Gov Sovereigns/Treasurys

Highlights One of the biggest mistakes in finance is to equate risk with volatility. The correct measure of risk is the negative skew in payoff distributions. If 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. This would be the point at which to scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Feature It is the crucial question that all investors should ask at all times. What is the relative risk of the two major asset classes - bonds and equities - and are their relative return prospects commensurate with the relative risk? Chart of the WeekBelow A 2% Yield, 10-Year Bonds Are Riskier Than Equities Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? But first, there is an even more fundamental question: what do we mean by risk? Conventional wisdom says that the risk of an investment is captured by its volatility. Indeed, through instruments such as the VIX futures and currency volatility options, volatility has become a multi-trillion dollar asset-class in its own right. Therefore, volatility must measure the risk of an investment, right? Wrong. The Biggest Mistake In Finance As a measure of risk, volatility is clearly wrong. Volatility regards price gains in exactly the same way as it regards price losses. But investors don't mind gains, they only mind losses! Consider an investment whose price moves alternately sideways and sharply higher. The maths would say that the returns have high volatility, implying that the investment is very risky. In truth though, the investment is highly desirable and 'risk-free' - because its price never declines. At our recent New York conference, Nobel Laureate Daniel Kahneman warned that one of the biggest mistakes in finance is to equate risk with volatility. After decades of empirical and theoretical studies - which culminated in the 2002 Nobel Prize for Economics - Kahneman proved that investors are not concerned about the symmetrical fluctuations in investment returns. Instead, they are concerned about the asymmetry - or skew - in payoff distributions. Kahneman explained the underlying psychology. "People are limited in their ability to comprehend and evaluate extreme probabilities, so highly unlikely events are overweighted." If the payoff distribution is symmetric, the overweighting of unlikely events in the loss tail and the gain tail exactly cancels out. But if the distribution is asymmetric, the longer tail determines the perceived attractiveness of the payoff. Where the longer tail is on the gain side, the distribution is said to have positive skew (Figure I-1). The classic example is a lottery. When people play the lottery, their loss is limited to the ticket price, but their gain could be tens of millions. People perceive the positive skew as attractive because they overweight the minuscule probability of becoming a millionaire. As a result, they overpay for the lottery ticket versus its expected value. Where the longer tail is on the loss side, the distribution is said to have negative skew (Figure I-2). This is like a lottery in reverse. The gain size is relatively limited, but the loss could be very large. People perceive the negative skew as unattractive because they overweight the probability of a large loss. As a result, they demand overpayment to take it on. Figure I-1People Like Positive Skew Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? Figure I-2People Dislike Negative Skew Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? For investments with negative skew, this overpayment takes the form of an excess return demanded from the market - a 'risk premium' - versus investments with less negative skew. Are Bonds A Greater Risk Than Equities? We are now in a position to tackle the question in the title. To determine whether bonds are riskier than equities or vice-versa, we must compare the skews of their return profiles.1 The important point is that for a bond, the skew of its return profile changes with its yield. At yields above 2.5%, 10-year bond returns show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, returns start to exhibit negative skew (Chart I-2). And at yields below 1%, the negative skew becomes extreme. Chart I-2Bond Risk Increases At ##br##Low Bond Yields Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? Chart I-3Equity Risk Does Not Increase At##br## Low Bond Yields Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? The reason is obvious. 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. Close to this lower bound for yields, bond mathematics necessarily creates a negatively skewed return profile. Simply put, prices have little upside, but they have a lot of downside! Chart I-4A 40Bps Rise In Yields Would Make Global ##br##Bonds Riskier Than Equities A 40Bps Rise In Yields Would Make Global Bonds Riskier Than Equities A 40Bps Rise In Yields Would Make Global Bonds Riskier Than Equities Turning to equities, the empirical evidence shows that equity returns always exhibit negative skew. Worst losses are typically around 1.5 times the size of best gains (Chart I-3). But the negative skew of equity returns is largely independent of the bond yield. The upshot is that there is a crossover bond yield below which the negative skew on 10-year bonds exceeds that on equities. This crossover bond yield is around 2%. In negative skew terms, we can say that at a 10-year bond yield below 2%, 10-year bonds are riskier than equities. And at a yield above 2%, equities are riskier than 10-year bonds (Chart of the Week). So in negative skew terms, 10-year bonds are riskier investments than equities in Europe and in Japan. But equities are riskier investments than 10-year bonds in the United States. Still, given that developed financial markets tend to move en masse, the relationship that is most significant is the aggregate one. At a global level, 10-year bond yields are 40bps below the crossover yield at which equities become riskier than bonds (Chart I-4). QE Distorted The Relative Valuation Of Equities Versus Bonds Which segues us neatly to today's ECB monetary policy meeting. Many people, worried about the end of QE, point out that the $10 trillion of bonds that the 'big four'2 central banks have bought is not far short of the size of the euro area economy. However, in the context of a global fixed income market of $220 trillion,3 $10 trillion of buying is small change. For the $220 trillion global bond and bank loan complex, the much more significant driver of yields has been the expected path of policy interest rates. As ECB Chief Economist Peter Praet put it, serial QE has been nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Chart I-5A Promise To Keep The Policy Rate Ultra-Low ##br##Pulls Down Bond Yields A Promise To Keep The Policy Rate Ultra-Low Pulls Down Bond Yields A Promise To Keep The Policy Rate Ultra-Low Pulls Down Bond Yields Central bankers know that QE depressed bond yields by signalling an extended period of ultra-low interest rates (Chart I-5). They also know that if the prospective return on bonds drops, so must the prospective return on competing investments such as equities. Thereby, the absolute valuations of bonds and equities both rise. However, one largely overlooked impact of QE - even by central bankers - has been the effect on the relative valuation of equities versus bonds. To repeat, when 10-year bond yields drop below 2%, their return distribution becomes more negatively skewed than that for equities. But if bonds become riskier investments, the 'risk premium' (excess return) on equities must disappear. Meaning equity valuations and prices get a second boost, compressing the prospective 10-year equity return to become 'bond-like'. Is this the case? Unlike for 10-year bonds, we do not know the 10-year prospective return from equities with certainty. However, we can get a good estimate from today's starting valuation. But which valuation metric to use? We are cautious of using profit based metrics as these will be flattered by the advanced position in the business cycle as well as the structural uptrend in profit margins. Instead, at an aggregate level, world equity market capitalisation to world GDP has been an excellent predictor of the prospective 10-year return on world equities. Today, this valuation metric is at the same level as in 2000 and 2007, and implies a prospective return of less than 2% a year (Chart I-6). Chart I-6World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Nevertheless, while the global 10-year bond yield stays below 2%, this is a sustainable valuation for equities. Effectively, equities and bonds are offering broadly similar negative skews, and therefore should offer broadly similar prospective returns. However, if 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. Though not there yet, this would be the point when we would scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 One simple way to quantify this skew is to find an extended period of time in which the price ended where it started, and then to calculate the period's worst 3-month loss as a multiple of the best 3-month gain. We define skew = -ln(worst 3-month loss / best 3-month gain) using log returns for 3-month loss and 3-month gain. 2 The Federal Reserve, ECB, Bank of Japan and Bank of England. 3 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. Fractal Trading Model* This week's trade is to position for an underperformance of the Japanese energy sector (led by JXTG Holdings And Inpex) versus the overall Japanese market. This is a longer trade than normal with a maximum duration of 26 weeks. Set a profit-target at 8% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-7 Short Japan Oil & Gas Short Japan Oil & Gas The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Duration: The modest bond-bullish message from our technical indicators does not yet outweigh the bond-bearish forces we expect to prevail on a 6-12 month horizon. Maintain below-benchmark duration. 10-Year Yield: The 10-year Treasury yield has risen a lot, but still has considerable upside on a 6-12 month horizon. The 10-year TIPS breakeven inflation rate is still 35 bps below its fair value range, and it is difficult to craft a realistic scenario where a higher cost of inflation protection is offset by lower real yields. Risk Premiums & Treasury Returns: Despite the recent increases in short-dated Treasury yields, Treasuries with 1-2 years remaining until maturity still do not offer adequate compensation for the likely future path of rate hikes. Negative risk premiums in 1-year and 2-year hold-to-maturity Treasury positions are also likely to coincide with very low Treasury index total returns during the next 1-2 years. Feature Chart 1The Long End Catching The Train The Long End Catching The Train The Long End Catching The Train The sell-off in U.S. bond markets continued last week with the 10-year yield breaking above its previous peak of 2.62%. Of course yields at the short end of the curve made new cyclical highs long ago and have increased even further during the past few weeks (Chart 1). In this report we look at both the long and short ends of the yield curve and ask whether yields are finally fairly priced. But first, a quick re-cap of our cyclical investment stance. In our prior two bulletins we noted that the cyclical outlook for bonds remains bearish, and this continues to be the case. The main reason is that, despite recent increases, the long-term cost of inflation protection is still below levels consistent with the Fed's 2% inflation target. However, we have also warned that the message from some near-term technical indicators is starting to shift. Specifically, net speculative positions in 10-year Treasury futures are now 2% net short. Positioning at these levels has historically been consistent with a modest decline in the 10-year yield during the subsequent three months (Chart 2). Also, the U.S. Economic Surprise Index (ESI) sits at a lofty +65 and is poised to mean revert as investor expectations grow increasingly optimistic. Our simple auto-regressive model of the ESI projects that it will decline to +28 during the next month.1 A positive value on the ESI is consistent with a continued increase in Treasury yields (Chart 3), but we will be watching closely for signs that the ESI is about to break below zero. Chart 2Message From Our Near-Term Indicators (I) Message From Our Near-Term Indicators (I) Message From Our Near-Term Indicators (I) Chart 3Message From Our Near-Term Indicators (II) The Long And Short Of It The Long And Short Of It Taken together, the modest bond-bullish message from our technical indicators does not yet outweigh the bond-bearish forces we expect to prevail on a 6-12 month horizon. We therefore maintain our below-benchmark duration bias. We also maintain our overweight allocation to spread product versus Treasuries. Though inflationary pressure in the economy is starting to build, it is still not sufficient to spur significant spread widening. We will elaborate further on our spread product views in next week's report. How High For The 10-Year? In the current environment we find it instructive to split the nominal 10-year yield into its two main components - the compensation for inflation protection and the real yield - and consider each in turn. Inflation Chart 4TIPS Breakevens Are Still Low TIPS Breakevens Are Still Low TIPS Breakevens Are Still Low As was mentioned in the first section of this report, the 10-year TIPS breakeven inflation rate has risen a lot. From a trough of 1.66% last June to 2.05% as of last Friday. But this is still somewhat too low (Chart 4). Historically, the 10-year TIPS breakeven rate has traded in a range between 2.4% and 2.5% when realized inflation is well-anchored around the Fed's 2% target. With inflation almost certain to move back to the Fed's target before the end of the cycle, and indeed our Pipeline Inflation Indicator shows that inflationary pressures continue to build (Chart 4, bottom panel), there is still another 35 bps to 45 bps of cyclical upside in the 10-year breakeven rate. Real Yield As for the 10-year real yield, a simple model introduced in a report last month shows that it is driven by a combination of: The fed funds rate. The expected change in the fed funds rate during the next 12 months, as measured by our 12-month Fed Funds Discounter. Implied rate volatility as measured by the MOVE index. Included as a proxy for the term premium embedded in 10-year yields. The model is shown in Chart 5, where we also incorporate very conservative assumptions for each of the three independent variables. We assume that: The fed funds rate is raised three times this year, in line with the FOMC's median projection (Chart 5, panel 2). The 12-month discounter falls to 25 bps by year end. In other words, we assume that by then investors will only be looking for one rate hike only in 2019 (Chart 5, panel 3). The MOVE volatility index stays flat at historically low levels (Chart 5, bottom panel).2 Chart 5A Simple Model Of The Real 10-Year Treasury Yield A Simple Model Of The Real 10-Year Treasury Yield A Simple Model Of The Real 10-Year Treasury Yield The key message from Chart 5 is that it is very difficult to craft a reasonable scenario where the 10-year real yield has meaningful downside from current levels. Even using the benign assumptions described above, our model projects that the 10-year real yield will increase 4 bps in the next 11 months. From current levels that suggests a 10-year real yield of 0.61% by the end of the year. Summing it all up, on a cyclical horizon we project another 35 bps to 45 bps of upside in the inflation component of the 10-year Treasury yield, and at least 4 bps of upside in the real component. This suggests that the 10-year nominal Treasury yield should move into a range between 3.01% and 3.11% by the time that inflation reaches the Fed's target. Bottom Line: The 10-year Treasury yield has risen a lot, but still has considerable upside on a 6-12 month horizon. The 10-year TIPS breakeven inflation rate is still 35 bps below its fair value range, and it is difficult to craft a realistic scenario where a higher cost of inflation protection is offset by lower real yields. Is The Front End Fairly Priced? At this time last year the 1-year Treasury yield was 0.84% and the fed funds rate was 0.66%. During the past 12 months the fed funds rate rose from 0.66% to 1.42%, equating to an average fed funds rate of 1.10% during this period (using monthly compounding). An investor who bought a 1-year Treasury note last year and held to maturity would have earned a risk premium of -26 bps relative to a position in cash. Not a great return by any means, but yields have moved a lot since then. The 1-year yield is now 1.79% and the 2-year yield is 2.05%. Is it possible that front-end yields now provide adequate compensation for the path of rate hikes during the next 1-2 years? And more importantly, does the risk premium earned on short-maturity notes tell us anything about the total returns we can expect to earn from the overall Treasury index? These are the two questions we consider in this section. Calculating The Ex-Ante Risk Premium In Short-Maturity Yields Table 1 shows three different scenarios for the path of Fed rate hikes during the next two years. The median FOMC scenario assumes that the funds rate rises in line with the Fed's median projection. That is, the rate is lifted three times this year and twice next year. The hawkish scenario assumes that the funds rate is raised once per quarter between now and mid-2019, and the dovish scenario assumes that after hiking rates in March and June of this year the Fed is forced to go on hold. Table 1Fed Rate Hikes Scenarios & The Implied Risk Premium The Long And Short Of It The Long And Short Of It We see that the 1-year yield is priced exactly in line with the FOMC's median projection. That is, if the fed funds rate is hiked three times in 2018, then 12 months from now an investor will have been indifferent between a position in a 1-year note and a position in cash. In this same scenario an investor holding a 2-year note to maturity will end up losing 4 bps relative to a position in cash. Unsurprisingly, the hawkish scenario leads to much more negative realized risk premiums for both 1-year and 2-year hold-to-maturity trades. The dovish scenario leads to a small positive risk premium on a 2-year horizon, but a small negative risk premium on a 1-year horizon. This is because our dovish scenario still assumes there are two rate hikes this year. Our initial conclusion is that despite the recent increases in short-dated Treasury yields, Treasuries with 1-2 years remaining until maturity do not offer adequate compensation for the likely future path of rate hikes. Especially since a position in a 1-year or 2-year note is somewhat riskier than a position in cash, due to the additional duration risk. Short-Maturity Risk Premiums And Treasury Returns But there is one more possible application for the above analysis. We calculated the actual risk premiums earned in 1-year and 2-year hold-to-maturity positions going back to 1973, and found that these risk premiums correlate quite well with changes in the average yield for the Bloomberg Barclays Treasury index for the same time horizon. In other words, 12-month periods in which an investor in a 1-year note would have earned a positive risk premium relative to an investor in cash tend to coincide with a falling Treasury index yield, and vice-versa (Chart 6). The correlation is even stronger on a 2-year horizon (Chart 7). Chart 61-Year Risk Premium & 12-Month Change ##br## In Treasury Index Yield The Long And Short Of It The Long And Short Of It Chart 72-Year Risk Premium & 24-Month Change ##br## In Treasury Index Yield The Long And Short Of It The Long And Short Of It Using the relationships from Charts 6 & 7 we are able to calculate the expected change in the average index Treasury yield in each of our three scenarios for Fed rate hikes. We can then translate those yield changes into expectations for total returns from the Treasury index. Those projected total return figures are shown in the final column of Table 1. Our calculation shows that the median FOMC scenario translates into a projected Treasury index 1-year total return of 2.7%, and an annualized 2-year return of 1.7%. The annualized 2-year return in the hawkish scenario is only 84 bps, while it is 2.3% in the dovish scenario. Chart 8Very Low Returns On The Horizon Very Low Returns On The Horizon Very Low Returns On The Horizon Of course, these figures come with a good deal of uncertainty. Nowhere in the calculation do we consider possible price changes in longer-maturity bonds, which of course are a significant part of the index. In fact, Chart 8 shows that while the total return projections derived from this exercise give a good sense of the general direction in Treasury index returns, there is still considerable variability from year to year. Perhaps the most accurate statement we can make is that with 1-year and 2-year risk premiums likely to be negative - or at least very close to zero - during the next 1-2 years, we should also expect very low total returns from the overall Treasury index. Bottom Line: Despite the recent increases in short-dated Treasury yields, Treasuries with 1-2 years remaining until maturity still do not offer adequate compensation for the likely future path of rate hikes. Negative risk premiums in 1-year and 2-year hold-to-maturity Treasury positions are also likely to coincide with very low Treasury index total returns during the next 1-2 years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 For further details on the model please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 2 For further details on the model please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Duration Strategy: Global bond yields continue to move higher, driven by rising inflation expectations and falling investor risk aversion. With global interest rates still not at levels that will restrict growth or draw capital away from booming equity markets, the path of least resistance for yields remains upward. Maintain a below-benchmark overall portfolio duration stance, with a bearish curve steepening bias in the U.S. and core Europe. U.K. Gilts: The momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. Stay overweight Gilts. Feature Revisiting Our Duration Strategy After The Rise In Yields Global government bond markets have started 2018 in a grumpy mood. The price return on the overall Barclays Global Treasury index is already down -0.6% so far in January, and yields are up for almost every country and maturity bucket within the developed market universe. Only longer-dated Peripheral European debt (Italy, Spain, Portugal, even Greece) has seen lower yields month-to-date, as the powerful growth upturn in the Euro Area has resulted in sovereign credit upgrades and narrowing spreads to core European bonds. The global sell-off has been led by the U.S., with the benchmark 10-year U.S. Treasury yield climbing all the way to 2.66% last week, already surpassing the 2016 high seen last March. Rising inflation expectations are the biggest culprit, with the 10-year TIPS breakeven rate climbing to 2.07%, the highest level since 2014. Chart of the WeekNo Good News For Bonds Right Now No Good News For Bonds Right Now No Good News For Bonds Right Now The relentless surge in global stock markets - driven by faster worldwide economic growth and an absence of volatility - is also helping fuel the bearishness in government bond markets. The economic growth momentum is showing no signs of abating. The IMF just raised its global growth forecast for both 2018 and 2019 to 3.9% in both years - the fastest pace since 2011 - largely because of the impact of the U.S. tax cuts but also because of much faster expected growth in Europe.1 The IMF noted that "the cyclical rebound could prove stronger in the near term as the pickup in activity and easier financial conditions reinforce each other." We could not agree more. With robust growth pushing a majority of economies to operate beyond full employment, and with financial conditions remaining highly accommodative, global bond markets are now pricing in both higher inflation expectations and less accommodative monetary policy (Chart of the Week). While we only expect actual rate increases in the U.S. and Canada in 2018, the pressures on global central banks to respond to the coordinated growth upturn with hawkish talk will keep government bond markets on the defensive - especially if global inflation rates are moving up at the same time. Diminishing demand for government bonds from recently reliable sources may also act to push up yields in the months ahead. A reduced pace of asset purchases from the European Central Bank (ECB) and Bank of Japan (BoJ), combined with the Fed reducing the reinvestments of its maturing Treasury holdings, means that the private sector must now absorb a greater share of bond issuance, on the margin. In the U.S. in particular, the biggest swing factor for the Treasury market could end up being the retail investor. Households have been notably risk-averse in the years since the Great Financial Crisis, keeping relatively high allocations to fixed income and relatively low allocations to equities after suffering such steep losses in the 2008 crash. Those attitudes are changing, however, with the U.S. equity market continuing to hit new all-time highs amid increased media coverage of the rally (as well as the bullish Tweets from the White House taking credit for it). The latest University of Michigan U.S. consumer confidence survey showed that the expected probability of another year of rising stock prices is now at the highest level (66%) in the fifteen years that question was asked. U.S. investment advisors are also very optimistic, with the Investors' Intelligence bull/bear ratio back to the highest level since 1987! (Chart 2) Yet actual equity returns over the past three years have lagged those seen during periods of elevated investor sentiment, like in 1987, 2005 and 2014 (Chart 2). What is missing now is a big surge of retail investor money into equities that can fuel the next leg of the equity rally, particularly through mutual funds and ETFs. Chart 2The Bond-Bearish Equity Party##BR##Is Just Getting Started The Bond-Bearish Equity Party Is Just Getting Started The Bond-Bearish Equity Party Is Just Getting Started This is starting to happen. The rolling 12-month total of net flows into U.S. equity mutual funds and ETFs is about to accelerate into positive territory for the first time since 2012, according to data from the Investment Company Institute (3rd panel). This could soon pose a problem for U.S. bond markets as, since 2008, there has been a reliable negative correlation between U.S. retail flows into equity funds and flows into fixed income funds, especially at major turning points (bottom panel). For example, after that 2012 bottom in net equity flows, the rolling total of net flows into bond funds collapsed from over $400bn to zero in a span of 18 months, with the vast majority of the outflow from bonds going into equities. An exodus of U.S. retail investors from fixed income would be a major problem for bond markets, especially at a time when net Treasury issuance is expected to increase due to wider fiscal deficits and the Fed will be buying fewer bonds as it begins to unwind its massive balance sheet. Other buyers like commercial banks and global reserve fund managers can pick up some of the slack if the retail bid fades from U.S. Treasuries. However, in an environment of strong global growth, rising inflation and more hawkish central banks, it may require higher yields to entice those buyers to ramp up their allocations. In the near-term, the next wave of global bond-bearish news will have to come from upside surprises in inflation, not growth. The Citi Global Economic Data Surprise index - which has historically correlated with swings in global bond yields - is now at elevated levels which should raise the odds of data disappointments as growth expectations get revised up (Chart 3). The Citi Global Inflation Data Surprise index, however, remains just below zero after last year's plunge, but is showing signs of stabilizing (bottom panel). U.S. inflation is already starting to bottom out, but Euro Area core inflation has been underwhelming of late. It will likely take a rise in the latter to trigger the next move higher in global yields, as the market will begin to more aggressively price in less accommodative monetary policy from the ECB. For now, U.S. Treasuries are driving the path of yields, with the "leadership" of the bond bear market expected to switch to Europe later on in 2018. In terms of our recommend duration strategy and country allocations, we are sticking with our current positions which are finally beginning to move in favor of our forecasts (Chart 4): Chart 3The Next Leg Higher In Global Yields##BR##Must Be Driven By Inflation Surprises The Next Leg Higher In Global Yields Must Be Driven By Inflation Surprises The Next Leg Higher In Global Yields Must Be Driven By Inflation Surprises Chart 4Our Recommended##BR##Country & Curve Allocations Our Recommended Country & Curve Allocations Our Recommended Country & Curve Allocations Underweights to countries where we expect central banks to hike rates (U.S., Canada) or more openly discuss a tapering of asset purchases (Germany, France). Overweights to countries where we expect no change in policy rates (U.K., Australia) or only modest changes to asset purchase programs (Japan). Positioning for steeper yield curves in countries where growth is strong, economies are at or beyond full employment, but where inflation expectations remain far enough below central bank targets to prevent policymakers from turning more hawkish faster than expected (U.S., Germany, Japan). Bottom Line: Global bond yields continue to move higher, driven by rising inflation expectations and falling investor risk aversion. With global interest rates still not at levels that will restrict growth or draw capital away from booming equity markets, the path of least resistance for yields remains upward. Maintain a below-benchmark overall portfolio duration stance, with a bearish curve steepening bias in the U.S. and core Europe. U.K. Gilts: The BoE's Hands Are Tied In our final report of 2017, we updated our recommended allocations in our Model Bond Portfolio based on the key views stemming from the 2018 BCA Outlook.2 We upgraded our country allocation to U.K. Gilts to overweight, primarily as a "defensive" position within a portfolio positioned for an expected rise in global bond yields. That may sound surprising given the current elevated level of inflation and low unemployment rate in the U.K. Yet our view is based on the notion that the Bank of England (BoE) will have a very difficult time trying to raise interest rates at all in 2018 when other major global central banks are likely to take a more hawkish turn. The main reason that the BoE will be unable to do much on the interest rate front is that the U.K. economy is likely to slow in the coming quarters. The OECD leading economic indicator is decelerating steadily, and is pointing to a real GDP growth rate below 2% in 2018 (Chart 5). The updated IMF forecast for the U.K. calls for growth to only reach 1.5% in both 2018 and 2019. The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumption growth has already been slowing since early 2017, driven by diminishing consumer confidence (Chart 6, 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 (3rd panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing down 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 5U.K. Growth Set To Slow U.K. Growth Set To Slow U.K. Growth Set To Slow Chart 6The 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 December 2017 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide house prices came in at 1.1% and 2.5% respectively (Chart 7, top panel). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) survey 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 -54% in November 2017. U.K. homeowners have had to take a lot of hits over the past couple of years. A 2016 hike in the stamp duty for second homes and buy-to-let properties prompted a plunge in more "speculative" property transactions. The squeeze on real household incomes that has damaged consumer spending has also made homes less affordable, even with very low mortgage rates. Most importantly, the 2016 Brexit vote and subsequent uncertainty over the U.K.'s future relationship with Europe has placed an enormous cloud over housing demand - both from potential reduced immigration to the U.K. and businesses and jobs potentially relocating to European Union countries. The Brexit uncertainty is also weighing on U.K. business investment spending. U.K. capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017, and is even lower in real terms (Chart 8, top panel). Capex is generally import-intensive, and the rise in import costs due to the depreciation of the Pound after the 2016 Brexit vote raised the cost of investment. Chart 7No Growth In##BR##U.K. Housing No Growth In U.K. Housing No Growth In U.K. Housing Chart 8Brexit Gloom Trumps Export##BR##Boom For U.K. Companies Brexit Gloom Trumps Export Boom For U.K. Companies Brexit Gloom Trumps Export Boom For U.K. Companies This explains why U.K. capital spending has lagged even with manufacturing indicators in decent shape, such as the Confederation of British Industry (CBI) survey which shows the highest readings on total industrial orders and export orders since 1988 and 1995, respectively (2nd panel). Yet non-financial credit growth stalled out in the latter half of 2017, while the CBI survey of business optimism has turned into negative territory. Brexit uncertainties are clearly trumping strong export demand, thus U.K. capital investment is likely to remain sluggish in 2018 even with robust global growth. With U.K. economic growth likely to slow in 2018, the lingering problem of high inflation should start to fade. Already, both headline and core CPI inflation have stabilized, with the latter actually drifting a touch lower in the latter half of 2017 (Chart 9). The small gap between the two can be explained by the rise in global oil prices seen over the past year. The impact of oil on U.K. inflation expectations is relatively modest compared to other countries with much lower realized inflation rates, as we discussed in last week's Weekly Report.3 What is far more relevant is the path of British pound. The 16% plunge in the trade-weighted sterling index after the 2016 Brexit vote was a major reason why U.K. realized inflation blew through the BoE's 2% target last year. The currency has since stabilized at a depressed level and traded in a relatively narrow range in 2017. The trade-weighted index is now 3% above year-ago-levels, which should help U.K. inflation rates drift lower in the next 6-12 months - especially if U.K. growth underwhelms at the same time. Already, the more stable currency has allowed the inflation rates of import prices and producer prices to fall sharply last year (bottom panel), which should soon start to feed through into overall inflation rates. Lower realized inflation would be a welcome boost for the spending power of U.K. households and businesses, but will likely be dwarfed by the impact of oil prices in the near term. More importantly, the slowing momentum of economic growth, now fueled more by Brexit uncertainty than high inflation, will limit the BoE's ability to continue normalizing the very low level of U.K. interest rates. Our 12-month U.K. discounter shows that markets are pricing in 25bps of rate hikes over the next twelve months (Chart 10). The forward path of interest rates shown in the U.K. Overnight Index Swaps curve suggests that the hike could come by October. That is unlikely to happen given the slump in leading economic indicators, and peaking in currency-fueled inflation, currently underway. Chart 9Currency-Fueled U.K. Inflation Is Peaking Out Currency-Fueled U.K. Inflation Is Peaking Out Currency-Fueled U.K. Inflation Is Peaking Out Chart 10Stay Overweight U.K. Gilts Stay Overweight U.K. Gilts Stay Overweight U.K. Gilts A stand-pat BoE, combined with more stable and potentially falling U.K. inflation, will limit the ability for U.K. Gilt yields to rise by as much as we are expecting in the U.S., and even core Europe, over the next 6-12 months. Gilts have become a relative safe haven within a global bond bear market in the developed markets, with a yield beta of around 0.5 to U.S. Treasuries and German government bonds. This has already allowed Gilts to outperform the Barclays Global Treasury index (in currency-hedged terms) since the most recent cyclical low in global bond yields last September (bottom panel). We continue to expect Gilts to outperform in 2018. Stay overweight. Bottom Line: The momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. Stay overweight Gilts. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 http://www.imf.org/en/Publications/WEO/Issues/2018/01/11/world-economic-outlook-update-january-2018 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Allocation In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Importance Of Oil", dated January 16th 2018, available at gfis.bcaresearch.com. Recommendations A Melt-Up In Equities AND Bond Yields? A Melt-Up In Equities AND Bond Yields? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Trade #1: Go Short The December 2018 Fed Funds Futures Contract. The trade has gained 64 bps since we initiated it. We are lifting the stop to 60 bps and targeting a profit of 75 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities. The trade is up 13.1%. We are targeting a profit of 15%, and are tightening the stop further to 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts. The trade is up 0.7%. We see this as a multi-year trade with significant upside potential. The unwinding of heavy short positions could cause the yen to strengthen temporarily. The euro is vulnerable to negative growth surprises. A retracement of some of its recent gains is likely. Feature Looking Back, Thinking Forward I had the pleasure of speaking at BCA's Annual Investment Conference held in New York on September 27th of last year where I offered three "tantalizing" trade ideas. Chart 1 reviews their performance. They were the following: Trade #1: Go Short The December 2018 Fed Funds Futures Contract We argued last summer that U.S. growth was likely to accelerate, taking rate expectations higher. That has indeed happened. Aggregate hours worked rose by 2.5% in Q4 over the previous quarter. Assuming that productivity increased by 1.5% in Q4 - equal to the pace recorded in Q3 - real GDP probably increased by nearly 4%. A variety of leading indicators point to continued above-trend growth in the months ahead (Chart 2). Chart 1Three Tantalizing Trades: ##br##An Update Three Tantalizing Trades: An Update Three Tantalizing Trades: An Update Chart 2Leading Indicators Pointing ##br##To Above-Trend U.S. Growth Leading Indicators Pointing To Above-Trend U.S. Growth Leading Indicators Pointing To Above-Trend U.S. Growth We think the Fed will raise rates four times this year, one more hike than projected by the dots and roughly 35 bps more in tightening than implied by current market expectations. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. We have been saying for a while that above-trend growth will take the unemployment rate down to a 49-year low of 3.5% by the end of this year. If the unemployment rate falls this much, the Fed will probably turn more hawkish. Stronger inflation numbers should also give the Fed confidence to keep raising rates once per quarter. Core inflation surprised on the upside in December. We expect this trend to continue in the coming months, as the ISM manufacturing index, the New York Fed's Inflation Gauge, and our own proprietary pipeline inflation index are already foreshadowing (Chart 3). Chart 3U.S. Inflation ##br##Should Accelerate U.S. Inflation Should Accelerate U.S. Inflation Should Accelerate Chart 4A Pick-Up In Wage Growth ##br##Would Put Upward Pressure On Service Inflation A Pick-Up In Wage Growth Would Put Upward Pressure On Service Inflation A Pick-Up In Wage Growth Would Put Upward Pressure On Service Inflation As we noted two weeks ago,1 service sector inflation should get a lift from faster wage growth this year (Chart 4). Goods inflation should also rise on the back of higher oil prices and the lagged effects of a weaker dollar (Chart 5). In addition, health care inflation is likely to pick up from its current depressed level, especially if the Congressional Budget Office is correct that insurance premiums will rise due to the elimination of the individual mandate (Chart 6). Housing inflation will moderate, but this is unlikely to stymie the Fed's tightening plans since excessively low interest rates could lead to even more overbuilding in the increasingly vulnerable commercial real estate sector. Chart 5Higher Oil Prices And A Weaker Dollar ##br##Are A Tailwind For Inflation Higher Oil Prices And A Weaker Dollar Are A Tailwind For Inflation Higher Oil Prices And A Weaker Dollar Are A Tailwind For Inflation Chart 6Health Care Inflation ##br##Should Move Higher Health Care Inflation Should Move Higher Health Care Inflation Should Move Higher Granted, four rate hikes equal four opportunities to defer raising rates. It is easy to imagine scenarios where the Fed stands pat, but hard to conjure scenarios where the Fed has to raise rates five times or more this year. Thus, the risk to our four-hike view is to the downside. As such, we will be looking to take profits of 75 bps on the trade, and are putting in a stop of 60 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities Capital spending tends to accelerate in the late innings of business-cycle expansions. We are in such a phase now, as evidenced by capital goods orders, capex intention surveys, and our global capex model (Chart 7). Increased capital spending will benefit industrial companies. Conversely, rising bond yields will hurt rate-sensitive utilities. Valuations in the industrial sector have gotten stretched, but are not at extreme levels (Chart 8). Based on enterprise value-to-EBITDA, industrials are still only slightly more expensive than utilities compared to their post-1990 average. Chart 7Capex Is Shifting Into ##br##Higher Gear Capex Is Shifting Into Higher Gear Capex Is Shifting Into Higher Gear Chart 8Industrial Stocks: Valuations Are Stretched, ##br## But Not Yet Extreme Industrial Stocks: Valuations Are Stretched, But Not Yet Extreme Industrial Stocks: Valuations Are Stretched, But Not Yet Extreme While we do think global growth will slow this year from the heady pace of 2017, it should remain firmly above-trend. A bigger-than-expected slowdown - especially if it is concentrated in China - would undoubtedly hurt industrials. A stronger dollar could also be a headwind. Thus, we are keeping this trade on a short leash, with a target of 15% and a stop of 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The Japanese economy is on fire. Growth almost reached 2% in 2017 and leading indicators suggest a solid start to 2018 (Chart 9). The unemployment rate has fallen to 2.7%, a full point below 2007 levels. The ratio of job openings-to-applicants has surpassed its bubble peak. The Tankan Employment Conditions Index is pointing to an exceptionally tight labor market. Wages excluding overtime pay are rising at the fastest pace in twenty years (Chart 10). Chart 9Japanese Growth Momentum Is Positive Japanese Growth Momentum Is Positive Japanese Growth Momentum Is Positive Chart 10Signs Of A Tight Labor Market Signs Of A Tight Labor Market Signs Of A Tight Labor Market Inflation is low but is starting to edge up. The most recent release surprised on the upside. Inflation expectations moved higher on the news, benefiting our long Japanese 10-year CPI swap trade recommendation (Chart 11). A simple scatterplot between the unemployment rate and core inflation suggests the Phillips curve remains intact in Japan -- amazingly, it even looks like Japan (Chart 12)! Chart 11Inflation Expectations Have Edged Higher Inflation Expectations Have Edged Higher Inflation Expectations Have Edged Higher Chart 12The Phillips Curve In Japan Looks Like Japan Three Tantalizing Trades - Four Months On Three Tantalizing Trades - Four Months On Still, with core inflation excluding food and energy running at only 0.3%, there is a long way to go before inflation reaches the BoJ's target -- and even longer if the BoJ honours its promise to generate a meaningful overshoot to compensate for the below-target inflation of prior years. This suggests the BoJ will not meaningfully water down its Yield Curve Control regime anytime soon. As such, five-year yields are likely to stay put while yields with maturities in excess of ten years should move higher. Our "tantalizing trade" being short 20-year JGBs versus their 5-year counterparts still has a long way to run. Too Risky To Short The Yen The exceptionally strong correlation between USD/JPY and U.S. Treasury yields has broken down this year (Chart 13). Had the relationship held, the yen would have actually weakened against the dollar. Still, we are reluctant to get too bearish on the yen (Chart 14). The yen real effective exchange rate is close to multi-decade lows. Positioning on the currency is heavily short. The current account surplus has mushroomed from close to zero in 2014 to 4% of GDP at present. And even if the BoJ keeps the Yield Curve Control regime in place, investors may still anticipate its demise, leading to a temporary bout of yen strength. Chart 13Strong Correlation Is Broken Strong Correlation Is Broken Strong Correlation Is Broken Chart 14Too Risky To Short The Yen Too Risky To Short The Yen Too Risky To Short The Yen What's Propping Up The Euro? The euro has been on a tear since last week, egged on by the ECB minutes, which hinted at a faster pace of monetary normalization. Growing confidence that Angela Merkel will be able to form a grand coalition also helped the common currency, along with hopes that the new government will loosen the fiscal purse strings. The euro is often thought of as the "anti-dollar." And sure enough, the euro's strength has been reflected in a broad-based decline in the dollar index in recent days. BCA's Global Investment Strategy service went long the dollar on October 31, 2014. We "doubled up" on this call in the fall of 2016, controversially arguing that "Trump will win and the dollar will rally." Obviously, in retrospect, I should have rung the register and declared victory on our long dollar view when I had the chance. EUR/USD fell to 1.04 on December 2016, within striking distance of our parity target. Bullish dollar sentiment had reached unsustainably lofty levels. That was the time to sell the greenback. But hubris got the best of me. While our other currency trade recommendations have delivered net gains of 11% since the start of 2017, the long DXY trade has stuck out like a sore thumb. Hindsight is 20/20. The key question is what to do today. EUR/USD is still trading below the level it was at when we went long the DXY. Relative to the IMF's Purchasing Power Parity exchange rate of 1.32, the euro is 7% undervalued. That said, PPP exchange rates may not be a reliable benchmark in this case. Given current market expectations, EUR/USD would need to strengthen to 1.41 over the next ten years just to cover the carry cost of being short the dollar. Even assuming lower inflation in the euro area, that would still leave the euro trading above its long-term fair value. It is possible, of course, that rate differentials will narrow further, but the scope for this is more limited than it might appear. The market currently expects policy rates ten years out to be 95 basis points higher in the U.S., down from a spread of nearly 180 basis points in late December (Chart 15). Given that euro area inflation expectations are 40-to-50 bps lower than in the U.S., this implies a real spread of about 50 bps - broadly in line with our estimate of the real neutral rate gap between the two regions. Ultimately, the fate of the euro in 2018 will rest on the same question that drove the currency in 2017: Will euro area growth surprise on the upside, prompting investors to price in a faster pace of monetary normalization? The bar for success is certainly higher at present. Chart 16 shows that euro area consensus growth estimates have risen significantly since the start of last year. The expected lift-off date for policy rates has also shifted in by more than a year to mid-2019. Considering that Jens Weidmann stated earlier this week that he thinks current market pricing is broadly consistent with when the ECB expects to hike rates, there is little scope for the lift-off date to move forward. Chart 15Little Scope For Rate Differentials ##br## To Narrow Further Little Scope For Rate Differentials To Narrow Further Little Scope For Rate Differentials To Narrow Further Chart 16Euro Area Growth Estimates Have Been Revised Up ##br##Since The Start Of 2017 Euro Area Growth Estimates Have Been Revised Up Since The Start Of 2017 Euro Area Growth Estimates Have Been Revised Up Since The Start Of 2017 Meanwhile, financial conditions have tightened significantly in the euro area relative to the U.S., the euro area credit impulse has turned negative, and the U.S. economic surprise index has jumped above that of the euro area (Chart 17). Euro area inflation has also dipped. Especially worrying is that core inflation in Italy has fallen back to a near record-low of 0.4% (Chart 18). How is Italy supposed to navigate its way out of its debt trap if nominal growth stays this weak? On top of all that, long speculative euro positions have soared to record-high levels (Chart 19). Given the choice of betting whether EUR/USD will first hit 1.30 or 1.15, we would go with the latter. If our bet turns out to be correct, we will use that opportunity to shift to neutral on the dollar. Chart 17The Euro Is Vulnerable ##br##To Negative Growth Surprises The Euro Is Vulnerable To Negative Growth Surprises The Euro Is Vulnerable To Negative Growth Surprises Chart 18Euro Area Core Inflation ##br##Has Dipped Euro Area Core Inflation Has Dipped Euro Area Core Inflation Has Dipped Chart 19Euro Positioning: From Deeply Short ##br##To Record Long Euro Positioning: From Deeply Short To Record Long Euro Positioning: From Deeply Short To Record Long Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Duration: Economic fundamentals indicate that U.S. TIPS breakeven inflation rates have further cyclical upside and this will drive nominal bond yields higher on a 6-12 month horizon. In the near term, however, positioning data suggest that the uptrend in U.S. bond yields is due for a pause. Maintain a below-benchmark duration stance. Oil & U.S. Bonds: The cost of inflation compensation is an important driver of U.S. bond yields and the oil price is an important driver of the cost of inflation compensation. This will continue to be true until long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%. At that point the oil price will become a less important driver of U.S. bond yields. Australia: Maintain an overweight position in Australian government debt. Economic data are still mixed and the RBA will stay on hold for the foreseeable future. Against a backdrop of Fed rate hikes, Australian debt should outperform. Feature Chart of the WeekHigher Yields, Driven By Inflation Higher Yields, Driven By Inflation Higher Yields, Driven By Inflation There was certainly no shortage of possible catalysts for last week's bond rout (Chart of the Week). The Bank of Japan (BoJ) reduced its buying of long-dated JGBs, there was a rumor that China plans to slow or stop its purchases of U.S. Treasury debt, and U.S. inflation expectations started to ramp back up - driven by a combination of higher oil prices and a strong December core CPI print. But of all these factors we think it is only the third that merits much attention. Once the BoJ started targeting the level of the yield curve in September 2016, its quantity targets became irrelevant. A reduction in the pace of BoJ buying only matters if it foreshadows a shift to a higher yield curve target. Our foreign exchange strategists don't think such a move is likely in the next 12-18 months.1 China, for its part, still has a highly managed currency and now that capital is no longer flowing out of the country it will start to rebuild its foreign exchange reserves. Given that the U.S. Treasury market remains the world's most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States (Chart 2). The compensation for 10-year U.S. inflation protection broke above 2% last week, after having been as low as 1.66% as recently as last June. This 34 basis point increase in inflation compensation coincided with a 36 basis point increase in the nominal U.S. 10-year yield and a Brent crude oil price that rose from $45 per barrel last June to $70 per barrel as of last Friday. We think these correlations will continue to be the most important factors driving bond yields during the next 6-12 months, and the bulk of this report is dedicated to disentangling the linkages between oil prices, inflation, inflation expectations and nominal bond yields. But first we reiterate our cyclical investment stance. Last week's U.S. CPI report provided further evidence that U.S. core inflation is in the process of bottoming-out (Chart 3). The 10-year U.S. TIPS breakeven inflation rate will settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's target. By that time the nominal 10-year yield will be in a range between 2.8% and 3.25%. Likewise, our energy strategists anticipate that an ongoing steady decline in commercial inventories will keep crude prices well supported on a 6-12 month horizon. Chart 2China's Forex Reserves Are Rising China's Forex Reserves Are Rising China's Forex Reserves Are Rising Chart 3U.S. Inflation Turns The Corner U.S. Inflation Turns The Corner U.S. Inflation Turns The Corner However, on a shorter time horizon (3 months or less), recent shifts in speculative positioning signal that the uptrends in bond yields and the oil price might be due for a pause (Chart 4). After having been solidly "net long" since the middle of last year, net speculative positions in the 10-year U.S. Treasury futures contract have just dipped into "net short" territory. Historically, net speculative positions have been a decent indicator of 3-month changes in the 10-year U.S. Treasury yield, and at current levels they signal that the 10-year yield could decline modestly during the next three months (Chart 5). Similarly, speculators in the oil futures market are now more "net long" than at any time since last February. While this positioning indicator does not work quite as well for the oil market as for the Treasury market, net longs at more than 20% of open interest (most recent reading is 26%) have more often than not been met with 3-month price declines since 2010 (Chart 6). Chart 4Net Speculative Positioning##BR##For Oil And Bonds Net Speculative Positioning For Oil And Bonds Net Speculative Positioning For Oil And Bonds Chart 5Net Speculative Positions &##BR##10-Year Treasury Yield (2010 - Present) The Importance Of Oil The Importance Of Oil Chart 6Net Speculative Positions &##BR##WTI Oil Price (2010 - Present) The Importance Of Oil The Importance Of Oil Bottom Line: The outlook for U.S. inflation suggests that TIPS breakeven rates have further cyclical upside and this will drive nominal bond yields higher. However, positioning data in both bond and oil markets suggest that the recent run-up in yields might be due for a near-term pause. Maintain a below-benchmark duration stance on a 6-12 month horizon. Oil, TIPS, Inflation And U.S. Bond Yields: Sorting Out The Mess During the post-financial crisis period two relationships have been both (i) incredibly robust and (ii) unlike relationships observed in prior periods. They are: The cost of inflation protection has been an unusually important determinant of nominal U.S. bond yields. The oil price has shown a very strong correlation with the cost of inflation protection. Both relationships can be explained by the Federal Reserve's asymmetric ability to control inflation. We consider each relationship in turn. The Importance Of Inflation Chart 7TIPS Beta Declines When##BR##Breakevens Are Low TIPS Beta Declines When Breakevens Are Low TIPS Beta Declines When Breakevens Are Low A common rule of thumb is to estimate the TIPS beta - the proportion of movement in U.S. nominal bond yields that is explained by movement in TIPS (real) yields - at around 0.8. In other words, this assumes that 80% of the movement in nominal bond yields is explained by the real component. However, we observe that since the financial crisis the 10-year TIPS beta has been a much lower 0.68, and at times it has been closer to 0.5 on a 12-month rolling basis (Chart 7). We also observe that the TIPS beta tends to be lower when TIPS breakeven inflation rates are un-anchored to the downside. There is a very good reason for this. The reason is that the Fed's ability to influence inflation is asymmetric. The Fed has a strong track record of successfully tightening to bring inflation down, but has been less successful at easing to drive it up. This asymmetric ability to influence prices is due in no small part to the zero-lower bound on interest rates. Because the Fed's ability to ease policy is constrained while its ability to tighten is not, bond market participants may at times question the Fed's ability to ease and revise their inflation expectations lower. It is also during these periods that inflation expectations become more volatile and a more important determinant of nominal bond yields. This is because they are increasingly driven by the swings in the economic data and less by the Fed's policy bias. The Importance Of Oil This is where the oil price comes in. Oil and other commodities are crucial inputs to the production process. As such, not only do these prices rise in response to stronger aggregate demand, but higher prices also signal mounting cost-push inflationary pressures. But despite this obvious truth, there is not always a strong correlation between oil prices and inflation expectations. This is because the Fed's reaction function influences the relationship. Consider the pre-crisis (2004-2008) period. Long-maturity TIPS breakeven inflation rates stayed range-bound between 2.4% and 2.5% even as the oil price increased dramatically (Chart 8). Since investors perceived that the Fed would simply tighten policy to tamp out any inflationary pressures that might arise, there was no desire to demand greater compensation for inflation. However, this logic does not work in reverse. When commodity prices fell in 2014, inflation expectations declined alongside. In fact we observe that the correlations between long-maturity TIPS breakeven inflation rates and both oil and commodity prices have been much stronger in the post-crisis period, when inflation expectations have been un-anchored (Table 1). Chart 8The Unstable Correlation: Breakevens & Oil The Unstable Correlation: Breakevens & Oil The Unstable Correlation: Breakevens & Oil Table 1Correlations Between TIPS Breakeven Inflation & Commodities The Importance Of Oil The Importance Of Oil Investment Conclusions The Fed's asymmetric reaction function leads to two crucial investment conclusions. First, long-maturity inflation expectations (as measured by the U.S. TIPS breakeven inflation rate) can fall when deflationary pressures mount, but their upside is capped in the 2.4% to 2.5% range. This is because the market has no reason to question the Fed's ability to lower inflation by lifting rates. The upside limit of 2.4% to 2.5% will remain in place unless the Fed changes its inflation target. A change to the inflation target that allows for higher inflation is an idea that is quickly gaining traction among policymakers, but is unlikely to be implemented this year. Second, when long-maturity inflation expectations are below their 2.4% to 2.5% upper-bound they become both (i) a more important driver of nominal yields - as evidenced by the lower TIPS beta - and (ii) more sensitive to swings in commodity prices. For this reason, the oil price will continue to be an important driver of inflation expectations and nominal U.S. bond yields for the next few months, but will decrease in importance as TIPS breakevens move back to their 2.4% to 2.5% range. Once inflation expectations are re-anchored, nominal bond yields will once again be predominantly driven by the real component and swings in the price of oil will be less important for bond markets. The dynamics described above are not merely theoretical. Consider the evidence from five developed countries presented in Charts 9 & 10. Chart 9 shows that the oil price is tightly correlated with inflation expectations in the U.S., Eurozone and Japan, but also that inflation expectations in the U.K. and Australia did not respond to the recent increase in oil prices. The reason is that core inflation in the U.K. and Australia is already relatively close to the central bank's target (Chart 10). It is only where core inflation is far below target (in the U.S., Eurozone and Japan) that the oil price remains an important driver of bond yields. Chart 9Oil & Inflation Expectations Highly Correlated... Oil & Inflation Expectations Highly Correlated... Oil & Inflation Expectations Highly Correlated... Chart 10...But Only When Inflation Is Low ...But Only When Inflation Is Low ...But Only When Inflation Is Low The U.K. in particular presents an interesting case study. U.K. core inflation was quite far below target throughout 2015 and 2016, and during this time period U.K. inflation expectations were tightly linked with the oil price. It is only in the past few months that U.K. core inflation has moved back above target, and not surprisingly the correlation between the U.K. 10-year CPI swap rate and the price of oil has started to break down. Bottom Line: At present, the cost of inflation compensation is an important driver of U.S. bond yields and the oil price is an important driver of the cost of inflation compensation. Both of these dynamics will continue to be true for the next few months, but will decline in importance as TIPS breakeven inflation rates rise. When long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%, then the oil price will become a less important driver of U.S. bond yields. Australia: Too Soon To Expect A Hike Chart 11Australia: A Solid Rebound In Growth... Australia: A Solid Rebound In Growth... Australia: A Solid Rebound In Growth... Over the last quarter much of the economic data from Australia have improved. Real GDP growth rebounded sharply to 2.8% YoY in Q3 from 1.9% the previous quarter (Chart 11). Iron ore prices have been rising since mid-October. Employment growth is robust and the unemployment rate is well below its estimated natural level. This begs the question - with so much going right is it time for the Reserve Bank of Australia (RBA) to lift rates? Our answer is an emphatic "no." First, most data improvements have been relatively minor and the overall economic picture remains mixed. As we mentioned in our recent Special Report,2 the RBA is stuck between conflicting forces. Booming house prices and rising household indebtedness on the one hand, and an economy still working off excess capacity on the other. Nevertheless, our expectation is that the RBA will allow the economy to recover further for the following reasons: Consumer health is fragile. Policymakers left cash rates unchanged at the last monetary policy meeting in December, and Governor Philip Lowe expressed concerns about household consumption. Consumption is a significant driver of economic growth and the combination of declining savings, elevated debt levels and weak income growth is worrisome (Chart 12). Since then, real income growth has dipped back into positive territory, but only barely so. Meanwhile, house prices are still surging, despite macro-prudential measures aimed at tightening lending standards, thereby supporting consumer spending through the wealth effect. Given an extreme household debt to income ratio, consumption would be very vulnerable if the RBA were to curb house price gains by raising rates. Labors markets have plenty of slack. The unemployment rate has fallen to a four year low and other labor market statistics show a broad-based improvement over the last quarter. However, the unemployment rate is still significantly higher than it was in the previous cycle and other improvements in the labor market have also occurred from extremely weak levels. In 2017Q1, the underemployment rate and part-time workers as a percentage of total workers both reached all-time highs. Those numbers have dipped slightly in Q3, with underemployment falling to 8.3% and part-time workers as a percentage of total declining to 31.7%, but those elevated levels suggest there still needs to be significant improvement before spare capacity is worked off and real wage growth starts to move higher (Chart 13). Chart 12...But Consumers Can't Afford A Rate Hike ...But Consumers Can't Afford A Rate Hike ...But Consumers Can't Afford A Rate Hike Chart 13Still Plenty Of Slack In Australian Labor Markets Still Plenty Of Slack In Australian Labor Markets Still Plenty Of Slack In Australian Labor Markets Inflation is still too low. Headline and core inflation readings came in at 1.8% and 1.9% respectively in Q3 (Chart 14). While headline slowed, core inflation recovered over the last quarter. Tradeable goods inflation collapsed into negative territory at -0.9%, as a result of currency strength and increased competition among retailers. Going forward, we expect consumer price growth to be muted given the lack of inflationary pressures. The output gap is wide, despite rebounding growth, and the IMF forecasts that it will be years before the Australian economy reaches capacity. The trade-weighted Aussie dollar index has risen almost 5% since it bottomed in early December, while the AUD/USD has broken above its 40-week moving average. Continued currency strength would exert even further deflationary pressure. As stated above, the labor market also requires significant improvement to work off excess capacity. All of these factors caused the RBA to dial back its inflation forecast in the November statement. It now expects that inflation will remain quite flat for the next two years, only touching the lower-end of its 2%-3% target range at the end of 2019. Consequently, inflation will not be forcing the RBA's hand in the foreseeable future. One of our key themes for 2018 is that global growth will be less synchronized. Central banks will therefore employ diverging monetary policies, presenting cross-country bond market investment opportunities. As such, we recently shifted to a slight overweight position in Australian debt within our model portfolio, arguing that it would outperform global government bond benchmarks during a year expected to be driven by Fed tightening and ECB/BoJ tapering concerns. Historically, relative yield moves have closely tracked relative shifts in monetary policy (Chart 15). In the U.S., above-trend growth, a tight labor market and the continued recovery in inflation will force the Fed to become more aggressive. If the RBA stays inactive as we expect, then this gap should continue to move in favor of Australian debt. Additionally, there is still a modest yield pickup in Australian debt relative to the global index and as we expect global bond yields to rise, low-beta Australian government bonds should offer considerable protection. Chart 14Australia: Lacking Inflationary Pressures Australia: Lacking Inflationary Pressures Australia: Lacking Inflationary Pressures Chart 15Australian Relative Yields Track Relative Policy Australian Relative Yields Track Relative Policy Australian Relative Yields Track Relative Policy This also leads us to continue holding our tactical Long Dec 2018 Australian Bank Bill futures trade from last October. We initially entered into this trade as a more focused way of expressing that the RBA will stay on hold. The trade is currently 6 bps in the money and with markets still pricing about 30 bps of rate hikes during the next 12 months, there is plenty of room for further profit as market expectations are revised down. Bottom Line: Maintain an overweight position in Australian government debt. Economic data are still mixed and the RBA will stay on hold for the foreseeable future. Against a backdrop of Fed rate hikes, Australian debt should outperform. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com 1 Please see BCA's Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com. 2 Please see BCA's Global Fixed Income Strategy Special Report, "Australia: Stuck Between A Rock And A Hard Place", dated July 25, 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Importance Of Oil The Importance Of Oil Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Economic fundamentals indicate that TIPS breakeven inflation rates have further cyclical upside and this will drive nominal bond yields higher on a 6-12 month horizon. In the near term, however, positioning data suggest that the uptrend in bond yields is due for a pause. Maintain a below-benchmark duration stance. Oil & Bonds: The cost of inflation compensation is an important driver of bond yields and the oil price is an important driver of the cost of inflation compensation. This will continue to be true until long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%. At that point the oil price will become a less important driver of yields. Fed: The Fed will start actively discussing alternative monetary policy frameworks in 2018. While we think the Fed will eventually adopt a policy framework that tolerates higher inflation, this shift probably won't occur this year. Feature There was certainly no shortage of possible catalysts for last week's bond rout (Chart 1). The Bank of Japan (BoJ) reduced its buying of long-dated JGBs, there was a rumor that China plans to slow or stop its purchases of U.S. Treasury debt, and U.S. inflation expectations started to ramp back up - driven by a combination of higher oil prices and a strong December core CPI print. But of all these factors we think it is only the third that merits much attention. Once the BoJ started targeting the level of the yield curve in September 2016 its quantity targets became irrelevant. A reduction in the pace of BoJ buying only matters if it foreshadows a shift to a higher yield curve target. Our foreign exchange strategists don't think such a move is likely in the next 12-18 months.1 China, for its part, still has a highly managed currency and now that capital is no longer flowing out of the country it will start to rebuild its foreign exchange reserves. Given that the U.S. Treasury market remains the world's most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States (Chart 2). Chart 1Higher Yields, Driven By Inflation Higher Yields, Driven By Inflation Higher Yields, Driven By Inflation Chart 2China's Forex Reserves Are Rising China's Forex Reserves Are Rising China's Forex Reserves Are Rising The compensation for 10-year U.S. inflation protection broke above 2% last week, after having been as low as 1.66% as recently as last June. This 34 basis point increase in inflation compensation coincided with a 36 basis point increase in the nominal 10-year yield and a Brent crude oil price that rose from $45 per barrel last June to $70 per barrel as of last Friday. We think these correlations will continue to be the most important factors driving bond yields during the next 6-12 months, and the bulk of this report is dedicated to disentangling the linkages between oil prices, inflation, inflation expectations and nominal bond yields. But first we reiterate our cyclical investment stance. Last week's CPI report provided further evidence that core inflation is in the process of bottoming-out (Chart 3). The 10-year TIPS breakeven inflation rate will settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's target. By that time the nominal 10-year yield will be in a range between 2.8% and 3.25%. Likewise, our energy strategists anticipate that an ongoing steady decline in commercial inventories will keep crude prices well supported on a 6-12 month horizon. Chart 3U.S. Inflation Turns The Corner U.S. Inflation Turns The Corner U.S. Inflation Turns The Corner Chart 4Net Speculative Positioning For Oil And Bonds Net Speculative Positioning For Oil And Bonds Net Speculative Positioning For Oil And Bonds However, on a shorter time horizon (3 months or less), recent shifts in speculative positioning signal that the uptrends in bond yields and the oil price might be due for a pause (Chart 4). After having been solidly "net long" since the middle of last year, net speculative positions in the 10-year U.S. Treasury futures contract have just dipped into "net short" territory. Historically, net speculative positions have been a decent indicator of 3-month changes in the 10-year U.S. Treasury yield, and at current levels they signal that the 10-year yield could decline modestly during the next three months (Chart 5). Similarly, speculators in the oil futures market are now more "net long" than at any time since last February. While this positioning indicator does not work quite as well for the oil market as for the Treasury market, net longs at more than 20% of open interest (most recent reading is 26%) have more often than not been met with 3-month price declines since 2010 (Chart 6). Chart 5Net Speculative Positions & 10-Year Treasury Yield It's Still All About Inflation It's Still All About Inflation Chart 6Net Speculative Positions & WTI Oil Price It's Still All About Inflation It's Still All About Inflation Bottom Line: The outlook for U.S. inflation suggests that TIPS breakeven rates have further cyclical upside and this will drive nominal bond yields higher. However, positioning data in both bond and oil markets suggest that the recent run-up in yields might be due for a near-term pause. Maintain a below-benchmark duration stance on a 6-12 month horizon. Oil, TIPS, Inflation And Bond Yields: Sorting Out The Mess During the post-financial crisis period two relationships have been both (i) incredibly robust and (ii) unlike relationships observed in prior periods. They are: The cost of inflation protection has been an unusually important determinant of nominal U.S. bond yields The oil price has shown a very strong correlation with the cost of inflation protection Both relationships can be explained by the Federal Reserve's asymmetric ability to control inflation. We consider each relationship in turn. The Importance Of Inflation Chart 7TIPS Beta Declines When ##br##Breakevens Are Low TIPS Beta Declines When Breakevens Are Low TIPS Beta Declines When Breakevens Are Low A common rule of thumb is to estimate the TIPS beta - the proportion of movement in U.S. nominal bond yields that is explained by movement in TIPS (real) yields - at around 0.8. In other words, this assumes that 80% of the movement in nominal bond yields is explained by the real component. However, we observe that since the financial crisis the 10-year TIPS beta has been a much lower 0.68, and at times it has been closer to 0.5 on a 12-month rolling basis (Chart 7). We also observe that the TIPS beta tends to be lower when TIPS breakeven inflation rates are un-anchored to the downside. There is a very good reason for this. The reason is that the Fed's ability to influence inflation is asymmetric. The Fed has a strong track record of successfully tightening to bring inflation down, but has been less successful at easing to drive it up. This asymmetric ability to influence prices is due in no small part to the zero-lower bound on interest rates. Because the Fed's ability to cut rates is constrained by the zero-bound while its ability to lift rates is not, bond market participants may at times question the Fed's ability to ease and revise their inflation expectations lower. It is also during these periods that inflation expectations become more volatile and a more important determinant of nominal bond yields. This is because they are increasingly driven by the swings in the economic data and less by the Fed's policy bias. The Importance Of Oil This is where the oil price comes in. Oil and other commodities are crucial inputs to the production process. As such, not only do these prices rise in response to stronger aggregate demand, but higher prices also signal mounting cost-push inflationary pressures. But despite this obvious truth, there is not always a strong correlation between oil prices and inflation expectations. This is because the Fed's reaction function influences the relationship. Consider the pre-crisis (2004-2008) period. Long-maturity TIPS breakeven inflation rates stayed range-bound between 2.4% and 2.5% even as the oil price increased dramatically (Chart 8). Since investors perceived that the Fed would simply tighten policy to tamp out any inflationary pressures that might arise, there was no desire to demand greater compensation for inflation. However, this logic does not work in reverse. When commodity prices fell in 2014, inflation expectations declined alongside. In fact we observe that the correlations between long-maturity TIPS breakeven inflation rates and both oil and commodity prices have been much stronger in the post-crisis period, when inflation expectations have been un-anchored (Table 1). Chart 8The Unstable Correlation Breakevens & Oil The Unstable Correlation Breakevens & Oil The Unstable Correlation Breakevens & Oil Table 1Correlations Between TIPS Breakeven Inflation And Commodities It's Still All About Inflation It's Still All About Inflation Investment Conclusions The Fed's asymmetric reaction function leads to two crucial investment conclusions. First, long-maturity inflation expectations (as measured by the TIPS breakeven inflation rate) can fall when deflationary pressures mount, but their upside is capped in the 2.4% to 2.5% range. This is because the market has no reason to question the Fed's ability to lower inflation by lifting rates. The upside limit of 2.4% to 2.5% will remain in place unless the Fed changes its inflation target. A change to the inflation target that allows for higher inflation is an idea that is quickly gaining traction among policymakers, but is unlikely to be implemented this year (see section titled "The Fed In 2018: Contemplating A Major Change" below). Second, when long-maturity inflation expectations are below their 2.4% to 2.5% upper-bound they become both (i) a more important driver of nominal yields - as evidenced by the lower TIPS beta - and (ii) more sensitive to swings in commodity prices. For this reason, the oil price will continue to be an important driver of inflation expectations and nominal bond yields for the next few months, but will decrease in importance as TIPS breakevens move back to their 2.4% to 2.5% range. Once inflation expectations are re-anchored, nominal bond yields will once again be predominantly driven by the real component and swings in the price of oil will be less important for bond markets. The dynamics described above are not merely theoretical. Consider the evidence from five developed countries presented in Charts 9 & 10. Chart 9 shows that the oil price is tightly correlated with inflation expectations in the U.S., Eurozone and Japan, but also that inflation expectations in the U.K. and Australia did not respond to the recent increase in oil prices. The reason is that core inflation in the U.K. and Australia is already relatively close to the central bank's target (Chart 10). It is only where core inflation is far below target (in the U.S., Eurozone and Japan) that the oil price remains an important driver of bond yields. Chart 9Oil & Inflation Expectations Highly Correlated... Oil & Inflation Expectations Highly Correlated... Oil & Inflation Expectations Highly Correlated... Chart 10...But Only When Inflation Is Low ...But Only When Inflation Is Low ...But Only When Inflation Is Low The U.K. in particular presents an interesting case study. U.K. core inflation was quite far below target throughout 2015 and 2016, and during this time period U.K. inflation expectations were tightly linked with the oil price. It is only in the past few months that U.K. core inflation has moved back above target, and not surprisingly the correlation between the U.K. 10-year CPI swap rate and the price of oil has started to break down. Bottom Line: At present, the cost of inflation compensation is an important driver of bond yields and the oil price is an important driver of the cost of inflation compensation. Both of these dynamics will continue to be true for the next few months, but will decline in importance as TIPS breakeven inflation rates rise. When long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%, then the oil price will become a less important driver of bond yields. The Fed In 2018: Contemplating A Major Change? As was alluded to in the prior section, the biggest potential change for bond markets in 2018 would be if the Fed changed its monetary policy framework to one that tolerated higher levels of inflation. For example, let's imagine that the Fed suddenly lifted its inflation target from 2% to 3%. This would likewise shift the upper-bound range for long-maturity TIPS breakeven inflation rates to approximately 3.4% to 3.5%. It would mean that nominal bond yields have further upside over the course of the cycle, and also that oil and commodity prices would play an important role in bond markets for much longer. It would also lengthen the period where spread product can outperform Treasuries since the Fed would not be so quick to choke off the recovery. We still think it is unlikely that such a change will be implemented this year, but recent weeks have seen a marked increase in the number of Fed policymakers either advocating for a different policy framework or saying that the Fed should start researching alternative frameworks. What's crucial to remember is that the reason policymakers are unsatisfied with the current 2% inflation target is that it brings the zero-lower bound on interest rates into play too often. So any potential change in policy framework would be to one that tolerates higher inflation rates. Bernanke's Idea Chart 11The Implications Of A Price Level Target The Implications Of A Price Level Target The Implications Of A Price Level Target One potential new policy approach was put forward by ex-Fed Chairman Ben Bernanke in a recent blog post.2 Bernanke made the case for "Temporary Price Level Targeting", a policy where the Fed continues to use a 2% inflation target when the fed funds rate is sufficiently far from zero, but then switches to a price-level target when the fed funds rate is close to the zero bound. In his own words, the strategy would be communicated as follows: The Committee therefore agrees that, in future situations in which the funds rate is at or near zero, a necessary condition for raising the funds rate will be that average inflation since the date at which the federal funds rate first hit zero be at least 2 percent. Chart 11 provides an illustration of this example. Under the current framework the Fed targets 2% PCE inflation and forecasts that it will achieve this target sometime in 2019. In Bernanke's proposed framework the Fed would not target 2% inflation, but rather a price level that is consistent with 2% trend growth in prices since the zero-lower bound was hit in December 2008. In order to achieve this goal by the end of 2019 the Fed would need to tolerate a significant overshoot of inflation during the next two years (bottom panel). Who's On Board? The Appendix to this report is a list of all Fed Governors and Regional Fed Presidents. It also shows our own assessment of each committee member's policy bias. We noted from the most recent Summary of Economic Projections that 6 FOMC participants expect three rate hikes in 2018, 6 expect fewer than three rate hikes and 4 expect more than three hikes. From recent speeches we attempted to discern which member owns which forecast and then we attributed a "dovish" policy bias to those with a forecast for fewer than three hikes, a "neutral" bias to those expecting three hikes, and a "hawkish" bias to those expecting more than three hikes. We also show which FOMC participants are voters in 2018, although we do not think that distinction carries much practical importance. The Committee tends to arrive at decisions by consensus anyways, and all participants voice their opinions at every meeting whether or not it is their turn to vote. But it is the "notes" column of the Appendix that is most striking. There we highlighted all the FOMC participants who have recently made comments regarding the exploration of alternative policy frameworks. A general consensus seems to be forming that alternative frameworks should be studied this year, and a few policymakers (San Francisco Fed President John Williams, in particular) have strongly made the case that the Fed should switch to some sort of price level targeting regime. The Appendix also identifies the biggest source of uncertainty for the Fed this year. Namely that there are four vacant Governor positions that need to be filled. The New York Fed will also need a new President when William Dudley retires later this year. Who is nominated to fill those vacant positions will go a long way toward determining how aggressively the Fed pursues alternative policy frameworks. Bottom Line: The Fed will start actively discussing alternative monetary policy frameworks in 2018. While we think the Fed will eventually adopt a policy framework that tolerates higher inflation, this shift probably won't occur this year. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com 2 https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ Appendix Table 2Composition Of The FOMC It's Still All About Inflation It's Still All About Inflation Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Bond Bear On Pause? Bond Bear On Pause? Bond Bear On Pause? The start of a new year often brings optimism and nowhere is this more evident than in economic projections. In three of the past four years (2017 being the exception) Bloomberg consensus GDP growth expectations ended the year lower than where they began. A related pattern played itself out in the Treasury market. At the turn of each of the past four years the average yield on the Bloomberg Barclays Treasury Index increased in December only to fall back in January. In two of those instances the January decline exceeded the December increase. Should we expect a similar January bond rally this year? Our favorite short-term indicators are not sending a strong signal (Chart 1). Net speculative futures positions weakly suggest that the 10-year yield will be lower in three months, but our auto regressive model suggests the Economic Surprise Index will still be in positive territory at the end of the month. In a recent report we showed that yields tend to rise in months where the Surprise Index is above zero.1 Perhaps most importantly, our 2-factor Treasury model shows that yields are significantly lower than is suggested by global economic fundamentals. Maintain below-benchmark duration. 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 49 basis points in December and by 335 bps in 2017. At 94 bps, the average index spread is 28 bps tighter than at the beginning of 2017 and investment grade corporate spreads are extremely expensive compared to history (Chart 2). After adjusting for changes in the average duration of the index over time, we calculate that A-rated corporate spreads have only been tighter 5% of the time since 1989 (panel 2), and Baa-rated spreads have only been tighter 7% of the time (panel 3). Essentially, at this stage of the credit cycle we should expect excess returns no greater than carry. As for the credit cycle itself, we noted in our last report that with corporate balance sheets deteriorating, low inflation and still-accommodative monetary policy are the sole supports for corporate spreads.2 We expect spreads will start to widen later this year once inflation rises and policy becomes more restrictive. With excess returns likely to be lower in 2018 than in 2017, we should also expect a lower marginal return from increasing the riskiness within credit portfolios.3 For investors looking to scale back on credit risk, our model shows that Financials and Technology are the most attractive low-risk sectors. Energy, Basic Industry and Communications are all attractive high-risk sectors (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* January Effect January Effect Table 3BCorporate Sector Risk Vs. Reward* January Effect January Effect 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 23 basis points in December and by 602 bps in 2017. The average index option-adjusted spread tightened 1 bp on the month and 66 bps in 2017. Though spreads appear somewhat more attractive than for investment grade corporates, there is still not much room for spread compression in high-yield. In fact, we calculate that if the high-yield index spread tightens another 117 bps, junk bonds will be the most expensive they have been since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Given trends in corporate leverage, another 100 bps of spread tightening should be viewed as unlikely. More realistically, we expect excess returns in the range of 200 bps to 500 bps (annualized) between now and the end of the credit cycle (Chart 3). Given our forecast for default losses, flat spreads translate to a 12-month excess return of 213 bps. An additional warning sign for junk spreads is that the slope of the 2/10 Treasury curve is hovering around 50 bps. We showed in a recent report that when the 2/10 slope is between 0 bps and 50 bps, junk bonds underperform Treasuries in 48% of months, and average monthly excess returns (though still positive) are much lower than when the curve is steeper.4 MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in December and by 51 bps in 2017. The conventional 30-year zero-volatility MBS spread narrowed 2 bps in December, the combination of a flat option-adjusted spread (OAS) and a 2 bps decline in the compensation for prepayment risk (option cost). The Z-spread widened 2 bps in 2017, as an 8 bps OAS widening was offset by a decline of 6 bps in the compensation for prepayment risk. The substantial OAS widening in early 2017 was almost certainly caused by investors pricing-in the eventual run-off of the securities on the Fed's balance sheet. Now that run-off has begun we see no obvious catalyst for further OAS widening in the months ahead. Turning to the compensation for prepayment risk, with Treasury yields biased higher as the Fed continues to lift rates, we see little risk of a material increase in refinancing activity. This will ensure that overall MBS spreads stay capped near historically low levels (Chart 4). All in all, with MBS OAS looking more attractive relative to Aaa-rated credit than at any time since 2015 (panel 3), we think this is an opportune time for investors looking to de-risk their portfolios to shift some of their spread product allocation away from corporate bonds and into MBS. We already upgraded our recommended allocation to MBS from underweight to neutral in October, and will likely further increase exposure as we advance toward the end of the credit cycle. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 5 basis points in December, but outperformed by 216 bps in 2017. Sovereign bonds underperformed the Treasury benchmark by 36 bps in December, Foreign Agencies and Domestic Agencies underperformed by 8 bps and 1 bp, respectively. Local Authorities outperformed the benchmark by 17 bps, and Supranationals underperformed by 1 bp. Sovereign bonds were the best performers within the Government-Related index in 2017, delivering excess returns of 538 bps relative to duration-matched U.S. Treasuries. This outperformance was concentrated early in the year and was driven by the sharp depreciation of the U.S. dollar (Chart 5). With the market still priced for a relatively modest 63 bps of Fed rate hikes during the next 12 months, further sharp dollar depreciation appears unlikely. We recommend an underweight allocation to Sovereign debt. We remain overweight Local Authority and Foreign Agency bonds, sectors that delivered excess returns of 420 bps and 248 bps, respectively in 2017. Despite the outperformance, both of these sectors still offer attractive spreads after adjusting for credit rating and duration. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 15 bps and 17 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 28 bps and 42 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 99 bps in December and by 332 bps in 2017 (before adjusting for the tax advantage). The average Aaa Municipal / Treasury (M/T) yield ratio fell 5% in December, and is 12% below where it began 2017 (Chart 6). The recent decline follows a sharp increase that was driven by fluctuating supply trends related to the passage of U.S. tax legislation. The final tax bill ends the practice of advance refunding municipal bonds. As a result, December set a new high of $55.6 billion for municipal issuance as issuers rushed to get their advance refunding deals to market before the bill was passed (panel 3). Now that the bill has passed, visible supply has evaporated and the average M/T yield ratio has fallen back to one standard deviation below its post-crisis mean. The absence of advance refunding will bias municipal bond issuance lower in 2018, thus removing one potential risk for yield ratios. The M/T yield ratio for short maturity debt has risen considerably relative to the yield ratio for long maturity debt in recent months (panel 2), and the risk/reward trade-off now appears more balanced. We close our recommendation to favor long maturities versus short maturities on the Aaa Muni curve. The third quarter update of our Muni Health Monitor showed a slight improvement (panel 5), but still no clear reversal of trend. Although health remains supportive for now - and consistent with municipal upgrades outpacing downgrades - with yield ratios close to their lows we maintain an underweight allocation to Municipal bonds.  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-flattened in December. The 2/10 Treasury slope flattened 13 bps on the month, and the 5/30 Treasury slope flattened 15 bps. The evolution of the Treasury curve in 2018 will come down to a trade-off between how quickly inflation rises versus how quickly the Fed lifts rates. For example, in a recent report we showed that the 10-year Treasury yield will likely settle into a range between 2.80% and 3.25% by the time that core PCE inflation reaches the Fed's 2% target.5 That same report shows that if that adjustment occurs relatively quickly, and the Fed has only lifted rates once or twice between now and then, then the 2/10 Treasury slope is much more likely to steepen than to flatten. Conversely, if the Fed lifts rates three or four more times between now and the time that inflation returns to target, then the curve is more likely to flatten. For our part, we think it is wise to maintain a position long the 5-year bullet and short a duration-neutral 2/10 barbell. Such a position profits from a steeper curve, and our model shows that the butterfly spread is currently priced for significant curve flattening (Chart 7). According to our model, the 2/5/10 butterfly spread is discounting 27 bps of 2/10 flattening during the next six months.6 In other words, if the 2/10 slope steepens or flattens by less than 27 bps, then our recommended position will profit. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 41 basis points in December, but underperformed by 43 bps in 2017. The 10-year TIPS breakeven inflation rate went on a wild ride last year. It started 2017 at 1.95% and, driven by strong inflation prints and continued post-election euphoria, reached as high as 2.09% in January. The breakeven dropped to a low of 1.66% in June, as inflation started to disappoint in the second quarter, but has rebounded during the past couple of months and just recently broke back above 2%. The 10-year TIPS breakeven rate is currently 2.02%, above where it began 2017. According to our TIPS Financial Model, the recent widening in breakevens is in line with the message from other related financial market instruments (Chart 8). Specifically, oil prices, the trade-weighted dollar and the stock-to-bond total return ratio. Further, measures of pipeline inflation pressure continue to signal an increase in inflationary pressures (panels 3 and 4), and the trimmed mean PCE shows that the realized inflation data are forming a tentative bottom (bottom panel). The annualized 6-month rate of change in the trimmed mean PCE ticked up to 1.68% in November, higher than the 12-month rate of change (1.67%). The 1-month rate of change is higher still at 2.19%, annualized. We continue to see signs that inflation will start to rebound in the coming months, and this will cause long-maturity TIPS breakeven inflation rates to reach a range between 2.4% and 2.5% by the time that inflation returns to the Fed's target. Remain overweight TIPS versus nominal Treasury securities. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities performed in line with the duration-equivalent Treasury index in December and outperformed by 92 basis points in 2017. In 2017, Aaa-rated ABS outperformed the Treasury benchmark by 79 bps and non-Aaa ABS outperformed by 217 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp in December, but tightened 21 bps in 2017. It now sits at 31 bps, only 4 bps above its all-time low (Chart 9). At 31 bps, Aaa-rated ABS now offer only a 3 bps spread advantage over Agency-backed MBS, and offer 11 bps less spread than Agency-backed CMBS. With consumer lending standards tightening and delinquency rates rising, we view no more than a neutral allocation to ABS as appropriate. On lending standards, the Fed's October Senior Loan Officer's Survey showed a continued tightening in lending standards on both credit cards and auto loans (panel 4), and also that demand for credit card and auto loans was essentially unchanged from the prior quarter. It also included a set of special questions regarding the reasons for changes in the supply and demand for consumer credit. Banks cited a less favorable or more uncertain economic outlook, a deterioration in existing loan quality and a general reduced risk tolerance as reasons for tightening the supply of credit. The hard data confirm that banks are seeing a deterioration in the quality of their consumer loan books (bottom panel). Although delinquencies remain depressed compared to history, with ABS spreads near all-time tights, rising delinquencies and tightening lending standards make for a poor risk/reward trade-off in the 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 20 basis points in December and by 201 bps in 2017. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps in December and 13 bps in 2017. At its current level of 64 bps, the index spread is about one standard deviation below its pre-crisis mean, and only 13 bps above its all-time low reached in 2004 (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in December and by 133 bps in 2017. The index option-adjusted spread for Agency CMBS tightened 3 bps in December and 13 bps in 2017. At its current level of 42 bps, the sector offers greater option-adjusted compensation than a position in Agency-backed MBS (28 bps) and Aaa-rated consumer ABS (31 bps). Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing.   Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.94% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.92%. PMIs across the world continue to surge. December PMI data show increases in the four largest economic blocs (U.S., Eurozone, China, Japan), and more broadly show that 86% of the 36 countries with available data currently have PMIs above the 50 boom/bust line. Meanwhile, bullish sentiment toward the U.S. dollar continues to trend lower in response to strong growth in the rest of the world (bottom panel). This is also a bearish development for U.S. bonds. 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 2.48%. 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, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights U.S. Treasuries: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in U.S. inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. Canada: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds and stay long inflation protection (both through linkers and CPI swaps). 2017 Model Portfolio Performance Wrap-Up: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps of underperformance versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Feature Chart of the WeekGlobal Bond Yields Are Too Low Global Bond Yields Are Too Low Global Bond Yields Are Too Low 2018 has started much as 2017 ended, with growth-sensitive assets rallying alongside robust economic data. Most major global equity markets are already up 2-3% after the first week of the year, with the U.S. NASDAQ, Japanese Nikkei and Italian MIB indices advancing over 4%. Global credit markets are also off to a strong start, with spreads for U.S. High-Yield corporate debt and EM hard currency corporate debt tighter by -17bps and -8bps, respectively. Even commodity markets have joined the party, with the benchmark Brent oil price hitting the highest level in nearly three years. The pro-growth, pro-risk backdrop is keeping upward pressure on global government bond yields. This is occurring primarily through the inflation expectations component of yields, which are rising in all developed economies (even Japan). Real yields, which are not rising despite the strength of the broad-based global growth upturn (Chart of the Week), have been drifting lower, providing some offset to rising inflation expectations. The primary trend for global yields remains upward, however - especially if growth remains solid and inflation expectations continue to push higher, giving central banks like the U.S. Federal Reserve the confidence to continue hiking interest rates. We continue to favor below-benchmark duration exposure, and overweight corporate bond allocations versus government debt, for global fixed income investors over the next 6-9 months. U.S. Treasuries: Still More Reasons To Sell Than Buy U.S. Treasury market participants have a lot to things to be nervous about at the moment. Likely future Fed rate hikes, the weakening U.S. dollar, rising oil prices, ongoing U.S. labor market strength, persistently booming economic growth, the never-ending equity bull market, the potential impact of the Trump fiscal stimulus, the Fed starting its balance sheet runoff - all factors that should force bond investors to expect yields to rise. Yet longer-dated Treasury yields continue to trade too low relative to the bond-bearish fundamentals. The current benchmark 10-year Treasury yield at 2.48% remains well below the fair value from our 2-factor regression model, which is now up to 2.94% (Chart 2). That valuation gap of 46bps is close to the widest levels seen in July 2016 and September 2017, which were both episodes that proved to be excellent entry points for bearish Treasury positions. The two inputs into our Treasury yield model are the global manufacturing PMI and bullish sentiment towards the U.S. dollar (USD). The PMI is included as an indicator of global growth and currently sits at 54.5 - the highest level in nearly seven years - led by strong readings in almost every major economy (Chart 3). This has been the primary driver of the fair value for the 10-year Treasury yield since global growth bottomed out and began to accelerate in mid-2016. Chart 210-Year Treasuries Are##BR##Overvalued On Our Model 10-year Treasuries Are Overvalued On Our Model 10-year Treasuries Are Overvalued On Our Model Chart 3Global Growth##BR##Is Booming Global Growth Is Booming Global Growth Is Booming Sentiment towards the USD is the second input to our Treasury model. It is included as a weakening greenback represents an easing of monetary conditions that could trigger a need for more Fed rate hikes that can push the Treasury curve higher from the short-end (and vice versa for a rallying USD). At the same time, a depreciating USD can drive U.S. inflation higher through higher costs of imported goods & services, which can raise bond yields through higher inflation expectations or greater Fed tightening expectations (again, the opposite holds true for a strengthening USD). Right now, both the strong PMI and weak sentiment towards the dollar are boosting the fair value of the 10-year Treasury yield. The fall in value of the greenback is particularly unusual, as it is flying in the face of widening interest rate differentials between the U.S. and the rest of the world (Chart 4, top panel). This is clearly a function of the fact that global growth is rapidly improving - especially in Europe - but very few central banks have yet to respond to that growth with interest rate hikes that match what the Fed has been delivering. So while actual interest rate differentials remain USD-supportive, expectations of some eventual tighter monetary policy outside the U.S. that could narrow those interest rate gaps are triggering speculative inflows into non-USD currencies. With the trade-weighted USD now 5% below levels of a year ago, this should lead to higher headline inflation in the U.S. in the next few months (middle panel). Combined with the continued strength in global oil prices, that means that the two biggest factors that weighed on realized U.S. inflation- the USD rally and oil price collapse of 2014/15 - are now both acting to boost inflation expectations (bottom panel). Throw in the growing body of evidence that a tight U.S. labor market that is putting gentle upward pressure on wage growth, and U.S. inflation expectations - which still remain 40-50bps below levels consistent with the Fed's inflation target - should continue to move higher in the next six months. Rising longer-term inflation expectations would typically result in bear-steepening pressures on the Treasury yield curve. That is not happening at the moment, however, with the 2-year/10-year Treasury curve still at a relatively flat 53bps at the time this report went to press. The flatness of the Treasury curve has worried investors, and even some Fed officials, given the well-known leading relationship between the yield curve and U.S. economic growth. It is too early to draw any conclusions between the shape of the curve and future U.S. economic growth, however, for several reasons: As mentioned above, inflation expectations are still well below levels consistent with the Fed's 2% inflation target on the PCE deflator (which translates to 2.5% on the CPI index used to price TIPS and CPI swaps). Both the European Central Bank (ECB) and Bank of Japan (BoJ) are still buying bonds through their asset purchase programs, although at a slower pace than previous years. This continues to depress local bond yields in Europe and Japan with spillover effects into the U.S. Treasury market - even as the Fed begins the slow runoff of Treasuries from its massive balance sheet. Data on mutual fund and ETF flows shows that there has been significant and sustained buying of bond funds by U.S. retail investors over the past couple of months. There has also been net selling of equity funds, however, suggesting that U.S. retail investors are rebalancing as the equity markets surge higher. Investor positioning in the U.S. Treasury market is very short at the moment, with the J.P. Morgan survey of "active" bond manager duration exposure at an all-time low and the net positioning on Treasury futures now slightly favoring shorts (Chart 5). It makes little sense to interpret a flattening Treasury curve as a signal that the bond market believes that the Fed was making a policy mistake if professional bond investors were running massive duration underweight positions that would benefit if bond yields rise. Chart 4Upside Pressure On U.S. Inflation##BR##From Oil & The USD Upside Pressure on U.S. Inflation from Oil & The USD Upside Pressure on U.S. Inflation from Oil & The USD Chart 5Big Duration Underweight##BR##Among U.S. Bond Managers Big Duration Underweight Among U.S. Bond Managers Big Duration Underweight Among U.S. Bond Managers All these factors muddy the economic signal provided by the Treasury curve at the moment. Nonetheless, we remain of the view that the Fed would not continue on its rate hiking path without U.S. inflation expectations moving sustainably back to levels consistent with the Fed's inflation target. In other words, the Treasury curve must bearishly steepen first through rising inflation expectations before bearishly flattening later through actual Fed rate hikes. The latter will dampen future U.S. growth expectations and eventually result in a cyclical peak in longer-dated Treasury yields, but from levels closer to 3% on the 10-year after inflation expectations "fully" normalize. Bottom Line: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. The Bank Of Canada Keeps On Playing Catch-Up The Canadian economic story continues to be the best within the developed world. The year-over-year growth rate for real GDP accelerated to over 3% late last year, primarily on the back of robust consumer spending (Chart 6). Even the lagging parts of the economy, like business investment and government spending, began to perk up last year. The momentum remained powerful at the end of 2017, with the unemployment rate in December hitting a 40-year low. The economic boom forced the Bank of Canada (BoC) to begin lifting interest rates last year, with two 25bp hikes occurring in July and September that unwound the easing from 2015. The rapid pace of growth has absorbed spare capacity much faster than the BoC originally projected. More hikes will be required if the current pace of growth is maintained, particularly with the BoC estimating that the neutral policy rate is around 3% and the current Overnight Rate is only at 1%. The Canadian consumer has been enjoying a powerful shopping spree. Real consumer spending growth is at 4% on a year-over-year basis - the highest level since early 2008 (Chart 7). This is led by a powerful surge in spending on consumer durables, where annual growth has surged to 10% (middle panel). Consumer confidence is booming and Canadian workers are enjoying the fastest pace of income growth since 2014 (bottom panel). Chart 6Robust Canadian Growth,##BR##Led By The Consumer Robust Canadian Growth, Led By The Consumer Robust Canadian Growth, Led By The Consumer Chart 7Canadian Consumers Are##BR##Confidently Spending Canadian Consumers Are Confidently Spending Canadian Consumers Are Confidently Spending Surprisingly, the powerful surge in consumer spending has occurred alongside some cooling of the overheated Canadian housing market. The growth rates of existing home sales and prices have both decelerated massively from the pace of the boom years in 2012-16 (Chart 8). The performance of house prices in the three biggest Canadian cities is now a mixed bag, with Vancouver prices reaccelerating, prices in Toronto decelerating and prices in Montreal growing only modestly (middle panel). Regulatory actions to limit the speculative buying of Canadian real estate by foreigners has helped dampen the surge in house prices in some markets. Although the bigger macro-prudential measures designed to tighten mortgage finance rules and reduce the amount of leverage in Canadian housing transactions has likely had a bigger effect. Canadian banks must now conduct stress tests to check if borrowers are able to pay off their mortgages if Canadian interest rates continue to rise. This represents a reduction in the marginal supply of riskier mortgage lending that will help restrain house price inflation in Canada's major cities. In addition, the supply of Canadian homes is growing with new home-building activity, both for single and multiple units, having picked up and overall residential investment growth now up nearly 5% on a year-over-year basis (bottom panel). With signs that the Canadian housing market has stopped rapidly inflating, the BoC can focus its interest rate policy on domestic growth and inflation considerations without worrying about pricking the housing bubble. On that front, the latest edition of the BoC's Business Outlook Survey, released yesterday, provided plenty of reasons to tighten monetary policy further. The overall survey indicator surged back to the peak seen last summer just before the BoC delivered its first rate hike (Chart 9). Capital spending intentions also rebounded back to the 2017 peaks, which bodes well for future gains in investment spending (second panel). Chart 8Canadian Housing Looking##BR##A Bit Less Frothy Canadian Housing Looking A Bit Less Frothy Canadian Housing Looking A Bit Less Frothy Chart 9BoC Business Outlook Survey Signaling##BR##Tightening Capacity Constraints BoC Business Outlook Survey Signaling Tightening Capacity Constraints BoC Business Outlook Survey Signaling Tightening Capacity Constraints The most interesting parts of the Business Outlook Survey were the capacity utilization measures. A greater share of companies were reporting labor shortages (third panel), with the highest percentage of firms reported difficulties in meeting unexpected increases in demand since 2007 (bottom panel). This suggests that the recent surge in employment, wage growth and price inflation are all sustainable. Headline and core CPI inflation are up to 2.1% and 1.8%, respectively, as of November. This is around the midpoint of the BoC's 1-3% target range (Chart 10). The Bank of Canada forecasts that CPI inflation will continue to rise and remain near 2% target in 2018, but all the risks are to the upside. The unemployment rate is now down to 5.7%, the lowest level since 1976 and well below the OECD's estimate of the NAIRU level at 6.5%. Average hourly earnings growth has surged in response, rising to just under 3% on a year-over-year basis since the trough in early 2017. The Phillips Curve appears to be alive and well in Canada. Canadian interest rate markets have already responded aggressively to the stronger growth and inflation data. Our interest rate discounters now show that the money markets are now expecting 61bps of BoC rate hikes over the next six months and 91bps over the next twelve months (Chart 11). With a 25bp hike at next week's BoC meeting now priced with almost full certainty, the current market pricing suggests at least one more hike will happen by June and nearly three more hikes by year-end. That would be even more hikes than we expect from the Fed in 2018, which is important for the Canadian dollar (CAD). The CAD has appreciated 16% since it bottomed out in early 2016, occurring alongside the rise in global oil prices over the same period (second panel). The price of Canada's Western Select grade of crude oil has lagged the move in other oil benchmarks massively over the past several months, due to a lack of pipeline capacity getting oil out of Alberta that has created a supply glut. This may limit the degree to which additional gains in global energy prices benefit the Canadian dollar from a terms-of-trade perspective. This will not prevent the BoC from delivering additional rate hikes, however - especially if that merely matches the 75bps of Fed rate hikes that the FOMC is projecting, and which we expect, over the rest of the year. In terms of investment strategy, the combination of robust Canadian economic growth and rising inflation pressures leads us to continue recommending an underweight stance on Canadian government bonds, as we have maintained since July 11, 2017. This week, we are introducing two new tactical trades that should benefit as Canadian inflation moves higher and the BoC tightens more aggressively in response (Chart 12): Chart 10The Canadian Phillips Curve Is Not Dead The Canadian Phillips Curve Is Not Dead The Canadian Phillips Curve Is Not Dead Chart 11The Market Now Expects A Lot From The BoC The Market Now Expects A Lot From The BoC The Market Now Expects A Lot From The BoC Chart 12Two New Tactical Trades In Canada Two New Tactical Trades In Canada Two New Tactical Trades In Canada Short the June 2018 Canada Bankers' Acceptance futures contact vs. the December 2018 contract (middle panel). The market is now discounting the likely maximum amount of tightening that the BoC can deliver by year-end, while there are only little more than two hikes priced by June. Assuming that the BoC hikes next week, that means that there is only one more hike expected by June. With three more BoC meetings scheduled between next week and June, that provides plenty of opportunities for hawkish surprises from the BoC before then. In other words, this trade is a way to play for the BoC being forced to front-load more rate hikes into the first half of 2018 versus the latter half. Long 10yr inflation expectations through linkers versus nominal government bonds, or using CPI swaps (bottom panel). Given the pickup in domestic inflation pressures currently underway, plus the rise in global inflation coming from the surge in commodity prices, there is room for Canadian market-based inflation expectations to rise from the current level of 1.7%. Bottom Line: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will likely hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds. 2017 GFIS Model Bond Portfolio Performance: A Brief Review The turn of the year marked the end of the first full calendar year for the Global Fixed Income Strategy (GFIS) model bond portfolio. This now allows us to report the performance of the portfolio on the same basis as our clients. In the future, we will publish quarterly reviews of the portfolio returns after the end of each quarter in a calendar year (in April, July, October and January). The GFIS model portfolio returned 3.45% in 2017. This underperformed our custom performance benchmark (a blend of the Barclays Global Aggregate Index with global high-yield corporate debt) by -13bps (Chart 13). That underperformance can be entirely attributed to our government bond duration allocations, which lagged the benchmark by -46bps. Our recommended credit positions were a positive contributor, generating 33bps of outperformance primarily through overweights to U.S. Investment Grade and High-Yield corporate bonds. The detailed breakdown of the 2017 returns is presented in Table 1. In terms of the government bond portion of the portfolio, the underperformance can be isolated completely to the longest maturity bucket (10+ years). The combined performance of that bucket for all countries lagged that of the benchmark by -52bps. Given our expectation that global yield curves would bear-steepen in the latter half of 2017, it is no surprise that the bulk of our underperformance came by having too little exposure at the long-end. Also, having too much exposure in Japanese government bonds offering no yield also represented a major drag on the income component of the model portfolio's returns (Chart 14). Chart 13GFIS Model Bond Portfolio##BR##2017 Return Breakdown GFIS Model Bond Portfolio 2017 Return Breakdown GFIS Model Bond Portfolio 2017 Return Breakdown Table 1GFIS Model Bond Portfolio##BR##2017 Return Breakdown Let The Good Times Roll Let The Good Times Roll In terms of our credit allocations, favoring U.S. corporate exposure vs. non-U.S. corporates was the right call, generally speaking (Chart 15). However, we did not have enough portfolio weight in that trade to offset the drag on the overall yield from the Japan government bond overweight. Chart 14GFIS Model Portfolio Government Bond Performance Attribution By Country Let The Good Times Roll Let The Good Times Roll Chart 15GFIS Model Portfolio Spread Product Performance Attribution Let The Good Times Roll Let The Good Times Roll Looking ahead, the new model bond portfolio allocation for 2018 that we discussed in our final report of 2017 should offer a better chance of outperforming the benchmark.1 Specifically, we dialed down the Japan overweight, increased the U.S. Investment Grade corporate bond overweight, and reduced the curve steepening exposure in Euro Area governments. This not only boosted the overall yield of the portfolio, but also moderated the overall portfolio duration underweight. This portfolio will do well in the first half of 2018 if our base case of an inflation-driven rise in global government bond yields, led primarily by the U.S. where corporate debt is also expected to outperform Treasuries, comes to fruition. Bottom Line: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps underperformance of versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Allocation In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Let The Good Times Roll Let The Good Times Roll Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 Short Palladium Short Palladium 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. * 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 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. 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

This will be the last U.S. Bond Strategy report of the year. The next publication will be on January 9 with our Portfolio Allocation Summary for January 2018. Until then we extend our best wishes for a wonderful holiday and a Happy New Year. Highlights Duration: Rising core inflation will cause the nominal 10-year Treasury yield to increase, driven mostly by the inflation component. We target a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation is back close to the Fed's target, likely sometime in the middle of 2018. Yield Curve: The yield curve will steepen modestly during the next six months as inflation recovers and the Fed lifts rates only gradually. This mild steepening will transition to flattening once long-maturity TIPS breakeven inflation rates have recovered to pre-crisis levels. Credit Cycle: Our indicators suggest that we are moving into the late stages of the credit cycle, but for now we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will be monitoring to gauge the end of the cycle. Feature Chart 1Fed Sees Stronger Growth In 2018 Fed Sees Stronger Growth In 2018 Fed Sees Stronger Growth In 2018 As was widely anticipated, the Fed delivered the fifth rate hike of the cycle last week, bringing the target range for the fed funds rate up to 1.25% to 1.5%. What's more, neither the Summary of Economic Projections nor Janet Yellen's final post-meeting press conference gave much indication that the Fed is worried enough about inflation to deviate from its current pace of tightening. To wit, the Fed did not alter its median projections for inflation or the near-term pace of rate hikes. As in September, the Fed still expects core PCE inflation to rise from its current 1.45% to 1.9% by the end of 2018. It also still expects to lift rates three more times next year. However, the Fed did respond to recent strong growth and employment data by revising its projection for GDP growth higher and its projection for the unemployment rate lower (Chart 1). It also revised the post-meeting statement to indicate that it now believes the economy has reached full employment. In other words, the Fed believes there is no longer any slack in the labor market. This dichotomy between stronger growth and a tight labor market on the one hand and low inflation on the other gets to the heart of the first big challenge that incoming Fed Chairman Jay Powell will face next year. Specifically, how much faith should the Fed have in its framework for forecasting inflation? Chart 2 shows that Janet Yellen's Phillips Curve model of core inflation does not explain this year's decline.1 It also shows that inflation is close to 0.5% below fair value, almost the largest deviation since 1995 (Chart 2, panel 2). It is this deviation that prompted Chair Yellen to say the following at last week's press conference: [W]e've had an undershoot of inflation for a number of years. We absolutely recognize that. I think until this year [the] undershoot was understandable. In other words, until this year the Fed's model did a good job of explaining low inflation. But now that a large residual has opened up between inflation and the Fed's model, it is reasonable for both the market and the Fed to question whether the underlying relationship between inflation and economic growth has changed. The market has already rendered its verdict in the affirmative. The compensation for inflation priced into the 10-year Treasury yield is only 1.88%. Historically, a level between 2.4% and 2.5% suggests the market has faith in the Fed's 2% inflation target. Further, the yield curve has been flattening dramatically. The 2/10 Treasury slope is down to 51 bps, and the fed funds/10-year slope is down to 94 bps. In other words, the bond market is discounting that the Fed can only deliver another 3-4 rate hikes before the economy starts to struggle, at which point inflation will still be below target. The recent revisions to the Fed's own economic projections also suggest that the perceived relationship between economic growth and inflation has weakened. The Fed revised its projection for GDP growth higher and its projection for the unemployment rate lower, but left its projections for inflation and the fed funds rate unchanged. This can only mean that the Fed views the relationship between economic growth and inflation as having weakened since September. So how much longer can the Powell Fed tighten policy without inflation actually trending higher? This is the single biggest question for bond markets and we detailed the three possible answers in last week's report.2 The most likely scenario is that the Fed's Phillips Curve model starts to work again next year. Core inflation trends higher and this eases the flattening pressure on the yield curve allowing the Fed to continue tightening. In support of this outcome, pipeline inflation measures have hooked up in recent weeks, suggesting that core inflation is about to bottom (Chart 3). Chart 2The Fed's Inflation Model The Fed's Inflation Model The Fed's Inflation Model Chart 3Pipeline Inflation Measures Pipeline Inflation Measures Pipeline Inflation Measures However, in the scenario where inflation does not move higher, the next most likely outcome is that risk assets sell off in the next couple months. This would lead to a tightening of financial conditions and would cause the Fed to react by adopting a more dovish policy stance. We showed in last week's report that risk off episodes in junk spreads become more frequent once the 2/10 Treasury slope breaks below 50 bps. It is also possible that the Fed proactively adopts a more dovish policy stance without having its hand forced by tighter financial conditions, but this now seems like the least likely outcome. Implications For Treasury Yields In the most likely scenario where core inflation trends higher during the next six months, Treasury yields will rise driven mostly by the inflation component (Chart 4). A return to the range of 2.4% to 2.5% on the 10-year TIPS breakeven inflation rate would put between 52 bps and 62 bps of upward pressure on the nominal 10-year Treasury yield. This means that even if the real 10-year yield remains flat we should see the nominal 10-year yield in a range between 2.87% and 2.97% by the time that core inflation gets back to the Fed's target. But even a flat real 10-year yield seems like a fairly conservative assumption. We can think of the real 10-year yield as being driven by three main factors: (i) the fed funds rate itself, (ii) expectations for future changes in the fed funds rate and (iii) a term premium. In Chart 5 we show that a simple model based on these three factors does a good job explaining the fluctuations in the real 10-year Treasury yield.3 Chart 4Market Not Priced For Rising Inflation Market Not Priced For Rising Inflation Market Not Priced For Rising Inflation Chart 5A Simple Model Of The Real 10-Year Treasury Yield A Simple Model Of The Real 10-Year Treasury Yield A Simple Model Of The Real 10-Year Treasury Yield The model works better prior to the Great Recession because we deliberately chose pre-crisis coefficients for our three independent variables. Chart 6 shows the coefficients for the three variables estimated over rolling 5-year intervals, and the dashed horizontal lines show the coefficients we chose for our model. It is clear from Chart 6 that the zero-lower bound caused the estimated coefficient on the fed funds rate to decrease and the estimated coefficient on the 12-month discounter to increase. We expect both will converge slowly back toward pre-crisis levels now that the fed funds rate is well off the zero bound. Chart 6Controlling For The Zero Lower Bound Controlling For The Zero Lower Bound Controlling For The Zero Lower Bound The key conclusion from this modeling exercise is that, even with fairly conservative assumptions, it is difficult to craft a reasonable scenario where the real 10-year Treasury yield declines during the next 12 months. The forecast in Chart 5 assumes that the Fed lifts rates three times next year - consistent with its median projections - but also that rate hike expectations fall so that by the end of 2018 the market only expects one further rate hike during the next 12 months. Finally, we assume that implied interest rate volatility stays flat at historically low levels. Even in that relatively benign scenario our model suggests that the real 10-year Treasury yield would drift higher during the next 12 months. This leads us to project a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation moves back close to the Fed's 2% target. Implications For The Yield Curve The slope of the yield curve during the next 6-12 months will depend both on how quickly core inflation rises and how quickly the Fed tightens policy. Table 1 shows different scenarios for the fed funds rate, the 2-year/fed funds slope - which can be thought of as the expected number of rate hikes during the next two years - and the 10-year Treasury yield. For example, if core inflation rises back close to the Fed's target by next June and the Fed has only delivered one or two more rate hikes during that time period, then it is very likely that the yield curve will have steepened, at least modestly. If the Fed gets three or four hikes off before inflation gets back to target, then it is much more likely that the yield curve will have flattened. We think a modest curve steepening is the most likely outcome for the next six months. This is premised on the view that core inflation will start to trend higher in the coming months, and will approach the Fed's target by the middle of next year. During that timeframe the Fed will only deliver one or two rate hikes, consistent with its median projection for three hikes in 2018. Once core inflation is back closer to target and the compensation for inflation priced into long-dated Treasury yields is back to its pre-crisis 2.4% to 2.5% range, then aggressive curve flattening becomes much more likely. Table 1Scenarios For The Number Of Fed Rate Hikes By The Time That Inflation Returns To Target Ill Placed Trust? Ill Placed Trust? Bottom Line: The Fed is playing a dangerous game by continuing to signal a gradual pace of rate hikes in the face of inflation data that have not kept pace with its projections. Ultimately we think the Fed's models will be proven correct during the next six months and core inflation will resume its gradual cyclical uptrend. Rising core inflation will cause the nominal 10-year Treasury yield to increase, driven mostly by the inflation component. We target a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation is back close to the Fed's target, likely sometime in the middle of 2018. The yield curve will steepen modestly during the next six months as inflation recovers and the Fed lifts rates only gradually. This mild steepening will transition to flattening once long-maturity TIPS breakeven inflation rates have recovered to pre-crisis levels. Credit Cycle Update: Favorable For Now, But Will Turn In 2018 The U.S. Financial Accounts (formerly Flow of Funds) were released this month. This gives us the opportunity to update our Corporate Health Monitor (CHM), as well as our other indicators of non-financial corporate sector leverage. Recall that historically three conditions must be met before the credit cycle turns and a sustained period of corporate spread widening kicks in. They are: Corporate balance sheet health must be deteriorating Monetary policy must be restrictive Bank lending standards must be tightening Chart 7 provides a snapshot of the current state of affairs for these three criteria. Chart 7Credit Cycle Indicators Credit Cycle Indicators Credit Cycle Indicators Chart 8Corporate Health Monitor Corporate Health Monitor Corporate Health Monitor Corporate Balance Sheet Health The CHM is our number one indicator of non-financial corporate sector balance sheet health (Chart 7, panel 2). It has been signaling "deteriorating health" since 2015, but ticked down in the third quarter and has been moving slowly back toward "improving health" territory since the beginning of the year. It is worth mentioning that in order to get a leading signal from our CHM we use de-trended versions of the Monitor's underlying components. The six financial ratios that we combine to calculate the CHM are shown in their not de-trended forms in Chart 8. We also show a not de-trended version of the overall Monitor in the second panel of Chart 7. Notice that while the traditional (de-trended) CHM has been signaling "deteriorating corporate health" since 2015, the not de-trended version remains in "improving health" territory. Box: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets The unusual length of the current recovery has caused the not de-trended and de-trended versions of the CHM to diverge by much more than in prior cycles. While this almost certainly means that the negative signal from our traditional (de-trended) Monitor came too early this cycle, we should also expect the negative signal from the not de-trended version of our model to arrive too late. So while the truth lies somewhere in between the de-trended and not de-trended versions, we are fairly confident in saying that the condition of "deteriorating corporate health" has already been met for this cycle. Restrictive Monetary Policy Panels 3 and 4 of Chart 7 show two different indicators for the stance of monetary policy. The first is the real effective fed funds rate relative to the Laubach-Williams (2003) estimate of its equilibrium level. According to this measure, monetary policy moved into restrictive territory following last week's rate hike. However, a much simpler indicator for the stance of monetary policy is the slope of the yield curve. While the slope of the yield curve is not flashing red just yet, it has been rapidly flattening and is approaching levels that signaled a restrictive stance of monetary policy in prior cycles. In last week's report we showed that monthly excess returns to high-yield bonds have averaged only 12 bps when the slope of the 2/10 Treasury curve is between 0 bps and 50 bps, and that monthly excess returns have been negative 48% of the time in those periods.4 Tightening Bank Lending Standards The Federal Reserve's most recent Senior Loan Officer Survey showed that banks continue to modestly ease standards on commercial & industrial (C&I) loans (Chart 7, bottom panel). We traditionally view this third condition as more of a confirming indicator of the turn in the credit cycle. That is, tighter bank lending standards are typically preceded by deteriorating corporate health and restrictive monetary policy. An Additional Measure Of Corporate Sector Leverage In addition to the components of our CHM, we also track a measure of gross leverage for the non-financial corporate sector, calculated as total debt divided by EBITD (Chart 9). Historically, the trend in corporate bond spreads has followed the trend in gross leverage, or at the very least, deviations in direction between spreads and leverage have tended not to last very long. Chart 9Rising Gross Leverage Is A Risk For Spreads Rising Gross Leverage Is A Risk For Spreads Rising Gross Leverage Is A Risk For Spreads Our measure of gross leverage ticked higher in Q3, EBITD grew at an annualized rate of 4.1% but this was not enough to offset the 5.4% annualized increase in corporate debt. Overall, gross leverage has been roughly flat this year even though corporate spreads have tightened. Going forward, our leading indicators are still consistent with mid-single digit profit growth. If that view pans out then the pace of debt accumulation will need to fall in order for leverage to decline. We will be watching this measure of leverage closely during the next couple of quarters, if leverage continues to increase then we will be quicker to call the end of the credit cycle. Bottom Line: Our indicators suggest that we are moving into the late stages of the credit cycle, but for now we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will be monitoring to gauge the end of the cycle. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 The Phillips Curve model of inflation shown in Chart 2 is re-created from Janet Yellen's September 2015 speech: https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 3 We use our 12-month fed funds discounter to measure rate hike expectations and the MOVE implied volatility index as a proxy for the term premium. 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification