Fixed Income

Highlights Stage 1: The first stage of the bond bear market is being driven by a re-anchoring of inflation expectations. This stage will be complete when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. Stage 2: How high Treasury yields rise in Stage 2 of the bond bear market will be determined by expectations for the terminal fed funds rate. Assuming a 3% terminal rate, we would expect the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%. Risks: If our model suggests that economic surprises are likely to turn negative at a time when we also see extended net short bond positioning, then that would likely present an opportunity to tactically increase portfolio duration even though the cyclical bond bear market would remain intact. The risk of a growth slowdown emanating from China or other emerging markets also bears monitoring. Feature Some degree of calm returned to financial markets last week. The S&P 500 bounced back above 2700 and the VIX fell back below 20. Corporate bond spreads also tightened somewhat - the average High-Yield index spread tightened from 369 bps to 341 bps and the investment grade spread tightened from 95 bps to 93 bps - but the factors we are monitoring to determine the end of the credit cycle continue to send warning signs (Chart 1). We view the recent turmoil as markets adjusting to a Fed that must now become less responsive to financial conditions because inflationary pressures are mounting. As we discussed in last week's report, this dynamic is best explained using our Fed Policy Loop.1 It follows from our Fed Policy Loop analysis that we should track measures of inflation and inflation expectations and start taking credit risk off the table as these indicators rise. In that regard, neither TIPS breakeven inflation rates nor commodity prices - an indicator of pipeline inflation pressure - corrected much in the past few weeks (Chart 1, bottom panel). This suggests that the end of the credit cycle is approaching. We reiterate our view that it will soon be time to scale back the credit risk in our recommended portfolio. We will likely begin this process once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We discuss the intuition behind this target range in the section titled "A Fair Value For TIPS Breakevens" below. Currently, the 10-year TIPS breakeven inflation rate sits at 2.09% and the 5-year/5-year forward rate is 2.18%. Unlike credit spreads, the sell-off in Treasuries did not abate at all last week. Volatility also returned to the rates market, coinciding with a steeper yield curve (Chart 2). We are not nearly as anxious to increase the duration of our recommended portfolio as we are to scale back on credit risk, and believe that Treasury yields still have considerable cyclical upside. Chart 1No Correction In Breakevens No Correction In Breakevens No Correction In Breakevens Chart 2No Correction In Bond Yields No Correction In Bond Yields No Correction In Bond Yields In this week's report we discuss how we see the Treasury bear market proceeding in two stages, and also start the process of thinking about how high the 10-year Treasury yield can get before the next recession hits. We also highlight several near-term risks that could temporarily derail the cyclical bond bear market. The Two-Stage Treasury Bear Market. Stage 1: Re-Anchoring Of Inflation Expectations For some time it has been our view that the economic recovery is unlikely to end before inflation returns to the Fed's 2% target. This is simply because when inflation is very low the Fed has an incentive to keep policy accommodative, and restrictive monetary policy is typically a pre-condition for recession. It therefore struck us as odd that as recently as June 2017 the 10-year TIPS breakeven inflation rate was only 1.66%, well below levels consistent with the Fed's target. It was as though the market expected that inflation would never move higher no matter how long the Fed maintained an easy policy stance. That notion always seemed far-fetched, and this is why the first stage of the cyclical bond bear market was always likely to be driven by the re-anchoring of inflation expectations. This is the stage we are in currently, and indeed it is almost complete. We will deem that inflation expectations have become re-anchored (and the first stage of the cyclical bond bear market is complete) when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. This means that, assuming unchanged real yields, the nominal 10-year Treasury yield has another 21 bps to 41 bps of upside in Stage 1. A Fair Value For TIPS Breakevens To arrive at our fair value target for the inflation compensation embedded in the 10-year Treasury yield, we looked back to the last period when inflation was well-anchored around the Fed's 2% target. This occurred between July 2004 and June 2008. We note that during this timeframe the 10-year TIPS breakeven inflation rate spent 56% of its time between 2.3% and 2.5%. The 5-year/5-year forward TIPS breakeven rate spent 73% of its time in that range (Chart 3).2 The 2.3% to 2.5% range therefore seems like a good starting point, but we must also consider whether something has changed since the mid-2000s that might lead to a different fair value range today. One possible difference would be if the spread between CPI and PCE inflation changed significantly. The Fed targets 2% PCE inflation, but TIPS are linked to CPI inflation. CPI inflation was somewhat higher than PCE inflation in the mid-2000s, and this is one reason why TIPS breakevens were somewhat higher than 2% throughout that period. At present, we observe that the spread between CPI and PCE inflation is only slightly above where it was in the mid-2000s (Chart 4), and note that it will probably trend lower in the coming months. Chart 3TIPS Breakevens When Inflation Is ##br##Anchored (July 2004 to June 2008) The Two-Stage Bear Market In Bonds The Two-Stage Bear Market In Bonds Chart 4CPI Versus ##br##PCE CPI Versus PCE CPI Versus PCE The two biggest reasons for divergences between PCE and CPI inflation are: The different treatment of medical care inflation in the two indexes. CPI includes only out-of-pocket medical care expenses. PCE includes spending by the government on a person's behalf. The greater weight of shelter in CPI. Lately, the difference in medical care inflation between the two indexes has narrowed considerably and our models suggest that shelter inflation will continue to moderate in the months ahead (Chart 4, bottom 2 panels). This suggests that the spread between CPI and PCE inflation will continue to tighten. If the spread were to fall much below its average level from the mid-2000s, then we would revise our target range for TIPS breakevens down accordingly. The second reason why the fair value range for TIPS breakevens might be different than it was in the mid-2000s is if the inflation risk premium has undergone a structural shift. The compensation for inflation priced into bond yields can be split into (i) an expectation for future inflation and (ii) a risk premium to compensate investors for the uncertainty in that expectation. Other factors, such as changes in the post-crisis regulatory environment that impact the attractiveness of TIPS as an investment vehicle, could also potentially cause a structural shift in the inflation risk premium. We addressed this possibility in a report last year, but so far we see no conclusive evidence that such a structural shift has occurred.3 Indeed, the fact that breakevens have risen back close to their pre-crisis range in recent months suggests that the inflation risk premium is probably not structurally lower. Bottom Line: The first stage of the bond bear market is being driven by a re-anchoring of inflation expectations. This stage will be complete when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. The nominal 10-year Treasury yield has another 21 bps to 41 bps of upside before this phase of the bear market is complete. The Two-Stage Treasury Bear Market. Stage 2: Fed Rate Hikes & The Terminal Rate Debate Once inflation expectations are re-anchored the cyclical bond bear market will shift into Stage 2. With no further upside in the cost of inflation protection the emphasis in this stage will be on the path of real yields. The main question will be: How high will the Fed have to lift the real interest rate to contain inflationary pressures? Or alternatively: What is the terminal fed funds rate in this cycle? The answers to the above questions will ultimately determine how high the real 10-year Treasury yield can rise, and provide us with an end-of-cycle target for the nominal 10-year yield. Anchoring Around The Fed's Projections Chart 5Stage 2 Is All About The Terminal Rate Stage 2 Is All About The Terminal Rate Stage 2 Is All About The Terminal Rate At the moment, most FOMC participants estimate the terminal fed funds rate to be in the range of 2.75% to 3%. This may or may not be proven correct, but at least for now the market is likely to anchor around that expectation. In other words, the only way we will find out if that projection is too low is if the fed funds rate is lifted close to the 2.75% to 3% range but inflation continues to rise and economic growth shows no signs of slowing. With the fed funds rate still at 1.42%, we are at least four rate hikes away from that range. This means that any potential upward revisions to the Fed's terminal rate projections are more likely a story for late-2018 or early-2019. Notice in Chart 5 that the Fed has responded to falling inflation by lowering its median projected terminal fed funds rate, but has been more hesitant to increase its projection in response to rising inflation. This means the Fed could wait until inflation is much closer to its target before making any significant upward revisions to its terminal rate projection. The market would likely react more quickly than the Fed, but not by much. Notice that the decline in the 5-year/5-year forward overnight index swap rate was more or less coincident with the downward revisions to the Fed's projected terminal rate between 2014 and 2016 (Chart 5, bottom panel). Our view is that the market will anchor around the Fed's terminal rate projections for at least the next six months. With that in mind, we can make some back-of-the-envelope calculations for how high the 10-year Treasury yield will get before the end of the cycle. To do this we consider that the nominal 10-year yield consists of four components: Inflation expectations Inflation risk premium Real rate expectations Real risk premium Our target range of 2.3% to 2.5% for the 10-year TIPS breakeven inflation rate encompasses both the inflation expectations and inflation risk premium components. If we then assume a terminal fed funds rate of 3%, we get a real rate expectation of 1% (we subtract the Fed's 2% inflation target). This means that even if we assume no real risk premium, we get a conservative estimate for the end-of-cycle level of the nominal 10-year Treasury yield of 3.3% to 3.5%. Turning To The Models As a check on our back-of-the-envelope calculations we created simple fair value models for both the 2-year and 10-year Treasury yields (Chart 6). Both models have three independent variables: The fed funds rate Our 12-month fed funds discounter (to capture expectations for future changes in the fed funds rate) The MOVE index of implied interest rate volatility (as a proxy for the term premium) These models allow us to input various scenarios for the expected path of rate hikes and implied volatility, and then come up with appropriate fair value targets for the 10-year and 2-year Treasury yields. The results from various scenarios are shown in Table 1. Chart 6Treasury Yield Models Treasury Yield Models Treasury Yield Models Table 1End-Of-Cycle Treasury Yield Projections Under Different Scenarios The Two-Stage Bear Market In Bonds The Two-Stage Bear Market In Bonds For example, let's assume that the terminal fed funds rate is 3%. Let's also assume that the Fed delivers four rate hikes this year and the market moves to expect another two rate hikes in 2019. That would mean the market is pricing-in a fed funds rate of 2.92% by the end of 2019 - very close to a 3% terminal rate assumption. If we further assume that implied rate volatility stays flat at its current level, then our model gives us a target of 3.59% for the 10-year Treasury yield. This would seem like a reasonable end-of-cycle target for the 10-year Treasury yield in an environment with a 3% terminal fed funds rate. Table 1 also demonstrates the importance of interest rate volatility. If we assume the exact same scenario for rate hikes but also allow the MOVE index to return to its recent lows, then our end-of-cycle target for the 10-year Treasury yield falls to 3.08%. Conversely, if we allow the MOVE index to rise to its historical average, the target for the 10-year yield rises to 4.25%. As we discussed in last week's report, interest rate volatility is more likely to fall than rise between now and the end of the cycle.4 This is due to the strong correlation between interest rate volatility and the slope of the yield curve. As the Fed tightens and the curve flattens, implied volatility tends to decline. In fact, because of its strong correlation with the slope of the yield curve, any scenario where implied rate volatility increases significantly would coincide with an environment where the terminal fed funds rate is being revised higher. If 3% turns out to be a reasonable estimate for the terminal fed funds rate, then implied rate volatility is much more likely to fall than rise. All in all, if we assume that the fed funds rate will only return to 3% before the next recession, then we should expect the 10-year Treasury yield to eventually settle into a range between 3.08% and 3.59% by the end of the second stage of the cyclical bond bear market. We plan to explore whether 3% is a reasonable expectation for the terminal fed funds rate in future reports. Bottom Line: How high Treasury yields rise in Stage 2 of the bond bear market will be determined by how expectations for the terminal fed funds rate evolve. If, for now, we assume that the Fed's 3% terminal rate projection is roughly correct, then the 10-year Treasury yield will peak somewhere between 3.08% and 3.59%. Three Risks To The Bond Bear Market It is important to point out that the two-stage cyclical bond bear market described above may not play out un-interrupted. In this section we highlight three potential risks that could cause us to, at least temporarily, increase the duration of our recommended portfolio. Risk 1: Positioning One risk that could flare up in the near-term is that short positioning in the Treasury market has ramped up significantly in recent weeks. Since the financial crisis, net short positions in 10-year Treasury futures have often coincided with a lower 10-year Treasury yield three months later (Chart 7). Similarly, we have also seen positioning in oil futures become extremely net long (Chart 7, bottom panel). In a recent report we analyzed the strong correlation between oil prices and TIPS breakeven inflation rates and concluded that the correlation would likely persist throughout Stage 1 of the bond bear market.5 A significant relapse in oil prices would very likely filter through to lower bond yields. Chart 7Risk 1 = Positioning Risk 1 = Positioning Risk 1 = Positioning Risk 2: Unrealistic Expectations Much like how consensus is forming around short bond positions, consensus economic expectations are also being revised higher. This is what happens when the economic data surprise positively for a significant period of time. Expectations eventually ratchet up and then become too optimistic for the data to surpass. It is this dynamic that causes the Economic Surprise Index to be mean reverting (Chart 8). In previous reports we have shown that months with negative data surprises tend to coincide with falling Treasury yields, and vice-versa.6 While negative data surprises are not an imminent risk - a simple auto-regressive model of the Economic Surprise Index shows we should expect an index reading of +15 in one month's time - the surprise index will eventually move below zero and this will likely coincide with at least some pull-back in bond yields. Risk 3: Global Growth Slowdown A third risk to the cyclical bond bear market is that we see a relapse in global growth that derails the economic recovery before Treasury yields reach our target range. At the moment our 2-factor Treasury model - based on Global Manufacturing PMI and bullish sentiment toward the dollar - still posits a fair value 10-year Treasury yield of 3.01% (Chart 9), but a significant growth scare emanating from outside the U.S. would cause both the Global PMI to fall and bullish sentiment toward the dollar to rise. Both of those factors are bullish for U.S. bonds. Chart 8Risk 2 = Economic Surprises Risk 2 = Economic Surprises Risk 2 = Economic Surprises Chart 9Risk 3 = China/EM Slowdown Risk 3 = China/EM Slowdown Risk 3 = China/EM Slowdown For now there is no strong signal that global growth is about to slow, but some trends in China and other emerging markets bear monitoring. Our Foreign Exchange strategists' Carry Canary Indicator tracks the performance of EM / JPY carry trades.7 These trades go short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian Real, Russian Ruble or South African Rand), and as such they are highly geared to a positive global growth back-drop. Historically, a deterioration in the performance of these carry trades has often coincided with a slowdown in global growth and we notice that the outperformance of these trades has moderated in recent weeks (Chart 9, panel 2). Further, we have also seen some coincident and leading indicators of Chinese economic activity start to roll over (Chart 9, bottom 2 panels). The slowdown appears relatively benign for now but could eventually morph into a significant global event. This could occur if the growth deterioration accelerates and infects the Global PMI, or if Chinese policymakers react too strongly to slowing growth and engineer a sharp depreciation of the currency (as in August 2015). The latter scenario would impart increased bullish sentiment to the U.S. dollar and cause U.S. bond yields to fall. Both risks seem low at the moment, but are still worth monitoring during the next few months. Bottom Line: If our model suggests that economic surprises are likely to turn negative at a time when we also see extended net short bond positioning, then that would likely present an opportunity to tactically increase portfolio duration even though the cyclical bond bear market would remain intact. The risk of a growth slowdown emanating from China or other emerging markets also bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 2 Percentages calculated using daily values. 3 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 7 Please see Foreign Exchange Strategy Weekly Report, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The ascent in Treasury yields is likely to flatten out over the coming months, now that rate expectations have almost converged to the Fed dots. This should provide some near-term support for stocks. The structural outlook for bonds remains quite bearish, however. Exploding budget deficits, a retreat from globalization, and the withdrawal of well-paid baby boomers from the labor force will all combine to push up inflation. As inflation increases, the positive correlation between bond yields and stock prices will break down. This will cause bond term premia to rise, pushing yields even higher. Investors should use any bond rally as an opportunity to reduce duration risk. They should also look to scale back exposure to equities later this year in advance of a recession starting in late-2019 or 2020. Feature More Than A Technical Correction Global equities moved higher this week following last week's drubbing. We noted in our February 6th report that the correction was amplified by technical factors.1 Rising volatility led to a wave of forced selling in so-called risk parity funds. These funds automatically adjust their exposure to stocks based on how volatile they are. When volatility spiked, the funds started selling stocks. This pushed down equity prices, causing volatility to rise further, which led to even more forced selling. The good news is that the losses suffered by investors in these funds have had little effect on the underlying health of the financial system. This is a major difference from 2008, when delinquent mortgages led to huge losses for banks and other highly levered institutions. The equity selloff has also made stocks more attractive. Even after this week's rebound, the S&P 500 trades at a forward P/E of 18 - roughly where it stood in early 2017 and not much higher than it was in 2015 (Chart 1). Chart 1A Healthy Valuation Reset A Healthy Valuation Reset A Healthy Valuation Reset If that were all there was to the story, one could breathe a sigh of relief. Unfortunately, there is more to it than that. When a building collapses during an earthquake, does one blame mother nature or the company that built it? Sometimes the answer is both. The stock market had been ripe for a correction for a long time. Why did it happen last week? The answer, at least in part, is that the foundation on which the equity bull market was built - the presumption that monetary policy would stay easy for as far as the eye could see - began to crumble. The timing is too conspicuous to ignore. Stocks began to swoon just as the payrolls report revealed that average hourly earnings had surprised on the upside. Investors began to fret that the remaining runway for low inflation was not as long as they had supposed. Bond Yields Should Level Off In The Near Term... Are investors correct to be concerned? As we argue in detail below, over the long term, the answer is definitely yes. Over the next 12 months, however, the picture is much more nuanced. Actual inflation remains fairly tame. Even after this week's higher-than-expected CPI print, core CPI excluding shelter is up by only 0.8% year-over-year. Moreover, despite their recent climb, global bond yields are still quite low in absolute terms. The yield on the JP Morgan global bond index stands at 1.7%, close to half of what it was in 2011 (Chart 2). Chart 2AYields Are Still Low By Historic Standards (I) Yields Are Still Low By Historic Standards (I) Yields Are Still Low By Historic Standards (I) Chart 2BYields Are Still Low By Historic Standards (II) Yields Are Still Low By Historic Standards (II) Yields Are Still Low By Historic Standards (II) Chart 3Market Pricing Has Almost ##br##Caught Up To The Fed's Dots Market Pricing Has Almost Caught Up To The Fed's Dots Market Pricing Has Almost Caught Up To The Fed's Dots Market expectations now place the fed funds rate at the level implied by the dots for end-2018 and only slightly below the dots for end-2019 (Chart 3). Expectations for the first ECB rate hike in the second half of 2019 have also converged with what the central bank is targeting. The nearly two rate hikes for the Bank of England that are priced in this year may, if anything, be too aggressive. The latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in global bond yields will level off, and perhaps even temporarily reverse. This should give some support to stocks. ... But The Long-Term Direction For Yields Is Up While bond yields are due for a pause, the long-term trend remains firmly to the upside. BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016.2 As luck would have it, this was the same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. We argued at the time that both cyclical and structural forces would conspire to put in a bottom for yields. Since then, the global economy has continued to grow at an above-trend pace. This has caused output gaps to shrink in every major economy (Chart 4). The U.S. has now reached full employment. Wage growth tends to accelerate once the unemployment rate falls below NAIRU (Chart 5). Faster wage growth will give households the wherewithal to spend more. With little spare capacity left, this will fuel inflation. Chart 4Output Gaps Have##br## Shrunk In Advanced Economies Output Gaps Have Shrunk In Advanced Economies Output Gaps Have Shrunk In Advanced Economies Chart 5U.S. Wage Growth Set##br## To Accelerate Further U.S. Wage Growth Set To Accelerate Further U.S. Wage Growth Set To Accelerate Further The shift from fiscal austerity to largesse across much of the world is adding to the inflationary pressures. The Trump tax cuts are starting to look like chump change compared to the massive amount of spending coming down the pike. The Senate agreed last week to raise the caps on spending by $153 billion in FY2018 and an additional $143 billion in FY2019. This does not even include the $80 billion that has already been allocated to disaster relief, the still-to-be-negotiated sum for infrastructure spending, or up to $25 billion in additional annual spending that our Geopolitical Strategy team estimates would result if "earmarks" are reinstated (Chart 6).3 Chart 6Let The Good Times Roll A Structural Bear Market In Bonds A Structural Bear Market In Bonds Meanwhile, Japan is on track to ease fiscal policy this year.4 In Germany, the Grand Coalition deal was only concluded after Chancellor Angela Merkel conceded to demands for more spending on everything from education to public investment on technology and defense. Globalization, which historically has been a highly deflationary force, is on the back foot. Global trade nearly doubled as a share of GDP from the early 1980s to 2008, but has been stagnant ever since (Chart 7). Donald Trump pulled the U.S. out of the Trans-Pacific Partnership and he may very well pull it out of NAFTA. Opposition towards open-border immigration policies is rising. More Mexicans left the U.S. over the past eight years than entered it. On the demographic front, the three decade-long increase in the global ratio of workers-to-consumers has finally reversed (Chart 8). As baby boomers leave the labor force, the amount of GDP they produce will plummet. However, their spending on goods and services will continue to rise once health care expenditures are included in the tally. The combination of more consumption and less production is inflationary. Against a backdrop of slow potential GDP growth, policymakers will welcome rising inflation as the only viable tool left to deflate away high debt levels. Chart 7Global Trade Has Crested Global Trade Has Crested Global Trade Has Crested Chart 8Peak In The Ratio Of Workers-To-Consumers Peak In The Ratio Of Workers-To-Consumers Peak In The Ratio Of Workers-To-Consumers Productivity Stuck In The Slow Lane Faster productivity growth could help stave off this outcome. Unfortunately, so far, a sustained productivity revival is more of a dream than a reality. Chart 9 shows that G7 productivity has been rising at a disappointingly slow pace since the mid-2000s. Optimists like to tout the impact of robotics and the "Amazon effect". However, as my colleague Mark McClellan discussed in a series of reports, neither factor is quantitatively all that important.5 In the case of the Amazon effect, profit margins in the retail sector are close to record highs (Chart 10). This calls into doubt claims that online shopping has undermined businesses' pricing power. Recent productivity growth in the U.S. distribution sector has actually been slower than in the 1990s, a decade that produced large productivity gains from the displacement of "mom and pop" stores with "big box" retailers such as Walmart and Costco. Chart 9G7 Productivity: Not What It Used To Be G7 Productivity: Not What It Used To Be G7 Productivity: Not What It Used To Be Chart 10Retail Sector Profit Margins Near Record Highs Retail Sector Profit Margins Near Record Highs Retail Sector Profit Margins Near Record Highs Meanwhile, student test scores across the OECD have declined over the past decade (Chart 11). The accumulation of human capital has been the single most important driver of rising living standards over the past few centuries.6 This tailwind is now dissipating at an alarmingly fast pace. Chart 11AThe Contribution To Growth From ##br##Rising Human Capital Is Falling A Structural Bear Market In Bonds A Structural Bear Market In Bonds Chart 11BStudent Test Scores Are ##br##Declining In Many Countries A Structural Bear Market In Bonds A Structural Bear Market In Bonds Will The Stock-Bond Correlation Flip? As inflation becomes a greater concern over the coming years, the bond term premium will rise. Chart 12 shows that the term premium has often been negative in the recent past. This means that investors have been willing to accept a discount on holding long-term bonds relative to what they would get by rolling over short-term bills. Chart 12The Term Premium Has Been Negative Over The Past Three Years The Term Premium Has Been Negative Over The Past Three Years The Term Premium Has Been Negative Over The Past Three Years It is not surprising that this has been the case. Since the late 1990s, Treasury prices have tended to go up when the stock market sells off (Chart 13). This has made owning bonds a good hedge against bad economic news. Chart 13Bond Prices Have Tended To Rise When Equity Prices Fall Since The Late 1990s Bond Prices Have Tended To Rise When Equity Prices Fall Since The Late 1990s Bond Prices Have Tended To Rise When Equity Prices Fall Since The Late 1990s The last few weeks have seen a reversal of this pattern. Since January 26, the 10-year yield has risen by 25 basis points while the S&P 500 has fallen by 4.9%. When economies are operating at full capacity, anything that adds to aggregate demand will lead to higher inflation rather than faster growth. The latter is good for stocks because it means stronger earnings. The former is bad for stocks if it leads to a more rapid pace of rate hikes. As bond yields temporarily level off, the positive correlation between yields and equity prices should return. However, this may simply prove to be the last hurrah for this relationship. Over the long haul, bonds and equities will become more alike in the sense that they will prosper or suffer at the same time. The equity risk premium will shrink not because equities will be revalued upwards but because bonds will be revalued downwards. The runoff of the Fed's balance sheet and a slower pace of central bank bond purchases elsewhere will only compound the damage to bonds. Investment Conclusions Global bond yields are on a structural upward trajectory, however the progression will be a choppy one. The rapid rise in bond yields will flatten out, but the 10-year Treasury yield will nevertheless finish the year at about 3.25% - around 25 basis points above the forwards. Yields will continue to rise into next year. The resulting tightening in financial conditions will cause the U.S. economy to slow, ultimately setting the stage for a recession in late-2019 or 2020. The next downturn will see inflation and bond yields dip again. However, they will do so from higher levels than today. As in the 1970s, bond yields and inflation will trend higher over the coming years, reaching "higher highs" and "higher lows" with every passing business cycle (Chart 14). Investors should use any bond rally as an opportunity to reduce duration risk. They should also look to scale back exposure to equities later this year. A structurally high path for inflation is not good for the dollar. However, the coming stagflationary era will not be unique to the U.S. Many other countries actually have higher debt levels and weaker growth prospects than the U.S. More relevant to the current environment, the increasingly popular narrative that attributes the dollar's ongoing decline in 2018 to heightened fears of large budget deficits does not really mesh with what is happening to real rates. Real yields have actually surged since the start of the year (Chart 15). In this respect, today's landscape looks a bit like the early 1980s, a period when massive tax cuts and increased defense expenditures led to rising real yields and a stronger dollar. Chart 14A Template For The Next Decade? A Template For The Next Decade? A Template For The Next Decade? Chart 15Real Yields Have Surged Since The Start Of The Year Real Yields Have Surged Since The Start Of The Year Real Yields Have Surged Since The Start Of The Year Momentum is a powerful force in currency markets. This is particularly true for the dollar, which scores higher than all other currencies on our Foreign Exchange Strategy team's "momentum factor"7 (Chart 16). Today, the trend is definitely not the dollar's friend. Nevertheless, the fundamentals may be shifting in favor of the greenback. EUR/USD has decisively decoupled from the 30-year Treasury/bund spread (Chart 17). If the relationship had held, the cross would be trading at 1.12, rather than today's level of 1.25. The latest BofA Merrill Lynch survey reported "short USD" as one of the most crowded trades among fund managers. Going long the dollar could be a successful non-consensus trade for the next few months. Chart 16USD Is A ##br##Momentum Winner A Structural Bear Market In Bonds A Structural Bear Market In Bonds Chart 17EUR/USD Has Diverged From##br## Interest Rate Spreads This Year EUR/USD Has Diverged From Interest Rate Spreads This Year EUR/USD Has Diverged From Interest Rate Spreads This Year Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The Return Of Vol," dated February 6, 2018. 2 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 3 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018. 4 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018. 5 Please see BCA The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017; and Special Report, "The Impact Of Robots On Inflation," dated January 25, 2018. 6 Please see BCA Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; and BCA The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011. 7 Please see BCA Foreign Exchange Strategy Special Report, "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017. 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Highlights The best recession indicators are not flashing red, but volatility is rising as the end of the cycle approaches; U.S. fiscal policy is surprising to the upside, as we expected; The next recession will usher in an inflationary political paradigm shift, with wealth transferred from Baby Boomers to Millennials; Expect a new U.K. election ahead of March 2019, but do not expect a second referendum unless popular opinion swings decisively against Brexit; Stay short U.S. 10-year Treasuries versus German bunds; short Fed Funds Dec 2018 futures; and initiate a short GBP/USD trade. Feature February has been tough for global markets, with the S&P 500 falling by 5.9% since the beginning of the month. Several clients have pointed out that the market may be sniffing out a recession and that the "buy the dip" strategy is therefore no longer applicable. It is true that markets and recessions go together (Chart 1), but it is not clear from the data that the equity market alone predicts recessions correctly. Chart 1Bear Markets & Recessions: Unclear Which One Leads The Other Bear Markets & Recessions: Unclear Which One Leads The Other Bear Markets & Recessions: Unclear Which One Leads The Other BCA's House View is that a recession is likely at the end of 2019.1 This view is in no small part based on our political analysis.2 President Trump ran on a populist electoral platform and populist policymakers globally have a successful track record of delivering higher nominal GDP growth than their non-populist counterparts (Chart 2). We assume that the Powell Fed will respond to such higher growth and inflation prospects no differently from the Yellen Fed and that it will restrict monetary policy to an extent that will usher in a mild recession by the end of next year. Chart 2Populists Deliver (Nominal) GDP Growth Bear Hunting And A Brexit Update Bear Hunting And A Brexit Update Of course, predicting recessions is extraordinarily difficult. Being six months early or late would still be an achievement, but the implications for the equity market would likely be considerably different. If our "late 2019" call is actually an "early 2019" recession, then equity markets may indeed be at or near their cyclical peaks. A "buy on dips" strategy may work for the next quarter or so, but superior returns over the course of the year may be achieved with a bearish strategy. To help guide clients through the uncertainty, our colleague Doug Peta, chief strategist of BCA's Global ETF Strategy, has recently updated BCA's methodology for identifying the inflection points that usher in a recession.3 In our 70-year history as an investment research house, we have picked up two definitive truths: valuation and technical indicators cannot call a recession. So what can? We encourage clients to pick up a copy of Doug's analysis.4 The report highlights the three BCA Research recession indicators: the orientation of the yield curve, the year-over-year change in the leading economic indicator (LEI),5 and the monetary policy backdrop. Charts 3, 4, and 5 show how successful the three indicators are in calling recessions. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive. However, it tends to be overly eager, preceding the onset of a recession by an average of nearly twelve months. When we combine the yield curve indicator with the LEI, the false positives go away. Chart 3The Yield Curve Has Called Seven Of The Last Eight Recessions... The Yield Curve Has Called Eight Of The Last Seven Recessions... The Yield Curve Has Called Eight Of The Last Seven Recessions... Chart 4... And So Has The Leading Economic Indicator ...And So Has The Leading Economic Indicator ...And So Has The Leading Economic Indicator To confirm the recession signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's equilibrium fed funds rate model has calculated an estimate of the equilibrium policy rate, every recession has occurred when the fed funds rate exceeded our estimate of equilibrium. In other words, recessions only occur when monetary policy settings are restrictive. Today, none of the indicators are even close to pointing to a recession, with the LEI at a cyclical peak. However, the yield curve and monetary policy are directionally moving towards the end of the cycle. Taken together, they suggest that the only controversy about our late 2019 recession call is that it is so early. So why the market volatility? Because wage growth in the U.S. has begun to pick up in earnest (Chart 6), revealing that BCA's concerns about inflation may at last be coming true. Investors, after more than a year of rationalizing weak inflation by means of dubious concepts (Amazon, AI, robots, etc.), may be reassessing their forecasts in real time, causing market turbulence. Chart 5Tight Policy Is A Necessary,##br## If Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, If Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, If Not Sufficient, Recession Ingredient Chart 6Wages Picking##br## Up In Earnest Wages Picking Up In Earnest Wages Picking Up In Earnest There is of course a political explanation as well. Our colleague Peter Berezin correctly called the end of the 35-year bond bull market on July 5, 2016.6 The timing of the call - mere days after the U.K. EU membership referendum - was not a coincidence. As Peter mused at the time, "the post-Brexit shock running through policy circles leads to a further easing in fiscal and monetary policy." He was not speaking about the U.K. alone, but in global terms. Indeed, the populists have begun to deliver. Ever since President Trump's election, we have cautioned clients not to doubt the White House's populist credentials.7 After a surge in bond bearishness immediately following the election, investors lost faith in the populist narrative due to the failure of Congress to pass any significant legislation, as if Congress has ever been a nimble institution under previous presidents. But investors are beginning to realize that their collective political analysis was extremely wrong. Not only have profligate tax cuts been passed, as we controversially expected throughout 2017, but Congress is now on the brink of a monumental two-year appropriations bill that will add nearly 1% of GDP worth of fiscal thrust in 2018 higher than what the IMF expected for the U.S. (Chart 7). In addition, Congress has set in motion the process to re-authorize the use of "earmarks" - i.e. legislative tags that direct funding to special interests in representatives' home districts (Chart 8).8 Chart 72018 Fiscal Thrust Was Unexpected Bear Hunting And A Brexit Update Bear Hunting And A Brexit Update Chart 8Here Comes Pork! Bear Hunting And A Brexit Update Bear Hunting And A Brexit Update By our back-of-the-envelope accounting, Congress is about to authorize just shy of $400bn in extra spending over the next two years.9 If earmarks are allowed back into the legislative process, we could see up to another $50bn in spending. An infrastructure deal, which now also looks likely given that the Democrats have realized that their "resistance"/ "outrage" strategy does not work against the Trump White House, could add significantly to that total. We are already positioned for these political developments through two fixed-income recommendations. We are short U.S. 10-year Treasuries vs. German Bunds, a recommendation that has returned 27.7 bps since September 2017. In addition, we are short the Fed Funds December 2018 futures, a recommendation that has returned 43.17 bps since the same initiation date. In addition, we went long the U.S. dollar index (DXY) on January 31, right before the stock market correction and precisely when the greenback appeared to bottom. Should investors prepare for runaway inflation this cycle? Is it time to load up on gold? We do not think so. The fiscal impulse from the two-year budget deal will become negative in 2020. The capex incentives from the tax cut plan are also front-loaded. The paradigm-shifting impact on inflation will require a policy paradigm shift. And we expect such a shift only after the next recession. To put it bluntly, U.S. voters elected a TV game show host due to angst at a time when unemployment stood at 4.6% (the rate on November 2016). Who will they elect with unemployment rising to 6% in the aftermath of the next recession, or God forbid if that next recession is worse than we think it will be? Policymakers are unlikely to sit around and wait for an answer to that question. Extraordinary measures will be taken to prevent the median voter from lashing out against the system when the next recession hits. Inflation, which is a redistributive mechanism, will be employed to transfer wealth from savers (mainly well-to-do retirees) to consumers (their children). In large part, this will be a generational wealth transfer between Baby Boomers (or at least those with some savings) and their Millennial children. Given that Millennials have become the largest voting bloc in the U.S. as of the 2016 election, this will be a populist policy with firm backing in the electorate. The next recession will therefore usher in the inflationary era of the next decade, regardless of how painful the actual recession is. In the meantime, we recommend that clients with a 9-to-12 month horizon continue to "buy on dips," given that a recession is not on the horizon. However, with the U.S. 10-year yield approaching 3%, China moderately slowing down (with considerable risk to the downside), and the U.S. dollar slide arrested, we think that the outperformance of EM equities is over. Brexit: We Can't Work It Out10 The EU agreed on January 29 to its negotiation guidelines for the temporary transition period after the U.K. officially leaves the bloc in March 2019.11 The British press predictably balked at the conditions - the term "vassal state" has been liberally bandied about - which in our view included absolutely nothing out of the expected. The EU conditions for the transition period are not the fundamental problem. Rather, the problem is that the "Vote Leave" campaign was never honest with its promises. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister in Prime Minister Theresa May's cabinet, famously quipped after the referendum that "there will continue to be free trade and access to the single market."12 The problem with that promise, however, was that it was predicated on using London's "superior negotiating position" vis-à-vis the EU in order to force the Europeans to redefine what membership in the Common Market means. As we pointed out in our net assessment ahead of the Brexit referendum, the problem with exiting the EU but remaining in the Common Market is that the issue of sovereignty is not resolved (Diagram 1).13 As such, Johnson and other Brexit supporters argued that they could change the relationship by forcing the EU to change how the Common Market works. Diagram 1Common Market Membership Is Illogical Bear Hunting And A Brexit Update Bear Hunting And A Brexit Update Except for one problem: the U.K.'s negotiating position is not, never was, nor ever will be, superior. Anyone with a rudimentary understanding of how trade works can understand this. For example, the U.K. is a significant market for Germany, at 6% of German exports (right in line with the 6% of total EU exports that go to the U.K.). However, the EU is a far greater destination for British exports, with 47% of all exports going to the bloc.14 As we expected, the EU has surprised the conventional wisdom by remaining united in the face of negotiations. And as we also predicted, the Tories are now completely divided.15 PM May will attempt to hammer out an internal deal on how to approach the transition deal. But her political capital is so drained by the disastrous early election results that there is practically no way that she can produce a set of negotiating guidelines that will not be pilloried in the press. As such, we expect a new election to take place in the U.K. ahead of March 2019, perhaps sooner. We do not see how May's negotiating position will satisfy all wings of the Conservative Party. In addition, we see no scenario by which the ultimate exit deal with the EU gets enough votes in Westminster. Investors betting on that election replacing a second Brexit referendum would be wrong. A Jeremy Corbyn-led, Labour government will only turn against Brexit once the polls definitively turn against it. This has not yet happened, as the gap between supporters and opponents of Brexit in the polls, while widening in favor of opponents, remains within a margin of error (Chart 9). As such, Corbyn would scrap the Tory-led negotiations with the EU and ask Brussels for even more time - and thus more market uncertainty! - in order to produce a Labour-led Brexit deal.16 In order for the probability of Brexit to definitively decline, the polls have to show that "Bregret" or "Bremorse" is setting in. Without a move in the polls, U.K. politicians will continue to pursue Brexit, no matter how flawed their tactics may be. Policymakers are ultimately not the price makers but the price takers. On the issue of Brexit, the U.K. median voter is only slightly miffed regarding the outcome. Current polls suggest that Labour could win the next election, albeit needing to rule with a coalition (Chart 10). This would prolong the uncertainty facing the economy. Not only is Corbyn the most left-leaning politician in a major European economy since François Mitterand, but also his coalition would likely include the Scottish National Party and potentially the Liberal Democrats. Keeping all their priorities aligned could be even more difficult than the balancing act PM May is performing between soft-Brexiters, hard-Brexiters, and the Democratic Unionist Party. Chart 9Bremorse: Rising, But Not Definitive Bremorse: Rising, But Not Definitive Bremorse: Rising, But Not Definitive Chart 10Anti-Brexit Forces On The Rise Anti-Brexit Forces On The Rise Anti-Brexit Forces On The Rise Meanwhile, on the economic front, the situation is not much better. Our colleague Rob Robis, BCA's chief bond strategist, recently penned a critical assessment of the U.K. economy.17 As Rob pointed out, the OECD leading economic indicator is decelerating steadily and pointing to a real GDP growth rate below 2% in 2018 (Chart 11). The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumer growth has been slowing since early 2017, driven by diminishing consumer confidence (Chart 12, top panel). High realized inflation, which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (third panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 11U.K. Growth Set To Slow U.K. Growth Set To Slow U.K. Growth Set To Slow Chart 12The U.K. Consumer Looks Tapped Out The U.K. Consumer Looks Tapped Out The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The January 2018 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide indexes came in at 1.9% and 3.1% respectively (Chart 13). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -47% in January 2018. Apparently, foreigners are no longer interested in a Brexit discount. Our global bond team goes on to point out that political uncertainty is also weighing on U.K. business investment spending. Capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017 and is even lower in real terms (Chart 14). Chart 13No Wealth Effect ##br## From Housing No Wealth Effect From Housing No Wealth Effect From Housing Chart 14Brexit Gloom Trumps ##br##Export Boom For U.K. Companies Brexit Gloom Trumps Export Boom For U.K. Companies Brexit Gloom Trumps Export Boom For U.K. Companies Putting all of this together, neither our global bond team nor our foreign exchange team expect the Bank of England to raise interest rates, despite the market pricing in 36 bps of rate hikes over the next twelve months. As Chart 15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating. Thus, the pass-through from a lower exchange rate is beginning to dissipate.18 In the long-term, we understand why investors are itching to bet on Brexit never happening. But to get from here to there, the market will have to riot. And that means more downside to U.K. assets. Chart 15U.K. Inflation:##br## Less Pass-Through From The Pound U.K. Inflation: Less Pass-Through From The Pound U.K. Inflation: Less Pass-Through From The Pound Chart 16GBP:##br## Stuck In A Rut GBP: Stuck In A Rut GBP: Stuck In A Rut Bottom Line: BCA's FX strategist, Mathieu Savary, has pointed out that the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart 16). As our FX and bond teams show in their respective research, the economics currently at play make it unlikely that the pound will be able to punch above the ceiling of this range. Our political assessment adds to this view. In fact, we expect that the coming political uncertainty, including an early election prior to March 2019, is likely to take the pound back to the floor of its trading range. As such, we are recommending that clients short cable, GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bcaresearch.com. 3 Please see BCA Special Report, "Timing The Next Equity Bear Market," dated January 24, 2014, and "Timing Equity Bear Markets," dated April 6, 2011, available at bcaresearch.com. 4 Please see BCA Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com. 5 The ten components of leading economic index for the U.S. include: 1. Average weekly hours, manufacturing; 2. Average weekly initial claims for unemployment insurance; 3. Manufacturers' new orders, consumer goods and materials; 4. ISM® Index of New Orders; 5. Manufacturers' new orders, nondefense capital goods excluding aircraft orders; 6. Building permits, new private housing units; 7. Stock prices, 500 common stocks; 8. Leading Credit Index TM; 9. Interest rate spread, 10-year Treasury bonds less federal funds; and 10. Index of consumer expectations. Source: The Conference Board. 6 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 9 We are referring to the Senate deal struck last week to authorize additional military spending ($80bn in FY2018 and $85bn in FY2019) and discretionary spending ($63bn in FY2018 and $68bn in FY2019), as well as to provide disaster relief in the amount of $45bn for both fiscal years. 10 Life is very short, and there's no time ... For fussing and fighting, my friend ... 11 Please see European Council, "Brexit: Council (Article 50) adopts negotiating directives on the transition period," dated January 29, 2018, available at consilium.europa.eu. 12 Please see "UK will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 13 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 14 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. The first test of that premise will be its negotiations with the EU itself. 15 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, available at bca.bcaresearch.com. 16 Investors should remember that Westminster voted decisively 319 to 23 to reject the Liberal Democrats' amendment seeking a referendum on the final Brexit agreement. Only nine Labour MPs voted in favor of the amendment after Jeremy Corbyn instructed his party to abstain. 17 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt-Up In Equities AND Bond Yields?" dated January 23, 2018, available at gfis.bcaresearch.com. 18 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com.

Highlights Spread Product: TIPS breakeven inflation rates are holding firm despite the correction in equity markets. Remain overweight spread product versus Treasuries for now, but be prepared to reduce exposure once long-maturity TIPS breakevens reach our target range of 2.4% to 2.5%. Volatility: While implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. Municipal Bonds: After-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. MBS: The option-adjusted spread offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to an investment grade corporate bond. Feature Chart 1Corporate Spreads Are Stoic Corporate Spreads Are Stoic Corporate Spreads Are Stoic The stock market is down and volatility is up dramatically. At least so far the pass through to credit spreads has been relatively mild (Chart 1), but this does not make us more optimistic. Rather, our sense is that last week's market action is yet another sign that we are approaching the end of the credit cycle. Same Loop, Different Day Last week's equity sell off is best viewed through the lens of the Fed Policy Loop that we introduced in 2015 (Chart 2).1 The Fed Policy Loop is a framework for understanding the interplay between monetary policy and risk assets. Its recent dynamics can be summarized as follows: The perception of easy Fed policy fuels the outperformance of risk assets, and seven months of falling inflation between last January and August kept that perception in place for all of 2017. The end result is that financial conditions eased dramatically - stock prices soared and credit spreads tightened. But easing financial conditions also sow the seeds of their own destruction. Easier financial conditions eventually beget stronger growth and stronger growth eventually begets higher inflation (Chart 3). Last week the market finally caught a whiff of inflation and started to price-in a more hawkish Fed reaction function. Chart 2The Fed Policy Loop On The MOVE On The MOVE Chart 3Financial Conditions Lead Growth And Growth Leads Inflation Financial Conditions Lead Growth And Growth Leads Inflation Financial Conditions Lead Growth And Growth Leads Inflation On a positive note, the Loop framework also tells us that the Fed will eventually ease policy in response to tighter financial conditions and this will allow the risk-on rally to resume. While this is undoubtedly true, the Fed's breaking point is also a lot higher when inflationary pressures are more pronounced. This is why we have repeatedly stressed that our cyclical call on spread product hinges on the path of long-dated TIPS breakeven inflation rates.2 Chart 4No Correction Here No Correction Here No Correction Here Last year, when the 10-year TIPS breakeven inflation rate was down around 1.6% - well below the 2.4% to 2.5% range that is consistent with inflation anchored around the Fed's target - the market understood that the Fed's tolerance for tighter financial conditions was quite low. This made it very difficult for risk assets to sell off meaningfully. But now, with the 10-year TIPS breakeven rate at 2.05% and the 5-year/5-year forward breakeven rate at 2.27%, the Fed can clearly tolerate more market pain. The bad news from a cyclical perspective is that, despite the equity correction, the market's assessment of inflationary pressure in the economy has barely budged. Long-maturity TIPS breakeven inflation rates are holding firm, as are the prices of crude oil and other commodities - prices that tend to correlate with TIPS breakeven rates (Chart 4).3 In other words, last week's correction didn't give our overweight spread product position any further room to run. While it may take a few more sessions, our sense is that the market and the Fed will hash out a new equilibrium in the near-term and that the true bear market in risk assets won't occur until inflationary pressures are even more pronounced. We continue to look for a range of 2.4% to 2.5% on long-maturity TIPS breakeven inflation rates before we scale back our cyclical overweight exposure to spread product. The inflation data take on extra significance between now and then, as each incoming report will help confirm or deny the message priced into TIPS breakevens. Every weak inflation print buys the credit cycle more time, every strong print hastens its demise. Next up: tomorrow morning's CPI. Don't Fear Rising Rate Vol The return of volatility was the other big story last week. The VIX index of implied equity volatility was as low as 9 in early January, but stood at 33 as of last Friday's market close. With rising inflation starting to weaken the "Fed put" in risk assets we think it is unlikely that equity volatility will return to its previous cycle lows.4 But what about the volatility in rates markets? The MOVE index of implied interest rate volatility also jumped last week, and its path going forward is of critical importance for Treasury yields. Chart 5 shows that the Kim & Wright estimate of the term premium embedded in the 10-year Treasury yield is highly correlated with the MOVE index, while the expectations component implied by that term premium is the mirror image of the fed funds rate. It follows that a surge in rate volatility would lead to much higher Treasury yields, particularly if the Fed continues to hike. However, it would be quite unusual for the MOVE index to increase significantly while the Fed is lifting rates. To see this we can simply observe the tight correlation between the MOVE index and the slope of the yield curve (Chart 6). The crucial question then becomes: Does the slope of the yield curve drive volatility or does volatility drive the slope of the curve? Chart 5Volatility And The Term Premium Volatility And The Term Premium Volatility And The Term Premium Chart 6Volatility And The Yield Curve Volatility And The Yield Curve Volatility And The Yield Curve Like most things in economics, the answer is a little bit of both. Chart 7Forecasters In Agreement Forecasters In Agreement Forecasters In Agreement It is relatively straightforward to see why higher rate volatility might lead to a steeper yield curve. To the extent that the slope of the yield curve reflects a term premium to compensate investors for the extra price risk in a long-dated bond, then investors should demand greater compensation to bear that extra risk when rate volatility is elevated. But that analysis ignores the other reason why the yield curve might be steep. Namely, the yield curve might be steep because the market expects the Fed to hike rates substantially. It would seem logical to expect that investors would be more uncertain about a forecast that calls for many rate hikes than they would be about a forecast that calls for only a few rate hikes. It therefore follows that an environment where the market expects a large change in the fed funds would also be an environment of elevated rate volatility. The two-way causation between rate volatility and the slope of the yield curve is reinforced by the fact that both trends also correlate with forecaster uncertainty about the macro environment. Chart 7 shows that the dispersion of individual forecasts for the 3-month T-bill rate and GDP growth correlate with both the MOVE volatility index and the slope of the yield curve. At the moment, disagreement amongst professional forecasters remains low relative to history. All in all, our sense is that once long-maturity TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5% they are unlikely to move much higher. Fed hawkishness will ramp up considerably and the yield curve will be much more likely to flatten. This means that while implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. We are not overly concerned about a huge spike in rate volatility leading to a blow-out in bonds. Two Attractive Ways To De-Risk As stated in the first section of this report, the higher that TIPS breakeven inflation rates rise the closer we get to calling the end of the credit cycle. If current trends continue, then it is likely we will begin to de-risk the spread product side of our recommended portfolio in the not-too-distant future. With that in mind, we have identified two lower risk spread sectors that are starting to look attractive. 1) Municipal Bonds Like all spread sectors, at first blush municipal bonds appear quite expensive relative to Treasuries. Chart 8 shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, relative to equivalent-maturity Treasury yields. The message is quite clear. Municipal bonds offer far less excess compensation relative to Treasuries than has been typical in the past. However, the valuation picture changes completely when we consider municipal bonds versus investment grade corporates. Chart 9 once again shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, but this time relative to equivalent-duration corporate bonds. We do not attempt to match credit quality in Chart 9, so Aaa-rated municipal bonds are being compared to the corporate bond index which has an average credit rating of A3/Baa1. Chart 8Munis Expensive Versus Treasuries Munis Expensive Versus Treasuries Munis Expensive Versus Treasuries Chart 9Munis Cheap Versus Corporates Munis Cheap Versus Corporates Munis Cheap Versus Corporates Chart 9 shows that after-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. In fact, a 10-year Aaa-rated municipal bond currently offers only 13 bps less yield than an equivalent duration A3/Baa1-rated corporate bond. In addition, whenever the after-tax yield on a 10-year Aaa-rated municipal bond has exceeded the yield on a 10-year corporate bond in the past, it has been a fairly good signal that investment grade corporates are too expensive and due for a correction. Not only did municipal bonds look more attractive than corporates before the crisis in 2007, but also before corporates sold off in 2011 and 2014 (Chart 9, bottom panel). Agency MBS Chart 10An Opportunity In MBS? An Opportunity In MBS? An Opportunity In MBS? As with munis, the option-adjusted spread (OAS) offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to investment grade corporate bonds (Chart 10). Further, in a rising rate environment the risk of a large increase in mortgage refinancings is low and this should keep MBS spreads well contained. The biggest potential risk for MBS spreads is that a large spike in Treasury yields causes MBS duration to extend, and sparks a spread widening. In our report from two weeks ago we introduced a model for excess MBS returns in an attempt to quantify what sort of increase in Treasury yields would be necessary to make duration extension a meaningful risk for MBS.5 We modeled monthly excess returns for conventional 30-year MBS relative to duration-matched Treasuries using the following equation: Formula On The MOVE On The MOVE The monthly change in Treasury yields enters the equation with a positive sign because it proxies for refinancing risk. Higher yields lead to lower refis, and lower refis lead to MBS outperformance. The squared change in yields enters the equation with a negative sign because it proxies for extension risk. If yields rise too much during the month, then MBS duration will extend and the sector will underperform. Chart 11Refi Risk Is Low Refi Risk Is Low Refi Risk Is Low From that equation we calculated that, holding the change in OAS flat, it would take a monthly increase in yields of at least 72 bps to lead to negative monthly excess returns. However, in January this appeared not to work very well. The duration-matched Treasury yield in our equation increased only 38 bps in January and the OAS was virtually flat, but MBS still managed to underperform Treasuries by 16 bps on the month. Upon further investigation, the reason our model failed in January is that mortgage refinancings actually increased on the month even though Treasury yields rose (Chart 11). This behavior is unusual and we would not expect it to persist going forward. However, we also made one modification to our model that we expect will lead to more accurate results on a real-time basis. Specifically, we removed the intercept term from the prior model and replaced it with a 1-month lag of the average index OAS. The rationale is that since the intercept term is in the equation to capture the carry return in an MBS trade, we should use a more accurate measure of MBS carry rather than relying on the regression to calculate the historical carry. Our new equation is as follows: Formula On The MOVE On The MOVE Chart 12 On The MOVE On The MOVE Interestingly, using our new equation we find that the monthly increase in Treasury yields required to spark MBS underperformance is now a function of the current average OAS of the MBS index. This would seem to make sense. If the carry buffer is higher, then it should take a greater duration extension for capital losses to overcome the carry and lead to negative excess returns. The relationship between the required monthly increase in yields and the index OAS is illustrated in Chart 12. At the current average index OAS of 31 bps, our equation suggests that a monthly increase in Treasury yields of 58 bps or higher is required for extension risk to become meaningful. Bottom Line: Both municipal bonds and Agency MBS are starting to look attractive relative to investment grade corporate bonds. We stand ready to upgrade these sectors at the expense of investment grade corporate bonds when the time comes to de-risk our spread product portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 For further details on the correlation between TIPS breakevens and commodity prices please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 4 Please see BCA Research Special Report, "The Return Of Vol", dated February 6, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Japan Economy & Inflation: Japan is in the midst of a solid cyclical upturn, driven by strong exports and rising investment spending. Yet despite signs that the economy is running at an above-potential pace with no spare capacity in labor or product markets, inflation remains tame. This puts no immediate pressure on the Bank of Japan (BoJ) to move away from its easy policy stance. Future BoJ Options: When the BoJ does finally consider a shift in its monetary policy, the first thing it will do is raise its yield target on the 10-year JGB. Before doing that, three things must happen - yen weakness, higher core Japanese inflation and much higher non-Japanese global bond yields. Feature Chart 1A 'Non-Systemic' Vol Spike A 'Non-Systemic' Vol Spike A 'Non-Systemic' Vol Spike Global financial markets appear to be calming down a bit after the Great Volatility Scare of 2018. While the equity market sell-off and spike in volatility was intensely compacted into a brief period of time, the changes has been relatively modest when looked at against the broader history of the past decade (Chart 1). This may have been a serious market tremor, but it is not clear that this was the beginning of "The Big One." What could turn investor sentiment into a more permanently bearish state would be a sign of a coordinated move to tighter monetary policy by all the major global central banks. The Federal Reserve is in the midst of a prolonged tightening cycle, while the European Central Bank (ECB) is more openly debating the future of its asset purchase program. Yet amidst all the current investor worries about higher inflation and rising global bond yields, any sign that the hyper-easy BoJ is openly moving to a less accommodative monetary policy could be the trigger for the next wave of market volatility. The BoJ's current policy is to manage short-term interest rates and asset purchases to keep the benchmark 10-year Japanese Government Bond (JGB) yield around 0%. What would it take for the BoJ to make a change to that policy? In this Special Report, we take a look at the current cyclical dynamics for Japanese economic growth and inflation, and determine what it would take to force the BoJ to consider altering its current policy. We conclude that three things that must ALL happen before the BoJ could possibly change its strategy: The USD/JPY exchange rate must increase back to at least the 115-120 range Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5% The 10-year JGB yield must reach an overvalued extreme versus the 10-year U.S. Treasury Strong Japanese Growth, But Where's The Inflation? If it was strictly a growth story, the BoJ could have a case to begin formally removing monetary accommodation relatively soon. The Japanese economy is enjoying a broad-based upturn led by robust export demand and a pickup in capital spending (Chart 2). Private consumption and government spending have also provided smaller, but still positive, contributions to Japanese GDP growth in the current cycle. The BoJ stated in its latest Outlook for Economic Activity and Prices (January 2018) that Japan's economy has entered a virtuous cycle from income to spending that would support continued growth this year. The leading economic indicator estimated by Japan's Cabinet Office is expanding at a solid rate that suggests real GDP growth could accelerate to a well-above potential pace around 2.5% in 2018. The manufacturing PMI is now at the highest level in four years, while the December Tankan survey was the highest reading since Japan's asset bubble burst in the early 1990s. The cyclical upturn in growth has boosted corporate profits, business confidence and capital spending (Chart 3). This is especially so on the manufacturing side of the Japanese economy, where machinery orders and capacity utilization are at the highest levels in almost three years and the level of industrial production is now back to pre-crisis highs. The high level of capacity utilization is a boost both to the economy - through capital spending, as firms need to invest to keep up with underlying demand - and to corporate profits as companies can spread their fixed costs of production over more units sold. Against this backdrop, it is no surprise that Japanese business confidence is solid (bottom panel). Chart 2Lots Of Good Economic News In Japan Lots Of Good Economic News In Japan Lots Of Good Economic News In Japan Chart 3A Cyclical Rise In Production & Confidence A Cyclical Rise In Production & Confidence A Cyclical Rise In Production & Confidence Japan's economy remains highly levered to global growth, as the pickup in machinery orders has been focused on foreign demand (Chart 4, bottom panel). With the global leading economic indicator still in a steady uptrend, however, overall export growth should remain in good shape in the next few quarters. For most countries, a solid economic upturn like Japan is currently enjoying would potentially trigger some inflationary pressures. Alas, Japan is not most countries. Over the past several years, the BoJ has consistently projected that Japanese inflation will be on a path to reach its 2% target. That can be seen in Chart 5, which shows Japanese core CPI inflation (ex fresh food) with the annual forecasts produced by the BoJ each year (the dotted lines). Yet the only time that core inflation got remotely close to that level was in 2014 - and, only then, after global oil prices had breached the $100/bbl level. Inflation expectations momentarily rose at that time, but plunged in 2015 as oil prices collapsed. Since then, CPI swaps have struggled to trade much above 0%, only starting to perk up last year as oil prices began rising once again (bottom panel). Chart 4Japan Is Benefiting From##BR##Strong Global Growth Japan Is Benefiting From Strong Global Growth Japan Is Benefiting From Strong Global Growth Chart 5Watch Oil & The Yen,##BR##Not The BoJ Inflation Forecasts Watch Oil & The Yen, Not The BoJ Inflation Forecasts Watch Oil & The Yen, Not The BoJ Inflation Forecasts Having inflation consistently below its target rate is frustrating to the BoJ. By its own estimates, Japan's output gap closed in 2016 and now sits at +1.35% - levels that have been consistent with headline CPI inflation rates of 2% or greater since the mid-1980s (Chart 6, top panel). Our own Japan headline CPI diffusion index, which measures the breadth of the moves in inflation across ten CPI sectors, is struggling to stay above the 50 line, unlike those previous periods where Japan had a large positive output gap. The main reason for this is that Japanese service sector inflation, consisting of around ½ of the total Japanese CPI index, remains anemic at 0.8% or a massive 2.3 percentage points below the rate of goods inflation (bottom panel). The odds of the BoJ successfully seeing Japanese inflation reach its target are low without any meaningful pickup in services inflation. The latter requires a boost to household purchasing power, which is next to impossible without faster wage growth. One of the fundamental reasons for Japan's low inflation continues to be the surprising lack of wage inflation despite strong Japanese profitability and a very tight labor market. Japanese firms are enjoying an extended period of robust earnings growth, with corporate profits up nearly 500% since the trough during the 2009 recession (Chart 7, top panel). Moreover, firms have not been cutting back on labor over that period. The jobs-to-applicant ratio has steadily climbed and is now at the highest level since 1974, and while the annual rate of employment growth remains well above the historical average (2nd panel). The result is an unemployment rate that is currently at 2.8%, well below the OECD's estimate of the full employment NAIRU at 3.6% (3rd panel). Yet despite firms remaining desperate to hire new employees to fill empty or newly created positions, at a time when there is no spare labor capacity, wage growth remains stagnant. Nominal wage growth is only 0.6%, or -0.6% in real terms. The problem of low real wage growth is not unique to Japan, of course (bottom panel), but it is unusual given how far the Japanese unemployment rate is below NAIRU. The subject of persistent low wages has become an important political matter for Japanese PM Shinzo Abe, given that breaking Japan out of its low inflation trap has become critical to the long-term success of his "Abenomics" program. Our colleagues at BCA Geopolitical Strategy discussed this exact topic in a Special Report published last week, noting that: Wages will be a decisive factor in Abe's economic success .... In this spring's "shunto" negotiations between businesses and unions, both the Abe administration and Keidanren, the top business group, are asking for 3% wage increases. The biggest union, Rengo, is only asking for one percentage point more. Abe has dedicated the current Diet session, beginning January 22, to "work-style reforms" that should be, on net, positive for wage growth. He wants to remove disparities between regular and irregular workers, particularly regarding wages, training opportunities, and welfare benefits. He also wants to impose limits on the workweek - putting a cap on the average 80-hour workweek of Japan's full-time workers so as to force companies to hire more irregular workers on a full-time basis (and to encourage employed people to have children). Companies that raise wages by 3% or more will see a cut in the corporate tax rate from around 30% to 25%.1 If Abe is successful in convincing Japanese companies to boost wages, this can help broaden the current cyclical economic upturn in Japan through faster consumer spending. Consumption has lagged other more robust parts of the economy during the current cycle (Chart 8, top panel), even though consumer confidence has surged in response to the healthy labor market (middle panel). Real disposable income growth has been unable to exceed 1% since 2010, a problem for consumer spending that has been exacerbated by the five percentage point rise in the household saving rate since 2013 (bottom panel). Chart 6Domestic Inflation,##BR##Like Services, Is Anemic Domestic Inflation, Like Services, Is Anemic Domestic Inflation, Like Services, Is Anemic Chart 7Japanese Companies##BR##Are Not Sharing The Wealth Japanese Companies Are Not Sharing The Wealth Japanese Companies Are Not Sharing The Wealth Chart 8Poor Fundamentals For##BR##The Japanese Consumer Poor Fundamentals For The Japanese Consumer Poor Fundamentals For The Japanese Consumer Putting it all together, the Japanese economy is in good shape, but inflation continues to undershoot the BoJ's goals. Bottom Line: Japan is in the midst of a solid cyclical upturn, driven by strong exports and rising investment spending. Yet despite signs that the economy is running at an above-potential pace with no spare capacity in labor or product markets, inflation remains tame. This puts no immediate pressure on the BoJ to move away from its easy policy stance. Plausible Next Steps For The BoJ The BoJ is in a difficult spot at the moment. The underwhelming pace of inflation is forcing the central bank to continue committing to its aggressive monetary easing programs, which include large-scale purchases of Japanese Government Bonds (JGBs) and Japanese equities via ETFs. Yet the BoJ already shifted from a quantity target for its JGB purchases to a price target back in September 2016 when it introduced the "Yield Curve Control" (YCC) element to its overall Quantitative & Qualitative Easing (QQE) program. By switching to a price level on the 10-year, the BoJ was aiming to reduce the amount of JGBs it was buying from 80 trillion yen per year to whatever level was required to keep the 10-year yield at 0%. After switching to the YCC framework, the growth in the BoJ's JGB holdings slowed sharply to a pace that is now below the pace of new JGB issuance for the first time since the QQE program started in 2013 (Chart 9). It is no coincidence that the peak in the pace of BoJ buying coincided with the cyclical trough in our own BoJ Central Bank Monitor, which suggests that tighter monetary policy is now required in Japan (top panel). The BoJ has been successful in keeping the 10-year JGB yield near its 0% target, but that outcome will be operationally harder to achieve in the future. The BoJ currently holds about 70% of all 10-year JGBs outstanding, and the increase in ownership has risen by 5-7% in each quarter (Chart 10). In other words, if this pattern lasts, without a major increase in issuance at that maturity, the BoJ will effectively own all the 10-year JGBs outstanding by the middle of 2019. Already, the BoJ owns around 43% of the entire stock of JGBs, draining liquidity away from the market for the risk-free asset (government bonds) that is needed by Japanese banks and major investors like pension funds and insurance companies (Chart 11). Chart 9BoJ Has Already 'Tapered'##BR##Its Bond Purchases BoJ Has Already 'Tapered' Its Bond Purchases BoJ Has Already 'Tapered' Its Bond Purchases Chart 10The BoJ Is Cornering##BR##The JGB Market BoJ Has Already 'Tapered' Its Bond Purchases BoJ Has Already 'Tapered' Its Bond Purchases With the BoJ unwilling to continue impairing the liquidity in the JGB market, it will be forced to consider alternatives to its current YCC program settings. Last week, the Japanese government nominated BoJ Governor Haruhiko Kuroda for another five-year term as the head of the central bank. Kuroda has received the full trust from PM Abe in his handling of monetary policy. However, maintaining the current monetary policy has some limitations. What can the BoJ realistically do? Until realized inflation reaches the BoJ target, there can be no shift to a less accommodative monetary policy involving a full tapering of asset purchases or interest rate increases. Yet the BoJ cannot continue to buy bonds at the current pace without essentially "cornering the market" for 10-year JGBs. The solution that would be the least disruptive, in our view, would be increasing the YCC yield target from the current 0%. It has been rumored over the past year that the BoJ would consider raising that yield curve target, although that idea has been repeatedly shot down by Governor Kuroda - no surprise, given how far inflation is from the BoJ target. The BoJ has been already been effectively "tapering" by buying fewer bonds under YCC than QQE. An explicit announcement to reduce the pace of bond buying, however, would be taken as a hawkish sign by the markets. Just ask the ECB, who is dealing with its own communication problems with the markets as it tries to prepare for the inevitable exit from its bond buying program. Explicitly raising the yield curve target would only be an option for the BoJ if it felt that a) the domestic economy could tolerate some increase in longer-term bond yields; b) Japanese inflation was likely to reach (or even surpass) the BoJ's 2% target; and c) the global economy was strong enough to push global bond yields to a sustained higher trajectory. We see the following as being a necessary "checklist" of events that must occur before the BoJ would even contemplate a more to a higher target on the 10-year JGB yield (Chart 12): Chart 11JGB Ownership Shares##BR##By Investor Category JGB Ownership Shares By Investor Category JGB Ownership Shares By Investor Category Chart 12These Must ALL Happen Before##BR##The BoJ Lifts Its JGB Yield Target These Must ALL Happen Before The BoJ Lifts Its JGB Yield Target These Must ALL Happen Before The BoJ Lifts Its JGB Yield Target 1) The USD/JPY exchange rate must increase back to at least the 115-120 range The recent rise in the yen versus the U.S. dollar has flied in the face of interest rate differentials that should be highly supportive of the U.S. dollar (top panel). This is not the only currency pair where this has happened, of course, but it matters far more for Japan given the low readings on headline inflation. A strengthening yen makes a difficult job - boosting Japanese inflation sustainably to 2% - almost impossible. 2) Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5% This is fairly obvious, but the BoJ cannot be confident that its 2% inflation target can be reached if core inflation continues to muddle along at levels well below that target. If wage growth were to also rise at the same time and pace as core inflation, both within hailing distance of 2%, then the BoJ would be even more convinced that some modest change to its yield target was required. 3) The 10-year JGB yield must reach an overvalued extreme versus U.S. Treasuries Table 1JGB Yield Model What Would It Take For The Bank Of Japan To Raise Its Yield Target? What Would It Take For The Bank Of Japan To Raise Its Yield Target? Or put more simply, global bond yields must rise by enough for the BoJ to say that there has been a shift in the global growth/inflation backdrop, justifying a structurally higher level of bond yields. The BoJ could then point to non-Japanese factors as the reason to bump up the target for 10-year JGB yields. We can evaluate this using the BoJ's own model for the 10-year JGB yield that was introduced back in 2016 (Table 1). This model includes Japanese potential GDP growth, the 10-year U.S. Treasury yield and the share of JGBs owned by the BoJ (along with "dummy variables" to identify the dates of the BoJ's QQE and negative interest rate policy). In the bottom two panels of Chart 12, we show a scenario that would lower the residual of the model (i.e. how far JGB yields are below fair value) to the same extremes seen during the QQE era since 2013. That would require a move in the 10-year U.S. Treasury yield to 3.5% AND an increase in the BoJ ownership share of the entire stock of JGBs to 50%. That would increase the fair value of the 10-year JGB yield to 0.18%, leaving the current yield around 10bps too expensive. Importantly, all three items in our checklist would have to happen at the same time for the BoJ to contemplate any shift in its yield curve target. That is especially true for USD/JPY. Japan would face considerable international pressure if the yen was held at undervalued levels by an overly accommodative BoJ policy that was no longer needed with Japanese inflation approaching the 2% target. What are the odds of all three of these items in our checklist being reached in 2018? Quite low, perhaps no more than 20%. For that reason, we do not see the BoJ being a new reason for frazzled global investors to worry about another spike in volatility. Bottom Line: When the BoJ does finally consider a shift in its monetary policy stance, the first thing it will do is raise its yield target on the 10-year JGB. Before doing that, three things must happen - yen weakness, higher core Japanese inflation and much higher non-Japanese global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Kuroda Or No Kuroda, Reflation Ahead", dated February 7th 2018, available at gps.bcaresearch.com.

Highlights The spike in volatility last week led to a sharp correction in equities. However, the bull market in equities is not over yet. The Fed's response to the selloff will be critical. Policymakers will closely monitor financial conditions. The most overvalued assets are at greatest risk during a selloff. Feature Financial markets did not give new Fed Chair Jay Powell a warm welcome last week. Volatility spiked, and risk assets fell sharply. Nonetheless, BCA's view is that strong economic growth and stout earnings growth will keep the bull market intact. The selloff is reminiscent of the 7% drop in the S&P 500 in May of 2006.1 Back in the spring of 2006, then Chairman Ben Bernanke had just taken the helm at the Federal Reserve. Global growth was strong, the U.S. dollar was selling off and global share prices were surging and overbought. From May through June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish, allowing U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM assets. The February 2018 may not play out exactly like May 2006. That said, there are enough similarities to draw parallels. Global growth is robust and inflationary pressures are accumulating. Bond yields are rising, and the greenback is selling off. A new Fed Chairman just took over the reins, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. The Fed's response to the tighter financial conditions will be crucial. The May 2006 selloff turned out to be just a correction in a bull market that lasted another 18 months. Still, investors today are also concerned about what to sell first as the end of the expansion draws closer. A Shake Up BCA strategists believe that the market turmoil since last week reflects a technical correction from overbought and over complacent levels, but the cyclical bull run is not yet over.2 Nonetheless, investors should note that the bull market is entering its late stages. The low inflation and low volatility era is ending as the U.S. economy begins to face late-cycle, supply-side constraints, especially in the labor market. Therefore, the equity advance will be associated with higher volatility than in the past few years. Chart 1 shows that the VIX soared by roughly four times more on February 5 than expected, based on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction in the past few days of other risk gauges, such as junk bonds, EM stocks, and gold prices, is consistent with this thesis. Chart 1Last Monday's VIX Spike Was Abnormally Large Powell's First Week Powell's First Week Importantly, the implosion of volatility funds is unlikely to reverberate across the global financial system in the same way as it did during the 2007-2009 financial crisis. The mortgage crisis a decade ago was so toxic that the losses were concentrated in the books of highly leveraged financial institutions. However, that does not appear to be the current case with volatility funds. The cyclical underpinnings for the bull market in equities is intact. The odds of a recession remain low (Chart 2). Corporate earnings continue to come in above expectations, aided by a wave of share buybacks linked to the U.S. Tax Cut and Jobs Act (Chart 3). Global economic growth remains upbeat as well. Chart 2Odds Of A Recession##BR##Remain Low Odds Of A Recession Remain Low Odds Of A Recession Remain Low Chart 3Buybacks, Surging Capex##BR##Raising The Bar For 2018 EPS Growth Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Chart 4U.S. Equities And Vol##BR##Climbed Through The 1990s U.S. Equities And Vol Climbed Through The 1990s U.S. Equities And Vol Climbed Through The 1990s This does not mean that everything will be smooth sailing. Last week's selloff marked an inflection point in the low-volatility world that has prevailed in the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Volatility will stay elevated relative to what investors have come to anticipate. As the experience of the 1990s shows, stocks can still climb when volatility trends higher (Chart 4), but this is going to make for a more challenging investment environment. Bottom Line: Rising volatility does not mean the end of the bull market or the economic expansion. Bear markets outside of recessions are rare, and our view remains that the odds of a recession this year or next remain low. Moreover, the additional dose of fiscal stimulus passed by Congress late last week may extend the expansion into 2020. Stay overweight stocks versus bonds.3 The Policy Response The Fed's reaction to this new regime will be critical. The 7.2% drop in equities last week occurred on Jay Powell's first as Chairman of the Fed. Chart 5 shows that it is not unusual for the equity markets to be in turmoil in the early months of a new Fed Chair's tenure. BCA expects that Powell and his FOMC colleagues will adopt Janet Yellen's gradual approach to raising rates this year. Nonetheless, the January readings on average hourly earnings suggest that supply-side constraints are beginning to bite. The runway for low inflation and easy monetary policy may not be as long as some had hoped. Just like Yellen, Jay Powell will seek a consensus among his colleagues. The composition of the FOMC will probably shift in a more hawkish direction, but the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important and often underappreciated source of continuity. Last week, several Fed speakers reinforced that the central bank will continue to monitor incoming economic and financial data, and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. remain more expansionary than they were six months ago (Chart 6). As a result, U.S. economic growth is poised to accelerate even more in the first half of the year (Chart 7). This will push the unemployment rate further below NAIRU and ultimately force up wage and price inflation. Chart 5New Fed Chairs##BR##And The Equity Market New Fed Chairs And The Equity Market New Fed Chairs And The Equity Market Chart 6Decline In Equity Market##BR##Tightened Financial Conditions Decline In Equity Market Tightened Financial Conditions Decline In Equity Market Tightened Financial Conditions However, at 2.1% on February 8, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets need to worry about the Fed falling behind the curve (Chart 8). A shift above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would signal that the FOMC will have to boost the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We will likely take some money off the table if core inflation rises, even if it is still below 2%, when the TIPS breakeven reaches 2.4%. Chart 7Lagged Effect Of Easier##BR##Monetary Conditions Will Boost Growth Lagged Effect Of Easier Monetary Conditions Will Boost Growth Lagged Effect Of Easier Monetary Conditions Will Boost Growth Chart 8Breaking Down##BR##The Rise In Yields Breaking Down The Rise In Yields Breaking Down The Rise In Yields A sustained move above 3% on the nominal 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we think core inflation will move4 above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this probably will be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of a recession (Table 1). If the next recession occurs in late 2019, as we forecast, the equity bull market could last a while longer. The additional fiscal impulse from the spending bill passed by Congress last week may extend the expansion into early 2020. A modest overweight on global risk assets is warranted for now, but investors should consider reducing their risk exposure later this year. Table 1Too Soon To Get Out Powell's First Week Powell's First Week Bottom Line: The Fed and the market are now in agreement on rate hikes in 2018. BCA's U.S. Bond Strategists' stance is that the 2/10 curve will flatten from here, as the upside in long maturity yields will be limited once the TIPS breakeven inflation rates reach our target fair value range of 2.4-2.5%. Nonetheless, at that point, the nominal 10-year yield5 is likely to be between 3.0 and 3.25%. Stay underweight duration for now. Where Do We Go From Here? Clients have asked our view on the appropriate order in which to reduce risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the most over-valued ones are at greatest risk, and thus profits should be taken here first. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time span? We include multiple measures because there is no widely accepted approach. More than one time period was used in some cases to capture regime changes. Table 2 provides our best approximation for nine asset classes. The approaches range from sophisticated methods6 developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (i.e. oil), to simple deviations from a time trend (i.e. real raw industrial commodity prices and gold). Table 2Valuation Levels For Major Asset Classes Powell's First Week Powell's First Week We averaged the valuation readings where there were multiple estimates for a single asset class. The results are shown in Chart 9. Chart 9Valuation Levels For Major Asset Classes Powell's First Week Powell's First Week By far, U.S. equities stand out as the most expensive at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads follow at 0.7, tracked closely by U.S. Treasuries (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are very expensive in absolute terms based on the fact that government bonds are pricey. Oil is sitting very close to fair value, despite the rapid price run up in the past couple of months. This makes oil exposure doubly attractive because the fundamentals point to higher prices when the underlying asset is not expensive. Historical analysis around equity market zeniths provides an alternative approach to the sequencing question. Table 3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table 3Asset Class Leads & Lags Vs. Peak In S&P 500 Powell's First Week Powell's First Week Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, tech stocks or small-cap versus large-cap relative returns. Sometimes they reached their zenith before the S&P 500, and sometimes after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyze due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time was long and variable. The U.S. corporate bond market offers the most consistent lead/lag relationship. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio before we scale back on equities. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over as expected to the EM economies. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of China's economy in the coming months. Oil is a different story. OPEC 2.0 will likely cut back on supply in the face of an economic downturn, which will help keep prices elevated.7 Therefore, we may not trim energy exposure this year. In terms of equities, our recommended portfolio is still overweight cyclicals for now. Our themes of a synchronized global capex boom, rising bond yield, and firm oil price means we will stay overweight in the industrials, energy and financial sectors. Utilities and homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. Our U.S. Equity Strategists have already started a gradual shift away from cyclicals toward defensives. This transition will continue in the coming months as we reduce risk. We will also shift small caps to neutral on earnings disappointments and elevated debt levels.8 Bottom Line: The economic expansion is not over, but investors are already wondering what to sell first as the next peak in equities nears. Market participants should look to trim credit exposure before scaling back on equities, and BCAs' U.S. Equity Strategy service is already scaling back on cyclicals and reduced small caps to neutral from overweight last month. At under $60/ barrel WTI, oil is 5% below our Commodity & Energy Strategy's target of $63/bbl. Moreover, global inventories will continue to draw on the back of OPEC supply restraint as shale production growth alone will not satisfy stronger global demand driven by stronger global economic growth. If prices hit the low $70 range, supply restraint and demand growth will ebb, capping incremental upside. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Insight "Buy The Dip," published February 8, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's Global Investment Strategy Special Report "The Return Of Vol," published February 6, 2018. Available at gis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Watching Five Risks," published January 24, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 6 Please see BCA Research's The Bank Credit Analyst Monthly Report, published January 25, 2018. Available at bca.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Vs. The Fed," published February 8, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?," published January 22, 2018. Available at uses.bcaresearch.com.

Highlights Persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds on a global scale. Hence, the risk is that financial market distortions will infect the economy, not the other way round. A global mini-downturn in the first half of 2018 is now all but guaranteed. High conviction equity sector recommendation: underweight the major cyclical equity sectors: specifically, Banks, Materials and Energy; but overweight Airlines. High conviction currency recommendation: yen first; euro second; pound third; dollar fourth. Feature Stock markets ascend by walking up the stairs, but they descend by jumping out of the window. Unfortunately, investors often misinterpret the low volatility of a market ascent as a sign that equity risk has diminished. In fact, the low volatility just tells us that walking up the stairs is a slow and dull process (Chart I-2). It tells us nothing about equity risk. Chart of the WeekA Global Mini-Downturn In H1 2018 Is Now All But Guaranteed A Global Mini-Downturn In H1 2018 Is Now All But Guaranteed A Global Mini-Downturn In H1 2018 Is Now All But Guaranteed Chart I-2Stock Markets Climb Up The Stairs, And Then Jump Out Of The Window Stock Markets Climb Up The Stairs, And Then Jump Out Of The Window Stock Markets Climb Up The Stairs, And Then Jump Out Of The Window The risk of equities, as we have just seen, is that they do periodically jump out of the window. Meaning that equities have the potential to suffer much more intense short-term losses than short-term gains. This ratio of potential losses to potential gains is technically known as negative skew. For a reminder why equity returns have this unattractive asymmetry, please revisit our Special Report 'Negative Skew': A Ticking Time-Bomb.1 That said, equity returns always possess negative skew, so there is nothing new about stock markets jumping out of the window, as they have this week. Persistent QE, ZIRP And NIRP Have Created A Severe Financial Distortion The much bigger story is that persistent QE, ZIRP and NIRP2 have imparted negative skew on bond returns too. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Approaching this lower bound for yields, bond prices have diminishing upside with increasing downside (Chart I-3). So at low bond yields, mathematics necessarily forces bond markets also to walk up the stairs and then jump out of the window (Chart I-4 and Chart I-5). Chart I-3Approaching The Lower Bound For Yields, Bond Prices ##br##Have Diminishing Upside With Increasing Downside Low Vol: The Time-Bomb Explodes Low Vol: The Time-Bomb Explodes Chart I-4In A Low Yield Era, Bond Markets ##br##Also Climb Up The Stairs... In A Low Yield Era, Bond Markets Also Climb Up The Stairs... In A Low Yield Era, Bond Markets Also Climb Up The Stairs... Chart I-5... And Then Jump Out ##br##Of The Window ... And Then Jump Out Of The Window ... And Then Jump Out Of The Window As the risk of owning 10-year bonds has increased to become 'equity-like', it has removed the requirement for an excess return, a risk premium, on equities. In other words, persistently ultra-accommodative monetary policy has diminished the prospective 10-year annual return on global equities to become 'bond-like', collapsing from 9% in 2012 to 1.5% today - exactly the same rate of return that is now offered by the global 10-year bond (Chart I-6). In effect, persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds. Chart I-6Equities' Prospective Returns##br## Have Become 'Bond-Like' Equities' Prospective Returns Have Become 'Bond-Like' Equities' Prospective Returns Have Become 'Bond-Like' However, as we explained last week in Beware The Great Moderation 2.0,3 the nose-bleed valuation of the world stock market is justified only as long as bond yields stays low. Above a 2% yield, the payoffs offered by bonds gradually lose their negative skew and thereby become less risky than those offered by equities. So equities must once again compensate by offering an excess prospective return, necessitating a derating of today's elevated valuations. Specifically, we wrote that the big threat to equity valuations "comes from the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1% or the U.S. 10-year T-bond yield rising to 3%." To which one client responded "markets do not respect round numbers... if the trigger-point is 3%, then you must act well before that." Wise words indeed. The U.S. 10-year T-bond yield got as far as 2.88% before triggering a reversal in equity valuations. Financial Distortions Threaten The Real Economy Chart I-7Financial Conditions 'Easiness' Is Just ##br##Tracking The Stock Market Financial Conditions 'Easiness' Is Just Tracking The Stock Market Financial Conditions 'Easiness' Is Just Tracking The Stock Market Many people naturally assume that the economy drives the financial markets. This may be true some of the time, or even most of the time. But in the last three downturns, the causality ran the other way round - financial market distortions dragged down the economy. The bursting of the dot com bubble triggered the downturn in 2001; the large-scale mispricing of U.S. mortgages caused the Great Recession in 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession in 2011. Which begs the question: is there a financial distortion or mispricing that could once again drag down the economy? The answer is an emphatic yes. To repeat, six years of persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds on a global scale, compressing the prospective 10-year annual return on world equities from 9% to 1.5%.4 Thereby, equity returns which would have accrued in the future have been brought forward to the here and now in the form of elevated capital values. But if higher bond yields correct the severely distorted valuation relationship between equities and bonds, the effect will be to move these returns from the present back to the future, depressing capital values today. Now note that while world GDP is worth around $80 trillion, the combination of equities and correlated risk-assets such as corporate and EM debt is worth double that, around $160 trillion, and real estate is worth $220 trillion. If returns from these richly valued asset-classes are redistributed from the present back to the future, through lower capital values today, there is a very real risk that current spending could take a hit. Supporting this broad thesis, central bank measures of 'financial conditions easiness' just track tick for tick the level of the stock market (Chart I-7). What To Do Now The upturn in bond yields which started last summer threatens to impact activity through two separate channels. As just discussed, the first is the financial market channel via a setback to global risk-asset capital values. The second is the bank credit channel. Changes in the bond yield very clearly and reliably lead changes in credit flows, the credit impulse, by 6 months. Therefore, the rise in bond yields is only now starting to pull down the credit impulse - and thereby the global activity mini-cycle, which is the all-important driver of mainstream European investments. It follows that a global mini-downturn in the first half of 2018 is now all but guaranteed (Chart of the Week). And that the higher that bond yields go from here, the more marked this mini-downturn will be. This reinforces two high conviction investment recommendations. First, it is now appropriate to underweight cyclical equity sectors: specifically, Banks, Materials and Energy. Against this, the one cyclical sector to upgrade to overweight is Airlines, given the sector's negative correlation with the oil price. Second, the payoff profile for exchange rates is just tracking expected long-term interest rate differentials (Chart I-8). This means that when the expected interest rate is close to the lower bound, the currency possesses a highly attractive payoff profile called positive skew. In essence, for any central bank already at the realistic limit of ultra-loose policy - such as the BoJ and ECB - the direction of policy rate expectations cannot go significantly lower. Conversely, tightening expectations for the Federal Reserve are approaching a magnitude that threatens either risk-asset prices and/or economic growth. So these expectations cannot go significantly higher (Chart I-9). Chart I-8Exchange Rates Are Tracking Long-Term ##br## Interest Rate Differentials Exchange Rates Are Tracking Long-Term Interest Rate Differentials Exchange Rates Are Tracking Long-Term Interest Rate Differentials Chart I-9Expected Interest Rates In The Euro Area And ##br##U.S. Will Converge One Way Or The Other Expected Interest Rates In The Euro Area And U.S. Will Converge One Way Or The Other Expected Interest Rates In The Euro Area And U.S. Will Converge One Way Or The Other On this basis, we reiterate our high conviction pecking order for currencies in 2018. Yen first; euro second; pound third; dollar fourth. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'Negative Skew: A Ticking Time-Bomb', July 27 2017 available at eis.bcaresearch.com. 2 Quantitative Easing, Zero Interest Rate Policy and Negative Interest Rate Policy. 3 Please see the European Investment Strategy Weekly Report, 'Beware The Great Moderation 2.0', February 1 2018 available at eis.bcaresearch.com. 4 This 1.5% forecast comes from regressing the world equity market to GDP multiple through 1998-2008 with subsequent 10-year returns, observing a very tight relationship, and then using the same relationship on current world equity market cap to GDP. Fractal Trading Model* This week's recommended trade is to go long utilities versus the market. The profit target is 3.5% outperformance with a symmetrical stop-loss. It was an excellent week for our other trades with short palladium hitting its 6% profit target, while underweight Japanese energy and long USD/ZAR are both in comfortable profit. 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-10 World Utilities World Utilities 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

Dear Client, In light of recent market turbulence, we are publishing our weekly report earlier than usual. Caroline Miller, Garry Evans, and I will also be hosting a webcast Wednesday morning at 10am EST to discuss the investment outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Monday's stock market rout was largely driven by technical factors. Strong economic growth and positive earnings surprises should keep the equity bull market intact. Nevertheless, investors need to adjust to the fact that volatility is likely to pick up, just as it did in the last few years of the 1990s bull market. The market's expectations of where the funds rate will be over the next two years have almost converged with the Fed dots. In the near term, this will limit the ability of the 10-year Treasury yield to rise much above 3%. Looking further out, inflation is likely to move above the Fed's target early next year, setting the stage for a recession starting in late 2019. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Feature VIX Kicks Last week's Global Investment Strategy report, entitled "Take Out Some Insurance," argued that equities had become dangerously overbought and were highly vulnerable to a correction.1 We noted that the VIX had likely bottomed for the cycle and that going long volatility had now become an attractive hedge against stock market declines. As many of my colleagues have noted, betting on continued low volatility had become an increasingly crowded trade in recent years. Back in January, we observed that net short volatility positions had reached record-high levels (Chart 1). We warned that "traders have been able to reap huge gains over the past few years by betting volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility."2 Precisely such a vicious cycle erupted on Monday, causing the S&P 500 to suffer its worst daily percentage loss since August 18, 2011. The question is where do we go from here? So far, the sell-off in stocks looks largely technical in nature. Chart 2 shows that the VIX soared by roughly four times more on Monday than one would have expected based solely on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction of other "risk gauges" such as junk bonds, EM stocks, and gold prices over the past few days is consistent with this thesis. Chart 1Volatility Is Back Volatility Is Back Volatility Is Back Chart 2Monday's VIX Spike Was Abnormally Large The Return Of Vol The Return Of Vol Cyclical Outlook Still Solid It is impossible to know if today's rebound will persist or if the correction still has further to run. What we do know is that the cyclical underpinnings for the bull market remain intact. Leading economic data remain buoyant (Chart 3). Corporate earnings continue to come in above expectations (Chart 4). Chart 3Global Economic Backdrop Remains Buoyant Global Economic Backdrop Remains Buoyant Global Economic Backdrop Remains Buoyant Chart 4Optimism Over 2018 Earnings Growth Optimism Over 2018 Earnings Growth Optimism Over 2018 Earnings Growth None of our recession-timing indicators are flashing red (Chart 5). The Conference Board's LEI is rising at a healthy 5.5% y/y pace. Historically, a decisive break below zero in the year-over-year change in the LEI has been a reliable recession indicator. Likewise, while the U.S. 2/10-year Treasury curve has flattened, it has not inverted yet. Moreover, even once the yield curve inverts, the lags can be quite long before the recession begins. For example, in the last cycle, the yield curve inverted in early 2006, but the recession did not begin until December 2007. This does not mean that everything will be smooth sailing from here. Monday's sell-off marked an inflection point in the low-volatility world that has prevailed over the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Going forward, volatility will remain elevated relative to what investors have come to expect. As the experience of the 1990s shows, stocks can still go up when volatility is trending higher (Chart 6), but this is going to make for a much more challenging investment environment. Chart 5No Signs Of An Imminent End To This Business Cycle No Signs Of An Imminent End To This Business Cycle No Signs Of An Imminent End To This Business Cycle Chart 6Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise The Powell Put? How the Fed and other central banks react to this new world will be critical. It is perhaps not a complete coincidence that Monday's crash occurred on the first day that Jay Powell took over the helm of the Fed. Investors are increasingly worried that the Fed will turn from friend to foe. The faster-than-expected increase in average hourly earnings in January put those fears in stark relief. Accelerating wage growth suggests supply-side constraints are beginning to bite. This, in turn, means that the runway for low inflation and easy monetary policy may not be as long as some had hoped. As BCA editors discussed in our 2018 Outlook, "Policy And The Markets: On A Collision Course," central banks are in the process of winding down the extraordinary stimulus that investors have gotten used to.3 Whether this undermines the case for holding stocks and other risk assets depends on how quickly the adjustment occurs. On the plus side, we continue to think the adjustment will be fairly gradual, at least for the time being. Core CPI inflation outside of shelter is still running at 0.7% (Chart 7). This gives the Fed plenty of wiggle room. Just like Janet Yellen, Jay Powell will seek to build a consensus among his colleagues. Granted, the composition of the FOMC is likely to shift in a somewhat more hawkish direction. However, the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important, and often underappreciated, source of continuity. As in the past, the Fed will continue to monitor incoming economic and financial data and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. and most other countries remain more expansionary than they were six months ago (Chart 8). Chart 7Core Inflation Outside Housing Is Still Low Core Inflation Outside Housing Is Still Low Core Inflation Outside Housing Is Still Low Chart 8Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Just as importantly, the implosion of volatility funds is unlikely to reverberate across the financial system in the same way as it did during the financial crisis. What made the mortgage crisis so toxic was that the losses were concentrated in the books of highly leveraged financial institutions. In the case of volatility funds, that does not appear to be the case. Investment Implications Global bond yields remain quite low by historic standards and this should continue to support stocks. Indeed, even after the recent bond sell-off, average global bond yields are still close to half of what they were in 2011 - a time when global excess capacity was much greater than it is today (Chart 9). In keeping with our structurally bearish view on bonds, which we first articulated on July 5, 2016 in a note entitled "The End of 35-Year Bond Bull Market," we expect global bond yields to grind higher.4 However, in rate-of-change terms, the swift repricing of yields over the past few months has likely run its course. Chart 10 shows that market expectations of where the funds rate will be at the end of 2018 and 2019 have almost converged with the Fed dots. This convergence helped our short December-2018 fed funds futures trade, which we closed at our stop for a gain of 70 bps last Friday. A sustained move above 3% on the 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we do expect core inflation to move above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this is likely to be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of recessions (Table 1). If the next recession occurs in late 2019, as we expect, the equity bull market could last a while longer. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Chart 9Yields Are Still Low By Historic Standards Yields Are Still Low By Historic Standards Yields Are Still Low By Historic Standards Chart 10Market Pricing Has Almost Caught Up To The Fed's Dots Market Pricing Has Almost Caught Up To The Fed's Dots Market Pricing Has Almost Caught Up To The Fed's Dots Table 1Too Soon To Get Out The Return Of Vol The Return Of Vol Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Please see Global Investment Strategy Weekly Report, "Will Bitcoin Be DeFANGed?" dated January 12, 2018. 3 Please see The Bank Credit Analyst, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017. 4 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Global Bond Rout: Overheated financial markets are going through a much needed correction with higher bond yields being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however. Monetary policy settings remain accommodative in almost all major economies, while global growth momentum is showing no signs of slowing. The current turbulence is an early indication of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. Fixed Income Strategy: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Feature Risk assets worldwide are finally correcting after the relentless run-up seen in January, with the trigger being the steady rise in global bond yields seen since the beginning of the year. The big decline in U.S. equity markets, particularly after the release of last Friday's U.S. employment data which featured the highest year-over-year growth rate in wages seen in almost a decade, suggests that investors are growing increasingly worried about accelerating inflation and a more aggressive tightening response from central banks (NOTE: markets were undergoing another bout of selling yesterday as this publication went to press, but the conclusions reached in this report are unchanged). Chart of the WeekThe Cyclical Rise In Yields##BR##Has Room To Run The Cyclical Rise In Yields Has Room To Run The Cyclical Rise In Yields Has Room To Run However, taking a step back to look at the big picture, nothing has really changed in the past few days. Global growth remains strong, which has already steadily increased pressure on policymakers to raise interest rates according to our own BCA Central Bank Monitors (Chart of the Week). In the U.S. - the epicenter of the latest bout of market angst - financial conditions remain highly accommodative and supportive for future growth, while bond volatility remains low by historical standards even after the most recent upward blip. Credit spreads and equity valuations in non-U.S. markets, from Europe to the emerging world, are also no impediment to future growth in those regions. We have been expecting global bond yields to rise in 2018 as markets adjust to both a normalization of global inflation expectations and a shift to a less aggressive pace of bond buying by the Fed, European Central Bank (ECB) and Bank of Japan (BoJ). As we described in our 2018 Outlook report published last December:1 The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. The current market sell-off is likely too soon to be the ultimate realization of that forecast. Monetary policy settings remain accommodative and inflation is still below central bank targets in almost all major economies, while global growth momentum is showing no signs of slowing. This is an early indication, however, of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. We continue to recommend a pro-growth fixed income investment strategy, staying below-benchmark overall duration, focusing on lower-beta government bond markets, overweighting corporate debt over sovereign debt, and prioritizing inflation protection in bond portfolios. In the coming weeks, however, we will begin to discuss strategies to play for the shift to a more hostile investment backdrop that we expect later in 2018. The U.S. Bond Vigilantes Are Back In Charge Global monetary policies that remain "too" accommodative given robust growth and some pickup in realized inflation have prompted bond markets to reprice, through both higher inflation expectations and real yields. Rising yields have triggered a spike in market volatility measures like the U.S. VIX index, although there were also several bouts of higher volatility in 2017 (Chart 2). Growth-sensitive financial assets shrugged off those higher volatility episodes, mainly because growth expectations were not impacted. We see no reason why this current bout of market turbulence should differ from last year's volatility spikes, and have any meaningful impact on forecasts for future economic growth (and, by extension, corporate profits). At least, not without a more meaningful tightening of global monetary policy, particularly in the U.S. where inflation pressures are gaining steam. The December Payrolls report released last week may finally contain that missing piece of the inflation puzzle - faster wage growth. Headline Average Hourly Earnings expanded 2.9% on a year-over-year basis, with the 3-month annualized growth rate surging to pre-crisis levels above 4% (Chart 3). Coming at a time when the U.S. labor market remains tight by any measure (top panel), a pickup in wage growth supports the other evidence indicating that U.S. inflation is on the upswing, like the modest acceleration in core PCE inflation (3rd panel) and steady climb in TIPS breakevens (bottom panel).2 Chart 2This Is A Correction,##BR##Not A Reversal, In Risk Assets This Is A Correction, Not A Reversal, In Risk Assets This Is A Correction, Not A Reversal, In Risk Assets Chart 3U.S. Wage Inflation##BR##Finally Appears U.S. Wage Inflation Finally Appears U.S. Wage Inflation Finally Appears A faster inflation backdrop is making the Fed's current monetary policy plans more credible for investors. The U.S. Overnight Index Swap (OIS) curve is now fully pricing in the Fed's three planned interest rate hikes for 2018, and has almost priced in the additional 50bps of hikes the Fed is projecting for 2019 (Chart 4). Rate expectations even further out the curve have been climbing, as well. Our measure of the market's expectation for the so-called "terminal rate" - the 5-year U.S. OIS rate, 5-years forward - is now up to 2.66%, only 9bps below the current median projection ("dot") for the terminal rate. Markets have been highly skeptical that the Fed would ever be able to raise rates as high as its projections in recent years - justifiably so, given that U.S. realized inflation has been persistently falling short of the Fed's 2% inflation target. Now, with core inflation having clearly bottomed out and shorter annualized rates of change closing in on 2%, markets are coming around to the idea that the Fed inflation forecasts will be realized. If that happens, then the Fed should be expected to follow through on its published projections, not only for 2018 but for the remainder of the current tightening cycle. On that basis, there is not a lot more room for the market's pricing of the expected path of U.S. interest rates to converge to the Fed's projections. That suggests that the shorter-end of the U.S. Treasury curve may be approaching a cyclical peak - unless the Fed were to begin revising up its "dots" in response to a faster pace of U.S. economic growth and inflation. That would require the Fed to start believing that a faster pace of rate hikes, or a higher equilibrium real interest rate, was required in the U.S. The current real interest rate remains around 0% (subtracting core PCE inflation from the fed funds rate), as the Fed's rate hikes since beginning the tightening cycle in December 2015 have matched the increase in realized inflation. Measures of the so-called "r-star" equilibrium rate, like the Williams-Laubach measure, are also indicating that the real fed funds rate should be around 0% (Chart 5). The real fed funds rate has historically been highly correlated to the employment/population ratio in the U.S., and the current level of that ratio (60%) suggests that the Fed does not have to target a real funds rate above 0%. The conclusion is that it would take a sign of even greater U.S. labor market utilization - i.e. a rising employment/population ratio - for the Fed to conclude that it must raise its interest rate projections. Chart 4Market Pricing Has Caught Up##BR##To The Fed's Forecasts Market Pricing Has Caught Up To The Fed's Forecasts Market Pricing Has Caught Up To The Fed's Forecasts Chart 5A 0% Real Fed Funds Rate##BR##Is Still Appropriate A 0% Real Fed Funds Rate Is Still Appropriate A 0% Real Fed Funds Rate Is Still Appropriate Without such a boost to the Fed's expected path of interest rates, any remaining increases in U.S. Treasury yields will have to come from higher inflation expectations. On that front, the current level of the 10-year TIPS breakeven at 2.14% remains 30-40bps below the 2.4-2.5% range that is consistent with the Fed's 2% inflation target (adjusting for the typical gap between CPI and PCE inflation and allowing for a small inflation risk premium). That suggests that the 10-year nominal Treasury yield can rise to the 3.10-3.25% range to fully discount a sustainable return of inflation to the Fed's target, with the Fed delivering on its interest rate projections in response. That target range is also not far from the current fair value from our 2-factor 10-year U.S. Treasury yield model, which has risen to 3.01% (Chart 6).3 It will be critical to watch the future behavior of the parts of the U.S. economy that are most sensitive to interest rates, like consumer durables and housing, for signs that the latest rise in U.S. bond yields is having any negative effect on U.S. growth. A slowing trajectory for U.S. growth in response to higher interest rates would certainly give the Fed some second thoughts on moving ahead with its rate hike plans. On that note, the year-over-year change in the 10-year Treasury yield is now in positive territory, which has typically led to a slower contribution to U.S. real GDP growth from consumer durables (Chart 7, top panel). The rise in U.S. mortgage rates should also lead to slower growth in residential investment, although housing has already been providing very little marginal contribution to U.S. growth over the past two years (2nd panel). Chart 6Fair Value On The 10-Year##BR##UST Yield Is 3%...And Rising Fair Value On The 10-Year UST Yield Is 3%...And Rising Fair Value On The 10-Year UST Yield Is 3%...And Rising Chart 7Rising U.S. Capex Should Offset##BR##Slowing Interest-Sensitive Spending Rising U.S. Capex Should Offset Slowing Interest-Sensitive Spending Rising U.S. Capex Should Offset Slowing Interest-Sensitive Spending The potential offset to any slowdown in interest-sensitive spending, however, is capital spending by businesses, which is being boosted by easy financial conditions (bottom panel), loosening bank lending standards and a rise on the expected after-tax return on investment following the Trump corporate tax cuts. It will likely take higher interest rates, and much tighter financial conditions, before the capex cycle peaks out. Bottom Line: Overheated financial markets are going through a much needed correction, with higher bond yields, most notably in the U.S., being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however, and monetary policies will need to tighten further in response to strong growth and rising inflation pressures. The cyclical interest rate tipping point for risk assets has not yet been reached, even in the U.S., but is getting incrementally closer. Don't Forget The Other Factor Driving Global Bond Yields - Reduced Central Bank Buying Amidst all the worries about higher inflation and the related impact on global bond yields, it should not be forgotten that the major developed market central banks have been cutting back on their bond purchases. Global bond yields have been correlated to the growth rate of the combined balance sheet of the "G-4" central banks (Fed, ECB, BoJ and Bank of England) since the ECB started its bond buying program in 2015 (Chart 8). The current rise in global yields has been in line with the projected slower pace of aggregate bond buying by those central banks. Based on our projection for the year-over-year growth rate of the G-4 central bank balance sheets - which incorporate the Fed letting maturing bonds run off its balance sheet and cutbacks in the pace of buying of new bonds by the ECB and BoJ - there is still more room for bond yields to rise over the course of 2018. A slower pace of central bank "liquidity" creation is something that we anticipated to weigh on risk asset returns in 2018. By driving down the yields on safe assets like government debt to highly unattractive levels, central banks induced huge inflows into global equity and credit markets, both in the developed and emerging worlds. As central banks are now buying fewer bonds, however, there is not only reduced downward pressure on government bond yields but also diminished scope for additional inflows into riskier assets. Looking at the growth rate of the G-4 central bank balance sheet versus the rolling 12-month returns on global equities and credit, the current pullback in overheated risk assets is merely bringing returns back down to levels consistent with central banks taking their foot off the monetary accelerator (Chart 9). Chart 8The Central Bank Impact On##BR##Bond Yields Is Slowly Unwinding... The Central Bank Impact On Bond Yields Is Slowly Unwinding... The Central Bank Impact On Bond Yields Is Slowly Unwinding... Chart 9...Which Impacts Risk Asset##BR##Returns, As Well ...Which Impacts Risk Asset Returns, As Well ...Which Impacts Risk Asset Returns, As Well For global fixed income markets, we had anticipated that 2018 would be a year of much lower expected returns on spread product like global corporate debt, although those would still beat the returns likely from government debt - at least until government bond yields reached our cyclical targets. Our view has not changed, even in light of the current pullback in risk assets and yesterday's decline in government bond yields. For now, we continue to recommend an overweight stance on global corporate debt, but favoring U.S. Investment Grade and High-Yield debt over European equivalents (and over Emerging Market hard currency debt). We will discuss our eventual recommended exit strategy in upcoming reports, but for now, our advice is to sit tight and ride out this current bout of market turbulence. Bottom Line: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th, 2017, available at gfis.bcaresearch.com. 2 It is interesting to note that it took a sharp pickup in the Average Hourly Earnings measure to get the market's attention about wage inflation. Many Fed officials and market commentators (including here at BCA!) have consistently pointed out the inherent flaws in looking at Average Hourly Earnings as an accurate measure of wage pressures in the U.S. Yet the big market response to the latest surge in Average Hourly Earnings is a sign that investors still look at that indicator as the "true" measure of wage inflation. 3 The standard deviation of the fair value estimate from that model is 17bps, which means that yields could rise as high as 3.18% before reaching an "undervalued" level for U.S. Treasuries - assuming no further increases in fair value, of course. Recommendations Forewarned Is Forearmed Forewarned Is Forearmed Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Waiting For A Signal Waiting For A Signal Waiting For A Signal TIPS breakeven inflation rates are fast approaching our end-of-cycle targets (Chart 1). The 10-year and 5-year/5-year rates are currently 2.14% and 2.36% respectively, only slightly below our target range of 2.4% to 2.5%. If this trend continues it is highly likely that we will start to slowly reduce the credit risk in our portfolio in the coming weeks. Already, we find that some lower risk spread products (Foreign Agency bonds and Munis) are attractively valued relative to corporates. But there are also risks to exiting credit too early. First and foremost is that the recent widening in TIPS breakevens might reverse before it bleeds into higher core inflation. As we noted in last week's report, the St. Louis Fed's Price Pressures Measure is still supportive of an overweight allocation to corporate bonds (Chart 1, bottom panel) and core PCE inflation has only just risen to 1.5% year-over-year.1 Investors should maintain below-benchmark duration and an overweight allocation to corporate bonds for now, but be wary that the time to make end-of-cycle preparations is drawing nearer. 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 72 basis points in January. The average index option-adjusted spread tightened 7 bps on the month, and currently sits at 85 bps. Investment grade corporate bond spreads continue to tighten, and with each additional basis point the evidence of extreme overvaluation grows. As of today, the 12-month breakeven spread for an A-rated corporate bond has only been tighter 3% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 4% of the time (panel 3). Further, the average spread on the Foreign Agency bond index is now 3 bps greater than the average spread of an equivalent-duration corporate bond, despite having an average credit rating that is three notches higher (Aa2/Aa3 versus A3/Baa1). Even a 10-year Aaa-rated Municipal bond now offers 7 bps greater after-tax yield than a duration-equivalent corporate bond for investors in the top marginal tax bracket (see page 9). The bottom line is that with such poor value in investment grade corporate spreads, we only need to see a stronger signal from our inflation indicators before reducing exposure.2 Depending on how inflation (and TIPS breakevens) evolve, that time could come relatively soon. The Federal Reserve's Senior Loan Officer Survey, released yesterday, showed that lending standards for commerical & industrial (C&I) loans eased somewhat in the fourth quarter of 2017, and also noted that banks expect to ease standards further on C&I loans to large and middle-market firms in 2018. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Warning Signs Warning Signs Table 3BCorporate Sector Risk Vs. Reward* Warning Signs Warning Signs 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 149 basis points in January. The average index option-adjusted spread tightened 24 bps on the month, and currently sits at 324 bps. Last week's equity sell-off and spike in the VIX suggest that some near-term junk spread widening could be in the cards (Chart 3). However, we expect it is still a bit too soon to move out of junk bonds for the cycle. That decision will be made based on whether our inflation indicators continue to rise in the coming weeks and/or months, suggesting that the monetary policy back-drop is becoming less accommodative. In terms of value, high-yield corporates offer better risk-adjusted value than their investment grade brethren. The 12-month breakeven spread for a Ba-rated high-yield bond has currently been tighter than it is today 14% of the time since 1995. The same figure comes in at 25% for a B-rated bond and 31% for a Caa-rated bond. Similar measures for investment grade corporates are significantly lower (see page 3). Further, assuming a default rate of 2.35% for the next 12 months and a recovery rate of 51%, we calculate that a position in high-yield bonds will return 209 bps in excess of Treasuries if spreads stay flat at current levels. Another 100 bps of spread tightening would imply an excess return of just over 6%, but this would bring junk spreads to all-time tight valuations and is probably too optimistic. Remain overweight high-yield for now. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in January. The conventional 30-year zero-volatility MBS spread narrowed 2 bps on the month, all concentrated in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) was flat on the month, and currently sits at 29 bps. After having widened for most of last year, the OAS for a conventional 30-year mortgage bond is now more attractive relative to an equivalent-duration investment grade corporate bond than at any time since 2014 (Chart 4). This makes MBS a reasonably attractive sector for investors looking to shift away from corporate bonds and de-risk their spread product portfolios. Further, there would appear to be very little risk of spread widening in the MBS sector. First, the schedule of run-off from the Fed's mortgage portfolio is already well known, and likely in the price. Second, mortgage refinancings are likely to stay contained in a rising interest rate environment (bottom panel). Finally, the risk of duration extension in MBS only becomes material when Treasury yields spike higher very quickly - on the order of 72 bps or more in a month - as we showed in last week's report.3 Investors should stay at neutral on MBS for now, but stand ready to increase exposure when the time comes to move out of corporate bonds for the cycle. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in January. Sovereign bonds outperformed by 118 bps, Local Authorities by 67 bps, Foreign Agencies by 54 bps, Domestic Agencies by 8 bps and Surpranationals by 3 bps. USD-denominated Sovereign bonds continue to look expensive compared to Baa-rated U.S. Credit (Chart 5), yet they still managed to deliver almost identical excess returns during the past 12 months because of the U.S. dollar's large depreciation. Going forward, with the dollar's rapid decline unlikely to accelerate, we would avoid Sovereign bonds in favor of U.S. corporates. Valuation is more attractive elsewhere in the Government-Related index. Foreign Agency bonds now offer greater spreads than equivalent-duration U.S. corporate bonds, despite benefitting from higher credit quality (panel 4). Local Authority spreads also look attractive compared to recent history (bottom panel). We continue to recommend overweight allocations to both sectors. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 12 bps and 16 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 29 bps and 40 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 53 basis points in January (before adjusting for the tax advantage). The average AAA-rated Municipal / Treasury (M/T) yield ratio was flat on the month. Two market technicals spurred Muni outperformance in January. First, supply plunged after many advance refunding issues were pulled forward in anticipation of the U.S. tax bill (Chart 6). Second, the repeal of the state and local tax deduction led to increased demand for Munis, as evidenced by the recent jump in fund inflows (panel 3). In terms of credit quality, state and local government net borrowing as a percent of GDP likely fell to 0.9% in 2017 Q4 - assuming that corporate tax revenues are held constant. This is consistent with current low yield ratios (panel 4). Meanwhile, tax revenue growth should stay strong in the coming quarters due to recent increases in property prices and retail sales. While M/T yield ratios remain low compared to history, excessive valuations in investment grade corporate bonds mean that Munis are starting to look attractive by comparison. For example, for investors in the top marginal tax bracket, we calculate that the after-tax yield on a Aaa-rated municipal bond is 7 bps higher than the duration-equivalent yield offered by the investment grade corporate bond index, even though the corporate bond index offers an average credit rating of only A3/Baa1. While the bottom panel shows that this yield differential has been higher in the past, it is nevertheless an indication that we are approaching the end of the credit cycle. Stay underweight Munis for now, though an upgrade is likely when it comes time to exit our corporate bond overweights. 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 bear steepened out to the 10-year maturity point in January, as bond markets started to price-in a rebound in inflation. The 2/10 slope steepened 7 basis points on the month and the 5/30 slope flattened 11 bps. The 2/10 slope steepened even further in the first five days of February and currently sits at 69 bps, up from its recent low of 50 bps. More near-term curve steepening is possible if long-maturity TIPS breakeven inflation rates continue to widen, especially since the Fed's median projected rate hike path for the next 12 months is already fully discounted (Chart 7). However, the yield curve is much more likely to be flatter by the end of the year than it is today. In large part because the upside in long-maturity yields will be limited once TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5%. In terms of positioning, we continue to advocate a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell. The 5-year continues to look very cheap on the curve (panel 3), or put differently, our model suggests that the 2/5/10 butterfly spread is currently priced for 29 bps of 2/10 curve flattening during the next six months (panel 4).4 This seems excessive for the time being. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate increased 15 bps on the month. At 2.14% and 2.36%, respectively, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are still below our target range of 2.4% to 2.5%, but only modestly so. The big run-up in TIPS breakeven rates coincided with a jump in oil prices and, as we discussed in a recent report, this is no coincidence (Chart 8).5 The Fed has an asymmetric ability to influence inflation - it has an unlimited ability to tighten policy but its ability to ease policy is restricted by the zero-lower bound on interest rates. It is for this reason that when TIPS breakeven inflation rates become un-anchored to the downside, they also become much more sensitive to swings in commodity prices. In these environments the market sees inflation as increasingly determined by price pressures in the economy and not by the Fed's reaction function. The logical conclusion is that we should expect the tight correlation between oil prices and long-maturity TIPS breakeven rates to persist until breakevens reach our target fair value range of 2.4% to 2.5%. At that point, it is unlikely that further increases in commodity prices would filter through to long-maturity breakevens, because the market would anticipate a tightening response from the Fed. Stay overweight TIPS versus nominal Treasury securities for now. We will reduce exposure when our fair value target of 2.4% to 2.5% is achieved. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in January. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 2 bps on the month and now stands at 33 bps, only 6 bps above its all-time low (Chart 9). All in all, a 33 bps spread is still reasonably attractive for a sector that is Aaa rated with an average duration of 2. By way of comparison, the intermediate maturity Aaa Credit index offers an OAS of only 17 bps and has an average duration above 3. However, credit trends are clearly shifting against the Consumer ABS sector. The consumer credit delinquency rate has put in a bottom, albeit from a very healthy level, and the trend in the household debt service ratio suggests that delinquencies will continue to rise (panel 3). Further, the Federal Reserve's Senior Loan Officer Survey shows that lending standards on auto loans have tightened on net in each of the past 7 quarters, while credit card lending standards have tightened for 3 consecutive quarters. Even though lending standards on both auto loans and credit cards moved slightly closer to net easing territory in the fourth quarter of 2017, the reading from lending standards is still consistent with a rising delinquency rate (bottom panel). We retain a neutral allocation to consumer ABS due to still attractive spreads for a low-duration, high credit quality sector. However, if the uptrend in consumer delinquencies is sustained then our next move will probably be to reduce allocation to this sector. 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 January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 7 bps on the month and currently sits at 59 bps. The spread is now only 8 bps above the lowest level seen since the inception of the index in 2000 (Chart 10). Much like in the Consumer ABS sector, historically low CMBS spreads are observed at a time when lending standards are tightening in the commercial real estate (CRE) sector. The Federal Reserve's most recent Senior Loan Officer Survey shows that lending standards for nonfarm nonresidential CRE loans have tightened for 10 consecutive quarters, though they have been tightening less aggressively of late (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in January. The index option-adjusted spread narrowed 1 bp on the month and currently sits at 40 bps. With an average spread of 40 bps and an average duration of around 5, this sector is not quite as attractive as Consumer ABS on a spread per unit of duration basis. However, it still offers greater expected compensation than a position in Conventional 30-year residential MBS which has an option-adjusted spread of 29 bps and a similar duration. 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 3.01% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 3.06%. The Global PMI actually ticked down in January, but only slightly from 54.5 to 54.4. This small decline was more than offset in our model by the large drop in dollar sentiment, which just moved into "net bearish" territory (bottom panel). Of the four major economic blocs, PMIs increased in the U.S. and Japan, ticked down from an extremely high level in the Eurozone and held steady in China. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.84%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 4 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 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)