Gov Sovereigns/Treasurys

Highlights Bonds are universally unloved. The economic 'mini-upswing' is extended. 6-month bank credit impulses have rolled over. Europe is entering a period of high-impact political events. Equities are universally loved. If bond prices bounce back, Bank equities are losers and Real Estate equities are winners. Feature From time to time it is worth stepping out of the herd and asking: is the herd heading in the right direction? Given the seemingly universal dislike of high-quality government bonds, this week's report goes through five reasons why bonds could make a surprising comeback in the coming months.1 Chart of the WeekBrexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing Brexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing Brexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing 1. Bonds Are Universally Unloved The extent of herding in bonds is extreme on both a 65-day and 130-day basis (Chart I-2). The herd is a good metaphor for financial markets given the capacity for investor sentiment to move en masse. However, excessive herding is dangerous, because it destroys market liquidity. Chart I-2The Extent Of Herding In Bonds Is Extreme The Extent Of Herding In Bonds Is Extreme The Extent Of Herding In Bonds Is Extreme Liquidity - defined as the ability to buy or sell an investment in large volume without moving its price - requires healthy disagreement. After all, at today's price, if you sell a bond and I buy it from you, we are disagreeing about the attractiveness of the price. If many investors disagree on the attractiveness of the price, then there will be plenty of liquidity. The main reason for healthy disagreement and plentiful liquidity is that the market is usually split between short-term momentum traders and long-term value investors. If the price fluctuates downwards, the momentum trader interprets this as a strong sell-signal but the value investor sees it as an equally strong buying-opportunity. Hence, the two types of investor can trade with each other in large volume without moving the price (much). However, if the value investor flips to become a momentum trader and sells rather than buys, the price must fall until it attracts a bid from a deep value investor. If the deep value investor then also flips to become a momentum trader, the price must fall further until it attracts a bid from an even deeper value investor. And so on... As everybody in turn flips to the same view, the herd and the trend will get stronger and stronger. The tipping point comes when there is nobody left to flip and to join the herd. If a value investor then suddenly reverts to type and puts in a buy order, he will find that there are no sellers left. Liquidity has evaporated, and to replenish it might require a substantial reversal in the price. On both our 130-day and 65-day herding indicators, bonds appear vulnerable to such a reversal in the coming weeks. 2. The Economic 'Mini-Upswing' Is Extended Chart 1-3Major Economies Exhibit ##br##Very Clear 'Mini-Cycles' Major Economies Exhibit Very Clear 'Mini-Cycles' Major Economies Exhibit Very Clear 'Mini-Cycles' A typical business cycle lasts multiple years. But within this longer cycle, major economies exhibit very clear 'mini-cycles' whose upswings and downswings last 6-12 months (Chart I-3). As we demonstrated in Slowdown: How And When? 2 these mini-cycles result from the perpetual interplay between changes in bond yields, accelerations/decelerations in credit growth, and accelerations/decelerations in economic growth. The inception of the current mini-upswing coincided with last February's G20 meeting in Shanghai. At the start of 2016, global growth appeared to be stalling and financial markets were fragile. In response, a so-called 'Shanghai Accord' facilitated a synchronized stimulus in the major economies - either directly, or in the case of the U.S., a watering down of monetary tightening expectations. By spring last year, bond yields were forming a typical mini-cycle bottom. But in June, the Brexit shock sent yields sharply, but briefly, lower. Conversely, the Trump shock-victory in November accelerated the upswing in yields that was already well underway (Chart of the Week). Absent these two political shocks, 2016 produced a typical mini-upswing whose duration is now approaching 12 months - making it long in the tooth. Mini-upswings do not die of old age. But it would be highly unusual for the economy's credit-sensitive sectors not to feel a strong headwind now from the sharp upswing in bond yields. 3. 6-Month Bank Credit Impulses Have Rolled Over 6-month credit impulses have indeed rolled over in the major economies (Chart I-4 and Chart I-5), exactly as would be expected after a sustained upswing in bond yields. Chart I-46-Month Credit Impulses Have ##br##Rolled Over In Major Economies... 6-Month Credit Impulses Have Rolled Over In Major Economies... 6-Month Credit Impulses Have Rolled Over In Major Economies... Chart I-5... And ##br##Globally ... And Globally ... And Globally Now you could argue that the upswing in bond yields is simply a response to improved expectations for growth. The problem with that argument comes from the inter-temporal and geographical distribution of that potential growth pickup. U.S. fiscal stimulus and infrastructure spending is an uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Furthermore, this stimulus is unlikely to benefit Europe or other economies outside the U.S. Yet the recent rise in bond yields and weakening of credit impulses has occurred everywhere. Compared to Trump's intangible stimulus, the choke on credit-sensitive sectors is a certain headwind whose impact will be felt sooner and more universally. 4. Europe Is Entering A Period Of High-Impact Political Events The next few months will also see a sequence of potentially high-impact political events in Europe. The Netherlands and France hold elections in which disruptive populist politicians are likely to perform well, though probably not well enough to gain power. Meanwhile, Greece appears to be reneging on the terms and conditions of its latest bailout - whose next tranche of funds it needs to make a large debt repayment in July. Into this sensitive mix, add the start of the formal and potentially acrimonious divorce proceedings between the U.K. and the EU27, due to start by the end of March. To be clear, the probability of a shock outcome in any of these individual events is low. But the probability of a shock from at least one of these multiple events is not so low. If the probability of an individual shock is, let's say, 20% then the probability that the event goes smoothly is clearly 80%. Therefore, the probability that all four events go smoothly would be 0.8 to the power of 4, equal to 41%.3 Which means that the probability of at least one shock would be a significant 59%. Perhaps the probability of an individual shock in any of these four events is less than 20%. However, there are also other more nebulous sources of risk, such as the possibility of early elections in Italy, and a disruptive outcome. To reiterate, an individual risk might be low or very low. But the chance of at least one shock in the upcoming sequence of events must be close to evens. And this is the chance that high-quality government bonds will receive significant haven demand at some point in the coming months. 5. Equities Are Universally Loved High-quality government bonds are universally unloved, but mainstream equities have the opposite problem. They are universally loved. The extent of herding in equities is extreme on a 65-day basis (Chart I-6). Chart I-6The Extent Of Herding In Equities Is Extreme The Extent Of Herding In Equities Is Extreme The Extent Of Herding In Equities Is Extreme This perfect symmetry of herding behaviour suggests to us that if investors suddenly fall out of love with equities - even briefly - then unloved bonds would be the very likely beneficiaries. Pulling all of the five arguments above together, we conclude that the odds of a tactical retracement in high-quality government bond yields in the next 3-6 months are more than evens. And we would position accordingly. In this eventuality, stock market investors should note that the sector that might be most vulnerable is Bank equities (Chart I-7). Conversely, the sector that might be one of the biggest beneficiaries is Real Estate equities (Chart I-8). Chart I-7If Bond Prices Bounce Back, ##br##Bank Equities Are Losers... If Bond Prices Bounce Back, Bank Equities Are Losers... If Bond Prices Bounce Back, Bank Equities Are Losers... Chart I-8... And Real Estate ##br##Equities Are Winners ... And Real Estate Equities Are Winners ... And Real Estate Equities Are Winners Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Our analysis throughout uses the JP Morgan Global Government Bond Index as the best representation of the direction of high-quality government bonds, including those in Europe. 2 Published on February 2, 2017 and available at eis.bcaresearch.com 3 Strictly speaking, this assumes that all four events are independent - that is, the outcome of one does not influence the outcome of another. Fractal Trading Model There are no new trades this week. 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

Highlights Duration: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. USTs vs. Bunds: U.S. Treasury yields will remain under upward pressure from a hawkish Fed with the U.S. economy operating at full employment. The opposite is true in Europe, at least until Euro Area inflation is much higher. Stay overweight core Europe versus the U.S. in global hedged bond portfolios Feature Chart of the WeekCan The Bond Selloff Continue? Can The Bond Selloff Continue? Can The Bond Selloff Continue? Last week brought the first serious test of the bond bear phase that has been in place since last July. The 10-year U.S. Treasury yield dipped as low as 2.33% after a benign January U.S. Payrolls report that substantially reduced the odds of a March Fed rate hike. German Bund yields also dipped as renewed worries about the upcoming French election triggered a flight to quality out of French and Peripheral sovereign debt. Even the chartists got in on the act, talking of an imminent breakdown below the "head & shoulders neckline" on the 10-year U.S. Treasury that would herald a 25bp decline in yields. Adding to the growing sense of nervousness among investors is a fear that the "Trumpflation" trade could soon run out of gas, with a correction of both elevated equity prices and bond yields likely in the absence of concrete economic news from the White House. Yet all it took was for Trump to simply mention that a "phenomenal" announcement on his tax plan was coming in the next few weeks to restart the Trump trades, pushing equity indices to new highs and driving up bond yields. Given all the conflicting forces at play in developed bond markets - accelerating growth, rising inflation, fiscal and political uncertainties, bearish bond investor positioning - we believe it is important to stay grounded by focusing only on the most relevant factors while trying to sift out the signal from the noise. This week, we are introducing a new "Duration Checklist" for both U.S. Treasuries and German Bunds, highlighting the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio duration stance. From this checklist, we can confirm that the bond-bearish backdrop remains intact, with more indicators pointing to higher yields in the U.S. relative to core Europe. Describing The Elements Of Our Checklist The individual components of bond yields that we typically monitor - term premia, inflation expectations and shifts in the market-implied path of policy rates - have all contributed to the rise in U.S. and European bond yields since last July (Chart of the Week). Some of the factors that have driven yields higher are global in nature, like faster economic growth and rising energy prices, while others are more country-specific, like rising wage inflation in the U.S. To account for those different factors, we need to include a variety of indicators in our new GFIS Duration Checklist. The goal of list is to answer the specific question: "what should we watch to maintain a below-benchmark duration stance in the U.S. and core Europe?" The items in the Checklist are shown in Table 1, broken down into the following groupings: Table 1Stay Bearish On Treasuries & Bunds A Duration Checklist For U.S. Treasuries & German Bunds A Duration Checklist For U.S. Treasuries & German Bunds Accelerating Global Growth: Here, we are looking at indicators that are pointing to a quickening pace of global economic growth that would put upward pressure on all developed market bond yields. Specifically, we are looking to see if: a) the annual growth in the global leading economic indicator (LEI) is accelerating; b) our diffusion index for the global LEI is above 50 (suggesting a majority of countries with an expanding LEI) and rising; c) the global ZEW economic sentiment index is increasing; d) the global data surprise index is moving higher; and e) our measure of the global credit impulse (the 6-month change in credit growth among the major economies, one of BCA's favorite leading economic signals) is expanding. These global indicators are all shown in Chart 2. The global LEI growth rate, the global ZEW index and global data surprises are all moving higher, consistent with upward pressure on bond yields, and thus warrant a "check" in our GFIS Duration Checklist. The LEI diffusion index is well above 50, but has hooked down slightly in the past few months, as has the global credit impulse. These moves are relatively modest, and it is not yet certain whether they represent a change in trend in these series. For now, we are giving these indicators a "check", but with a question mark attached. If we see additional declines in the diffusion index and the global credit impulse in the next few months, we would interpret that as a sign that the cyclical global upturn is in danger of losing momentum, thus reducing the upward pressure on bond yields. Accelerating Domestic Growth: These are economic data that are specific to each country that would be consistent with higher yields; a) manufacturing purchasing managers' indices (PMIs) that are above 50 and rising; b) expanding consumer confidence; c) rising business confidence; d) faster growth in corporate profits. The relevant data for the U.S. are shown in Chart 3, which shows that all elements are increasing in a fashion that is bearish for U.S. Treasuries. The popular perception is that the recent surge in business confidence (both for corporate CEOs and small business owners) is simply a "Trump effect" from the new president's pro-business economic platform. However, the acceleration in corporate profit growth, which our own models are suggesting will continue in the coming quarters, is a sign that there is a more fundamental reason for firms to feel more optimistic. Chart 2Global Growth Still Pointing To Higher Yields Global Growth Still Pointing To Higher Yields Global Growth Still Pointing To Higher Yields Chart 3U.S. Domestic Upturn Is Solid U.S. Domestic Upturn Is Solid U.S. Domestic Upturn Is Solid We give all the U.S. domestic growth indicators a "check" pointing to a need to stay below-benchmark U.S. duration. The specific Euro Area growth data is shown in Chart 4. Similar to the U.S., all the indicators are moving higher in a bond-bearish direction, warranting a "check" on the Euro Area Duration Checklist. The political tensions stemming from the busy election calendar in Europe this year represent a potential negative shock to confidence. As we discussed in our Special Report published last week, however, we do not foresee a populist election shock in France akin to Brexit or Trump that would derail the Euro Area economic expansion.1 Rising Domestic Inflation Pressures: These are data that are specific to each country that would be consistent with faster inflation and higher yields: a) the annual growth in the oil price, in local currency terms, is accelerating; b) wage inflation is rising; c) the unemployment gap (the difference between the unemployment rate and the full employment NAIRU rate) is closed or nearly closed; The U.S. inflation data is shown in Chart 5, with all the indicators warranting a bond-bearish "check" in our U.S. Duration Checklist. The rising trend in oil prices continues to put upward pressure on headline U.S. inflation, even with the strong U.S. dollar. Meanwhile, the unemployment gap is now closed and U.S. wage inflation is grinding higher. This should be consistent with additional modest gains in core inflation that will put upward pressure on the inflation expectations component of U.S. Treasury yields (bottom panel). Chart 4Euro Area Domestic Upturn Is Solid Euro Area Domestic Upturn Is Solid Euro Area Domestic Upturn Is Solid Chart 5U.S. Inflation Trends Still Bearish For USTs U.S. Inflation Trends Still Bearish For USTs U.S. Inflation Trends Still Bearish For USTs It is a different story in the Euro Area, as can be seen in Chart 6. While the rapid acceleration in the Euro-denominated price of oil is starting to feed through into faster headline inflation, there still exists a positive unemployment gap that is helping keep wage growth, and core inflation, muted. A continuation of the recent economic upturn will likely put more downward pressure on Euro Area unemployment, but, for now, only the oil price acceleration justifies a "check" in the Euro Area Duration Checklist. Chart 6Euro Area Inflation Is A Mixed Bag Euro Area Inflation Is A Mixed Bag Euro Area Inflation Is A Mixed Bag Central Bank Policy Stance: Here, we are not including any charts, but are only stating whether the central bank has a bias to tighten monetary policy. That is certainly the case in the U.S., where the Fed has already delivered a 25bp hike in December and continues to signal that up to three more hikes will occur in 2017 if the FOMC growth forecasts are realized. So we put a "check" in this box on the U.S. side of the checklist. The European Central Bank (ECB) continues to maintain an unusually accommodative monetary stance, using a combination of asset purchases, negative policy rates and dovish forward guidance. We continue to see a potential shift away from this super-easy policy bias in the latter half of the year - in response to the upturn in economic growth and acceleration of Euro Area inflation towards the ECB's 2% target - as the biggest risk for both Euro Area bonds, in particular, and global bonds, in general. For now, however, the ECB is signaling no imminent shift to a more hawkish stance, so we are placing an "x" in the central bank portion of the Euro Area checklist. Risk-Seeking Behavior In Financial Markets: Here, we are checking to see if pro-growth, pro-risk asset classes are outperforming and whether market volatilities are rising. Risk asset outperformance and stable vol suggests that investors are less interested in risk-free government bonds: a) the domestic equity index is rising but is not yet 10% above the 200-day moving average (a level that has coincided with post-crisis equity market and bond yield peaks); b) domestic corporate bond spreads are either flat or falling rapidly; c) domestic equity market volatility is low and falling rapidly. The U.S. indicators are shown in Chart 7, while the Euro Area data is shown in Chart 8. The story is the same in both regions, with equity markets in a bullish trend but not yet at a fully-stretched extreme, credit spreads (both for Investment Grade and High-Yield) tight, and equity market volatility at multi-year lows. We view these indicators as signs that investors are less interested in owning U.S. Treasuries and German Bunds than owning equities and corporate debt. This will help bond yields drift higher on the margin as economic growth and inflation rise in the coming months. Thus, we place a "check" on all three elements in both the U.S. and Euro Area Duration Checklists. Chart 7Risk-Seeking Behavior In The U.S. Risk-Seeking Behavior In The U.S. Risk-Seeking Behavior In The U.S. Chart 8Risk-Seeking Behavior In Europe Risk-Seeking Behavior In Europe Risk-Seeking Behavior In Europe Contrarians may look at those same charts and say that this is more of a sign that investors are too optimistic and are now exposed to any negative growth shock, potentially representing a trigger for a selloff of risk assets and a move into government debt. We prefer to view the bullish performance of growth-sensitive assets as a sign of underlying investor risk appetite. Domestic Bond Market Technicals: Here, we are simply looking at measures of price momentum and market positioning in government bonds, to assess if there is room for additional yield increases as investors reduce exposure: a) the domestic 10-year bond yield is not stretched to the upside versus the 200-day moving average; b) the domestic Treasury index total return momentum (26-week rate of change) is not stretched to the downside; c) bond investor positioning is not already short. The 10-year U.S. Treasury technicals are shown in Chart 9, while the German Bund technicals are shown in Chart 10. The story is quite simple here - the rapid run-up in global bond yields late last year has led to stretched, oversold conditions on both sides of the Atlantic. Sentiment remains bearish in U.S. Treasuries, with massive net shorts in bond futures, suggesting that an overhang of positions remains a major headwind to higher yields. While we do not have positioning data for Euro Area bond investors, the momentum charts for German Bunds look very similar to the U.S. Treasury charts. Clearly, we must place an "x" in all these boxes on both Duration Checklists. Chart 9Stretched Technicals In U.S. Treasuries... Stretched Technicals In U.S. Treasuries... Stretched Technicals In U.S. Treasuries... Chart 10...And In German Bunds ...And In German Bunds ...And In German Bunds So What Are The Checklists Telling Us? Adding it all up, and the vast majority of the indicators in both checklists are pointing to continued upward pressure on bond yields, justifying a below-benchmark duration stance. The lack of core inflation pressure in the Euro Area, however, suggests that there is less upward pressure on German Bund yields relative to U.S. Treasuries, thus we continue to recommend an overweight stance on Bunds versus Treasuries in global hedged bond portfolios. Oversold conditions suggest that yields will have a tough time rising quickly from here while the market continues to consolidate the late 2016 bond selloff. However, a major bond market reversal is unlikely given the solid upturn in global growth. Bottom Line: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. Maintain a below-benchmark portfolio duration stance in the near term, favoring German Bunds over U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Our View On French Government Bonds", dated February 7, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Duration Checklist For U.S. Treasuries & German Bunds A Duration Checklist For U.S. Treasuries & German Bunds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Rate Volatility: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Treasury Yields: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. MBS: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Feature Low interest rate volatility has been a constant feature of the investing landscape during the past few years. In fact, you need to go back to the 1970s to find another period when interest rate volatility was consistently at or below its current level (Chart 1). Not surprisingly, the implied volatility priced into Treasury options is also as low as it has been during the past 30 years, with the exception of the period just prior to the financial crisis in 2007 (Chart 2). Chart 1Yield Volatility: Lowest Since The 70s Yield Volatility: Lowest Since The 70s Yield Volatility: Lowest Since The 70s Chart 2Implied And Realized Yield Volatility Move Together Implied And Realized Yield Volatility Move Together Implied And Realized Yield Volatility Move Together This begs the question of whether the current low-vol environment can be sustained, or whether overly complacent investors are in for a shock. At the very least, we believe that rate volatility has already passed its cyclical trough and will start to move up this year. Investors should prepare themselves for higher volatility. In this week's report we examine the key macro drivers of interest rate volatility and discuss the implications of rising vol for both Treasury yields, and crucially, mortgage-backed securities. Macro Uncertainty & Rate Volatility Chart 3Macro Drivers Of Rate Volatility Macro Drivers Of Rate Volatility Macro Drivers Of Rate Volatility In a Special Report published in 2014,1 we posited that the long-term trends in volatility across all asset classes are largely driven by common macroeconomic factors. Specifically, investor uncertainty regarding the outlook for economic growth and monetary policy. A 2004 paper by Alexander David and Pietro Veronesi2 provides some theoretical justification for this view, as the authors observed that investors tend to overreact to new information when macro uncertainty is high, and underreact when uncertainty is low. To test the linkage between interest rate volatility and macro uncertainty we consider three measures of uncertainty. The first two measures, shown alongside the MOVE index of implied Treasury volatility in Chart 3, are measures of GDP growth and T-bill rate forecast dispersion. We measure dispersion - the disagreement among forecasters - by looking at individual forecasts of GDP growth and T-bill rates and calculating the difference between the 75th and 25th percentiles. The series shown in Chart 3 are equal-weighted averages of the forecast dispersion calculated for five different time horizons, ranging from the current quarter to four quarters ahead. As can be seen in the top two panels of Chart 3, implied interest rate volatility is higher when the disagreement among forecasters is greater, consistent with our thesis. The third measure of uncertainty we consider is the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index tracks uncertainty about the macro environment by counting the number of mentions of certain key words in major global newspapers. Elevated readings from this index have also coincided with high rate volatility in the past (Chart 3, bottom panel). GDP Growth Forecast Dispersion Chart 4Forecast Dispersion & Corporate Lending Forecast Dispersion & Corporate Lending Forecast Dispersion & Corporate Lending Disagreement among GDP growth forecasts reached an all-time low in the fourth quarter of 2016, but has since recovered to slightly more typical levels. Historically, we have found that C&I lending standards and corporate sector balance sheet health correlate most closely with GDP growth forecast dispersion (Chart 4) and both measures suggest that forecast dispersion is biased upward. T-Bill Rate Forecast Dispersion T-bill rate forecast dispersion was abnormally low between 2011 and 2014 for two reasons. The first reason is quite simply the zero-lower-bound on interest rates. A short rate bounded at zero necessarily trimmed the distribution of possible T-bill rate forecasts, since forecasters logically assumed that further interest rate cuts were not possible. This impact will gradually dissipate the further the fed funds rate moves off zero. Chart 5Fed Says March Meeting Is Live Fed Says March Meeting Is Live Fed Says March Meeting Is Live The second reason for extremely low T-bill rate forecast dispersion was the Fed's forward guidance. During this timeframe the Fed was actively trying to convince the public that interest rates would remain low. The most obvious example being the "Evans Rule", where the Fed promised not to lift interest rates at least until the unemployment rate had fallen below a specific threshold. This activist forward guidance limited the range of conceivable T-bill rate forecasts and crushed interest rate volatility. Nowadays, the Fed is engaged in a different sort of forward guidance, trying to convince markets that every FOMC meeting is live and that rate hikes could occur at any moment. Essentially, the Fed is trying to inject volatility into the rates market. Just a few weeks ago, when asked about the low probability markets are assigning to a March rate hike (Chart 5), San Francisco Fed President John Williams replied flatly: "I don't agree. All our meetings are live." Global Economic Policy Uncertainty We have written a lot about the policy uncertainty index in recent reports,4 focusing specifically on how it has diverged from its historical relationships with many asset prices. At the very least, we expect that sustained elevated policy uncertainty will place upward pressure on asset price volatility at the margin. Bottom Line: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Rate Volatility & Treasury Yields Long-dated nominal Treasury yields can be decomposed in a few different ways. In recent reports we have focused on the decomposition of the nominal 10-year Treasury yield into its real and inflation components. By identifying different macro drivers for each component we concluded that nominal Treasury yields will increase this year, driven by a rising inflation component and relatively stable real yields.5 Alternatively, we can think of the nominal 10-year Treasury yield as consisting of an expectations component equal to the market's expected path of short rates over the next ten years, and a term premium that reflects all of the other market imbalances and uncertainties associated with taking duration risk. This second approach is complicated by the fact that it requires a model of ex-ante interest rate expectations and every commonly used model is fraught with its own unique difficulties.6 Setting that aside, if we use the Kim & Wright (2005)7 estimate of the 10-year term premium we observe an expectations component that generally tracks the fed funds rate and a term premium component that is correlated with implied Treasury volatility (Chart 6), although the latter correlation is less than perfect. This decomposition also suggests that nominal Treasury yields should rise. The Fed is much more likely to hike rates than cut them and we have concluded that rate volatility is likely to trend higher from current depressed levels. However, the relationship between rate volatility and the term premium is complicated. The main reason for the complicated relationship between interest rate volatility and the term premium is the fact that elevated interest rate volatility also tends to be correlated with high equity volatility (Chart 7). So while higher rate volatility puts upward pressure on the term premium, the associated increase in equity volatility tends to raise investor risk aversion and increase the perceived value of bonds as a hedge against equity positions. This mitigates some (or often all) of the impact of rising rate volatility on the term premium. Chart 6Which Way For The ##br##Term Premium? Which Way For The Term Premium? Which Way For The Term Premium? Chart 7MOVE & VIX Have Opposing##br## Impacts On Bond Yields MOVE & VIX Have Opposing Impacts On Bond Yields MOVE & VIX Have Opposing Impacts On Bond Yields Bottom Line: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. Rate Volatility & MBS The relationship between rate volatility and MBS is much more straightforward than for Treasury yields. We observe a tight correlation between nominal MBS spreads and the MOVE implied volatility index (Chart 8). Chart 8 suggests that, even in the near-term, MBS spreads are too low for current levels of rate vol. The relationship between MBS spreads and rate volatility is easily explained. The defining characteristic of a negatively convex asset, such as MBS, is that its duration is positively correlated with the level of interest rates (Chart 9). This correlation leads to increased losses when yields rise and lower gains when yields fall. It's not surprising that negatively convex assets perform best in low volatility environments. Chart 8MBS Spreads Are Linked To Vol MBS Spreads Are Linked To Vol MBS Spreads Are Linked To Vol Chart 9MBS Duration Moves With Yields MBS Duration Moves With Yields MBS Duration Moves With Yields We maintain an underweight allocation to MBS given that spreads are already low and that the volatility environment is poised to become less favorable. Further, if the Fed continues along its planned normalization path it is likely to cease the reinvestment of its MBS portfolio at some point in 2018. There are two reasons why this poses a risk for MBS. The first reason is that the unwinding of the Fed's MBS portfolio is likely to place upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility is likely to increase. The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 10). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 11), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 10Annual MBS Excess Returns ##br## Vs. Net Supply Since 1989 The Road To Higher Vol Is Paved With Uncertainty The Road To Higher Vol Is Paved With Uncertainty Chart 11Net Issuance Will Turn##br## Positive In 2018 Net Issuance Will Turn Positive In 2018 Net Issuance Will Turn Positive In 2018 During the past three years the Fed has been buying between $20bn and $40bn MBS per month, just to keep its balance sheet stable. Net new MBS issuance will not be strong enough to overcome this hurdle in 2017, but net MBS issuance (adjusted for Fed purchases) will swing quickly into positive territory in 2018 if the Fed decides to let its MBS portfolio run down. Bottom Line: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "Volatility, Uncertainty And Government Bond Yields", dated May 13, 2014, available at usbs.bcaresearch.com 2 "Inflation and earnings uncertainty and volatility forecasts", Alexander David and Pietro Veronesi, Manuscript, Graduate School of Business, University of Chicago (2004). 3 Please see www.policyuncertainty.com for further details. 4 Please see Theme # 4 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Bond Volatility - The Unwelcome Guest That Will Not Leave", dated June 16, 2015, available at usbs.bcaresearch.com 7 Don H. Kim and Jonathan H. Wright, "An Arbitrage-Free Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates", FEDS 2005-33. https://www.federalreserve.gov/econresdata/feds/2005/index.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global competitiveness equalisation occurs: For Germany, at EUR/USD = 1.35 For the Euro area, at EUR/USD = 1.20 For Spain, at EUR/USD = 1.17 For France, at EUR/USD = 1.15 For Italy, at EUR/USD = 1.10 But today EUR/USD = 1.07. The main culprit for the over-competitive euro is the ECB. Feature President Trump is right about one thing. The ECB's own analysis - available at https://www.ecb.europa.eu/stats - shows that the trade-weighted euro needs to appreciate by 10% to cancel the euro area's competitive advantage versus its major trading partners including the United States. To cancel Germany's competitive advantage, the ECB calculates that the euro needs to appreciate by 25% (Chart I-1). Chart I-1ECB Analysis Supports President Trump: ##br##The Euro Is Over-Competitive ECB Analysis Supports President Trump: The Euro Is Over-Competitive ECB Analysis Supports President Trump: The Euro Is Over-Competitive Even more controversially, the central bank's own analysis shows that the ECB itself is to blame for the euro area's significant competitive advantage. Prior to the ECB's extreme and unprecedented policy easing, the euro area's competitiveness was exactly in line with its trading partners (Chart I-2). The ECB says that it does not target the exchange rate, but it is fully aware that negative interest rates and trillions of euros of asset purchases carry major ramifications for the euro's value. Chart I-2The ECB Caused The Over-Competitive Euro The ECB Caused The Over-Competitive Euro The ECB Caused The Over-Competitive Euro The ECB's Ultra-Looseness Is Counterproductive The ECB could be forgiven for its ultra-looseness if the euro area were on the edge of a deflationary abyss. But as we showed in Fake News In Europe1 euro area inflation and inflation expectations are little different to those in other major economies when compared on an apples for apples basis. Chart I-3Emergency Monetary Policy##br## Not Needed Emergency Monetary Policy Not Needed Emergency Monetary Policy Not Needed Furthermore, the euro area is among the world's top-performing major economies through the past three years (well before ECB easing started), and the percentage of the working age population in employment is at an all-time high. These are hardly the hallmarks of an imminent deflationary threat which warrants emergency monetary policy (Chart I-3). Perhaps the ECB's ultra-looseness is trying to quell a flare-up of ever-present political risk. If so, the strategy is becoming counterproductive. As well as irking President Trump, the extreme policy is riling Germany's Finance Minister, Wolfgang Schäuble, who has blamed Mario Draghi for "50 per cent" of the success of the populist right-wing Alternativ Für Deutschland. And by frustrating voters worried about the low interest rates on their hard-earned savings, the ECB is also playing right into the hands of Marine Le Pen's Front Nationale. Admittedly, the euro area's current economic 'mini-upswing' is likely approaching its end. But as we showed last week in Slowdown: How And When?,2 a deceleration is likely to be even more pronounced outside the euro area. Even the ECB acknowledges that "the risks surrounding the euro area growth outlook relate predominantly to global factors" rather than domestic factors. If the ECB is right, the extent of anticipated monetary tightening outside the euro area is overdone. If the ECB is wrong, then the extent of anticipated monetary tightening inside the euro area is underdone (Chart I-4 and Chart I-5). Either way, the investment conclusion is the same. Chart I-4Expected Divergence In Monetary Policy Drives##br## Relative Bond Market Performance... Expected Divergence In Monetary Policy Drives Relative Bond Market Performance... Expected Divergence In Monetary Policy Drives Relative Bond Market Performance... Chart I-5... And ##br##The Euro ... And The Euro ... And The Euro Stay underweight German bunds versus U.S. Treasuries. Stay long the euro, with our preferred crosses being euro/pound in the near term and euro/yuan in the long term. And given that euro/pound (inversely) drives relative stock market performance, stay underweight Eurostoxx600 versus FTSE100. The Great Currency Manipulation Manipulation: (noun) - the controlling or influencing of a situation cleverly. The creation of the euro in 1999 was arguably the greatest currency manipulation of modern times. To be absolutely clear, this is not a criticism, just a statement of fact. In 1999, when European policymakers killed national currencies such as the deutschemark, franc, lira and peseta and replaced them with the new-born euro, the action clearly fitted the dictionary definition of manipulation. Our preceding analysis about the euro area's competitive advantage today assumes that the euro started its life at the right value. The evidence suggests that this assumption is correct. In 1999, the euro area' external trade was in balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. Likewise the evidence suggests that national currencies such as the deutschemark, franc, lira and peseta converted to the euro at the right exchange rates. The euro area's constituent economies had much in common in 1999 and were broadly in balance with each other. Surprising as it now seems, in 1999 Germany and Italy scored identically on exports as a share of GDP (Chart I-6) and on total debt as a share of GDP (Chart I-7). And German wages had been rising in lockstep with productivity (Chart I-8). Chart I-6After The Euro, Germany's ##br##Exports Soared After The Euro, Germany's Exports Soared After The Euro, Germany's Exports Soared Chart I-7After The Euro,##br## Italy's Debt Soared After The Euro, Italy's Debt Soared After The Euro, Italy's Debt Soared Chart I-8After The Euro, German Wages##br## Lagged Productivity After The Euro, German Wages Lagged Productivity After The Euro, German Wages Lagged Productivity It was only in the decade after 1999 that the euro area developed its major internal imbalances. Germany depressed its wages relative to productivity and used the resulting ultra-competitiveness to build an export-driven business model. In the seven years before 1999, net exports had made zero contribution to Germany's economic growth (Chart I-9), but in the seven years after 1999, net exports accounted for all of Germany's economic growth (Chart I-10). Chart I-9Germany Pre Euro: Net Exports ##br##Contributed Nothing To Growth Germany Pre Euro: Net Exports Contributed Nothing To Growth Germany Pre Euro: Net Exports Contributed Nothing To Growth Chart I-10Germany Post Euro: Net Exports Contributed ##br##Everything To Growth Germany Post Euro: Net Exports Contributed Everything To Growth Germany Post Euro: Net Exports Contributed Everything To Growth Prior to the one-size-fits-all exchange rate, a rising deutschemark would have largely snuffed out the increased competitiveness from wage depression and thereby thwarted the export-driven business model. However, once locked in the euro, Germany's exchange rate could no longer rise sufficiently to choke off external demand. Meanwhile, Italy and Spain could suddenly rely on a debt-driven business model - especially given that their strong national cultures of homeownership provided the perfect collateral for borrowing. Prior to the one-size-fits-all interest rate, higher domestic interest rates would have thwarted this business model. But once locked in the monetary union, their interest rates could no longer rise sufficiently to choke off borrowing. By 2010, the imbalances had become monsters. Germany, through its wage depression, had become 20% over-competitive versus its major trading partners. Spain and Italy, through their reliance on debt-fuelled growth, had become 20% under-competitive. Understand that this is not a morality tale of good versus bad, as many commentators portray. The mirror-image imbalances were just the opposite sides of the same (euro) coin. Spain Is The Star-Performer Today, the good news is that the euro area's internal imbalances have narrowed sharply, as the under-competitive economies have taken draconian corrective measures. External competitiveness has also been boosted by a substantially weaker euro. The bad news is that Germany's over-competitiveness versus the world remains excessive. But as Wolfgang Schäuble correctly argues, it is extremely difficult for Germany to rebalance its global competitiveness when it is swimming against the tide of the ECB's extreme easing and resulting depression of the euro. The award for the most spectacular rebalancing goes to Spain. Eight years ago, Spain was 15% less competitive than France on the ECB's harmonised competitiveness indicator based on unit labour costs. Today, on the same measure Spain is 2% more competitive than France. This makes it very difficult to justify any yield premium on Spanish Bonos versus French OATs. The yield premium is a compensation for perceived redenomination risk. The expected annual loss of owning a Bono versus an OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. But if Spain is now as competitive as France, a new peseta ultimately should be as valuable as a new franc. The second item of the multiplication would be zero (Chart I-11). So irrespective of the probability of euro breakup, the yield premium should also be zero. Yet today, Spanish 10-year Bonos are still trading at a substantial 65 bps yield premium over French 10-year OATs (Chart I-12). Chart I-11Spain Is As Competitive ##br##As France... Spain Is As Competitive As France... Spain Is As Competitive As France... Chart I-12... Bonos Should Not Have A ##br##Yield Premium Over OATs ... Bonos Should Not Have A Yield Premium Over OATs ... Bonos Should Not Have A Yield Premium Over OATs Stay long Spanish Bonos versus French OATs. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 and available at eis.bcaresearch.com 2 Published on February 2, 2017 and available at eis.bcaresearch.com Fractal Trading Model* A tactically short position in equities is warranted. 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-13 Short MSCI AC World Short MSCI AC World * 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

Highlights In this report, we outline our tactical, cyclical and long term views on French government bonds, linked to France's political situation, cyclical dynamics, and structural outlook. Tactical View: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds. Cyclical View: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Secular View: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Feature Chart 1Fade The France Spread Widening Fade The France Spread Widening Fade The France Spread Widening After the stunning political victories in the U.K. and U.S. last year, there has been considerable speculation as to which country will fall next to the "populist wave." With a major political party aiming to take the country out of the Euro Area, France has naturally popped up on investors' radar screens. While it is easy to draw a parallel from Brexit to Trump to a possible "Frexit", the political and economic realities in France are very different from those in the U.K. and U.S. The upcoming presidential election will not provide a similar surprise, but could impact the economy's long trajectory. Meanwhile, this economy should beat expectations in the next twelve months. In this Special Report, we lay out our views on France from a political, cyclical and structural perspective and introduce two French bond trade ideas to benefit in the short and medium term. Tactical View: No Political Shocker Ahead In the short term (3-6 months), the domestic political landscape will dictate a large part of France's bond market price action leading up to the two-round French presidential election in April and May. Lately, political uncertainty surrounding the election has had a clear negative impact on French government bond yields (Chart 1). The spread between the benchmark 10-year French OAT and German Bund has widened 46bps off of the 2016 lows and is now close to levels seen during the Global Financial Crisis in 2008-9. The spread is still well below the wides seen during the European debt crisis in 2011-12, when markets were pricing in a serious Eurozone break-up risk. The current more moderate level seems reasonable to us, as a significantly wider spread to compensate for the political risk of a potential "Frexit" is not required, given the long odds of a Trump/Brexit-like upset victory. Last week, our colleagues at the BCA Geopolitical Strategy and Foreign Exchange Strategy services published a joint Special Report updating their view on the election, and concluded that Le Pen's odds of victory now stand at 15%.1 Either Francois Fillon (who is currently embroiled in a corruption scandal) or Emanuel Macron will win the French presidency, both of whom are running on structural reform platforms that should be market friendly. Moreover, Marine Le Pen has only a long-shot possibility to win the French presidential election, for several reasons:2 Assuming Le Pen becomes one of the final two candidates in the run-off election after the first round of voting in April, her probability of winning is low, as she continues to trail her centrist opponents by a massive 20% in the polls. That lead would have to fall to 3-5%, within the margin of error of the polling data, before investors would have to worry seriously about a Le Pen victory. Le Pen's personal approval rating peaked in 2012 (Chart 2). It fell despite the European refugee crisis, multiple terrorist attacks in France, and sluggish economic growth over the past two years, all of which should have helped boost her popularity. The problem for Le Pen is that 70% of the French support the euro (bottom panel), and she is running on an explicit campaign promise to try and pull France out of the euro if she wins the presidency. Leaving the euro area would mean a redenomination cost for Baby Boomer retirees, higher interest rates, higher inflation, and a likely economic recession. Judging by the high level of support for the euro, we suspect that the French population understands these risks. Given BCA's relatively sanguine view of the true political risks of the French election, the recent spread widening represents a tactical trade opportunity to go the other way and position for French outperformance. A Le Pen defeat will cause French policy uncertainty to recede and French bond yields will converge back to German levels. Vanishing uncertainty and lower bond yields will further fuel the current economic recovery, as explained in the next section. Bottom Line: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds on a tactical basis (a trade we are adding to our Overlay Trades list on Page 20). Cyclical View: An Outperforming Economy Over the medium-term (6 to 12 months), the cyclical dynamics of French growth and inflation, as well as potential shifts in Euro Area monetary policy, will drive the evolution of French bond yields. On this basis, there is room for French yields to rise in absolute terms. Current pricing in the French forward curve has the 10-year government bond yield reaching 1.40% by the end of 2017, up 26bps from the current level. That yield target will be easily exceeded based on the budding upturns in French economic growth and inflation. A low growth hurdle to overcome The Bloomberg survey of economists currently pencils in a French GDP growth forecast of 1.3% in 2017, almost unchanged from 1.2% in 2016. That figure should be surpassed, in our view. The current situation component of the French ZEW economic sentiment survey has spiked recently but still sits far from previous peaks (Chart 3). As this unfinished economic cycle progresses, growth will drift inevitably higher. Chart 2Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Chart 3An Un-finished Cycle An Un-finished Cycle An Un-finished Cycle More specifically, the business sector could positively surprise in 2017. Business sentiment and industrial production already started to hook upward toward the end of 2016, and the December surge in the French Manufacturing PMI signals that the economy is accelerating. Even the previously lagging French service sector PMI has now caught up to the Euro Area average (Chart 4). This upturn looks very well supported. Firms' order books have been replenished, and corporations are now in a position to hike prices, indicating that pricing power has returned (Chart 5). This is a crucial development, it will allow for further increases in corporate profit margins, and, in turn, give them some leeway to lift wages, hire more workers and/or invest anew. Chart 4A Solid Economic Upturn A Solid Economic Upturn A Solid Economic Upturn Chart 5Improving Business Sector Outlook Improving Business Sector Outlook Improving Business Sector Outlook Moreover, business cycle dynamics should then boost consumption. An improving labor market has already translated into confidence-building momentum among households. Consumers' disposable income growth has risen steadily, while households' intentions to make important purchases have reached levels not seen since before the Global Financial Crisis (Chart 6). Also, labor slack is diminishing in France, with the number of job seekers falling for the first time in a decade (bottom panel). If French households remain upbeat, the broader economy should do well. Historically, the INSEE survey of households' assessment of the future economic situation has been closely linked to GDP growth. Advancing that series by three months clearly shows that France's growth is set to accelerate. Using a simple regression, growth could reach a 1.7% year-over-year pace in the first half of 2017 (Chart 7). Chart 6Better Fundamentals For French Consumers Better Fundamentals For French Consumers Better Fundamentals For French Consumers Chart 7GDP Will Beat Expectations GDP Will Beat Expectations GDP Will Beat Expectations One note of caution on this optimistic French economic outlook comes from capital spending. The elevated political uncertainties from the upcoming election, as well as the potential U.K.-E.U. Brexit negotiations, have left French firms less inclined to expand business through increased investments. However, robust activity in the housing market should support overall gross fixed capital formation, as housing permits sprang to life in 2016 (Chart 8). To ensure that this economic expansion gains momentum, ample credit growth will be paramount. This could be a potential headwind, as France's non-financial private sector credit has reached high levels, especially compared to its European peers (Chart 9). These excesses could act as a speed limit on the overall economy, at some point. Chart 8Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Chart 9Private Non-Financial Leverage: High Private Non-Financial Leverage: High Private Non-Financial Leverage: High However, in the current cycle, this doesn't seem to be the case. Both money and loan growth are accelerating after several years of weakness (Chart 10, top panel). The ECB's Bank Lending Survey, which shows slowly increasing demand for credit (middle panel) and no tightening of lending standards (bottom panel) will help fuel this trend.3 The central bank's loose overall monetary stance will keep this positive credit impulse alive over the course of the year, while also helping exports by keeping the Euro weak. Finally, on the fiscal side, the IMF projects France's cyclically-adjusted primary budget balance to go from -0.6% of potential GDP in 2016 to -0.7% in 2017, representing a fiscal thrust of +0.1% (Chart 11). This modest number will obviously not supercharge the current cycle, but does represent a big change from the years of austerity since the last recession. Chart 10A Positive Credit Impulse A Positive Credit Impulse A Positive Credit Impulse Chart 11No More Austerity No More Austerity No More Austerity Building inflationary pressure The Bloomberg consensus forecast calls for French consumer price inflation to reach 1.2% in 2017, a modest advance from the current rate of 0.7%. That level should be reached, and likely surpassed, as most inflation measures have already entered an expansionary phase (Chart 12). That trend should persist in 2017 for several reasons: First, French unemployment will soon fall below the non-accelerating inflation rate of unemployment (NAIRU), which typically results in a rise in French underlying CPI inflation soon afterward (Chart 13). Chart 12Inflation Moving Higher Inflation Moving Higher Inflation Moving Higher Chart 13France Is Close To Full Employment France Is Close To Full Employment France Is Close To Full Employment Second, current French inflation appears about half a percentage point too low relative to the unemployment rate, based on the Phillips curve relationship since 2000 (Chart 14). Chart 14Inflation Should Be Higher Our Views On French Government Bonds Our Views On French Government Bonds Third, our French CPI diffusion index is well off the cyclical lows and points towards higher underlying inflation in the months ahead (Chart 15).4 In sum, French inflation will follow, and likely exceed, the current consensus expectation of 1.2%. This is important to appreciate, as inflation was a more important driver of higher nominal bond yields, relative to the real yield component, last year (Chart 15, bottom two panels). There is more to come in 2017. How to position for this view? In terms of valuation, French government bonds still appear quite expensive. Our bond valuation indicator shows that yields remain well below fair value, even after the recent backup (Chart 16). Combine this with our optimistic view on French growth and inflation, and investors should move to reduce duration within the French component of hedged global bond portfolios. Today, we open a new position in our model fixed income portfolio: reducing the exposure in the longest duration (+10 years) bucket in France, and placing the proceeds in the 1-3 year France bucket. This combination will lower our overall French duration exposure by one full year. If yields finish the year higher than currently priced on the forward curve, as we expect, this position will contribute positively to the excess return versus our benchmark. Bottom Line: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher this year. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Chart 15Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Chart 16French Bonds: Still Expensive French Bonds: Still Expensive French Bonds: Still Expensive Secular View: A Structural Ceiling On French Yields In the very long run (5 to 10 years), structural considerations are needed to forecast bond yields. Ten years ago, the French forward yield curve was implicitly forecasting that the 10-year French bond yield would be close to 4% today. Currently standing at 1.13%, the market missed the mark by 287bps! The forwards are now priced for the 10-year bond yield to reach 2.84% in ten years, possibly making the same mistake of over-estimating future bond yields. To gauge a fair value of the 10-year bond yield, using nominal potential GDP growth has proved to be useful in the past. From 2004 to 2014, and before the deflationary shock experienced since, France's 10-year bond yield was indeed trading very close to growth in French nominal potential GDP (Chart 17, shaded portion). Chart 17Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields As inflation will most likely return to more "normal" levels in the next few years, the relationship between the two should be reestablished soon. If so, the current 2.84% level on the 10-year French government bond yield, 10-years forward should translate to a nominal potential growth rate of around 2.8% in ten years' time (Chart 17). This outcome would represent an 80bp increase in the rate of trend French nominal potential growth from current levels, which could be difficult to achieve, in our view. Lots of work to do... Most likely, France's nominal potential growth will only slowly grind lower. Faster potential growth could be achieved either through increasing demographic growth or improving productivity. Unfortunately, neither outcome appears imminent. Since the French working age population is already expanding at a very slow pace, and is projected to decelerate in the years ahead, productivity increases are the only candidate to improve potential growth. On that front, a lot needs to be done; many structural weaknesses in the French economy have to be addressed. For years, France has been plagued by weak productivity, which has constrained growth. Compared to its European peers, inefficient use of available capital has led to a loss of competitiveness through higher unit labor costs. Clearly, France needs to improve workers' skills to lift total factor productivity growth (Chart 18). This will become increasingly difficult as France now faces - more than ever - difficulty attracting and retaining talent due to the recent turmoil that has hit the country such as the terrible rise in terrorist attacks. At the source, the poor productivity performance in France is grounded in the overly protective employment system. Like other European countries, high employment costs have led to misallocation of capital, potentially affecting the optimal capital labor input mix and total factor productivity.5 Indeed, friction in the labor market is often cited as the source of the problem. We tend to agree. French workers work too few hours, even fewer than in the Peripheral European economies. As the divide between the unemployment rate of persons under and over 25 years old gets larger, resolving the growing generational disparities has become paramount. Plus, upward mobility opportunities are scant - not everyone gets an equal chance to rise in status in French society (Chart 19). Chart 18Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Chart 19Friction In The Labor Market Friction In The Labor Market Friction In The Labor Market Recent reforms have the potential to fix some problems. The Pacte de Responsabilité et Solidarité (PRS) and the Crédit d'impôt compétitivité emploi (CICE) should help reduce unit labor costs through a reduced labor tax wedge.6 The Macron Law could raise real GDP growth by 0.3 percent per year through 2020, according to the OECD. However, the effectiveness might be fleeting in some other cases. For example, studies by the IMF suggest that the El Khomri Law - aimed at making the labor market more flexible - might have little impact on overall French unemployment, potentially reducing it by only 0.14 percentage points.7 Meanwhile, France's enormous public sector continues to crowd out the private sector. At 54% of GDP, government expenditures are simply too big, forcing the government to tax profits at a whopping 63% rate. This leaves little space for national savings - which now sit at a lowly 21.4% of GDP - to increase (Chart 20). Additionally, France ranks 115th out 136 countries in the Global Competitiveness Report in terms of the burden of government regulation, which further constrains productivity-enhancing investments.8 In sum, boosting potential GDP growth will remain an uphill battle. Everyone agrees that reforms are necessary. But will they happen? ...and France still has a tough crowd to win over It is not impossible that the next president will have a serious structural reform agenda. For example, the most reformist presidential contender, Francois Fillon, has made these proposals in his campaign platform: Abandon the national limit on weekly hours worked and leave that decision to individual companies; Decrease corporate taxation; Allow companies to fire employees when undergoing structural/managerial changes; Extend the retirement age; Cut public spending; Reduce the size of the state by cutting government employees. From a structural perspective, these measures would surely be promising for the future, and would lift French potential GDP growth over time. However, in the populist world we live in, we are skeptical that the electorate will give him an unambiguous mandate of this sort. That kind of mandate usually comes after a crisis, not before. More pain might be needed. Chart 20France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector Chart 21"Silent Majority" Wants Reform Our Views On French Government Bonds Our Views On French Government Bonds Moreover, reforming France has always proved very challenging. As such, will Mr. Fillon (or Mr. Macron) really be able to comply with his campaign promises, if elected? Winning a majority at the parliamentary election would be a necessary precondition. Although every President has been given a parliamentary majority since 2002, the elections have not happened yet. Confronting the unions on these measures will prove difficult for the next French president. The latest labor market reform push unveiled last year was met with massive resistance. Surely, deregulation that makes it easier to fire workers will inevitably dissatisfy insiders that benefit from high barriers to entry for new employees. This obstacle will be difficult to remove. In any case, it has always been puzzling why things have to be this way in France. According to economists Yann Algan and Pierre Cahuc, one possible response might lie in the French tendency to distrust their fellow citizen. Their theory, introduced more than ten years ago, posits the following: ...the French people's lack of trust gets in the way of their ability to cooperate, which brings the State to regulate work relations in minute detail. By emptying social dialogue of its content, these interventions prevent the adoption of favorable reforms to improve the function of the job market. Distrust even induces a fear of competition, leading to the set-up of regulatory barriers-to-entry, that create rent-seeking which favors corruption and mutual distrust. The French social model fosters a truly vicious circle. Corporatism and state intervention undermine the mechanisms of solidarity, destroy social dialogue and reinforce mutual distrust - that which in turn feeds categorical demands and the constant call for regulation, and thereby favors the expansion of corporatism and state intervention.9 Of course, their angle on things could sound somewhat extreme. But it might also explain why the issues discussed ten or twenty years ago concerning France's predicament remain mostly the same today. There might be something else besides pure rational thinking at play behind the French citizenry's propensity to stiff-arm reforms. Nonetheless, if these authors are correct, true changes will continue to be hard to come by in France. Meaning this invisible hand of distrust will continue to lead potential GDP growth lower, and, as history dictates, will represent a ceiling on how high long-term French bond yields can ever rise. That said, maybe our view could prove to be too backward looking. The new report co-written by our Geopolitical Strategy and Foreign Exchange Strategy teams takes a more optimistic view on the chances of French economic reform. They argue that France's recent economic underperformance will motivate its citizens to demand real action from their politicians, as occurred in Australia during the mid-1980s and 1990s and Germany in the 2000s - episodes of real structural reform occurring without any dramatic crisis to prompt them. A desire to compete with Germany economically, combined with government spending excesses and protest fatigue, could be leading France to elect a pro-reform government. As the French polling data shows, there is a "silent majority" in France that would favor supply side reforms (Chart 21). Plus, even those that traditionally favor the status quo, like "blue collar" and "left leaning" employees, are opposing reforms by extremely narrow margins. Undoubtedly, our colleagues raise very good points. As such, we will be watchful to see if reforms gain a greater chance of meaningfully transforming France in the next few years. The onus will be on the reformers to change the system. Bottom Line: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/Foreign Exchange Strategy Special Report, "The French Revolution", dated February 3, 2017, available at gps.bcaresearch.com and fes.bcaresearch.com 2 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?", dated November 16, 2016, available at gps.bcaresearch.com 3 https://www.ecb.europa.eu/stats/pdf/blssurvey_201701.pdf?6c44eff3bac4b858969b9cb71bd4a8fa 4 The diffusion index is the percentage of sectors within the French Consumer Price Index that are growing faster than their 24-month moving average. This indicator leads underlying inflation by 10 months. 5 For further details on this idea, please see "Employment Protection Legislation, Capital Investment and Access to Credit: Evidence from Italy", available at https://ideas.repec.org/p/sef/csefwp/337.html 6 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44080.0 7 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44081. 8 http://www3.weforum.org/docs GCR2016-2017/05FullReport TheGlobalCompetitivenessReport2016-2017_FINAL.pdf 9 http://voxeu.org/article/france-price-suspicion and more on these authors theory on the impact of trust on economic development can be found here: http://econ.sciences-po.fr/sites/default/files/file/yann%20algan/HB_FinalVersion1.pdf The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Our Views On French Government Bonds Our Views On French Government Bonds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Strong Growth & An Easy Fed Strong Growth & An Easy Fed Strong Growth & An Easy Fed More than a month has passed since the Fed's latest rate hike and, at least so far, the economy is displaying no ill effects. While the economic data continue to surprise to the upside, Fed rate hike expectations have moderated since mid-December (Chart 1). The combination of accelerating growth and accommodative monetary policy sets the stage for further outperformance in spread product. This message was underscored by last Friday's employment report which showed robust payroll gains of +227k alongside a slight deceleration in wage growth. This is consistent with an environment where growth remains above trend but the recovery in inflation proceeds more gradually. Against this back-drop we favor overweight positions in spread product and TIPS relative to nominal Treasuries, while also positioning for a bear-steepening of the Treasury curve. While we would not rule out a near-term correction in risk assets, due to extended positioning and elevated policy uncertainty, we would view any correction as a buying opportunity given the supportive growth and monetary policy back-drop. 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 5 basis points in January (Chart 2). The index option-adjusted spread tightened 2 bps on the month and, at 121 bps, it remains well below its historical average (134 bps). In a recent report1 we examined historical excess returns to corporate bonds given different levels of core PCE inflation. We found that excess returns are best when year-over-year core PCE is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with extremely accommodative monetary policy. When inflation is between 1.5% and 2% (year-over-year core PCE is currently 1.7%), average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. Excess returns do not turn decisively negative until core PCE is above 2%. Given the Fed's desire to nurture a continued recovery in inflation, we expect corporate bond excess returns to be low, but positive. The Technology sector is relatively defensive and is close to neutrally valued according to our model (Table 3). In addition, our Geopolitical Strategy service has observed that many of the firms in this sector carry significant exposure to China, a risk as U.S. protectionism ramps up.2 We therefore downgrade our position in Technology from overweight to neutral, and upgrade our positions in Wirelines, Media & Entertainment and Other Utilities from underweight to neutral. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Cue The Reflation Trade Cue The Reflation Trade Table 3BCorporate Sector Risk Vs. Reward* Cue The Reflation Trade Cue The Reflation Trade High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 124 basis points in January. The index option-adjusted spread tightened 21 bps on the month and, at 376 bps, it is currently 144 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default outlook, last week we upgraded high-yield from underweight to neutral. Still-tight valuation is the reason we maintain a neutral allocation as opposed to overweight. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is currently 152 bps (Chart 3). This is close to one standard deviation below its long-run average. Historically, we have found that a default-adjusted spread between 150 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of -164 bps. With the spread in this range a 90% confidence interval places 12-month excess returns between -500 bps and +171 bps. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 24 basis points in January. The conventional 30-year MBS yield rose 5 bps in January, driven by a 7 bps widening of the option-adjusted spread. The rate component of the yield held flat, while the compensation for prepayment risk (option cost) declined by 2 bps. MBS spreads remain extremely tight, relative both to history and Aaa-rated credit. Historically, the option-adjusted spread is correlated with net MBS issuance and robust issuance will eventually lead this spread wider. At least so far, net MBS issuance shows no sign of slowing down. While refinancing applications declined alongside the recent spike in Treasury yields, purchase applications have remained resilient (Chart 4). The Fed ceasing the reinvestment of its MBS portfolio would also significantly add to MBS supply. As we explained in a recent report,4 we expect the Fed will not start to wind down its balance sheet until 2018. However, if growth is stronger than we expect there is a chance the process could begin near the end of this year. In that same report we also observed that nominal MBS spreads are very low relative to both the slope of the yield curve and implied rate volatility. This poses a risk to MBS in the near-term. Government-Related: Cut To Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 21 basis points in January. Sovereign bonds outperformed by 75 bps, while Foreign and Domestic Agency bonds outperformed by 6 bps and 14 bps, respectively. Local Authorities outperformed by 34 bps and Supranationals outperformed by 2 bps. This week we downgrade the government-related sector from overweight to underweight, although we recommend maintaining an overweight allocation to both the Foreign Agency and Local Authority sectors. Sovereigns are not attractive compared to corporate credit, according to our model, and will struggle to outperform if the dollar remains in a bull market, as we expect it will. A stronger dollar increases the cost of debt servicing from the perspective on non-U.S. issuers. Foreign Agencies and Local Authorities both appear attractive relative to corporate credit, after adjusting for differences in credit rating and duration. Foreign Agencies in particular will perform well if oil prices continue to trend higher. Supranationals offer very little spread, and are best thought of as a hedge in spread widening environments. Domestic Agency debt can also be thought of in this vein, but with the added risk that spreads start to widen if any progress is made toward GSE reform. While any concrete movement on GSE reform is still a long way off, the new administration has brought the topic back into the headlines and this has led to some increased volatility in Domestic Agency spreads in recent weeks (Chart 5). Municipal Bonds: Upgrade To Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 40 basis points in January (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 2% in January and currently sits just below its post-crisis average. Even though net state & local government borrowing edged higher in Q4, issuance has rolled over in recent weeks and fund flows have sharply reversed course (Chart 6). As a result, our tactical yield ratio model - based on issuance, fund flows and ratings migration - shows that yield ratios are very close to fair value. Although the average M/T ratio still appears expensive if we include the global economic policy uncertainty index as an additional explanatory variable.5 While we remain cautious on the long-term prospects for state & local government health, we expect that improving trends in fund flows and issuance will support yield ratios for the next several months. Eventually we expect that increased state & local government investment will lead to higher issuance, but this will take some time to play out. In the meantime it will be crucial to monitor the federal government's progress on tax reform, particularly if there appears to be any appetite for removing municipal bonds' tax exempt status. Our sense is that the tax exemption will remain in place due to the administration's stated preference for increased infrastructure spending. But that outcome is highly uncertain. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview After a volatile end to last year, the Treasury curve was relatively unchanged in January. The 2/10 slope steepened by 1 basis point on the month and the 5/30 slope steepened by 2 bps. In previous reports we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen this year. This steepening will be driven by a continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. However, as we posited in a recent report,6 it could take until the end of this year before TIPS breakevens return to pre-crisis levels and core inflation returns to the Fed's target. To position for a steeper Treasury curve, we recommend that investors favor the 5-year bullet versus a duration-equivalent 2/10 barbell. Not only will the bullet outperform the barbell as the curve steepens, but the 5-year bullet is currently very cheap relative to the 2/10 slope (Chart 7). This trade has so far returned +29 bps since initiation on December 20. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 58 basis points in January. The 10-year TIPS breakeven inflation rate increased 10 bps on the month and, at 2.05%, it remains well below its pre-crisis range of 2.4% to 2.5%. The Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly adopt a more dovish policy stance if breakevens fall. This "Fed put" is a key reason why we remain overweight TIPS relative to nominal Treasuries, although we expect the uptrend in breakevens will moderate during the next few months. As we detailed in a recent report,7 while accelerating wage growth will ensure that inflation remains in an uptrend, the impact from wages will be mitigated by deflating import prices. Diffusion indexes for both PCE and CPI have also rolled over recently, suggesting that inflation readings will soften during the next couple of months. The anchor from slowly rising inflation will prevent TIPS breakevens from increasing too quickly, and breakevens are also too high compared to the reading from our TIPS Financial model - based on the dollar, oil prices and the stock-to-bond total return ratio (Chart 8). At the moment, only pipeline measures of inflationary pressure such as the ISM prices paid index (panel 4) suggest that breakevens will move rapidly higher in the near term. Remain overweight TIPS but expect the uptrend in breakevens to moderate in the months ahead. ABS: Maximum Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in January. Aaa-rated issues outperformed by 5 bps while non-Aaa issues outperformed by 17 bps. Credit card issues outperformed by 8 bps and auto loans outperformed by 5 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. At 51 bps, the spread remains well below its average pre-crisis level. As was noted in the Appendix to our year-end Special Report,8 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except Baa-rated corporates and Caa-rated high-yield in 2016. With ABS spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. The spread on Aaa-rated credit card ABS tightened 4 bps in January, and now sits at 49 bps. Meanwhile, the spread on Aaa-rated auto loan ABS tightened 1 bp on the month, and now sits at 54 bps. In early November we recommended favoring Aaa-rated credit cards relative to Aaa-rated auto loans. Collateral credit quality between credit cards and auto loans is clearly diverging in favor of credit cards (Chart 9, bottom panel), and in early November, our measure of the volatility adjusted breakeven spread (days-to-breakeven) was displaying no discernible valuation advantage in autos. Since November, however, autos have started to look more attractive (Chart 9, panel 3). If auto loan spreads continue to widen relative to credit cards we may soon shift back into autos. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month, and is now close to one standard deviation below its pre-crisis mean (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 22 basis points in January. The index option-adjusted spread for Agency CMBS tightened 4 bps on the month, and currently sits at 51 bps. The spread offered from Agency CMBS is similar to what is offered by Aaa-rated consumer ABS (52 bps) and greater than what is offered by conventional 30-year MBS (30 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.44% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.08%. The lower fair value is the result of a large spike in the uncertainty index in November that has yet to unwind (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. It is for this reason that we recently moved back to a below-benchmark duration stance.9 For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.44%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2016, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", dated January 18, 2016, available at gps.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 5 For further details on the model please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes for 2017", dated December 20, 2016, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 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 Duration: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth, which is supported by accelerating corporate profits. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Country Allocation: Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporates: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Feature Optimism reigns supreme in the markets at the moment, particularly in the U.S. where bullish investors traded in their "Make America Great Again" hats for "Dow 20,000" ballcaps last week. The string of better-than-expected economic data across the world is continuing - a fact confirmed by the latest corporate profit releases showing that an earnings recovery was already underway before Donald Trump's election victory. We have been looking for a meaningful pullback in government bond yields, and a widening of credit spreads, before returning to a below-benchmark portfolio duration stance and raising corporate allocations. That opportunity may not come to pass as economic data remains solid and leading indicators are accelerating. With no major inflation hiccups likely in the near-term to force the major central banks to rapidly shift to a more hawkish stance, and with equity markets remaining supported by accelerating earnings growth, the current "sweet spot" for risk can continue. Return expectations must be tempered, though, as much of the recent growth improvements is already reflected in bond and equity valuations. Any sign that the optimism shown in confidence surveys is not translating into improving hard economic data could trigger an equity market correction and a risk-off move to lower government bond yields and wider credit spreads. Given our view that global growth will be faster than consensus expectations in 2017, however, we think that a pro-risk overshoot phase is more likely than a risk-off correction in the near term. Any upset in equity markets would represent a medium-term opportunity to increase credit risk and reduce duration. This week, we are adapting a more pro-growth, pro-risk stance in our recommended portfolio allocations this week, making the following changes: Reduce overall portfolio duration to below-benchmark Reduce U.S. Treasury exposure to below-benchmark (2 of 5) Upgrade U.S. Investment Grade corporate exposure to above-benchmark (4 of 5) Upgrade U.S. High-Yield corporate exposure to neutral (3 of 5), favoring B- & Ba-rated names Importantly, we are maintaining our current allocations to Euro Area corporates (above-benchmark) and Emerging Market sovereign and corporate debt (neutral for both), given that we see more potential for upside surprises in the U.S. economy relative to the rest of the world. Duration: Re-Establish A Cyclical Below-Benchmark Stance We moved to a neutral stance on our overall duration recommendation back on December 6th, which we viewed as a tactical profit-taking exercise on our previous successful bearish bond call dating back to last July.1 Our view at the time was that global bonds were still in a cyclical bear phase, led by rising inflation expectations and better economic growth prospects in the developed world (especially in the U.S.). Given the extreme bearish positioning in government bond markets, at a time of oversold momentum, our stated plan of attack was to look to move back to a below-benchmark stance after a meaningful pullback in yields. The likely trigger for that move was expected to be some disappointment on actual economic data, especially given the heightened growth expectations in the U.S. after Trump's electoral victory. Global economic data continues to trend in a positive direction, however, which is preventing any pullback in bond yields despite a deeply oversold market (Chart of the Week). The Citigroup Data Surprise index for the major developed economies is at the highest levels since early 2014. The Global ZEW indicator, one of our favorites, is at the highest level since mid-2015. The global leading economic indicator from the OECD is back to levels last seen in 2013, suggesting that the positive growth momentum can continue to put upward pressure on real bond yields. There are few signs of disappointment at the country level, with the Purchasing Managers Indices for all major developed markets, as well as for China, all pointing to expanding global activity (Chart 2). Chart of the WeekYields Supported By Faster Growth Yields Supported By Faster Growth Yields Supported By Faster Growth Chart 2A Broad Based Upturn A Broad Based Upturn A Broad Based Upturn It will be interesting to see if this uptrend can withstand the "bull in the China shop" approach of the new Trump administration with regards to U.S. trade policy. Already, in just the first week of his presidency, Trump has aggressively pushed to implement much of his protectionist campaign promises, like pulling out of the Trans-Pacific Partnership, pushing to renegotiate the North American Free Trade Agreement and threatening the imposition of tariffs or border taxes in an effort to reduce the U.S. trade deficit. Global confidence surveys will be critical to monitor in the next month or two for any sign that Trump uncertainty is having a detrimental effect on business optimism outside the U.S. Importantly, the starting point is strong, with both consumer and business confidence measures in Europe and China rising steadily, as are net earnings revisions for global equities (Chart 3). A combination of improving economic sentiment, confirmed by stronger corporate profits, may be enough for the global economy to withstand the shifting plate tectonics of U.S. economic policy. In the U.S. itself, the GDP report released last week showed that 2016 ended on a soft note, with annualized growth of only 1.9% in the 4th quarter. However, a sector-by-sector forecast for U.S. GDP presented last month by our colleagues at BCA U.S. Bond Strategy shows that there is upside risk for most major elements of the U.S. economy (Chart 4).2 Rising consumer confidence amid a tight labor market should help boost consumption, while the large drag from inventory destocking seen last year will not be repeated in 2017. Chart 3An Improving Corporate Profit Backdrop An Improving Corporate Profit Backdrop An Improving Corporate Profit Backdrop Chart 4Upside Risks For U.S. Growth Upside Risks For U.S. Growth Upside Risks For U.S. Growth The wild cards for U.S. growth will come from all the sectors most impacted by potential policies from the Trump administration: business investment, government spending and net exports. Trump has been going full steam ahead with his protectionist leanings in his initial days in office, but how much he can quickly implement remains to be seen. For now, the U.S. dollar is not rising rapidly enough to generate much of a drag on U.S. GDP growth, unlike the 2014/15 surge in the greenback (see the bottom panel of Chart 4). More importantly, the improving trend in U.S. corporate profit growth and post-election surge in business confidence should support faster growth in U.S. capital spending, which is already showing signs of perking up a bit (Chart 5). As we discussed in a Weekly Report earlier this month, the bigger upside surprise for the U.S. economy this year will come from capital spending, not government spending, as Trump will have a much easier time passing pro-growth corporate tax cuts than getting his infrastructure spending program green-lighted quickly through the U.S. Congress.3 U.S. growth will be much faster than the Fed's current forecast of 2.1%, which will embolden the Fed to deliver on additional rate hikes later this year. The Fed will likely want to see some sign of clarity on the fiscal policy outlook before contemplating the next rate hike, and we are not expecting a rapid acceleration of U.S. inflation in the next few months that would force to Fed to act more quickly. The next rate hike will come at the June FOMC meeting, with the Fed delivering at least the 50bps of rate hikes by year-end currently discounted in the market, and possibly the full 75bps of hikes shown in the latest FOMC projections if the economy delivers faster growth in 2017, as we expect. When looking at the other major bond yields in the "Big-4" developed markets, all elements of valuation have repriced higher (Chart 6): Chart 5U.S. Corporate Profits & Confidence Are Stronger, Capex Is Next U.S. Corporate Profits & Confidence Are Stronger, Capex Is Next U.S. Corporate Profits & Confidence Are Stronger, Capex Is Next Chart 6All Yield Components Are Rising All Yield Components Are Rising All Yield Components Are Rising Central bank policy rate expectations have shifted away from cuts in the Euro Area, Japan and the U.K., with a small hike from the Bank of England now discounted in the U.K. Overnight Index Swap (OIS) curve; Term premiums have risen from the mid-2016 lows, but remain negative in the countries where central banks are still actively engaging in asset purchase programs; Inflation expectations are well off the 2016 lows in all markets, but with higher levels in the U.K. and U.S. We see much higher upside risks for growth and inflation, and tighter monetary policy, in the U.S. and U.K. than the Euro Area or Japan. To reflect this in our model portfolio, we are downgrading our U.S. country allocation to below-benchmark (2 of 5) this week, while maintaining our underweight in the U.K. (also 2 of 5). We are keeping the Euro Area at above-benchmark (4 of 5) and Japan at benchmark (3 of 5). Government bond yield curves should see mild steepening pressure from rising inflation expectations before central banks are forced to turn more hawkish. We are focusing our decision to reduce overall portfolio duration more at the longer end of yield curves, especially in the U.S. and U.K. (Chart 7). A large headwind to any significant move higher in bond yields remains investor positioning, with only the "active client" portion of the JP Morgan duration survey showing a flip back to a net long duration stance in recent weeks (Chart 8). A full unwind of the large short positions in government bond markets is unlikely in the absence of much weaker economic data or a big correction in equity markets. The latter is impossible to time, but nothing that we are seeing in the forward-looking data is pointing to an imminent slowing of economic growth. Thus, we are choosing to shift back to our desired strategic below-benchmark duration stance this week. Chart 7Rising Inflation = Steeper Yield Curves Rising Inflation = Steeper Yield Curves Rising Inflation = Steeper Yield Curves Chart 8Large Short Positions Still An Issue Large Short Positions Still An Issue Large Short Positions Still An Issue Bottom Line: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth and inflation. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporate Bonds: A Cyclical Upgrade In The U.S., Despite Tight Valuations Global corporate debt has enjoyed solid relative performance versus government bonds over the past several months, driven by the improvements in economic growth and earnings. Credit spreads have narrowed in response, for both Investment Grade and High-Yield. In the Euro Area, the U.K. and Japan, central bank asset purchases of corporate bonds have also helped to keep spreads tight and help support the overall positive backdrop for credit markets. High levels of corporate leverage remain an issue, especially in the U.S., but an improving profit backdrop and faster nominal GDP growth will help paper over problems associated with high company debt. In the U.S., the items in our "Corporate Checklist" are providing a generally positive signal (Chart 9): Our Corporate Health Monitor (CHM) is starting to signal a slight improvement in corporate credit metrics after several years of deterioration; Bank lending standards are no longer tightening, according to the Fed's Senior Loan Officer Survey, after a brief period of more stringent standards in 2015 & 2016; Bank equities are outperforming the overall market, which in the past has been a positive signal for credit availability and corporate debt performance; Monetary conditions are still only just neutral, even with the U.S. dollar at very expensive levels. The monetary backdrop could become a concern later on in the year if Fed rate hikes lead to another period of rapid U.S. dollar appreciation. Until then, the more positive backdrop for profits will continue to boost balance sheet health, resulting in reduced equilibrium risk premiums (i.e. spreads) on corporate bonds. Already, U.S. corporate debt has priced in the better news (Chart 10). In High-Yield, the massive rally in energy-related names after the recovery in oil prices last year (top panel) has driven the spread on the Energy sub-component of the Barclays Bloomberg benchmark index back to levels last seen when oil was at $100/bbl ... even though the price of oil is still in the low $50s! Meanwhile, junk spreads ex-energy now reflect the benign macro volatility environment, as proxied by the VIX index (middle panel). Chart 9A Better Fundamental Backdrop A Better Fundamental Backdrop A Better Fundamental Backdrop Chart 10Corporate Valuations Are Not Cheap... Corporate Valuations Are Not Cheap... Corporate Valuations Are Not Cheap... In Investment Grade, spreads have also tightened alongside falling volatility, although spreads are still somewhat higher than during the previous period when the VIX was this low back in 2014 (bottom panel), suggesting that spreads could compress even further if the macro backdrop stays benign. We have maintained a generally cautious stance on U.S. corporate credit for much of the past year, given the combination of poor corporate health, contracting profits and slowly tightening monetary conditions. Now that the backdrop has changed, the case for upgrading U.S. corporates versus U.S. Treasuries is more compelling. This is especially so given the improvement in global economic growth momentum, which usually correlates with periods of positive excess returns for both Investment Grade and High-Yield versus Treasuries (Chart 11). Given our more optimistic tone on global economic growth, led by the potential for upside surprises in the U.S., this week we are upgrading our recommended stance on U.S. Investment Grade corporates to above-benchmark (4 of 5) and U.S. High-Yield to at-benchmark (3 of 5). Within High-Yield, we are focusing our exposure on the high-to-middle quality tiers, as both B-rated and Ba-rated spreads look far more attractive than Caa-rated debt. That can be seen in Chart 12, which shows the option-adjusted spread (OAS) for the overall U.S. High-Yield index and the three main credit tier buckets, divided by the 12-month trailing volatility of excess returns for each grouping. These "vol-adjusted" spreads are at the long-run median level for B-rated and Ba-rated debt, while Caa-rated bonds (which are dominated by the now-expensive debt of energy-related companies) offers poor value relative to their volatility. Chart 11...But The Growth Outlook Remains Supportive ...But The Growth Outlook Remains Supportive ...But The Growth Outlook Remains Supportive Chart 12Avoid The Lower Credit Tiers In U.S. Junk Avoid The Lower Credit Tiers In U.S. Junk Avoid The Lower Credit Tiers In U.S. Junk Differentiating within the credit tiers is important, as the overall U.S. High-Yield spread is not particularly cheap once expected default losses are taken into account (Chart 13). If U.S. economic growth surprises to the upside, as we expect, then the default outlook will look better and High-Yield spreads will look more attractive. For this reason, we would look to shift to an above-benchmark stance on any risk-off correction in global equities or corporates. With the business cycle improving, buying any dips in U.S. corporate credit markets should pay off in 2017. One final point: we have had a long-standing recommendation to overweight Euro Area Investment Grade corporate debt versus U.S. equivalents. That view was based on the underlying support for Euro Area corporates from ECB purchases, coming at a time when Euro Area balance sheets were improving in absolute terms, and relative to the U.S., as shown by our Euro Area Corporate Health Monitor (Chart 14). However, with our U.S. CHM now showing some modest improvement, and with U.S. likely to show more upside growth surprises in 2017, we are not upgrading Euro Area debt from the current above-benchmark (4 of 5) ranking, even as we boost our U.S. corporate allocation. Chart 13Expect Carry-Like Returns, Given Tight Spreads Expect Carry-Like Returns, Given Tight Spreads Expect Carry-Like Returns, Given Tight Spreads Chart 14A Bullish Case For Both U.S. and Euro Area IG A Bullish Case For Both U.S. and Euro Area IG A Bullish Case For Both U.S. and Euro Area IG Bottom Line: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Vigilantes Take A Break For The Holidays", dated December 6, 2016, available at gfis.bcaresearch.com 2 Please see BCA U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "A "Post-Truth" Economic Upturn?", dated January 17, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). Economy: U.S. GDP growth will be solidly above trend in 2017, driven in large part by accelerating consumer spending. Feature The divergence in economic growth between the U.S. and the rest of the world has been one of our key investment themes for much of the past two years. All else equal, the greater the divergence in growth between the U.S. and the rest of the world, the more the U.S. dollar comes under upward pressure. A strengthening dollar limits how far the Fed can lift rates and caps the upside in long-dated yields. In fact, in a report published last October titled "Dollar Watching: An Update"1 we wrote: Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product until a December rate hike has been fully discounted by the market. Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. With the December rate hike now in the rearview mirror, global growth divergences do not appear to be a strong headwind for bond yields. In fact, the trade-weighted dollar has flattened off since the Fed lifted rates and bullish sentiment toward the dollar has plunged even though rate hike expectations remain elevated (Chart 1). This suggests that the dollar is so far not having much of an impact on the U.S. growth outlook or the expected path of monetary policy. Digging a little deeper, it appears we are witnessing a synchronized upturn in global growth led by the manufacturing sector (Chart 2). The Global Manufacturing PMI is in a clear uptrend, while the diffusion index suggests the improvement is broad based. Similarly, our Global Leading Economic Indicator is once again expanding, while its diffusion index is holding steady above the 50% line. Chart 1Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Chart 2Synchronized Global Recovery Synchronized Global Recovery Synchronized Global Recovery Although the extremely high level of economic policy uncertainty increases the odds of a near-term selloff in risk assets and related flight-to-quality into Treasury securities, the strength of the global growth impulse and sustainability of the U.S. economic recovery (see section titled "U.S. Economy: A Healthy Consumer Leads The Way" below) means we would view any risk-off episode as an opportunity to reduce portfolio duration and increase exposure to spread product. As such, given our 6-12 month investment horizon and the inherent difficulty in forecasting near-term market riot points, this week we begin the process of shifting our portfolio in this direction. Specifically, we move from an "At Benchmark" back to a "Below Benchmark" duration stance and we also upgrade spread product from neutral (3 out of 5) to overweight (4 out of 5), while downgrading Treasuries from neutral (3 out of 5) to underweight (2 out of 5). Within spread product we upgrade investment grade corporates from neutral (3 out of 5) to overweight (4 out of 5) and upgrade high-yield from underweight (2 out of 5) to neutral (3 out of 5). We expand on the rationale for each move below. Portfolio Duration Chart 3Treasuries Now Expensive Treasuries Now Expensive Treasuries Now Expensive Two weeks ago,2 we detailed our bearish 6-12 month outlook for U.S. bonds, while also pointing to three factors that had so far prevented us from adopting a below-benchmark duration stance. The three factors were: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation Two weeks ago the 10-year Treasury yield was trading 9 basis points cheap on our 2-factor model based on Global PMI and bullish dollar sentiment. Since then, bullish sentiment has declined and Flash3 PMI readings from the U.S., Eurozone and Japan were all strong. If we assume that final PMIs from these regions are in line with the Flash numbers and that the PMIs from all other countries remain flat, then we calculate that the 10-year Treasury yield is actually 4 basis points expensive relative to fair value (Chart 3). In short, valuation argues even more in favor of reducing portfolio duration than it did two weeks ago. Factor 2: Uncertainty Economic policy uncertainty remains elevated and, unusually, has de-coupled from surveys of consumer and business confidence (Chart 4). Certainly, there is a risk that confidence measures relapse in the near-term if it appears as though some of the new President's promises related to tax cuts and deregulation will not be delivered. However, this risk needs to be weighed against the bond-bearish combination of protectionism and fiscal stimulus favored by the new administration, especially at a time when the economy is close to full employment. Factor 3: Sentiment & Positioning Bond sentiment and positioning remain decidedly bearish according to our Bond Sentiment Indicator and net speculative positioning in Treasury futures, although the J.P. Morgan client survey shows that clients' duration positioning is close to neutral (Chart 5). It is likely that some further capitulation of short positions is necessary before Treasury yields can move decisively higher. However, these shifts in positioning can occur very quickly and given the reading from our valuation model we feel that now is the appropriate time to reduce duration exposure. Chart 4Elevated Uncertainty Remains A Near-Term Risk... Elevated Uncertainty Remains A Near-Term Risk... Elevated Uncertainty Remains A Near-Term Risk... Chart 5...As Does Bearish Positioning ...As Does Bearish Positioning ...As Does Bearish Positioning Bottom Line: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product In last week's report,4 we explored the performance of spread product throughout the four phases of the Fed cycle (Chart 6), which are defined as follows: Chart 6Stylized Fed Cycle Dollar Watching: Another Update Dollar Watching: Another Update Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Based on the fact that core PCE inflation remains below the Fed's target and the view that its uptrend will proceed only gradually, we concluded that we are presently in Phase I of the Fed cycle and would probably remain there for the balance of the year. Historically, spread product has performed well in Phase I of the Fed cycle, with only Phase IV producing higher average monthly excess returns. However, the Fed cycle is only part of the story. Our Corporate Health Monitor (CHM) - a composite measure of balance sheet health for the nonfinancial corporate sector - has been in "deteriorating health" territory since late 2013. Historically, this measure has an excellent track record of flagging periods of spread widening (Chart 7). Chart 7The Corporate Health Monitor And Credit Spreads The Corporate Health Monitor And Credit Spreads The Corporate Health Monitor And Credit Spreads To augment our analysis, this week we re-examine average monthly excess returns for investment grade corporate bonds in the four phases of the Fed cycle but this time we also split each phase into periods of improving and deteriorating corporate health (Table 1). Table 1Investment Grade Corporate Bond Excess Returns* Given Reading From ##br##BCA Corporate Health Monitor And The Phase Of The Fed Cycle (July 1989 To Present) Dollar Watching: Another Update Dollar Watching: Another Update Table 1 shows there have been 14 months since 1989 when Phase I of the Fed cycle coincided with deteriorating corporate health, according to the CHM. Conversely, Phase I of the Fed cycle coincided with improving corporate health in 25 months. However, 13 of the 14 months when Phase I of the Fed cycle coincided with deteriorating corporate health are the most recent 13 months. In other words, the current combination of tightening (but still-supportive) monetary policy and weak corporate balance sheets is unprecedented. The other factor we have not yet considered is valuation, as measured by the starting level of corporate spreads. In Table 2 we present average monthly excess returns for investment grade corporate bonds split by both the phase of the Fed cycle and the investment grade corporate option-adjusted spread. At present, the average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is 120 bps. Table 2Investment Grade Corporate Bond Excess Returns* Given Previous Month Option-Adjusted Spread** ##br##And The Phase Of The Fed Cycle (July 1989 To Present) Dollar Watching: Another Update Dollar Watching: Another Update In Table 2 we observe that usually spreads are much lower in Phase I of the Fed cycle, typically between 50 bps and 100 bps, and that periods when spreads are above 100 bps generally coincide with higher excess returns. However, we must also recall that corporate health is typically still improving in Phase I of the Fed cycle, so today's higher spread levels might be justified by worse credit quality. Chart 8Value Is Stretched In Junk Value Is Stretched In Junk Value Is Stretched In Junk It goes without saying that the unusual combination of deteriorating corporate health and still-supportive Fed policy is a complicated environment for credit investors to navigate. Our view is that accommodative Fed policy will prevent material spread widening, at least until inflation breaks above the Fed's target and we shift into Phase II of the Fed cycle, but it is also probably not reasonable to expect spreads to tighten much further from current levels. We are looking for low, but positive, excess returns from spread product, consistent with the available carry. Bottom Line: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade our allocation to high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). We retain only a neutral allocation to high-yield due to the longer-run risks posed by poor corporate health, and tight valuations for high-yield bonds (Chart 8). U.S. Economy: A Healthy Consumer Leads The Way U.S. GDP growth decelerated to 1.9% in Q4 from 3.5% in Q3. Growth in consumer spending slowed to 2.5% from 3.0%, while fixed investment spending picked up to 4.2% from 0.1%. The headline 1.9% GDP print also includes a -1.7% contribution from net exports and +1.0% contribution from inventories. Taking a step back from the quarterly data, we see that the growth in real final sales to domestic purchasers - a measure of growth that strips out the volatile trade and inventory components - has clearly shifted into a higher range during the past couple of years (Chart 9). Further, leading indicators for each individual component of growth all suggest that further acceleration is in store (Chart 10). Chart 9Growth Finds A Higher Gear Growth Finds A Higher Gear Growth Finds A Higher Gear Chart 10Contributions To GDP Growth Contributions To GDP Growth Contributions To GDP Growth But crucially, it is the fundamental drivers underpinning the outlook for consumer spending that lead us to believe that U.S. economic growth will maintain an above-trend pace throughout 2017. As was observed by our U.S. Investment Strategy service in a recent report,5 income growth - the main driver of consumption trends - appears poised to accelerate, driven by accelerating wage growth that is starting to kick in now that the economy has finally reached full employment (Chart 11). The boost in consumer confidence could also lead to a lower savings rate, further increasing the impact on spending (Chart 11, bottom panel). Chart 11Consumer Spending = Income + Confidence Consumer Spending = Income + Confidence Consumer Spending = Income + Confidence Bottom Line: A healthy consumer is the back bone of the U.S. economy, and elevated consumer demand will also lend support to corporate fixed investment and the housing market. We expect that U.S. growth will be solidly above trend in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, titled "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 3 The flash estimate is typically based on approximately 85%-90% of total PMI survey responses each month and is designed to provide an accurate advance indication of the final PMI data. 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession One Year On From A Mini Recession One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Wage Growth Is Set To Accelerate Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Comapanies' Animal Spirits On The Rise Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through China's Reflation Still Coming Through China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's When U.S. Pushed Japan In The 1980's When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Inflation Has Been Slow To Pick Up Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Euro Hasn't Weakened Much Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise TIPS Have Further to Go Room To Rise TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Interest Rate Differentials Suggest Stronger Dollar Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In January, the model outperformed global equities and the S&P 500 in USD terms, but underperformed in local-currency terms. For February, the model cut its weighting in stocks and increased its allocation to bonds (Chart 1). Within the equity portfolio, the weightings to both the U.S. and emerging markets were decreased. The model boosted its allocation to French bonds at the expense of Swedish and Canadian paper. The risk index for stocks, as well as the one for bonds, deteriorated in January. Feature Performance In January, the recommended balanced portfolio gained 1.4% in local-currency terms, and 3.6% in U.S. dollar terms (Chart 2). This compares with a gain of 3.2% for the global equity benchmark and a 2% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide other suggestions on currency risk exposure from time to time. The performance of bonds was a detractor from the model's performance in local currency terms in January. Chart 1Model Weights Model Weights Model Weights Chart 2Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Weights The model decreased its allocation to stocks from 57% to 53%, and upgraded its bond weighting from 43% to 47% (Table 1). Table 1Model Weights (As Of January 26, 2017) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators The model increased its equity allocation to France, Italy, and Sweden by one point each. Meanwhile, weightings were cut by 2 points in the U.S., and by 1 point in Germany, Spain, Switzerland, Emerging Asia, and Latin America. In the fixed-income space, the allocation to French paper was increased by 6 points and the U.K. by 1 point. The model cut its exposure to Swedish bonds by 2 points and Canadian bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time we do provide our recommendations. The dollar weakened in January and our Dollar Capitulation Index fell close to neutral levels. Uncertainty over the size of the fiscal push by the U.S. administration could prolong the dollar's consolidation phase, especially if coupled with any negative economic surprises. However, this would only be a pause since continued monetary policy divergence should translate into another leg up in the dollar bull market (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The deterioration of the value and cyclical components led to a higher risk index for commodities. The model continues to shun this asset class (Chart 4). The risk index for global equities increased to a 3-year high in January due to the deterioration in the value indicator. While the global risk index for global bonds also deteriorated, it remains firmly in the low-risk zone. The model slightly decreased its allocation in equities to the benefit of bonds (Chart 5). Chart 4Commodity Index And Risk Commodity Index And Risk Commodity Index And Risk Chart 5Global Stock Market And Risk Global Stock Market And Risk Global Stock Market And Risk Following the latest uptick in the risk index for U.S. equities, the allocation to this asset class was trimmed. U.S. stocks have been propped up by the growth-positive aspects of the new U.S. administration's policies and are at risk should this optimism deflate (Chart 6). The risk index for Canadian equities improved slightly in January as the better readings in the liquidity and momentum indicators offset continued worsening in value. That said, the overall risk index remains at the highest level in this business cycle. This asset remains excluded from the portfolio (Chart 7). Chart 6U.S. Stock Market And Risk U.S. Stock Market And Risk U.S. Stock Market And Risk Chart 7Canadian Stock Market And Risk Canadian Stock Market And Risk Canadian Stock Market And Risk The risk index for U.K. equities deteriorated, reaching a post-Brexit high. For the first time in over two years, the value component crossed into expensive territory (Chart 8) The model trimmed its allocation to Emerging Asian stocks following the slight uptick in the risk index. While the global reflationary pulse should bode well for this asset class, rumblings about protectionism threaten to de-rate growth expectations (Chart 9). Chart 8U.K. Stock Market And Risk U.K. Stock Market And Risk U.K. Stock Market And Risk Chart 9Emerging Asian Stock Market And Risk Emerging Asian Stock Market And Risk Emerging Asian Stock Market And Risk The unwinding of oversold conditions was the main reason behind the deterioration in the risk index for bonds in January. However, the latter is still in the low-risk zone as the bond-negative reading from the cyclical indicator remains overshadowed by the ongoing oversold conditions in the momentum indicator (Chart 10). The risk index for U.S. Treasurys deteriorated in January on the back of a less-stretched momentum indicator. While the cyclical backdrop is bond-bearish, there is arguably more room for scaling down optimism over the economy than there is to having an even more upbeat outlook. As a result, any resumption of the rise in Treasury yields could end up being very gradual (Chart 11). Chart 10Global Bond Yields And Risk Global Bond Yields And Risk Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk U.S. Bond Yields And Risk U.S. Bond Yields And Risk The risk index for euro area government bonds also deteriorated in January, but unlike the U.S., it is in the high-risk zone. There are notable differences in the risk readings within euro area markets (Chart 12). Given the upcoming presidential elections, France is next in line in terms of investors' focus on political risks. French bonds are heavily oversold based on the momentum indicator, pushing the overall risk index lower. An unwinding of the risk premium would bode well for French bonds, which the model upgraded in January (Chart 13). Chart 12Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Chart 13French Bond Yields And Risk French Bond Yields And Risk French Bond Yields And Risk The risk index for Spanish government bonds ticked down slightly reflecting minor improvements in all three of its components. However, it remains much higher than the risk index for the French paper, which is preferred by the model (Chart 14). With the risk index little changed in January, Swiss government bonds remain in the high-risk zone. The model continues avoiding this asset which possesses negative yields (Chart 15). Chart 14Spanish Bond Yields And Risk Spanish Bond Yields And Risk Spanish Bond Yields And Risk Chart 15Swiss Bond Yields And Risk Swiss Bond Yields And Risk Swiss Bond Yields And Risk Currency Technicals The dollar depreciated after the 13-week momentum measure indicated last month that the greenback could face near-term resistance. Further consolidation cannot be ruled out, but the 40-week rate of change measure is not signaling an end to the dollar bull market. The monetary policy divergence between the Fed and its peers provides underlying support for the dollar, while heightened uncertainty on the fiscal front implies more volatility going forward (Chart 16). EUR/USD was not able to stay below 1.05. The short-term rate-of-change measure is approaching neutral levels, which could test the EUR/USD bounce. A risk-off episode or continued solid economic data are two factors that could provide some support for the euro in the near term (Chart 17). The 40-week rate of change measure for GBP/USD continues to hover near the most oversold level since 2000 (excluding the great recession). Meanwhile, the 13-week momentum measure crossed into positive territory, but is not extended. The pound will remain event-driven and possibly range-bound in the near term as the mood bounces within the hard Brexit / soft Brexit spectrum (Chart 18). Chart 16U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* Chart 17Euro Euro Euro Chart 18Sterling Sterling Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com