart I-4Above A 2.85% T-Bond Yield, Equities And ##br##Bond Yields Have Been Negatively Correlated The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way In 2000, 2008 and 2011, the right direction to look was at the financial markets. Recall that it was instabilities in the financial markets - the bursting of the dot com bubble, the mispricing of U.S. subprime mortgages, and the widening of euro area sovereign credit spreads - that spilled over into economic downturns. In any case, for investment strategy, whether such financial instabilities do or do not spill over into the real economy is a secondary concern. The primary concern must always be to identify financial market vulnerabilities - and opportunities. Rich Valuations Are In A Precarious Equilibrium The single most important determinant of an investment's long term return is not the investment's cash flows per se, it is the price that you pay for the cash flows. This is the fundamental lesson of investment. An investment's cash flows might be growing strongly, but if you overpay for the cash flows - for example, in a bubble - you will end up with a negative return. Conversely, cash flows might be collapsing, but if you buy them at an overly depressed price, you will end up with a positive return. It turns out that the long term prospective return from most investments is well-defined. For government bonds, it is the yield to maturity;2 for equities and other risk-assets it is empirically well-defined by the starting valuation, which tends to be an excellent predictor of the prospective long term return (Chart I-5). Chart I-5World Equities Are Priced To Generate 2% A Year World Equities Are Priced To Generate 2% A Year World Equities Are Priced To Generate 2% A Year For the long term prospective return from bonds, the main determinant is central bank policy, and specifically the expected path for interest rates. For the long term prospective return from equities, the main determinant is the return that the market demands relative to that on offer from bonds. What establishes this relative return? The answer is relative riskiness, specifically the potential for short term losses versus short term gains, technically known as negative skew. Investors hate negative skew - the potential to experience larger short term losses than gains. Hence, investors demand relative returns that are commensurate with the investments' relative negative skews. This brings us to the crux of the matter. At low bond yields, bonds become much more risky: their returns take on negative skew. Intuitively, this is because the lower bound to interest rates forces a very unattractive asymmetry on bond returns: prices can fall a lot, but they can no longer rise a lot. At a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-6 and Chart I-7). Chart I-6At A 2% Bond Yield, 10-Year Bonds Have##br## The Same Negative Skew As Equities... The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Chart I-7...So At A 2% Bond Yield, Equities ##br##Must Also Offer A 2% Return The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Right now, the negative skews on bonds and equities are roughly the same, so investors are accepting roughly the same long term return from global equities as they can get from global bonds - a paltry 2% (Chart of the Week). This justifies an equity valuation as rich as at the peak of the dot com bubble. The trouble is that the valuation justification for $380 trillion of global risk-assets would crumble if the bond yield were to rise meaningfully. But which bond yield? As asset-classes tend to move as global rather than regional assets, the yield that matters is the global long bond yield. Given the large spread in yields across major bonds, a global yield of 2% equates to around 3% in the U.S. and 1% in Europe. This may explain why these are the yield levels at which the correlation between bond yields and equities has suddenly and viciously reversed. This brings us to the investment opportunity: 30-year government bonds. In recent years, 30-year yields have failed to sustain breaks through upper bounds: 3.2% for T-bonds; 2.0% for U.K. gilts; 1.4% for German bunds; and 0.9% for JGBs. Indeed, looking at these yields since 2015 it is hard to discern a bear market in 30-year government bonds (Charts I-8- I-11). Chart I-8Resistance At 3.2% Resistance At 3.2% Resistance At 3.2% Chart I-9Resistance At 2.0% Resistance At 2.0% Resistance At 2.0% Chart I-10Resistance At 1.4% Resistance At 1.4% Resistance At 1.4% Chart I-11Resistance At 0.9% Resistance At 0.9% Resistance At 0.9% With higher bond yields now hurting equities, and 30-year yields close to resistance levels, it is a good time to buy a small portfolio of 30-year government bonds. What Unites Italy With Japan? Italy and Japan are the only two major economies in which private indebtedness is considerably less than public indebtedness (Chart I-12 and Chart I-13). In the case of Italy, the very low private indebtedness means that its total indebtedness - as a share of GDP - is actually less than that in the U.K., France, Spain and Sweden. Chart I-12Private Indebtedness Is Less Than ##br##Public Indebtedness In Italy... Private Indebtedness Is Less Than Public Indebtedness In Italy... Private Indebtedness Is Less Than Public Indebtedness In Italy... Chart I-13...And In ##br##Japan ...And In Japan ...And In Japan The other thing that unites Italy with Japan is that their banking systems were left undercapitalised and in a 'zombie' state for years. Which, to a large extent, explains why private indebtedness has been declining in both economies. When somebody in the private sector pays down debt, say €100, and the banking system does not reallocate that €100 to a new private sector borrower, aggregate demand will contract by €100. To prevent this demand recession, the government must step in to borrow and spend the €100. Moreover, because the private sector is deleveraging, what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. Instead, government borrowing and spending turns out to be a very sensible economic policy. On this basis, Japan countered its aggressive private sector deleveraging with equally aggressive public sector leveraging and thereby kept its economy motoring along. By contrast, Italy had its hands tied by the EU fiscal compact - which mistakenly looks at public indebtedness in isolation rather than in combination with private indebtedness. Hence, the Italian government was prevented from recapitalizing its banking system, and the Italian economy stagnated for a decade (Chart I-14 and Chart I-15). Chart I-14The Italian Government Was Prevented ##br##From Recapitalising The Banks... The Italian Government Was Prevented From Recapitalising The Banks... The Italian Government Was Prevented From Recapitalising The Banks... Chart I-15...And The Italian Economy ##br##Stagnated For A Decade ...And The Italian Economy Stagnated For A Decade ...And The Italian Economy Stagnated For A Decade In this sense, the populist parties in Italy - The League and 5 Star Movement - have correctly identified that Italy's problem is not the euro per se, but the EU's fiscal dogma. Both parties have dropped calls for a referendum on Italy's membership of the euro area, but have doubled down on their intentions to ignore the EU's misguided fiscal rules, such as the 3 per cent limit on budget deficits. As long as Italian populists correctly focus their fire on EU rules rather than the single currency, investors should view the ongoing drama of Italian politics as an irritation, rather than an existential risk to the euro area. Nevertheless, for the time being, we prefer France's CAC over Italy's MIB and Spain's IBEX. This is less a function of politics, and more a function of the latter markets' outsize exposure to banks, a sector in which we remain underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Global equities and high yield and EM debt is worth around $160 trillion and global real estate is worth $220 trillion. 2 Assuming no default risk and no reinvestment risk. Fractal Trading Model* This week, we note that SEK/EUR is at a key technical turning point, and due a countertrend rally. As we already have a long SEK/GBP position open, we are not doubling up with SEK/EUR. In other trades, we are pleased to report that long USD/Chilean peso hit its 2.7% profit target, and is now closed. This leaves us with four open positions. 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-16 SEK/EUR SEK/EUR The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Despite recent softness in the data, Swedish growth will remain robust over the next 6-12 months, supported by loose monetary conditions and solid export demand. Inflation has climbed back to the Riksbank 2% target, and additional increases are likely over the next 6-12 months. Though debt levels are high, households are relatively healthy given strong wealth, solid disposable income and elevated saving rates. Swedish politics will not substantively impact the markets. If the Moderate Party comes to power, it is unlikely to make significant policy departures from the Social Democrats. Swedish banks' capital levels are elevated, particularly compared to their EU peers. Still, the massive exposure to domestic real estate suggests that banks could not withstand a meaningful decline in house prices. The uninterrupted, long-term surge in Swedish house prices suggests that a bubble has formed. A strong supply-side response has softened prices as of late, but a massive correction is not imminent given robust economic growth and very accommodative monetary policy. Negative interest rates are inconsistent with the robust growth Sweden is experiencing. Going forward, strong growth momentum, rising inflation and a tight labor market will force policymakers to raise rates earlier, and by more, than markets expect. Sweden government debt will underperform global developed market peers over the next 6-12 months. Feature Chart 1Watch What They Do,##BR##Not What They Say Watch What They Do, Not What They Say Watch What They Do, Not What They Say Sweden is a country that has been very frustrating to figure out for investors and analysts alike over the past few years. The economy has been performing very well, with real GDP growth averaging around 3% since 2013, well above the OECD's estimate of potential GDP growth of 2.2%. Over that same period, the unemployment rate has fallen from 8% to 6.5% while inflation has risen from 0% to 2%. These are the types of developments that would normally lead an inflation targeting central bank like the Riksbank to contemplate a tightening of monetary policy. Yet while the Riksbank has been projecting significant increases in policy rates and bond yields every year for the past few years, it has actually delivered additional interest rate cuts, bringing the benchmark repo rate down into negative territory in 2014 and keeping it there to this day (Chart 1). In this Special Report, we examine Sweden's economic backdrop, upcoming elections and the health of the financial system to determine the likely future path of Swedish interest rates. We conclude that investors should not fear an imminent collapse of the Swedish housing bubble or a shock outcome in the September general election. A shift in direction for monetary policy, however, is likely later this year, with the Riksbank set to become more hawkish in response to an economy that no longer requires ultra-loose monetary conditions. This has bearish strategic implications for Swedish fixed income, and could finally place a floor under the beleaguered krona. Economy: Sustained Growth Outweighs Potential Risks After experiencing slowing growth momentum in 2016, Sweden's economy made a solid recovery in 2017. Real GDP growth came in at 3.3% on a year-over-year basis in Q4/2017, following on the strong prints earlier in the year. The Riksbank believes that GDP growth will slow slightly in 2018 due to some softening in consumer spending and business investment. However, real consumption has remained resilient and should be supported by the continued recovery in wages. Capital spending has also been robust and industrial confidence remains in an uptrend. While both the OECD leading economic indicator and manufacturing PMI have pulled back in recent months, both are coming off elevated levels. The PMI remains well above the 50 line, suggesting that strong growth momentum remains intact (Chart 2). The National Institute of Economic Research's economic tendency survey bounced back in April on the back of manufacturing and construction strength, with readings for the survey having been above 100 (signifying growth stronger than normal) every month since April 2015. One important factor helping support above-trend growth is fiscal policy, which has become modestly stimulative after two years of major fiscal drag in 2015 and 2016. As an export-oriented country, Sweden is highly levered to the state of the global economy. Export growth remains supported by continued strong global activity, low unit labor costs and recent krona weakness. Real exports expanded at a 4.7% rate (year-over-year) at the end of 2017 and the outlook is bright given firming growth in Sweden's largest export partners and the considerable depreciation of the krona. This is confirmed by our export model, which is signaling a pickup in export growth through the rest of the year before moderating slightly in 2019 (Chart 3). Chart 2Swedish Growth Cooling Off A Bit,##BR##But Remains Strong Swedish Growth Cooling Off A Bit, But Remains Strong Swedish Growth Cooling Off A Bit, But Remains Strong Chart 3Export Growth##BR##Will Remain Solid Export Growth Will Remain Solid Export Growth Will Remain Solid Healthy employment growth has driven Sweden's unemployment rate to 6.5%, more than one full percentage point below the OECD's estimate of the full-employment NAIRU1 rate (Chart 4). The spread between the two (the unemployment gap) has not been this low in nearly two decades. During the last period when unemployment was below NAIRU in 2007-08, wage growth surged to over 4%. However, Swedish wage growth has been subdued following the 2008 financial crisis, has been the case in most developed countries, even as unemployment continues to fall. Currently, annual growth in average hourly earnings is now displaying positive upward momentum, both in nominal terms (+2.5%) and, even more importantly for consumer spending, in real terms (+0.9%). A tightening labor market will support additional wage increases in the coming months. Importantly, Swedish wages are also influenced by wages in countries that are export competitors. For example, they have closely tracked German wages in recent years. The strong wage increases coming out of the latest round of German labor union negotiations is therefore a positive sign for Swedish wage growth.2 In addition, there is scope for more improvement as the unemployment rate is still above its pre-crisis level. Sweden has experienced a large inflow of immigration over the last decade and the unemployment rate for non-EU-born residents is approximately four times higher than the national figure. The government is stressing education and skill-building programs to address this issue and speed up the integration process. To the extent that these programs are successful, there is scope for a decline in the immigrant unemployment rate that can pull the overall national unemployment rate even lower - as long as the economy continues to expand and the demand for labor remains robust. A rising trend in domestic price pressures from the labor market can extend the recent uptrend in Swedish inflation. Inflation has been steadily rising since the deflation scare at the end of 2013, driven by consistent above-trend economic growth which has soaked up all spare capacity in the Swedish economy (Chart 5). The latest print on headline CPI inflation was 1.9%, while CPIF inflation (the Riksbank's preferred measure that is measured with fixed interest rates) sits right at the central bank's 2% target. Market-based inflation expectations have eased a bit on the year, though most survey-based measures have remained firm. Chart 4Wage Pressures Intensifying Wage Pressures Intensifying Wage Pressures Intensifying Chart 5Inflation Back To Target, May Not Stop There Inflation Back To Target, May Not Stop There Inflation Back To Target, May Not Stop There Rising oil prices have lifted inflation and BCA's commodity strategists believe that there is some additional upside given high demand and declining inventories, suggesting additional inflationary pressure ahead. In addition, even though core prices have historically been weak in the summer months, our Swedish core CPI model suggests that inflationary pressures will continue to build over the next six months, primarily due to booming resource utilization (bottom panel). Additionally, inflation should remain supported by a weaker krona, which has declined 8.5% year-to-date despite robust domestic fundamentals. The real trade-weighted index (TWI) peaked in 2017 and is now at a post-crisis low. These depressed levels suggest the currency can rise without derailing export growth. Going forward, the Riksbank expects the krona to gradually appreciate, based on projections from the April 2018 Monetary Policy Report (MPR).3 However, the currency has closely tracked the real policy rate (Chart 6) and thus could continue to fall below the Riksbank's projected path if our base case scenario of inflation rising further before the Riksbank starts hiking rates plays out - providing an additional boost to inflation from an even weaker krona. While the cyclical economic story in Sweden still looks solid, there remains a significant potential structural headwind in the form of high household debt. Mortgage borrowing has propelled the debt-to-income ratio to over 180% and the debt-to-GDP ratio to over 80%, making Swedish households some of the most indebted in the developed world (Chart 7). The Riksbank projects that debt-to-income will reach 190% by 2021 and its financial vulnerability indicator is at a post-crisis high. While we are certainly not understating the risks associated with such a massive debt load, we do not view this as an imminent threat to the economy. Chart 6VERY Loose Monetary Conditions##BR##In Sweden VERY Loose Monetary Conditions In Sweden VERY Loose Monetary Conditions In Sweden Chart 7Swedish Households Can##BR##Manage High Debt Swedish Households Can Manage High Debt Swedish Households Can Manage High Debt Swedish households' financial situation is better than it appears, with wealth three times larger than liabilities. Additionally, disposable income, which suffers under Sweden's high tax rates, should receive a boost this year from the increase in child allowance and lower taxes on pensioners. Importantly, the Swedish personal saving rate has been trending upward since the financial crisis and currently is one of the highest in the developed world at 9.6%. In addition, while about 70% of Swedish mortgages are variable rate, consumers are prepared for higher interest rates. Survey data shows household expectations on rates are in line with the National Institute of Economic Research's forecast. Outside of a negative growth shock or a substantial and rapid rise in interest rates, which is not our base case, Swedish high household debt levels should not pose a risk to the current economic expansion. Bottom Line: Despite recent softness in the data, Swedish growth will remain robust over the next 6-12 months, supported by loose monetary conditions and solid export demand. Inflation has climbed back to the Riksbank 2% target, and additional increases are likely over the next 6-12 months. Though debt levels are high, households are relatively healthy given strong wealth and elevated saving rates. Politics: Moderating On All Fronts Sweden has become something of a poster child for a country where immigration policy has become unhinged. In the U.S., Sweden's struggle to integrate recent arrivals, particularly its large asylum population, is a frequent feature on right-wing news channels and websites. The narrative is that Sweden is overrun with migrants and that, as a result, anti-establishment and populist parties will be successful in the upcoming elections on September 9th. This view is based on some objective truths. First, Sweden genuinely does struggle to integrate migrants. As BCA's Chief Global Strategist, Peter Berezin, has showed, Sweden is one of the worst performers when it comes to integrating immigrants into its labor force (Chart 8) and in educational attainment (Chart 9).4 Peter posits that the likely culprit is the country's generous welfare state, which discourages migrants from participating in the labor force and perhaps creates a self-selection process where migrants and asylum seekers looking to enter Sweden are those most likely to abuse its generous public support system.5 Chart 8Immigrants Have Trouble##BR##Integrating Into The Labor Force Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore Chart 9Immigrants Have Trouble##BR##In Swedish Education Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore Second, the country's premier populist party - the Sweden Democrats - is relatively successful in the European context. Its ardently anti-immigrant policy has helped the party go from just 2.9% of the vote in 2006, to 12.9% in 2014. For much of 2017, Sweden Democrats have polled as the second most popular party in the country, behind the ruling Social Democrats (Chart 10). Chart 10Anti-Establishment Party Polling Well Anti-Establishment Party Polling Well Anti-Establishment Party Polling Well At the same time, the pessimistic narrative is old news and misses the big picture. In Europe, the anti-establishment parties are moving to the center on investment-relevant matters - such as EU integration - while the establishment parties are adopting the populist narratives on immigration. BCA's Geopolitical Strategy described this process in a recent Special Report that outlined how political pluralism - as opposed to the party duopoly present in the U.S. - encourages such a political migration to the center.6 Sweden is a dramatic case of increasing political pluralism. As such, its political evolution is relevant to the thesis that investors should not fear pluralism because the anti-establishment will migrate to the center while the establishment adopts anti-immigrant rhetoric. This is precisely what has been happening in Sweden for the past six months. First, the ruling Social Democrats - traditionally proponents of migration in the country - have called for tougher rules on labor migration, a major departure from party orthodoxy. Second, Sweden Democrats have seen an exodus of right-wing members, including the former leader, as the party moves to the middle ground on all non-immigration-related issues. This opens up the possibility for Sweden Democrats to join the pro-business Moderate Party in a coalition deal after the election. Should investors fear the upcoming election? Our high conviction view is no. There are three general conclusions we would make regarding the election: Anti-asylum policies will accelerate. All parties are becoming more anti-immigrant in Sweden as the public turns against the country's liberal asylum policies. This is somewhat irrelevant, however, as the influx of asylum seekers into Europe has already dramatically slowed due to better border enforcement policies by the EU (Chart 11). Meanwhile, the pace of migration to Sweden from other EU countries will not moderate, given that the country is part of the continental Labor Market. This is important as EU migrants make up 32% of total migrants into Sweden and tend to be more highly educated and much better at participating in the labor market. Euroskepticism is irrelevant: There is absolutely no support for exiting the EU, with Swedes among the most ardent supporters of remaining in the bloc. Less than a third of Swedes are optimistic about a life outside the EU, for example (Chart 12). As such, the pace of migration will only moderate in so far as the country accepts less refugees going forward. There will be no break with the EU Labor Market and no "Swexit" referendum on the investable time horizon. Chart 11Asylum Flows Are Slowing Asylum Flows Are Slowing Asylum Flows Are Slowing Chart 12Swedes Are Europhiles Swedes Are Europhiles Swedes Are Europhiles The Moderate Party is not a panacea: The pro-business, center-right, Moderate Party is often seen as a panacea for investors. It is true that the party's rise to power, in 1991, coincided with a severe financial crisis and that it was under its leadership that reform efforts began in earnest. However, the Social Democrats already initiated reforms ahead of their 1991 loss and accelerated structural changes well past Moderate Party rule, which ended in 1994. Some of the deepest cuts to the country's social welfare programs were in fact undertaken under Prime Minister Göran Persson, who was either the finance or prime minister between 1994 and 2006. Bottom Line: Swedish politics will not substantively impact the markets. Sweden Democrats are shifting to the center on non-immigration issues. Meanwhile, moderate parties are becoming more anti-immigrant. While there are no risks, we would also not expect major tailwinds. If the Moderate Party comes to power, it is unlikely to make significant policy departures from the Social Democrats. Banks: In Good Shape... For Now Chart 13Sweden's Banks Are In Excellent Shape Sweden's Banks Are In Excellent Shape Sweden's Banks Are In Excellent Shape Swedish banks have been generating solid earnings growth, far outpacing their EU peers, as net interest margins are at multi-year highs and funding costs are low (Chart 13). Solid domestic economic growth has helped boost lending volumes. Non-performing loans have been in a downtrend since 2010 and have stabilized at very low levels. While we expect lending volumes to stay strong and defaults to remain low over the medium term given robust economic growth, we are more cautious on the earnings front. Our base case is that the Riksbank will finally embark on the beginning of a monetary tightening cycle at the end of 2018, and banks will likely struggle to maintain the current solid pace of earnings growth with a policy-driven flattening of the Swedish yield curve. Sweden has stricter capital requirements than their EU peers and, as such, the banks are far better capitalized. Both the aggregate Liquidity Coverage Ratio, a measure of short-term liquidity resilience, and the Net Stable Funding ratio are above Basel Committee requirements and have steadily increased over the past few quarters. The ratio of bank equity to risk-weighted assets paints an overly sanguine picture given that banks use internal models to calculate risk weights and are likely underestimating the risk associated with their massive mortgage exposure. Still, our preferred metric, the ratio of tangible equity to tangible assets, has remained firmly at elevated levels. Sweden's banking system has long been dominated by four major banks (Nordea, SEB, Svenska Handelsbanken and Swedbank). However, Nordea, Sweden's only global systemically important bank, is planning to move its headquarters to Finland later this year. The move will drastically reduce the size of Sweden's national bank assets from 400% of GDP to just under 300%. Nordea has clashed with Sweden's government over higher taxes and increased regulation and the relocation is projected to save €1.1 billion over the long run. Importantly, Nordea will be overseen by the European Banking Union. Overall, we believe this lowers the risk to the Swedish banking system given the reduction in banking assets. More importantly, Swedish authorities will no longer be financially responsible for future problems that could develop at Nordea. Bottom Line: Swedish bank earnings growth has been solid, but will come under pressure once the Riksbank begins to raise rates this year. Capital levels are elevated, particularly compared to their EU peers. Still, the massive exposure to domestic real estate suggests that banks could not withstand a sharp or prolonged decline in house prices. Housing: The Beginning Of The End? House prices in Sweden have been in an uninterrupted, secular uptrend due to low interest rates, robust demand, a structural supply shortage and considerable tax incentives for home ownership. While many of its EU counterparts had significant housing corrections over the last decade, the Swedish market escaped relatively unscathed. In fact, the last meaningful decline was during the 1990s crisis, when house prices fell close to -20%. Chart 14The Overheated Housing Market##BR##Has Cooled Off The Overheated Housing Market Has Cooled Off The Overheated Housing Market Has Cooled Off Swedish authorities believe that the bubbling housing market poses the greatest risk to the Swedish economy, given the sheer magnitude of the uptrend and the Swedish banking sector's massive exposure (Chart 14). Valuation metrics indicate that housing is overvalued and, as such, the current five-month decline has prompted concerns that a meaningful correction may be underway. However, the recent pullback was a result of a strong supply-side response that began in 2013, specifically the construction of tenant-owned apartments. Last year had the most housing starts since 1990. That new supply is still insufficient to meet expected demand, however, and Swedish policymakers are implementing a 22-point plan to both increase and speed up residential construction. Swedish regulators have introduced multiple macroprudential measures over the past few years in order to both cool demand and boost household resilience. These include placing a cap on the size of mortgages (85% of the value of a home), raising banks' risk weight floors7 and multiple adjustments to amortization requirements. Data suggests that these policies have affected consumer behavior by both decreasing the amount of borrowing and causing buyers to purchase less expensive homes. Additionally, the government has recently approved legislation that will boost the ability of the financial regulator (Finansinspektionen) to act in the event of a potential downtown. The policy measures to cool the housing market have been fairly effective, with house prices now down -4.4% on a year-over-year basis (middle panel). However, economic history teaches us that asset bubbles never deflate peacefully. We are concerned over a structural horizon, but we believe that a massive correction is unlikely over the next year. Economic growth will like remain robust and monetary policy is very accommodative. It will take multiple rate hikes before monetary conditions are restrictive, thereby drastically weakening demand and prompting a sustained reversal in the house price uptrend. Bottom Line: The uninterrupted, long-term surge in Swedish house prices suggests that a bubble has formed. A strong supply side response has softened prices as of late, but a massive correction is not imminent given robust economic growth and very accommodative monetary policy. Monetary Policy: Riksbank On Hold, But Not For Long At the most recent monetary policy meeting in late-April, the Riksbank decided to keep the benchmark repo rate at -0.5%, further exercising caution after prematurely raising rates in 2010-2011. The Riksbank acknowledged that economic growth was "strong", but also maintained that inflation was "subdued" and monetary conditions needed to remain stimulative to ensure that inflation would sustainably stay at the 2% target. They revised their projected path for the repo rate downward, with the first hike now only coming at the end of this year. Even after that liftoff, however, the Riksbank plans to continue reinvesting redemptions and coupon payments from its government bond portfolio, accumulated during its quantitative easing program that ended last December, for "some time". Chart 15Our New Riksbank Monitor##BR##Is Calling For Rate Hikes Our New Riksbank Monitor Is Calling For Rate Hikes Our New Riksbank Monitor Is Calling For Rate Hikes In recent years, the Riksbank has moved the repo rate alongside the ECB's policy rate, in order to protect export competitiveness by preventing an unwanted appreciation of the krona. However, the fundamentals do not justify this. Inflation is in a clear uptrend and has recovered to the Riksbank's target, while euro area inflation is still well below the ECB's target. Additionally, Swedish growth has been outpacing that of the euro area, and relative leading indicators suggest this will continue. While the ECB continues to emphasize that it has no plans to raise interest rates anytime soon, it is now far more difficult for the Riksbank to justify keeping its policy rates below zero as the ECB is doing. It is one thing to have negative interest rates and a cheap currency when there is plenty of economic slack and inflation is well below target. It is quite another to have those same loose policy settings when the output gap is closed, labor markets are at full employment and inflation is at target. This can be seen by the reading from our new Riksbank Central Bank Monitor (Chart 15). The BCA Central Bank Monitors are composite indicators designed to measure cyclical growth and inflation pressures that can influence future monetary policy decisions. A reading above zero indicates that policymakers are facing pressures to raise interest rates. We have Monitors for most developed markets, but we had not yet built the indicator for Sweden. Currently, the Riksbank Monitor is in "tight money required" territory, as it has been since late-2015. Though the Monitor has been primarily being driven upward by the growth component, the inflation component is also above the zero line. Forward interest rate pricing in the Swedish Overnight Index Swap (OIS) curve indicates that markets are not expecting the Riksbank to begin hiking rates until July 2019. Only 95bps of hikes are priced by March 2020, suggesting that the market expects a very moderate start to the tightening cycle once it begins. Given the still-positive growth and inflation backdrop, we expect that the Riksbank will begin to hike earlier - likely by year-end as currently projected by the central bank - and by more than currently discounted by markets. Bottom Line: Negative interest rates are inconsistent with a robust Swedish economy that is operating with no spare capacity. Going forward, strong growth momentum, rising inflation and a tight labor market will force policymakers to raise rates earlier, and by more, than markets expect. Investment Implications With the market not priced for the move in Riksbank monetary policy that we expect, investors can position for that shift through the following recommended positions (Chart 16): Chart 16How To Position For##BR##Higher Swedish Interest Rates How To Position For Higher Swedish Interest Rates How To Position For Higher Swedish Interest Rates Underweight Swedish bonds within a global hedged fixed income portfolio. Swedish government debt has been a star performer since the beginning of 2017, outperforming the Barclays Global Treasury Index by 101bps (currency-hedged into U.S. dollars). Global yields have risen over that period while Swedish yields have remained fairly flat. This trend is unlikely to continue, moving forward. The Riksbank ended the net new bond purchases in its quantitative easing program last December, removing a powerful tailwind for Swedish debt performance. If the Riksbank begins to hike rates by year-end, as it is projecting and we expect, then interest rate convergence will begin to undermine the ability for Sweden to continue its impressive run of fixed income outperformance. Enter a Sweden 2-year/10-year government bond yield curve flattener. As the Riksbank begins to shift to a more hawkish tone over the coming months, markets will begin to reprice not only the level of Swedish interest rates but the shape of the Swedish yield curve. That means not only higher bond yields but a flatter curve, as too few rate hikes are currently priced at the short-end. Growth is robust, inflation is at target and the unemployment rate is well below NAIRU. With their mandates met, the Riksbank will be forced to act more aggressively. Importantly, there is no flattening currently priced into the Swedish bond forward curve, thus there is no negative carry associated with putting on a flattener now. Short 2-year Sweden government bonds vs. 2-year German government bonds. The yield spread between the Swedish and German 2-year yield is only 5bps, well below its long-run average of 27bps. Relative fundamentals suggest that the Riksbank will no longer be able to shadow the actions of the ECB (negative policy rates) as it has over the past few years. Growth in Sweden is likely to outpace that of the euro area once again in 2018. Swedish inflation is already at the Riksbank target while euro area inflation continues to undershoot the ECB benchmark. Also, the currencies have moved in opposite directions since 2017, with the Euro Area trade-weighted index (TWI) rising by 7% and Sweden TWI falling by 6%, suggesting that Sweden can better handle tighter monetary policy. With the ECB signaling that it is in no hurry to begin raising interest rates (even after it ends its asset purchase program at the end of the year, as we expect), policy rate differentials will drive the 2-year Sweden-Germany spread wider over the next 12-18 months, with no spread move currently priced into the forwards. Patrick Trinh, Associate Editor patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Non-Accelerating Inflation Rate Of Unemployment 2 https://www.reuters.com/article/us-germany-wages/german-pay-deal-heralds-end-of-wage-restraint-in-europes-largest-economy-idUSKBN1FP0PD 3 https://www.riksbank.se/globalassets/media/rapporter/ppr/engelska/2018/180426/monetary-policy-report-april-2018 4 Please see BCA Global Investment Strategy Special Report, "The Future Of Western Democracy: Back To Blood," dated November 18, 2016, available at gis.bcaresearch.com. 5 Please see BCA Global Investment Strategy Special Report, "The End Of Europe's Welfare State," dated June 26, 2015, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Should Investors Fear Political Plurality," dated November 29, 2017, available at gps.bcaresearch.com. 7 25% of the value of a mortgage loan must be included when banks calculate their required regulatory risk-weighted capital levels.

Highlights Chart 1Interest Rate Expectations Interest Rate Expectations Interest Rate Expectations Last week the Federal Reserve made some necessary tweaks to the language in its statement. Namely, with the year-over-year core PCE deflator now up to 1.88%, the Fed was forced to upgrade its assessment of inflation and note that it has "moved close" to the 2 percent target. To assuage concern that such a change might lead to a quicker pace of rate hikes, the statement also emphasized that the inflation target is "symmetric" and noted that its policy of "gradual increases in the federal funds rate" will continue. While the recent increase in inflation is not sufficient to nudge the Fed away from "gradualism", the more important observation is that yields are still not high enough to discount the Fed's gradual approach (Chart 1). The Fed has tightened policy once per quarter since December 2016, tapering asset purchases in place of a rate hike in September 2017. It should be obvious that, absent an economic shock, one rate hike per quarter is the Fed's definition of "gradual". And yet, the market is still priced for barely more than two hikes for the balance of 2018, and not even two rate hikes for all of 2019! Maintain a below-benchmark duration stance until the market comes to grips with the Fed's gradualism. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 4 basis points in April, bringing year-to-date excess returns up to -77 bps. The Corporate index option-adjusted spread tightened somewhat in the first half of April, but widened anew during the past couple of weeks and recently made a new high for the year. Despite this sell-off, valuation remains expensive for investment grade corporates. The 12-month breakeven spread for an A-rated bond has only been tighter 27% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 28% of the time. We are preparing to cyclically scale back our corporate bond exposure, and will start the process once TIPS breakeven inflation rates reach our target range, signaling that monetary conditions are sufficiently restrictive. Our target range is 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Those rates currently sit at 2.16% and 2.23%, respectively. In a recent report we noted that corporate bond excess returns fall sharply once the 2/10 Treasury yield curve flattens to below 50 bps, though they typically remain positive until the curve actually inverts.1 The 2/10 Treasury slope currently sits at 45 bps. That same report also notes that while the outlook for corporate revenue growth is strong, rising employee compensation costs will likely soon put a dent in profit margins and cause gross leverage to resume its uptrend (panel 4). This will apply further widening pressure to spreads later in the year. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Coming To Grips With Gradualism Coming To Grips With Gradualism Table 3BCorporate Sector Risk Vs. Reward* Coming To Grips With Gradualism Coming To Grips With Gradualism High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 121 basis points in April, bringing year-to-date excess returns up to 102 bps. The average index option-adjusted spread tightened 16 bps on the month, and currently sits at 343 bps. The 12-month trailing speculative grade default rate moved higher for the second consecutive month, hitting 3.92% in March. Moody's baseline forecast still calls for it to fall to 1.7% by March of next year. Based on Moody's default rate projection and our estimate of the recovery rate, we forecast High-Yield default losses of 0.85% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an unchanged junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -140 bps during this time horizon, and 100 bps of spread tightening would lead to an excess return of +654 bps. However, such a large spread tightening is almost certainly over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cyclical lows (top panel). This would be consistent with behavior typically seen late in the cycle, once the 2/10 Treasury slope flattens to below 50 bps.2 MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 18 basis points in April, bringing year-to-date excess returns up to -22 bps. The conventional 30-year zero-volatility MBS spread tightened 4 bps on the month, split between a 1 bp tightening of the option-adjusted spread (OAS) and a 3 bps decline in the compensation for prepayment risk (option cost). While mortgages are no longer excessively cheap compared to corporate credit (Chart 4), we still see limited potential for spread widening during the next 6-12 months. Rising interest rates should serve to limit mortgage refinancing, and muted refis are closely linked to tight MBS spreads (bottom panel). We also view extension risk as relatively limited for conventional 30-year MBS. Using a model of excess MBS returns that we introduced in February, we estimate that despite the 25 bps increase in duration-matched Treasury yields that occurred in April, extension risk trimmed only 2 bps off monthly excess returns.3 Our excess return Bond Map also shows that conventional 30-year MBS require far fewer days of average spread tightening to earn 100 bps of excess return than most other Aaa-rated structured products (Non-Agency Aaa-rated CMBS being the exception), although they are also more likely to deliver losses. But given the benign refinancing back-drop, we remain reasonably positive on the sector.4 Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 9 basis points in April, dragging year-to-date excess returns down to -7 bps. Sovereign debt underperformed the Treasury benchmark by 37 bps on the month, while Foreign Agencies underperformed by 15 bps and Domestic Agencies underperformed by 14 bps. Local Authorities delivered 14 bps of outperformance and Supranationals bested duration-equivalent Treasuries by 5 bps. Dollar strength hurt the performance of Sovereign debt last month, and relative valuation continues to show that Sovereigns are expensive relative to similarly-rated U.S. corporate bonds (Chart 5). We remain underweight USD-denominated Sovereign debt. Conversely, Foreign Agencies and Local Authorities continue to offer very attractive spreads, especially considering the duration and spread volatility characteristics of those sectors. Our excess return Bond Map shows that both sectors offer a superior risk/reward trade-off than the Barclays Aggregate and almost all of its components.5 The large presence of state-owned energy companies in the Foreign Agency sector means it should also benefit from higher oil prices in the coming months. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 65 basis points in April, bringing year-to-date excess returns up to 94 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% in April as fund inflows returned to the sector (Chart 6). Persistently low visible supply is also contributing to the strong technical environment for yield ratios. The tax-adjusted yield for a 10-year municipal bond is now about 46 bps below the yield offered by an equivalent-duration corporate bond. As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.6 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.7 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve rose considerably in April, steepening a touch out to the 5-year maturity point and flattening thereafter. The 2/10 Treasury slope flattened 1 basis point in April, and currently sits at 45 bps. The 5/30 slope flattened 9 bps on the month and currently sits at 34 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the slope of the yield curve during the next six months. With the 10-year TIPS breakeven inflation rate at 2.16%, it remains slightly below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. It will be difficult for the yield curve to flatten aggressively until that target is met. After that, curve flattening becomes much more likely. We continue to recommend a position in the 5-year bullet versus the duration-matched 2/10 barbell, primarily due to extremely attractive starting valuation. Our model suggests that the 2/5/10 butterfly spread is priced for 17 bps of 2/10 curve flattening during the next six months (Chart 7). With long-maturity TIPS breakevens still below target, we think that is too high a bar. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 93 basis points in April, bringing year-to-date excess returns up to 161 bps. The 10-year TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.16%. The 5-year/5-year forward TIPS breakeven inflation rate increased 6 bps and currently sits at 2.23%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.8 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. If the recent trend in inflation continues, then this re-anchoring will occur relatively soon. The annualized 6-month rate of change in the trimmed mean PCE deflator has already returned to the Fed's target, and the annual rate of change jumped from 1.71% to 1.77% in March (Chart 8). Pipeline measures of inflation pressure also continue to strengthen. Our Pipeline Inflation Indicator is in a strong uptrend and the prices paid component of the ISM manufacturing survey is closing in on 80, a level last seen in 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in April, bringing year-to-date excess returns up to -6 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 4 bps on the month and now stands at 40 bps, 7 bps above its pre-crisis low. Our recently introduced excess return Bond Map shows that both Aaa-rated credit card and Aaa-rated auto loan ABS exhibit lower risk and less potential for gains than the Barclays Aggregate index.9 It also confirms that credit card ABS are somewhat more attractive than auto loan ABS, offering approximately the same potential for excess return with less risk. Compared to other fixed income sectors, Aaa-rated ABS offer greater potential return and higher risk than Agency CMBS, Domestic Agencies and Supranationals. But the ABS sector also has a less attractive risk/reward profile than the Foreign Agency, Local Authority and Investment grade corporate sectors. Fundamentally, while consumer delinquencies remain low, they are heading higher alongside a rising household debt service coverage ratio (Chart 9). The persistent (though mild) deterioration in credit quality causes us to maintain a neutral allocation to the sector, despite reasonably attractive valuations. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in April, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month and currently sits at 69 bps, close to one standard deviation below its pre-crisis mean. Our excess return Bond Map shows that Aaa-rated non-Agency CMBS offer greater potential reward, but also greater risk, than the majority of other high-rated spread products. The exception is conventional 30-year Agency MBS, which offer a less attractive risk/reward trade-off.10 That being said, the fundamental picture for commercial real estate is less appealing than on the residential side. CMBS spreads continue to diverge from commercial property prices (Chart 10). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 26 basis points in April, bringing year-to-date excess returns up to 12 bps. The index option-adjusted spread was flat on the month and currently sits at 47 bps. According to our Bond Map, Agency CMBS offer greater potential excess return and less risk than both the Supranational and Domestic Agency sectors. We continue to view the Agency CMBS space as an attractive low-risk spread sector. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.70%. The drop in the model's fair value stems from a decline in the global PMI to 53.5 from a recent peak of 54.5. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. Logically, as slack dissipates in the economy and inflationary pressures mount, then the same level of global growth should be associated with a higher Treasury yield, all else equal. This means that at some point, as we approach the end of the cycle, the model will break down and consistently produce fair value readings that are too low. We suspect that we may be reaching this point. When we augment our model with an additional variable to measure the degree of resource utilization, in this case the employment-to-population ratio, we find that the new model projects a fair value of 3.28% for the 10-year Treasury yield (Chart 11). This 3-factor model would not have worked as well as our 2-factor model during the zero-lower bound period, as can be seen by looking at how rolling regression betas from each of the three variables moved sharply following the recession (bottom three panels). However, as we move further away from the zero-lower bound we expect the regression coefficients to return to pre-crisis levels, meaning that it will be important to monitor both trends in global growth and the amount of resource slack in the economy. 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 Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 4 For details on the Bond Map please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 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)

Highlights BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. Residential investment will add to GDP growth this year and support housing-related investments. Q1 results for S&P 500 earnings and revenues are exceeding raised expectations amid increase in tariff talk. Feature Last Friday's employment report shows a strong U.S. labor market with moderate wage pressures. The Fed can continue with a leisurely pace of rate hikes, which do not disrupt risk assets. The U.S. economy added 164,000 of net new jobs in April. Taking into account the 30,000 upward revision to the prior months, the increase in payrolls was in line with the consensus forecast of 195,000. With the 3-month moving average at 208,000 the pace of jobs growth is running comfortably above the trend growth in the labor force. This is reflected in the unemployment rate dropping from 4.1% to a new cyclical low of 3.9%. The jobless rate is nearing the 3.8% low seen during the height of the tech bubble in 2000. Even though the pace of jobs growth is strong and the unemployment rate is probing new lows, wage gains remain moderate. Average hourly earnings increased by just 0.1% m/m in April. Moreover, last month's gain was revised down to 0.2% m/m from an initially reported 0.3% m/m. As a consequence, the annual rate of wage inflation has slowed slightly to 2.6% from a recent high of 2.8% in January. The underlying trend in wage inflation is higher, but it is fairly shallow (Chart 1). The April employment report is "Goldilocks" for U.S. equities. The labor market is strong and the economy is growing about 3%. With modest wage and inflation pressures, there is no need for the Fed to turn more aggressive to cool a rapidly overheating economy. The modest trajectory of Fed rate hikes alongside modest income gains and stout consumer balance sheets will insulate the largest segment of the economy from higher interest payments and rising gasoline costs. Residential construction will also benefit from a gradual central bank, and housing-related assets are poised to outperform. Corporate profits can also continue to grow while the Fed maintains a gradual pace of rate hikes. The Q1 earnings and revenue reports for S&P 500 firms are outstanding. BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. As we stated in our report on April 2,1 conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 2 shows that at 41.8%, household purchases of essentials as a percentage of disposable income are near all-time lows and have dropped by more than 1% since early 2013. In contrast, spending on necessities rose by a record 3% in the five years ending 2008. This matches levels reached at the end of the 1980s when interest rates, inflation and oil prices all soared. Wrenching consumer-driven economic downturns ensued after both episodes. Chart 1Another Goldilocks##BR##Jobs Report For U.S. Risk Assets Another Goldilocks Jobs Report For U.S. Risk Assets Another Goldilocks Jobs Report For U.S. Risk Assets Chart 2Consumer Is Not Stressed##BR##Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs While investors remain concerned that rising rates and higher energy costs could derail the consumer and slow the economy, we take a different view. Energy represents 3.8% of consumers' spending on essentials while interest costs account for 15.9%. BCA expects that the Fed will continue to raise rates gradually in the next 12 months, in lockstep with the market's stance. However, we anticipate that the Fed will be more aggressive from mid-2019 through mid-2020 as inflation moves beyond the Fed's 2% target. BCA's U.S. Bond Strategy service notes that if we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will occur between 3.35% and 3.52%,2 roughly 35 to 50 bps higher than current levels. In previous research, we stated that a modest rise in rates would not be a burden on consumers.3 BCA's Commodity & Energy Strategy team forecasts that West Texas Intermediate oil prices will average $70/bbl. in 2018 and $64/bbl. in 2019. However, it also notes that tight balances in global oil make it likely those numbers will make excursions to $80/bbl.4 If production in Venezuela deteriorates more than expected or the supply in Iran or Libya is compromised, then oil could move beyond $80/bbl and, depending on the supply disruptions, to $90/bbl. Chart 3 shows that the consumer can easily withstand a rise in oil prices to $90/bbl. BCA's assumption is that natural gas and electricity prices will remain at current readings. Chart 3U.S. Consumer Is Well Insulated From Rising Energy Costs U.S. Consumer Is Well Insulated From Rising Energy Costs U.S. Consumer Is Well Insulated From Rising Energy Costs Bottom Line: Tighter labor markets and rising incomes will overcome rising interest rates and higher oil prices, and allow consumers to contribute to above-trend GDP growth. We see gradual upturns ahead for both oil prices and interest rates, but nothing so significant to trigger the collapse of consumer spending. Housing and housing-related assets will also flourish in the next year. Housing-Related Assets: An Update Residential investment will add to GDP growth this year and support housing-related investments. Chart 4 shows that housing in this cycle lagged previous slow-burn recoveries5 by a wide margin. Inventories of new and existing homes are near all-time lows, and the homeownership rate has turned higher alongside incomes and household formation (Chart 5). BCA's view is that escalating mortgage rates are not an impediment to housing construction. Nonetheless, housing did not contribute to economic growth in Q1 2018, but it did add 0.46% to real GDP in Q4 2017 as construction activity surged following last summer's hurricanes in Florida and Texas. Chart 4Residential Investment's Share##BR##Of GDP Has Lagged Prior Long Cycles Residential Investment's Share Of GDP Has Lagged Prior Long Cycles Residential Investment's Share Of GDP Has Lagged Prior Long Cycles Chart 5Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 6 estimates the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the gap implies an extra 1.35 million housing units. The equilibrium number of housing starts that cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' fully occurs in the next two years, which would add another 675,000 units per year, then total demand could be close to 2 million in each of the next two years. This compares with March's housing starts of 1.3 million. Clearly, this is an aggressive forecast, and we doubt starts will advance at this pace in the next few years, but it does suggest that housing construction is likely to perk up. Chart 6A Catch-Up Housing Construction##BR##Will Occur If This Gap Closes A Catch-Up Housing Construction Will Occur If This Gap Closes A Catch-Up Housing Construction Will Occur If This Gap Closes The above analysis suggests that residential investment will contribute to GDP growth this year and next. There are favorable implications for housing-related financial assets. We originally examined the implications of a rebound in residential construction activity in 2012.6 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables. We concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario in the following year (and beyond). Our original analysis is updated in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Secondly, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of houses for sale following the crisis period on housing-related asset returns. Table 1 presents the list of housing-related assets that we examined,7 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables contain useful information, with the exception of the two noted above, sales of new homes and inventories of unsold homes. The right-most column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset that varies from a low of 14% to a high of 22%. Table 1Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2017) Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors Charts 7 and 8 present a set of relatively conservative assumptions for the key housing market variables shown in Table 1, based on a rise in housing starts only modestly above the scrappage rate referred to in the previous section. We assume that house price appreciation and housing affordability are moderate due to further rate hikes from the Fed and mounting inflation. We also suppose that the homebuilders' confidence index stays flat, refi applications remain low linked to the uptrend in mortgage rates, and purchase applications rise in conjunction with housing starts. Chart 7A Set Of Conservative Assumptions... A Set Of Conservative Assumptions... A Set Of Conservative Assumptions... Chart 8...For Key Housing Market Variables ...For Key Housing Market Variables ...For Key Housing Market Variables Finally, Table 2 illustrates the predicted excess returns of housing-related assets in the coming 12 months, along with the annualized excess returns in 2017 and, for reference, in the entire sample period. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 2Excess Returns Of Housing-Related Assets* (%) Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors Investors can draw several important conclusions from our analysis: All but one of the housing-related assets are expected to outperform their respective benchmarks in the next year, even given our conservative assumptions about the pace of gains in the housing market. Our model predicts outperformance for the three corporate bond assets (shown in Tables 1 and 2) relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. Moreover, the model projects modest outperformance for agency MBS. With the exception of S&P 500 banks, the model's predicted excess returns are lower in the coming year than they have been on an annualized basis since the onset of the recovery. This highlights that housing-related assets have moved ahead at least some of the expected normalization in the housing market over the next few years. However, a full rise to our equilibrium estimate of 2 million starts during the next two years could potentially lead to an even larger outperformance than the model forecasts. Moreover, Charts 9A and 9B suggest that valuation will not be an impediment to the outperformance of housing-related assets. Chart 9AValuation Won't Be An Impediment... Valuation Won't Be An Impediment... Valuation Won't Be An Impediment... Chart 9B...For Housing Related Assets ...For Housing Related Assets ...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance in 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform, even given conservative assumptions about the housing factors. Stunning Results More than 80% of S&P 500 companies have reported Q1 results, and EPS and sales growth are well ahead of consensus expectations at the start of April. Moreover, the counter-trend rally in margins remains in place. We previewed the Q1 2018 S&P 500 earnings season earlier this year.8 82% of companies have released results so far, with 79% beating consensus EPS projections, which is well above the long-term average of 69%. Moreover, 76% have posted Q1 revenues that topped expectations, exceeding the long-term average of 56%. The surprise factor for year-over-year numbers in Q1 stands at a robust 7% for EPS and 1.5% for sales. The earnings surprise reading is well above the long-term average of 5%, while the sales surprise figure is right at the long-term average. Both the earnings and sales surprise figures are even more impressive given that analysts' views of Q1 results increased between the start of Q1 2018 and the actual Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, in effect lowering the bar for results. Table 3S&P 500: Q1 2018 Results* Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Even so, the results to date suggest that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is a stunning 26% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain high on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 3). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly stout in energy (84%), technology (35%), financials (30%), materials (30%) and industrials (25%). The technology, materials, real estate and industrial sectors likewise all experienced substantial sales gains (16%, 13%, 14% and 11% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 24%. BCA's U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors in January.9 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 10). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. The assessment grew to 20% at the start of the earnings reporting season in early April. As of May 4, 2018, the figure climbed slightly to 22%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 10High Bar For 2018... But Focus Will Quickly Turn To 2019 High Bar For 2018... But Focus Will Quickly Turn To 2019 High Bar For 2018... But Focus Will Quickly Turn To 2019 While the ebullience is linked to the tax bill, other factors such as solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. However, U.S. trade policy is a concern in several industries. Chart 11 shows that through April 27, 45 companies cited tariffs in their Q1 earnings calls, a jump from 5 in the Q4 2017 reporting season. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition.10 Analysts expect EPS growth to slow significantly in 2019 (9%) from the anticipated 2018 clip, which matches BCA's stance (Chart 12). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Chart 11Plenty Of Tariff Talk##BR##In Q1 Earnings Calls Plenty Of Tariff Talk In Q1 Earnings Calls Plenty Of Tariff Talk In Q1 Earnings Calls Chart 12Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data) and subsequently decelerate because of a modest margin squeeze as U.S. wage growth picks up (Chart 11). A slowdown in global growth will also crimp profit growth later this year. Incorporating the fiscal stimulus lifted the EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. Stay overweight stocks versus bonds. 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, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "A Signal From Gold?", published May 1, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst Monthly Report from February 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely", published April 19, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's The Bank Credit Analyst Monthly Report from March 2017. Available at bca.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report," U-3 Or U-6?," published February 13, 2012. Available at usis.bcaresearch.com. 7 Note that we have excluded fixed- and floating-rate home equity loan ABS from our list of housing-related assets because of a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," published January 16, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com.

Feature A Conversation With Ms. Mea I met with some of our European clients over the past few weeks, and used the opportunity to connect with Ms. Mea, a long-standing client of BCA who visited us last fall.1 As always, Ms. Mea was keen to scrutinize our viewpoints, delve into intricacies of our analysis and understand the differences between our interpretations of the global macro landscape and the prevailing market consensus. I hope clients find our latest dialogue insightful. Ms. Mea: It seems your negative call on emerging markets (EM) is finally beginning to work out: EM share prices in both absolute terms and relative to developed markets (DM) have dropped to their 200-day moving averages (Chart I-1). It seems we are at a critical juncture: If share prices bottom at these levels, a major upleg is likely and, conversely, if they break below this technical support, considerable downside may be in the cards. What makes you think this is not a buying opportunity? Indeed, EM stocks are testing a critical technical level. I doubt this is a buying opportunity. It looks like EM corporate profit and revenue growth have peaked (Chart I-2, top and middle panels). The question is not if but how much downside there is. I believe the downside will be substantial because the forces that drove this recovery are in the process of reversing. Chart I-1EM Equities Are At Critical Juncture EM Equities Are At Critical Juncture EM Equities Are At Critical Juncture Chart I-2EM Profits Have Topped Out EM Profits Have Topped Out EM Profits Have Topped Out First, the Chinese credit and fiscal stimulus of early 2016 has been reversed, and our China credit and fiscal spending impulse projects considerable downside in EM non-financial corporate earnings growth (Chart I-2, bottom panel). Second, Asia's manufacturing cycle is downshifting (Chart I-3). Korea's export growth is flirting with contraction (Chart I-3, bottom panel). Even if U.S. final demand remains robust, U.S. imports could slow, hurting the rest of the world. Chart I-4 illustrates that America's imports have been growing faster than its final demand, implying re-stocking of imported goods. Typically, periods of re-stocking are followed by waves of de-stocking. During the latter periods, import growth decelerates. Chart I-3Asia: Trade Is Decelerating Asia: Trade Is Decelerating Asia: Trade Is Decelerating Chart I-4U.S.: Final Demand And Imports U.S.: Final Demand And Imports U.S.: Final Demand And Imports Third, investor sentiment remains quite bullish on EM and EM equity valuations are not cheap in both absolute and relative terms (Chart I-5). Meanwhile, credit spreads as well as local bond yield spreads over U.S. Treasurys are very narrow. Chart I-5EM Equities Are Not Cheap EM Equities Are Not Cheap EM Equities Are Not Cheap Last but not least, U.S. wage growth and core inflation are rising. This warrants rising U.S. interest rate expectations and a rally in the dollar. As EM currencies depreciate against the greenback, EM stocks and bonds will sell off too. In a nutshell, it appears that the December and January spike in EM share prices was the final blow-off phase of this cyclical bull market. It is typical for a major market move to culminate with a bang. It seems this was the case with EM share prices, currencies and local bonds in December and January. Interestingly, the fact that EM share prices have failed to break above their previous highs is a bad omen (Chart I-1 on page 1). If our negative outlook on China's industrial cycle, commodities prices and the bullish view on the U.S. dollar play out, the current selloff in EM risk assets will progress into another bear market similar to the 2014-'15 episode. Ms. Mea: There is a widely held belief in the investment community that we are in the late expansion phase of the global business cycle. Late cyclical equity sectors, especially commodities and industrials, typically outperform at this stage. If so, this warrants overweighting EM as high commodities prices are going to help EM equities outperform DM ones. This is contrary to your recommended strategy of underweighting EM versus DM. Where and why do you differ from the consensus view? When discussing cycles, it is important to specify which economy we are referencing. With respect to the U.S. economy, I agree that we may be in a late-cycle expansion phase, when growth is strong, and wages and inflation are rising. In fact, in my opinion, U.S. wages and core CPI are likely to surprise to the upside (Chart I-6). Based on America's current economic dynamics, it makes sense to be overweighting late cyclicals. That said, just because the U.S. is in the late phase of its own expansion cycle doesn't mean China is at the same stage too. China's business cycle varies greatly from that of the U.S. and Europe. In my opinion, China's industrial sector in general, and capital spending in particular, are re-commencing the downtrend that took place between 2012-'16, but was interrupted by the injection of massive credit and fiscal stimulus in early 2016. Chart I-7 portrays China's manufacturing cycle along with the performance of EM stocks relative to their DM peers, as well as commodities prices. A few observations are in order: Chart I-6U.S. Wages And Inflation To Rise Further U.S. Wages And Inflation To Rise Further U.S. Wages And Inflation To Rise Further Chart I-7Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? China's capital spending and most of its industrial sectors were in their late cycle expansion phase in 2009-2011. The post-Lehman monetary and fiscal stimulus produced an unprecedented boom in investment spending. Yet, it was unsustainable because it created a misallocation of capital, enormous amounts of debt and asset bubbles. During this period, EM outperformed DM by a large margin, and global late cyclicals - such as materials, energy and industrials - outperformed the global equity benchmark. From 2012 to early 2016, there was a major downtrend in China's capital spending. Demand for capital goods/machinery and commodities downshifted and in some cases contracted (Chart I-8). After the new round of stimulus in early 2016, the Chinese economy recovered. However, the impact of this stimulus has now waned, and policymakers have been tightening policy since early 2017. Consequently, the downtrend in the mainland's industrial sector appears to be re-commencing and will likely deepen. In short, I view the rally in EM and commodities over the past two years as a mid-cycle hiatus in the bear market that began in 2011. Odds are that EM and commodities will sell off even if DM demand holds up. Chart I-9 denotes that global machinery and chemical stocks have already been underperforming the global equity benchmark. Energy stocks are still being supported by the rally in oil prices, but in my opinion it is a matter of time before oil prices roll over (we discuss our oil outlook below). However, given energy stocks have done so poorly relative to other sectors amid rising crude prices, they may not underperform, even if oil prices relapse. Chart I-8China: Construction Industry Profile China: Construction Industry Profile China: Construction Industry Profile Chart I-9Global Late Cyclicals Have Underperformed Global Late Cyclicals Have Underperformed Global Late Cyclicals Have Underperformed In 2010, I made the call that EM share prices, currencies and commodities had peaked for the decade. At the same time, I argued that technology, health care, and the equity markets with large weights in these sectors, namely the U.S., would deliver strong returns. This roadmap by and large remains pertinent. Chart I-10China Accounts For 50% Of ##br##Global Metals Demand Where Are EMs In The Cycle? Where Are EMs In The Cycle? Typically, winners of the previous decade perform poorly during the entire following decade. EM and commodities were the superstars of the last decade. There are still two more years to go in this decade. Consistent with this roadmap, we expect EM risk assets and commodities to relapse anew in the next 12-18 months. While the last two years were very painful not to chase the EM and commodities rallies, odds are that this has been a mid-cycle hiatus in a decade-long downtrend. Ms. Mea: Don't you think strong growth in DM will drive commodities prices higher, despite weakness in China? Are you bearish on oil because of China's demand too? I am optimistic about domestic demand in the U.S. and Europe. Yet, commodities prices, especially industrial commodities, are driven by China, not the U.S., EU or India. China consumes at least 50% of industrial and base metals (Chart I-10). Consistent with our view of a downtrend in China's capital spending in general, and construction in particular, we remain downbeat on industrial metals prices. Regarding oil prices, China's share in global oil demand is much smaller than it is for metals - the country consumes 14% of the world's petroleum products. Further, we are not negative on Chinese household demand for gasoline, but we are negative on mainland diesel demand. The latter fluctuates with industrial activity, as Chart I-11 illustrates. Importantly, oil prices will likely go down even if China's oil consumption growth remains robust. The basis is as follows: Investors' net long positions in oil are at record high levels (Chart I-12). Chart I-11China's Diesel Demand China's Diesel Demand China's Diesel Demand Chart I-12Investors Are Record Long Oil Investors Are Record Long Oil Investors Are Record Long Oil Traders have been buying oil because of rollover yield. Since the oil market is in backwardation, investors have been capturing rollover yield when they roll over contracts. Oil has been a carry trade over the past year as expectations of tight supply and a weaker U.S. dollar have spurred record numbers of investors to go long oil. As the U.S. dollar strengthens and China's growth slows, these traders will likely head for the exits with respect to their long oil positions. China has been importing more oil than it consumes since 2014. Our hunch is it has been accumulating strategic oil reserves. With oil prices spiking to $70, the pace of accumulation of strategic oil reserves may slow, and prices could retreat. China traditionally purchases commodities on dips. Finally, oil typically shoots up in the late stages of the business cycle. Chart I-13 illustrates that oil prices lag or at best are coincident with the global industrial cycle. In fact, often these spikes in oil prices - like the current one - occur due to supply constraints in the late stages of the business cycle. Nevertheless, they often mark the top. Chart I-13Oil Is Often Late To Peak Oil Is Often Late To Peak Oil Is Often Late To Peak In brief, while the case for oil is different than for industrial metals, risks to crude prices are tilted to the downside over the next six-to-nine months or so.2 Ms. Mea: One of the key drivers of your view on global markets has been a strong U.S. dollar. Why do you think the recent rebound in the dollar has staying power, and how far will it rally? Odds are that the U.S. dollar has made a major bottom and has entered a cyclical bull market. While we are not sure whether the greenback will surpass its early 2016 highs, it will at least re-test those levels on many crosses, especially versus EM and commodities currencies. The euro and other European currencies will likely not drop to their early 2016 lows, and as a result, EM currencies stand to depreciate considerably versus both the U.S. dollar and the euro. This will undermine the dollar- and euro-based investors' returns in EM equities and local currency bonds, and lead to an exodus of foreign funds. Contrary to market consensus thinking, the EM local interest rate differential over DM does not drive EM exchange rates. In fact, there is an inverse relationship between local interest rate spreads over U.S. rates and their currencies (Chart I-14). It is the exchange rate that drives local rates in EM. Currency depreciation pushes interest rates up, and exchange rate appreciation leads to lower interest rates. Many EM currencies correlate with commodities prices and global trade. The latter two will likely weigh on EM exchange rates in the next six to nine months. What's more, EM are much more leveraged to China than to DM. Both EM currencies as well as EM's relative equity performance versus DM mirror marginal shifts between Chinese and DM imports - the latter is a proxy for their domestic demand (Chart I-15). Chart I-14EM Currencies And Yields Differential Over U.S. EM Currencies And Yields Differential Over U.S. EM Currencies And Yields Differential Over U.S. Chart I-15EM Is Much More Sensitive To China Than DM EM Is Much More Sensitive To China Than DM EM Is Much More Sensitive To China Than DM As China's growth slumps, EM will likely catch pneumonia, while DM gets away with just a cold. This entails that EM currencies will come under downward pressure against both the U.S. dollar and the euro. Finally, provided EM ex-China has accumulated a lot of U.S. dollar debt, their currency depreciation will elevate debt stress. While we do not expect this to result in massive defaults, the ability of debtor companies with foreign currency liabilities to invest and expand will be curtailed. This is a negative for growth. EM debtors with dollar debt are much more vulnerable to an appreciating dollar than rising U.S. interest rates. From the perspective of their debt servicing costs alone, 10% dollar appreciation is much more painful than a 100 basis point rise in U.S. dollar rates. Hence, regardless of whether the greenback's rally occurs amid rising or falling U.S. bond yields, it will impose meaningful pain on EM debtors. In this context, EM sovereign and corporate spreads are too tight and will likely widen if and as EM currencies and commodities prices decline. Ms. Mea: In last week's statement, China's Politburo omitted the word "deleveraging" and the People's Bank of China cut the Reserve Requirement Ratio (RRR). Notably, onshore bond yields have dropped a lot. Does this not mean that stimulus is in the pipeline and the point of maximum stress for EM and commodities is now behind us? I doubt it. First, China's official media outlet, Caixin,3 explicitly stated that the Politburo statement does not mean either new stimulus or that the policy of battling financial excesses has been abandoned. Second, the RRR cut has led to only small net liquidity injections in the banking system. Its primary goal was to reduce interest rate costs for banks. Are falling bond yields in China a bullish or bearish signal for China-related risk assets? It is not clear. In 2017, interest rates rose considerably, yet China/EM risk assets completely ignored it. I was puzzled by this. Meanwhile, the recent drop in bond yields has coincided with falling EM share prices (Chart I-16). Third, the budget plan for 2018 does not entail major fiscal stimulus. Table I-1 denotes aggregate fiscal and quasi-fiscal spending will rise by 8% in 2018 compared to an actual rise of 8.6% in 2017 and 8.1% in 2016. All numbers are for nominal growth. Table I-1China: Fiscal And Quasi-Fiscal Spending (Annual Nominal Growth Rates) Where Are EMs In The Cycle? Where Are EMs In The Cycle? The government can always change its budgetary plans and boost fiscal spending beyond what is initially planned. This was the case in 2016. However, without material deterioration in growth, it is unlikely. The authorities undertook the 2015-2016 stimulus because of extremely weak growth and plunging global financial markets. Fourth, some commentators have noted that land sales have been strong, entailing more local government revenues and hence more infrastructure investment. Yet Chart I-17 portrays that the broad money impulse leads land sales. If their past relationship holds, land sales will decrease in the next 12 months. Chart I-16China's Bond Yields And EM Stocks China's Bond Yields And EM Stocks China's Bond Yields And EM Stocks Chart I-17China: Land Sales Are To Slump bca.ems_sr_2018_05_03_s1_c17 bca.ems_sr_2018_05_03_s1_c17 Finally, the regulatory clampdown on banks and shadow banking is ongoing. This along with the anti-corruption campaign in the financial industry could have a larger impact on credit origination than a marginal drop in interest rates or marginal liquidity provision. On the whole, if the authorities, again, open the credit and fiscal spigots wide, they will relinquish their pledge of structural reforms, a reduction of financial excesses and containing rising leverage. This would entail policymakers opting for a short-term gain in sacrifice of the country's long-term economic outlook. Growth financed by banks originating money out of thin air will ultimately (in the years ahead) lead to lower productivity and higher inflation - i.e., stagflation. I believe Beijing understands this and will not open the credit and fiscal taps too fast or too wide. In brief, China-related risk assets will likely sell off a lot before the next round of stimulus arrives. Ms. Mea: What about Chinese consumer spending and the outlook for technology companies that have become dominant in the EM equity index? Does your negative outlook for investment spending entail a downtrend in household spending? I have been bearish on China's industrial cycle and capex, but not on consumer spending. In fact, household expenditure growth is booming and is unlikely to slow a lot, even amid a downtrend in the construction sector. However, there are a number of reasons to expect a moderation of the current torrid pace of household spending: Capital spending accounts for 42% of GDP, and as it slumps, job creation and income gains will slow. If banks originate less credit, there will be less investment, and income growth will likely be affected. Contrary to widely held beliefs, Chinese households have become a bit leveraged - the ratio of household debt to disposable income is slightly higher in China than in the U.S. (Chart I-18). Further, borrowing costs in China are above those in the U.S. This entails that debt servicing costs as a share of disposable income are higher for households in China than in the U.S. Chart I-18Household Leverage: China And U.S. Household Leverage: China And U.S. Household Leverage: China And U.S. Not surprisingly, the authorities are clamping down on banks and shadow banking lending to households. It seems that policymakers in China worry much more about credit and leverage excesses than global investors. We published an in-depth Special Report on China's real estate market on April 6 where we argued that excesses remain large and a period of property price deflation cannot be ruled out.4 This means that property wealth effects could turn from a tailwind to a headwind for households for a period of time. All that said, I am not bearish on household spending, apart from real estate purchases. What does this entail for mega-cap companies' share prices, like Tencent and Alibaba? For sure, technology will continue to gain importance in China, like elsewhere. However, given these stocks have seen significant share price inflation and trade at high multiples, buying these stocks at current levels may not be a good investment. Valuations and business models as well as regulatory risks are key in the current circumstances. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. From a big-picture perspective, Chart I-19 demonstrates that Tencent's and Amazon's share prices have gone up 12- and10-fold, respectively, in real U.S. dollar terms since January 2010, as much as the run-up that occurred during previous bubbles. Chart I-19Each Decade Had A Mania Each Decade Had A Mania Each Decade Had A Mania With respect to performance of other heavyweights like TSMC and Samsung, the electronics cycle - like overall trade in Asia - has topped out, as evidenced by relapsing semiconductor prices (Chart I-20). Chart I-20Semiconductor Prices Have Rolled Over Semiconductor Prices Have Rolled Over Semiconductor Prices Have Rolled Over This is a very cyclical sector, and a further slowdown is to be expected following the growth outburst of the past 18 months. This may be enough to cause a meaningful correction in technology hardware and semi stocks. Ms. Mea: Finally, translating these themes into market strategy, what are your strongest conviction recommendations? Investment and asset allocation strategy should favor DM over EM in equity, currency and credit spaces. This strategy will likely pay off in both risk-on and risk-off environments. Our overweights within the EM equity universe are Mexico, Taiwan, Korea, India, Thailand and central Europe. In the meantime, Brazil, Turkey, South Africa and Malaysia are our strong-conviction underweights. In terms of sector trades, I would emphasize our long-standing short EM banks / long U.S. banks position. Finally, it seems EM currencies are breaking down versus the U.S. dollar. There is much more downside, and traders and investors should capitalize on this trend by being short a basket of EM currencies like the BRL, the ZAR, the CLP, the MYR and the IDR versus the dollar. For fixed-income investors, depreciating EM currencies are a major headwind for both local currency and U.S. dollar bonds, and we recommend defensive positioning. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Special Report "Ms. Mea Challenges The EMS View," dated October 19, 2017, available on emsbcaresearch.com 2 This differs from BCA's house view which is bullish on oil prices. 3 "Caixin View: Politburo Comments on Expanding Domestic Demand Don't Signal Stimulus," Caixin Global, April 2017. 4 Please see Emerging Markets Special Report "China Real Estate: A New-Bursting Bubble?," dated April 6, 2018, the link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Looking Beyond The Next Few Months The next couple of months could remain tricky for equity markets. But, with economic growth set to remain above trend for another year or so and central banks cautious about the pace of monetary tightening, we continue to expect risk assets to outperform over the 12-month horizon. To begin, our short-term concerns. Global growth has clearly slowed in recent months, with Q1 U.S. GDP growth coming in at 2.3%, well below the 2.9% in Q4; global PMIs have also come down from their recent peaks, led by the euro zone and Japan (Chart 1). Inflation has begun to spook investors, with a sharp pick-up in core U.S. inflation, including a rise to 1.9% YoY in the core PCE inflation measure that the Fed watches most closely (Chart 2). Geopolitics will dominate the headlines over the next six weeks, with the waiver on Iran sanctions expiring on May 12, the end of the 60-day consultation for U.S. tariffs on China on May 21, the possible imposition of tariffs on $50 billion of Chinese goods starting on June 4, and likely developments with North Korea and NAFTA. Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Chart 1Global Growth Has Slowed Global Growth Has Slowed Global Growth Has Slowed Chart 2...And Inflation Picked Up ...And Inflation Picked Up ...And Inflation Picked Up Investors inclined to make short-term tactical shifts might, therefore, want to reduce risk over the next one to three months. For most clients of the Global Asset Allocation service with a longer perspective, however, we continue to recommend an overweight on equities and other risk assets. In the U.S., in particular, fiscal stimulus will, according to IMF estimates, boost GDP growth by 0.8 percentage points this year and 0.9 percentage points next (Chart 3). U.S. corporate earnings should grow by almost 20% this year and around 12% next and, while this is already in analysts' forecasts, it is hard to imagine equity markets struggling against such a strong backdrop. Not one of the recession/bear market warning signals we are watching (inverted yield curve, rising credit spreads, Fed policy in restrictive territory, significant decline in PMIs, peak in cyclical spending) is yet flashing. Neither do we see any signs that higher interest rates or expensive energy prices are slowing growth. Lead indicators of capex have come off a little, but still point to robust growth (Chart 4). The housing market tends to be the most vulnerable to rising rates and the average rate on a 30-year U.S. fixed mortgage has risen to 4.5% (from 3.7% at the start of the year and a low of 3.3% in late 2016). But housing data still look strong, with a continued rise in house prices and mortgage applications steady (Chart 5). Perhaps the sector most vulnerable to rising U.S. rates in this cycle is emerging markets, where borrowers have grown foreign-currency debt to $3.2 trillion, according to the BIS - one reason for our longstanding caution on EM assets (Chart 6). With crude oil rising to $75 a barrel, U.S. retail gasoline prices now average $2.80 a gallon, up from below $2 in 2016, and transportation companies are complaining of rising costs. But, historically, oil prices have needed to rise by 100% YoY before they triggered recession (Chart 7). Chart 3U.S. Stimulus Will Boost The Economy Monthly Portfolio Update Monthly Portfolio Update Chart 4Capex Remains Robust Capex Remains Robust Capex Remains Robust Chart 5No Signs Of Higher Rates Hurting Housing No Signs Of Higher Rates Hurting Housing No Signs Of Higher Rates Hurting Housing Chart 6Could EM Be Most Affected By Higher Rates? Monthly Portfolio Update Monthly Portfolio Update Chart 7Oil Hasn't Risen Enough To Cause Recession Oil Hasn't Risen Enough To Cause Recession Oil Hasn't Risen Enough To Cause Recession Eventually, however, strong growth, especially in the U.S., will become a headwind for risk assets. There is still some slack in the labor market, with another 500,000 people likely to return to work eventually (Chart 8). When that happens, perhaps early next year, the currently sluggish wage growth will begin to accelerate. Fiscal stimulus is likely to prove inflationary, since it is unprecedented for a government to stimulate the economy so aggressively when it is already close to full capacity (Chart 9). These factors will push inflation expectations back to their equilibrium level, and the market will then need to adjust to the Fed accelerating the pace of rate hikes to choke off inflation, which will push up real bond yields (Chart 10). Chart 8Still 500,000 Who Could Return To Work Still 500,000 Who Could Return To Work Still 500,000 Who Could Return To Work Chart 9Stimulus Unprecedented In Such A Strong Economy Stimulus Unprecedented In Such A Strong Economy Stimulus Unprecedented In Such A Strong Economy Chart 10Eventually Real Rates Will Need To Rise Eventually Real Rates Will Need To Rise Eventually Real Rates Will Need To Rise When that starts to happen - perhaps late this year or early next year - the yield curve will invert, and investors will start to price in the next recession. That will be the time to turn defensive, but it is still too early now. Fixed Income: Markets are currently pricing only a 50% probability of three more Fed hikes this year, and only two hikes next year. As markets start to anticipate further tightening, long rates are also likely to rise (Chart 11). We see 10-year U.S. Treasury yields at 3.3-3.5% by year-end, and so recommend an overweight in TIPs and a short duration position. The ECB is unlikely to need to rush rate hikes, however, given the slack in the euro zone (Chart 12), and so the spread between U.S. and core euro yields should widen further. Corporate credit spreads are unlikely to contract further but, as long as growth continues, we see U.S. high-yield bonds, in particular, providing attractive returns within the fixed-income bucket. Our bond strategists find that between the 2/10 yield curve crossing below 50 BP and its inverting, high-yield debt has since 1980 given an annualized 368 BP of excess return.1 Chart 11Fed Expectations Drive Long Rates Fed Expectations Drive Long Rates Fed Expectations Drive Long Rates Chart 12Still Plenty Of Slack In The Euro Zone Still Plenty Of Slack In The Euro Zone Still Plenty Of Slack In The Euro Zone Equities: Our preference remains for developed equities over emerging, and for more cyclical, higher-beta markets such as euro zone and Japan. The risk of a stronger yen over the coming months is a concern for Japanese equities in local currency terms but, as our recommendations are expressed in U.S. dollars, the currency effect cancels out, and so we keep our overweight for now. At this stage of the cycle our preference is for value stocks (especially financials) over growth stocks (especially IT): value/growth usually performs in line with cyclicals/defensives, but the relationship has moved out of sync in the past year or so (Chart 13), mostly because of the performance of internet stocks, whose premium valuation makes them very vulnerable to any bad news. Currencies: A widening of interest-rate differentials between the U.S. and euro zone is likely to push down the euro against the U.S. dollar over the next few months, especially given how crowded the long-euro trade has become. The vulnerability of EM currencies to rising U.S. rates has been seen in the past few weeks, with sharp falls in currencies such as the Turkish lira, Brazilian real, and Russian ruble. We expect this to continue. Overall, we expect a moderate appreciation of the trade-weighted U.S. dollar over the next 12 months. Commodities: The crude oil price continues to rise in line with our forecasts, and we expect to see Brent crude above $80 a barrel before the end of the year. The price next year will depend on whether the OPEC agreement is extended, and how much U.S. shale oil production reacts to the higher price. On the assumption of a moderate increase in supply from both OPEC and the U.S., the crude price is likely to fall back moderately in 2019. We see the long-term equilibrium crude price in the $55-65 range, the level where global supply can be increased enough to satisfy around 1.5% annual growth in demand. We remain more cautious on industrial commodities, and see the first signs coming through of a slowdown in China, which will dent demand (Chart 14). Chart 13Value Stocks Look Attractive Value Stocks Look Attractive Value Stocks Look Attractive Chart 14Signs Of China Slowing bca.gaa_mu_2018_05_01_c14 bca.gaa_mu_2018_05_01_c14 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt," dated 24 April, 2018, available at usbs.bcaresearch.com GAA Asset Allocation

Highlights Bond Bear Market: TIPS breakeven inflation rates are still below target, and this gives us high conviction that Treasury yields will increase on a cyclical horizon. If we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will likely occur between 3.35% and 3.52%. Interest Sensitive Spending: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond Yields & Gold: A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Feature Chart 1The Bear Is Back The Bear Is Back The Bear Is Back After a brief pause in March, the cyclical bond bear market has resumed. The 10-year Treasury yield even briefly broke above 3% last week, with its 27 basis point rise off the early-April lows evenly split between the compensation for inflation protection and the 10-year real yield (Chart 1). To mark the occasion of the 10-year Treasury yield breaking above 3% for the first time since early 2014, this week we update our roadmap for the Two-Stage Cyclical Bond Bear Market, which we first outlined in late February.1 Specifically, we consider the questions of where the 10-year Treasury yield might be by the end of this year, and where it might ultimately peak for the cycle. On the second question we think bond investors can glean important information from trends in the price of gold. Tracking The Two-Stage Bear Market In our report from February we described how the cyclical Treasury bear market will proceed in two stages. The first stage is characterized by the re-anchoring of inflation expectations. Stage 1: The Re-Anchoring Of Inflation Expectations The 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate currently sit at 2.17% and 2.25%, respectively. Historically, when core inflation is well anchored around the Fed's target, both of those breakeven rates have traded in a range between 2.3% and 2.5% (Chart 2). This means that nominal Treasury yields still have room to rise as the market prices in a more realistic outlook for inflation. That could happen sooner rather than later. Core PCE inflation increased 0.15% in March, causing the 12-month rate of change to jump from 1.57% to 1.88% (Chart 2, bottom panel). Meanwhile, the annualized 3-month and 6-month rates of change remain well above the Fed's 2% target. Looking further out, we see inflationary pressures continuing to build in the U.S. economy. The employment data now clearly show very little slack in the labor market, and this appears to be finally filtering through to wages. The Employment Cost Index for Wages & Salaries rose 0.9% in the first quarter, its largest quarterly increase since 2007. The year-over-year growth rate in the index moved up to 2.7%, from 2.6% in Q4, and is right in line with its predicted value based on the prime age employment-to-population ratio (Chart 3).2 Chart 2Stage 1 Almost Complete Stage 1 Almost Complete Stage 1 Almost Complete Chart 3Faster Wage Growth Ahead A Signal From Gold? A Signal From Gold? As long as TIPS breakeven inflation rates remain below our target range we have high conviction that Treasury yields will increase, driven by a re-anchoring of inflation expectations. Once our TIPS breakeven target is met, the cyclical bond bear market will transition to stage two. Stage 2: The Terminal Fed Funds Rate After inflation expectations are re-anchored around the Fed's target, the most important question for bond investors becomes: How high will the Fed need to lift the policy rate to keep inflation from moving well above target? Or alternatively: What is the terminal (or peak) fed funds rate for this cycle (see Box)? Box: The Terminal Fed Funds Rate & The Equilibrium Fed Funds Rate Please note that in this report we refer to two separate, though related, concepts. We define the terminal fed funds rate as the peak fed funds rate for the business cycle. We also define the equilibrium fed funds rate as the fed funds rate that is consistent with neither an accommodative nor a restrictive monetary policy. The terminal fed funds rate is almost certainly higher than the equilibrium fed funds rate because monetary policy will likely turn restrictive before the end of the economic cycle. Chart 4Treasury Yield Models Treasury Yield Models Treasury Yield Models We can show why this question is so important using a simple model of Treasury yields based on expectations for changes in the fed funds rate and the MOVE index of implied rate volatility. The latter is a proxy for the term premium embedded in Treasury yields (Chart 4). For example, if we assume that the equilibrium fed funds rate - the rate consistent with neither accommodative nor restrictive monetary policy - is approximately 3%, and that by the end of this year the yield curve will price in a return to neutral monetary policy by the end of 2019. That would be consistent with a 10-year Treasury yield between 3.03% and 3.19% by the end of this year, assuming also that the MOVE index ranges between its current level and its historical low. This result can be seen in Table 1 by looking at the rows consistent with three rate hikes in 2018 and a 12-month discounter of 75 bps by year end. We could also assume that the equilibrium fed funds rate is 3%, but that the market will start to price in a restrictive monetary policy by the end of 2019 - i.e. a fed funds rate above its equilibrium level. That result would be consistent with a 10-year Treasury yield between 3.35% and 3.52% by the end of this year, once again assuming that the MOVE index ranges between its current level and its historical low. The bottom line is that with TIPS breakeven inflation rates still below target, we have high conviction that yields will increase on a cyclical horizon. Beyond that, if we assume that a 3% fed funds rate is roughly consistent with a neutral monetary policy stance, then we should expect the cyclical peak in the 10-year Treasury yield to be in a range between 3.35% and 3.52%. Tracking The Equilibrium Fed Funds Rate Using Nominal GDP And Gold It's worth pointing out that both examples in the prior section assumed that the MOVE index will either stay flat or decline. The reason for that assumption is that both examples assume a relatively low equilibrium fed funds rate of 3%. In other words, both examples assume that monetary policy will turn restrictive once the fed funds rate moves above 3%, causing economic growth to slow. If that assumption proves to be correct, and with the 10-year Treasury yield already close to 3%, the yield curve will undoubtedly flatten as the fed funds rate is raised. A flatter yield curve is highly correlated with lower implied rate volatility. In order for implied rate volatility to move meaningfully higher, and for us to see a much higher 10-year Treasury yield (as is shown in the bottom third of Table 1), the market will need to start discounting a higher equilibrium fed funds rate. Put differently, investors would have to believe that the fed funds rate necessary to slow economic growth and inflation is much higher than 3%. It is only in that scenario that the cyclical peak for the 10-year Treasury yield will significantly exceed the 3.35% to 3.52% range posited in the prior section. Table 1Treasury Yield Projections Under Different Scenarios A Signal From Gold? A Signal From Gold? But how can we decide whether or not the equilibrium fed funds rate is higher than 3%? One imperfect way is to simply track economic growth and look for signs that it is about to slow. Cyclical Nominal GDP Growth Chart 5 shows that one good signal of a recession is when nominal GDP growth falls below the fed funds rate. While this is a fairly reliable recession indicator, it is not always a good method for determining when monetary policy turns restrictive. For example, prior to the last recession nominal GDP growth started to wane when it was still far above the level of the fed funds rate. If we had been waiting for the fed funds rate to exceed nominal GDP growth we would have missed the inflection point toward slower growth. The method worked better prior to the 1990 recession when the fed funds rate was lifted above the pace of nominal GDP growth while the latter was still accelerating. That configuration gave a much clearer real-time signal of restrictive monetary policy. Chart 5Cyclical Spending Suggests That Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative A more refined version of this approach is to track only the cyclical sectors of the economy - those sectors that are most sensitive to interest rates. Growth in those sectors - consumer spending on durable goods, residential investment and nonresidential investment for equipment and software - tends to deteriorate prior to major downturns in overall nominal GDP (Chart 5, bottom panel). This method gives us a slightly earlier warning that monetary policy has turned restrictive. On that note, we observe that while cyclical spending as a percent of overall GDP is still in an uptrend, its rate of increase has declined during the past few quarters (Chart 6). This is mostly due to somewhat weaker consumer spending on durables. But we doubt that cyclical spending is in danger of rolling over any time soon. Chart 7 shows that the fundamentals underpinning the key cyclical sectors of the economy remain robust: Consumer sentiment is elevated compared to history, and income growth has started to move higher (Chart 7, top panel). The latter will be helped along by recently enacted tax cuts during the next few months. New orders for core durable goods already display solid growth, and survey indicators give no signal of imminent deterioration (Chart 7, panel 2). On residential investment, homebuilder confidence is near historical highs (Chart 7, panel 3), while mortgage purchase applications so far seem immune from the effects of higher interest rates (Chart 7, bottom panel). Chart 6Cyclical Spending Still Rising... Cyclical Spending Still Rising... Cyclical Spending Still Rising... Chart 7...And Fundamentals Remain Sound ...And Fundamentals Remain Sound ...And Fundamentals Remain Sound At the moment, this analysis tells us that monetary policy is probably still accommodative. Once the cyclical sectors of the economy start to slow, that will give us a signal that monetary policy is restrictive and that we are probably near the cyclical peak in Treasury yields. Inflation, Uncertainty And The Price Of Gold But is there another method we can use to track the equilibrium fed funds rate and the stance of monetary policy in real time? We think there is, and it relates to investors' perceptions of inflationary pressures in the economy. First, we recognize that when inflationary pressures are higher, the equilibrium fed funds rate is also higher. In other words, the Fed needs to lift rates further before monetary policy becomes restrictive and inflation starts to flag. This intuition is confirmed by the historical relationship between long-run inflation forecasts and the short-term interest rate (Chart 8). More interestingly, we also observe that uncertainty about the long-run inflation forecast is positively related to implied interest rate volatility, the slope of the yield curve and the price of gold (Chart 9). Once again, this is intuitive. If investors are more uncertain about the long-run inflation outlook they will demand a greater risk premium to bear inflation risk in the long-run, thus driving long-dated bond yields higher. Chart 8Inflation Forecasts &##br## Interest Rates Inflation Forecasts & Interest Rates Inflation Forecasts & Interest Rates Chart 9Inflation Uncertainty Drives##br## The Term Premium Inflation Uncertainty Drives The Term Premium Inflation Uncertainty Drives The Term Premium The gold price is positively correlated with inflation uncertainty because gold is in many ways the "anti-Fed" asset. Since it is perceived to be a long-run store of value, investors will bid up the gold price whenever there is a heightened risk that the Fed might "fall behind the curve" allowing inflation to overshoot its target. Conversely, the gold price tends to fall when the perception is that the Fed is "ahead of the curve" and is maintaining an overly restrictive monetary policy. Chart 10Gold Has Led The Fed Gold Has Led The Fed Gold Has Led The Fed This is why bond investors would be wise to heed the signal from gold. A sharply rising gold price signals that the fed funds rate is running further below its equilibrium level. This could occur because the Fed is cutting rates to levels that the market deems too low. Or, it could occur because the market now believes that the equilibrium fed funds rate is higher. A sharply falling gold price gives the exact opposite signal. It tells us that either the Fed is lifting the funds rate too far above equilibrium, or that the market is revising down its assessment of the equilibrium rate. This chain of events played out before our eyes during the past few years. The gold price started to fall sharply in early 2013, and continued its decline until late 2015 (Chart 10). A signal that investors were discounting a more restrictive monetary policy stance during that timeframe. But the Fed was not lifting rates during that period. In fact, with hindsight it now seems obvious that the gold price was falling because the market was revising down its assessment of the equilibrium fed funds rate. Investors should also note that the falling gold price signaled a lower equilibrium fed funds rate well before the Fed started to revise down its median forecast for the interest rate that is expected to prevail in the "longer run".3 Tracking the price of gold would have given us a much timelier signal than waiting for the Fed. Chart 10 also shows that the gold price has rebounded since early 2016, but has been confined to a trading range during the past few months. Not coincidentally, this rebound has coincided with the Fed ceasing the downward revisions to its estimate of the equilibrium fed funds rate. Going forward, we think that bond investors would be wise to closely track the price of gold. A significant move higher in the gold price would be a strong signal that the Fed is not tightening policy quickly enough to contain inflationary pressures. In other words, it would signal that the equilibrium fed funds rate should be revised higher. This would drive up implied interest rate volatility, apply steepening pressure to the yield curve, and lead to a higher end-of-cycle target for the 10-year Treasury yield. Bottom Line: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond investors should also track the price of gold. A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 208, available at usbs.bcaresearch.com 2 In a recent report we showed that nonfarm payrolls need to increase by 110k or more per month to drive the prime age employment-to-population rate higher, leading to faster wage growth. For further details please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 018, available at usbs.bcaresearch.com 3 The Fed's projection of the interest rate expected to prevail in the "longer run" is essentially its estimate of the equilibrium fed funds rate. Fixed Income Sector Performance Recommended Portfolio Specification