Gov Sovereigns/Treasurys

Executive Summary The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The recent market turmoil means that a 50 bps rate hike is off the table for the March FOMC meeting, but the Fed will proceed with a 25 bps rate hike this month and signal a further steady pace of tightening. As of Monday morning, the market is priced for close to 150 bps of tightening during the next 12 months. This is reasonable assuming that inflation moderates in the second half of the year and that long-dated inflation expectations remain well contained. A moderation of inflation in H2 remains our base case, but the war in Ukraine increases the risk that inflation will be sticky and that long-dated inflation expectations will move higher. The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Bottom Line: An ‘at benchmark’ portfolio duration stance makes sense for now, but the recent drop in Treasury yields could eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Stay tuned.   Feature The Russian invasion of Ukraine is ongoing and financial markets will surely remain volatile until a resolution is reached. For more details on how we see the crisis evolving please refer to last week’s BCA Special Report.1  As we go to press on Monday, the market is trying to digest the impact of sanctions that will block the access of some Russian banks to the SWIFT financial messaging system and freeze some Russian central bank reserves that are held abroad in USD and EUR. Taken together, the sanctions will impart a large stagflationary impulse to the Russian economy and, as would be expected, the Ruble is depreciating rapidly on Monday morning. The reaction in US bond markets is so far more muted. The 10-year Treasury yield is currently 1.86% - down from 1.99% last Wednesday – and the 2-year Treasury yield is 1.44% - down from 1.58% last Wednesday (Chart 1). Movements in the real and inflation components of US Treasury yields do show that the US market is pricing-in some stagflationary contagion. The real 10-year Treasury yield is down to -0.71% (from -0.54% last Wednesday) and the 10-year TIPS breakeven inflation rate is up to 2.57% (from 2.53% last Wednesday). The same divergence between a falling real yield and rising cost of inflation compensation is seen at the 2-year maturity point (Chart 1, bottom 2 panels). The market has also moved to price-in a shallower path for Fed rate hikes compared to last week (Chart 2). The market-implied odds of a 50 bps rate hike this month are now slim and the market is now looking for only 139 bps of cumulative tightening (just under six 25 basis point rate hikes) by the end of this year. Chart 2Fed Funds Rate Expectations Fed Funds Rate Expectations Fed Funds Rate Expectations Chart 1A Stagflationary Shock A Stagflationary Shock A Stagflationary Shock We agree with the market that the heightened uncertainty and tightening of financial conditions takes a 50 bps rate hike off the board for the March FOMC meeting. A 25 bps rate hike this month remains the most likely scenario. However, we also think the market might be over-estimating the extent to which contagion from Russia will limit the pace of Fed tightening later in the year. In fact, we are inclined toward the view that the lasting impact of the crisis on the US economy might be more inflationary than deflationary. Chart 3Expect US/German Yield Differential To Widen Expect US/German Yield Differential To Widen Expect US/German Yield Differential To Widen The inflationary risk is that a sustained upward shock to the oil price could keep headline inflation higher than it would otherwise be. This could also bleed through into other commodity prices and possibly even to inflation expectations. The textbook central bank response should be to ignore a commodity price shock and set policy based on trends in core inflation. However, in the current environment it will be difficult for the Fed to ignore yet another inflationary shock, especially if long-dated inflation expectations move higher. On the other hand, the economic fallout from a Russian recession will be much worse for Europe than for the United States. European Central Bank (ECB) Chief Economist Philip Lane recently estimated that the Ukrainian war could shave 0.3%-0.4% off Eurozone GDP this year.2 If the shock leads to a wider divergence between Fed and ECB policy expectations, then we would expect to see a widening of US yields versus European yields and upward pressure on the US dollar. Given that US bond yields can only diverge so far from yields in the rest of the world, a stronger dollar may cap any increase in US bond yields and eventually limit the extent of Fed tightening. So far, trends in the dollar and dollar sentiment have been supportive of rising US bond yields, but it will be important to watch this situation in the coming months to see if it changes (Chart 3). Investment Conclusions The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The Fed is likely to proceed with tightening policy at a steady pace, starting with a 25 bps rate hike this month. Trends in inflation and financial conditions will determine the pace of rate hikes in H2 2022. Right now, our sense is that the lasting impact of the Ukrainian crisis on the US economy will prove to be more inflationary than deflationary. With that in mind, the recent drop in Treasury yields may eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Checking In With Our Golden Rule Given the current market turmoil, we think it’s a good time to step back and check in with our Golden Rule of Bond Investing.3  The Golden Rule is a framework that investors can use to implement portfolio duration trades. It states that investors should determine the expected change in the fed funds rate that is priced into markets for the next 12 months and then decide whether the actual change in the funds rate will be greater or less than what is priced in the market. If you expect the fed funds rate to rise by more than what is priced in (a hawkish surprise), you should keep portfolio duration low. If you expect the fed funds rate to rise by less than what is priced in (a dovish surprise), you should keep portfolio duration high. It is admittedly a simple framework, but it does have a strong track record of performance. In general, hawkish surprises coincide with the Bloomberg Barclays Treasury index underperforming cash and dovish surprises coincide with the index outperforming cash (Chart 4). Chart 4The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing More specifically, if we look at rolling 12-month periods going back to 1990, we see that dovish surprises have coincided with positive excess Treasury returns versus cash 85% of the time for an average 12-month excess return of 4.0%. Conversely, hawkish surprises have coincided with negative excess Treasury returns 72% of the time for an average 12-month excess return of -1.5% (Chart 5 & Table 1). Table 112-Month Treasury Excess Returns And Fed Funds Rate Surprises (1990 - Present) Waiting For The Fog To Clear Waiting For The Fog To Clear Chart 5The Golden Rule’s Track Record Waiting For The Fog To Clear Waiting For The Fog To Clear As of today, the market is priced for 149 bps of Fed tightening during the next 12 months. That is very close to six 25 basis point rate hikes at the next eight FOMC meetings. Given our view that inflation will moderate in the second half of the year, this seems like a reasonable forecast that is consistent with our ‘at benchmark’ portfolio duration stance. However, as noted above, we believe the war in Ukraine could lead to an increase in inflationary pressures in the United States. Therefore, we see the balance of risks as tilted toward more rate hikes than are currently discounted rather than fewer. It will be vital to monitor long-dated inflation expectations during the next few months to assess how the pace of Fed rate hikes will evolve. Using The Golden Rule To Forecast Treasury Returns One more application of our Golden Rule framework is that we can use it to create forecasts for Treasury index returns. This is done by first looking at the historical correlation between the Fed Funds Surprise – the difference between the expected 12-month change in the fed funds rate and the realized change – and the change in the Treasury index yield (Chart 6). A regression between these two variables allows us to estimate the change in the Treasury index yield based on an assumed Fed Funds Surprise. Chart 6The Correlation Between Treasury Yields And Fed Funds Surprises Waiting For The Fog To Clear Waiting For The Fog To Clear Once we have an expected 12-month change in the Treasury index yield, we can translate that change into an expected return using the index’s average yield, duration and convexity. The result of this analysis is presented in Table 2. Table 2Using The Golden Rule To Forecast Treasury Returns Waiting For The Fog To Clear Waiting For The Fog To Clear Table 2 shows that we would expect the Treasury index to deliver a total return of 1.82% in a scenario where the Fed lifts rates by 150 bps during the next 12 months. This would equate to the Treasury index beating a position in cash by between 0.07% and 0.83%, depending on whether rate hikes are front-loaded or back-loaded. A pace of one 25 basis point rate hike per meeting (+200 bps during the next 12 months) would lead to the Treasury index underperforming cash by between -2.35% and -3.02%. Conversely, we can see that the index is expected to beat cash by between 3.25% and 3.92% if the Fed only lifts rates four times during the next 12 months. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see BCA Special Report, “Russia Takes Ukraine: What Next?”, dated February 24, 2022. 2 https://www.reuters.com/business/exclusive-ecb-policymakers-told-ukraine-war-may-shave-03-04-off-gdp-2022-02-25/ 3 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Waiting For The Fog To Clear Waiting For The Fog To Clear Other Recommendations Waiting For The Fog To Clear Waiting For The Fog To Clear

Executive Summary The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Given that a sustainable business cycle acceleration in China is unlikely in the short term, onshore government bond yields will likely drop further. In the long run, odds are that Chinese government bond yields will drop below US Treasury yields. For domestic asset allocators, we continue to recommend overweighting government bonds over stocks for now. The excess return of corporate bonds is driven by the corporate profit cycle. On a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. Bottom Line: Given our view that a meaningful growth recovery in China will only be a theme for the second half of this year, onshore asset allocators should continue favoring corporate credit over stocks and government bonds over corporate bonds. The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Feature In this report we (1) elaborate on our outlook for Chinese government and corporate bonds and (2) offer a framework for understanding how asset allocation for fixed-income (government and corporate bonds) and multi-asset portfolios (comprised of fixed-income plus equities) should be implemented. Domestic Government Bonds Chart 1Chinese Bond Yields Have Bucked The Global Trend Chinese Bond Yields Have Bucked The Global Trend Chinese Bond Yields Have Bucked The Global Trend The risk-reward profile of Chinese domestic government bonds remains attractive. Chinese government bond yields have been declining,  bucking the global trend of surging government bond yields (Chart 1, top panel). Odds are that Chinese bond yields will drop further, both cyclically and structurally: In contrast with the Americas and Europe, China’s consumer price inflation has remained subdued. Its core, trimmed mean and headline inflation rates have remained low (Chart 2). The ongoing growth slump will cap core inflation in China at around 1%, allowing monetary authorities to lower interest rates further. Real bond yields in China remain well above those in the majority of DM (Chart 1, bottom panel). Hence, risk-free bonds in China offer value. As to the Chinese stimulus and business cycle, the recent pickup in Chinese credit numbers has been entirely due to local government bond issuance. After excluding local government bonds, credit growth and its impulse have not improved (Chart 3). While infrastructure spending will pick up in the coming months (given large special bond issuance), sentiment among consumers and private companies remains downbeat and local government budgets are severely impaired by the collapse in revenues from land sales. Hence, it will take some time before a boost in infrastructure activity lifts broader business and consumer sentiment such that a sustainable economic recovery can take hold. Chart 2Chinese Consumer Price Inflation Is Subdued Chinese Consumer Price Inflation Is Subdued Chinese Consumer Price Inflation Is Subdued Chart 3Recent Credit Improvement Is Entirely Due to Local Government Bond Issuance Recent Credit Improvement Is EntirelyDue to Local Government Bond Issuance Recent Credit Improvement Is EntirelyDue to Local Government Bond Issuance The special bond quota for Q1 stands at RMB 1.46 trillion and is equivalent to 28% of local government aggregate quarterly revenue. Even though the special bond issuance in Q1 is massive, it will be largely offset by the drop in local governments’ land sales revenue. The latter is shrinking and makes up more than 40% of local government aggregate revenues. In brief, strong headwinds from the property market in the form of shrinking land sales might counteract the increase from front-loaded special bond issuance in Q1 2022. As to real estate construction, funding for property developers is down dramatically from a year ago (Chart 4). In the absence of financing, real estate developers will shrink construction volumes in the months ahead. Chart 5Debt Service Burden For Chinese Enterprises And Households Is High Debt Service Burden For Chinese Enterprises And Household Is High Debt Service Burden For Chinese Enterprises And Household Is High Chart 4Property Completions Will Roll Over Property Completions Will Roll Over Property Completions Will Roll Over   Structurally, high enterprise and household debt levels in China amid slumping incomes mean that borrowing costs should drop to facilitate debt servicing. BIS estimates that debt service costs for the private sector (enterprises and households) in China are 21% of disposable income, much higher than in many other economies (Chart 5). Finally, China’s large and persistent current account surpluses mean that the nation is a major international creditor rather than a debtor. Thus, China does not need to offer high yields to attract foreign capital. Structurally speaking, foreign fixed-income inflows into Chinese domestic bonds will likely continue. Chart 6Credit Cycle And Government Bond Yields Credit Cycle And Government Bond Yields Credit Cycle And Government Bond Yields Bottom Line: Bond yields will likely drop further as a sustainable business cycle acceleration in China is unlikely in the short term. Chart 6 illustrates that the total social financing impulse leads bond yields by nine months and a cyclical bottom in yields will probably occur a few months from now. In the long run, Chinese government bonds yields will likely drop below US Treasury yields. Onshore Corporate Bonds The proper measure of corporate bond performance is excess return over similar government bonds (herein excess return). The basis for using excess return instead of total return for corporate bonds is because investors can attain government bond return by purchasing them outright. Essentially, investors prefer corporate bonds over government bonds because of credit spreads. Hence, a corporate bond performance assessment – whether in absolute terms or relative to other asset classes – should be based on excess return. In China, the excess return on onshore corporate bonds1 usually moves in tandem with the business cycle and government bond yields. In particular: The excess return of corporate bonds is positive during periods of growth acceleration and negative during slowdowns (Chart 7, top panel). The middle panel of Chart 7 illustrates that the excess return of corporate bonds correlates with analysts’ net EPS revisions for onshore listed companies. This confirms the above point that corporate bonds correlate with the profit/business cycle. Significantly, even though industrial profit growth is not yet negative (Chart 8, top panel), earnings in commodity-user industries have crashed (Chart 8, bottom panel).  This explains the negative excess return for onshore corporate bonds in the past 12 months. Chart 7The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Chart 8Corporate Profit Cycle: Mind The Divergence Corporate Profit Cycle: Mind The Divergency Corporate Profit Cycle: Mind The Divergency Furthermore, the excess return of corporate bonds declines and rises with interest rate expectations (Chart 7, bottom panel). As the outlook for corporate profits remains sour, fixed-income investors should continue to favor government bonds over corporate bonds. Now, how do corporate bonds perform versus stocks? What drives their relative performance? To compare stock performance to corporate bond excess return, one should adjust for volatility. In other words, share prices are much more volatile than the excess return on corporate bonds. Hence, during risk-on periods equities always outperform corporate bonds and vice versa. Chart 9The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical Chart 9 demonstrates that even on a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. In short, the performance of stocks over corporate bonds is very pro-cyclical. Bottom Line: The excess return of corporate bonds is driven by corporate revenue and profits rather than by interest rate expectations. Getting China’s business cycle right is critical to the allocation between government and corporate bonds in fixed-income portfolios and to the allocation between corporate bonds and equities in multi-asset portfolios. Given our view that a meaningful growth recovery in China will only be a theme in the second half of this year, onshore asset allocators should continue favoring corporate bonds over stocks and government bonds over corporate credit. Offshore Corporate Bonds What drives the excess return of Chinese USD corporate bonds in absolute terms as well as versus Chinese non-TMT investable stocks2 and onshore corporate bonds? Given that the offshore corporate bond universe is dominated by property developers, their excess return correlates with perceived risks to the mainland property market in general and the financial health of property developers in particular (Chart 10, top panel). Property developers are very overleveraged, their sales are shrinking and their financing has dried up. Yet, authorities are compelling them to complete construction of their pre-sold housing. Property developers will therefore continue to experience financial distress. Odds are that bond prices of corporate developers – both investment grade and high yield - will continue falling (Chart 10, middle and bottom panels). Chart 11Investable Stocks Vs. Offshore Corporate Credit: Volatility-Adjusted Performance Investable Stocks Vs. Offshore Coporate Credit: Volatility-Adjusted Performance Investable Stocks Vs. Offshore Coporate Credit: Volatility-Adjusted Performance Chart 10A Massive Bear Market In Offshore Corporate Bonds A Massive Bear Market In Offshore Corporate Bonds A Massive Bear Market In Offshore Corporate Bonds On a volatility-adjusted basis, non-TMT investable stocks outpace the excess return of offshore corporate bonds during periods of growth improvement and underperform during growth slowdowns (Chart 11, top panel). The same pattern holds true when it comes to the performance of offshore corporate bond versus the aggregate MSCI Investable equity index (including TMT stocks) (Chart 11, bottom panel). The credit cycle leads the business cycle and, thereby, it leads these financial market trends. Bottom Line: The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Chinese offshore corporate bonds will continue underperforming EM corporate bonds as well as Chinese onshore corporate bonds. Investment Recommendations Investors often read market signals across asset classes to gauge which market moves will persist and which ones will be short-lived.  In this regard, we have two observations for Chinese onshore markets: Chart 12Moving In Tandem Moving In Tandem Moving In Tandem The sustainability of an equity rally is higher when it is confirmed by rising excess returns of corporate bonds and rising government bond yields (Chart 12). Presently, there is no strong signal to switch from government bonds to either corporate bonds or stocks. Unfortunately, the yield curve in China does not correlate with its business cycle and, hence, cannot be used as a tool in macro analysis.  Our key investment conclusions are: For fixed-income investors, we continue to recommend receiving 10-year swap rates in China and for dedicated EM local currency bond managers to remain overweight China. The renminbi has been firm versus the US dollar despite a considerable narrowing in the interest rate differential between China and the US. In the long run, the real interest rate differential between China and the US will drive the exchange rate, and it will favor the RMB. While US real bond yields might rise relative to Chinese bond yields in the coming months, triggering a period of yuan softness, it will prove to be transitory. The basis is that the Federal Reserve is very sensitive to asset prices. As US share prices decline and corporate spreads widen, the central bank will eventually turn dovish and will lag behind the inflation curve. When a central bank falls behind the inflation curve, real rates stay low and its currency depreciates. Chart 13China’s Stock-to-Bond Ratio China"s Stock-to-Bond Ratio China"s Stock-to-Bond Ratio For domestic asset allocators, we continue to recommend favoring government bonds over stocks (Chart 13). Within fixed-income portfolios, investors should overweight government bonds over corporate bonds. Finally, corporate bonds will fare better than equities in the near term. In a few months there will be an opportunity to shift these positions.  More aggressive stimulus from authorities and aggressive property market relaxation measures will create conditions for an improvement in domestic demand. Finally, the risk-reward profile for offshore USD corporate bonds remains unattractive. Chinese offshore corporate credit will continue underperforming EM USD corporate credit as well as Chinese onshore corporate bonds.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    Due to the lack of excess return data from the index provider (Bloomberg Barclays onshore bond indexes), we calculated the excess return on onshore corporate bonds as the ratio of the total return on the corporate bond index divided by the total return on the government bond index. This measure is not ideal as it does not account for duration mismatches between the corporate and government bond indexes. However, the key conclusions of this report will hold true for the duration-adjusted excess return not least because this framework is valid for financial markets in the US and Europe. 2    The reason to compare it to non-TMT (technology, media and telecommunication, i.e., Chinese tech and internet stocks) is that offshore corporate bond issuers are largely old economy industries.

Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing Global Inflation Pressures Easing Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. ​​​​​​Chart 4Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation   Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak ​​​​​ Chart 7There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply ​​​​​​ Chart 8US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions ​​​​​​ Chart 12Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive ​​​​​ For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract.  The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Tactical Overlay Trades

Executive Summary Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth The conditions for a major rally/outperformance in Malaysian equities are absent. Profits have been the primary driver of Malaysian equity prices historically, and the corporate earnings outlook is mediocre. Domestic demand is facing headwinds from tightening fiscal policy as well as from impaired credit channels.  Muted wage growth and deflating house prices are sapping consumer confidence. This will dent domestic demand going forward. This backdrop is bullish for bonds. Malaysian bonds offer value, as real bond yields are among the highest in Emerging Asia. The yield curve is far too steep given the growth and inflation outlook.  The Malaysian ringgit is cheap and has limited downside. Bottom Line: We recommend equity investors implement a neutral stance toward Malaysia in overall EM and Emerging Asian equity portfolios. Absolute return investors should avoid this bourse for now. Fixed-income investors, on the other hand, should stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. In the rate markets, investors should continue receiving 10-year swap rates or bet on yield curve flattening. Feature Chart 1Malaysian Equity Underperformance May Be Late, But It’s Not Yet Time To Overweight Malaysian Equity Underperformance May Be Late, But It's Not Yet Time To Overweight Malaysian Equity Underperformance May Be Late, But It's Not Yet Time To Overweight Malaysian stocks are still in search of a stable bottom in absolute terms. Relative to their EM and Emerging Asian counterparts however, a bottom has been forming over the past year (Chart 1). So, could Malaysia’s prolonged underperformance be coming to an end?  Our analysis suggests caution. The underlying reasons behind this market’s substantial and protracted underperformance – dwindling earnings both in absolute terms and relative to its peers – are yet to show any signs of a reversal.  While cheap, the ringgit is also negatively impacted by the meager corporate profits generated by Malaysian firms. Investors would do well to stay neutral on this bourse for now in EM and Emerging Asian equity portfolios. Fixed income investors, however, should continue to stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. Also, Malaysia’s yield curve is too steep and offers value given the sluggish cyclical growth outlook. It’s All About Profits Chart 2 shows that the bull and bear markets in Malaysian stocks have been all about the rise and fall in earnings per share (EPS). Stock multiples, the other possible driver of the equity prices, have been remarkably flat over the past two decades, with only brief periods of fluctuations around the GFC and COVID-19 pandemic. The same can be said about Malaysia’s relative performance vis-à-vis EM and Emerging Asian stocks. The trajectory of the relative stock performance was set by the relative earnings (Chart 3). Chart 3Malaysia’s Relative Performance Is Also Dictated By Relative Corporate Profits Malaysia's Relative Performance Is Also Dictated By Relative Corporate Profits Malaysia's Relative Performance Is Also Dictated By Relative Corporate Profits Chart 2Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Thus, it is reasonable to expect that for this bourse to usher in a new bull market in absolute terms, Malaysian firms need to grow their earnings sustainably. And in order to outperform the rest of the EM stocks, Malaysian earnings need to grow at a faster clip than their peers. The question therefore is, are there signs of profit recovery in Malaysian companies in absolute and relative terms? The short answer is no. Bottom-up analysts do not expect any change in the downward trend in Malaysia’s relative profits over the coming 12 months. This outlook is corroborated by our macro analysis, as is outlined below. Sluggish Growth  Malaysian profits are languishing in large part because of subdued topline growth. While profit margins are returning to pre-pandemic levels – thanks to cost cutting – subdued sales are causing the corporate profits to stay low. Chart 4Malaysian Domestic Demand Is Subdued Malaysian Domestic Demand Is Subdued Malaysian Domestic Demand Is Subdued Malaysian gross output as of Q4 last year was barely at pre-pandemic levels. The weak recovery is most evident in the dismal level of capital investments. Gross fixed capital formations – in both real and nominal terms – are still a good 15% below their pre-pandemic levels (Chart 4, top two panels). Apathy among businesses in ramping up productive capacity indicates a lack of confidence in consumer demand going forward. Consumption is indeed weak: Unit sales for passenger vehicles continue to be sluggish, and commercial vehicle sales are not faring any better. Consumer sentiment has ticked down in the latest survey indicating retail sales might decelerate (Chart 4, bottom two panels) Consistently, industrial production in consumer goods-related industries is struggling to surpass previous highs, even though strong export demand has provided a fillip to sales. In more domestic-oriented industries such as construction goods, the weakness is palpable (Chart 5). Meanwhile, unemployment rates have fallen marginally, but are still higher than they were before the pandemic. As a result, wages remain subdued. The resulting weak household income is contributing to depressed consumption. With mediocre household income growth, demand for houses has also slowed meaningfully. This is reflected in dwindling property unit sales. The advent of the pandemic and the resulting loss of household income have further aggravated the situation. In fact, prices of certain types of dwelling units, such as semi-detached houses and high-rise apartments, are deflating outright (Chart 6, top panel). Falling house prices weigh on consumer sentiment and discourage future consumption. Chart 6Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Chart 5Weak Domestic Demand Is A Headwind To Industrial Production Weak Domestic Demand Is A Headwind To Industrial Production Weak Domestic Demand Is A Headwind To Industrial Production What’s more, the housing sector does not expect an early recovery in sales and prices either. This is evident in the very depressed level of new construction starts (Chart 6, bottom panel). As such, this sector is likely to remain a drag on Malaysia’s post-pandemic recovery. Fiscal And Credit Headwinds Going forward, the recovery will face other headwinds worth noting. One of them is a restrictive fiscal policy. This is because the “statutory debt” ceiling of the government – at 60% of GDP – has already been reached (Chart 7, top panel). This ceiling for statutory debts was fixed by lawmakers as part of a stimulus bill (COVID-19 Act) passed in 2020; and leaves little room for additional fiscal stimulus. Indeed, the IMF estimates that the ‘fiscal thrust’ this year will be negative at 2% of GDP (Chart 7, bottom panel). The country’s credit channel is also compromised. The reason is that Malaysian banks are still saddled with unresolved NPLs. These NPLs are a legacy of a very rapid expansion of bank loans following the GFC. In just five years (2009 -2014), bank credit doubled in nominal terms to 1500 billion ringgit or from 95% of GDP to 125% (Chart 8, top panel). Such fast deployment of credit was bound to cause significant misallocation of capital. And yet banks were averse to recognize impaired loans in any good measure. In fact, during the years of rapid credit growth, banks were recognizing ever fewer amounts in absolute terms as impaired loans. They were also setting aside ever lower amounts as loan loss provisions (Chart 8, second panel). Chart 7Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Chart 8Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised While bad debt recognition and provisions have risen modestly over the past year, Malaysia’s reported NPL ratio remained under 1.5% of loans (Chart 8, third panel). Loan loss provisions have been equally meager. This indicates that banks’ balance sheets are far from clean. In reality, Malaysian borrowers never went through any deleveraging process following their last credit binge. The bank credit-to-GDP ratio remains at around the same level as it was in 2015 (125% of GDP). By comparison, during Malaysia’s previous deleveraging phase, bank credit was shed from 150% of GDP to 90% (1998 - 2008). Borrowers already saddled with large amounts of debt are much less likely to borrow more to invest and/or consume. This is therefore going to cap credit demand. Chart 9Banks Are Piling Up On Government Securities By Shunning Loans Banks Are Piling Up On Government Securities By Shunning Loans Banks Are Piling Up On Government Securities By Shunning Loans As for banks, an increase in impaired loans makes them reticent to engage in further lending. Instead, they seek to accumulate safer assets such as government bonds. In fact, this is what Malaysian banks have been doing. They have ramped up their holdings of government securities materially since 2015 at the expense of loans and advances (Chart 9, top panel).   After the pandemic-related slowdown in the economy, banks’ loan books are now probably more encumbered with impaired loans.  As such, banks are even less likely to ramp up their loan books in any major way. That will be yet another headwind to economic recovery (Chart 9, bottom panel).    Value In Fixed Income The headwinds to growth do not entail a bullish outlook for Malaysian equities. The outlook for Malaysian local currency bonds, however, is promising. A tightening fiscal policy amid weak domestic demand and subdued inflation is a bullish cocktail for domestic bonds. There is a good chance that Malaysian bond yields will roll over. At a minimum, they will rise less than most other EM countries or US Treasuries. Notably, Malaysia offers one of the highest real yields (nominal yield adjusted for core inflation) in Emerging Asia (Chart 10, top panel). Given the country’s mediocre growth outlook, odds are high that Malaysian local bonds will outperform their EM / Emerging Asian peers (Chart 10, bottom panel). Chart 10Malaysian Bonds Offer One Of The Best Values In Emerging Aisa Malaysian Bonds Offer One Of The Best Values In Emerging Asia Malaysian Bonds Offer One Of The Best Values In Emerging Asia Chart 11Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks The Malaysian swap curve is also far too steep given the country’s macro backdrop. Going forward, the 10-year/1-year swap curve is set to flatten from its decade-steep level of 130 basis points (Chart 11, top panel). That means investors should continue receiving 10-year swap rates. On a related note, a fall in bond yields will not augur well for Malaysian stocks in general, and bank stocks in particular. The middle panel of Chart 11 shows that bank stocks struggle in absolute terms whenever bond yields decline. Incidentally, at 38% of total, banks are by far the largest sector in the MSCI Malaysia Index. And in recent months bank stocks have been propelling the Malaysian market (Chart 11, bottom panel). Should the bourse begin to miss the tailwind from rising bond yields, Malaysian equity performance will be hobbled.    Finally, investors should stay overweight in Malaysian sovereign credit. The country’s orthodox fiscal policy has accorded a defensive nature to this market. As such, periods of global risk-off witness Malaysian sovereign spreads fall relative to their EM counterparts, as they did in 2015 and again in 2020. In the months ahead, rising US inflation and a slowdown in Chinese property markets could cause another such period. That will lead Malaysian sovereign US dollar bonds to continue outperforming their EM peers. What’s With The Ringgit? Chart 12Malaysia Has Not Been Able To Benefit From A Cheap Currency Malaysia Has Not Been Able To Benefit From A Cheap Currency Malaysia Has Not Been Able To Benefit From A Cheap Currency The Malaysian currency is cheap, both in nominal and real terms (Chart 12, top panel). As such, it will likely be one of the most resilient currencies in EM this year. That said, the ringgit has been cheap for a while now (since 2015), and yet the Malaysian economy does not seem to have benefitted much all these years. The inability to take advantage of a cheap currency points to a fundamental malaise in the Malaysian economy: Loss of manufacturing competitiveness, as explained in our previous report on Malaysia. Perhaps equally worryingly, the country has not been able to attract much in the way of capital inflows. What this implies is that global investors did not find Malaysian assets attractive enough despite the benefits of a significantly cheaper currency (Chart 12, bottom panel). A major reason investors have not found the country attractive is because the return on capital on Malaysian assets has continued to deteriorate relative to the rest of the world. The upshot of the above is that, should Malaysian firms be able to improve their profits going forward, Malaysian stocks’ relative performance would get a boost from both higher relative earnings and a stronger currency. However, given the sluggish business cycle outlook as explained above, a sustainable rally in Malaysian stocks or currency is not imminent. Investment Conclusions Chart 13Malaysian Relative Stock Valuations Are On The Cheaper Side Malaysian Relative Stock Valuations Are On The Cheaper Side Malaysian Relative Stock Valuations Are On The Cheaper Side Equities: Malaysian stocks have cheapened. Both in terms of P/E ratio and P/book ratio, they are at the lower end of the spectrum relative to their EM counterparts (Chart 13). Yet, given the mediocre growth outlook, we recommend that dedicated EM and Emerging Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines in view of the worsening risk outlook in global markets, and wait for a better entry point later in the year. For local asset allocators in Malaysia, it is too early to overweight stocks relative to bonds over a cyclical horizon. Even though the equity risk premium in general has been much higher since the advent of the pandemic, stocks have struggled to outperform bonds in a total return basis over the past two years. That will likely be the case for several more months given the country’s growth outlook and rising global risks. Fixed Income: Malaysian domestic bonds will outperform their overall EM / Emerging Asian peers. So will Malaysian sovereign credit. Fixed income investors should overweight them in their respective EM / Emerging Asian portfolios. In the rate markets, investors should continue receiving 10-year swap rates. Finally, Malaysian yield curves are set to flatten. Investors should position for a narrowing of the 10-year/1-year yield curve, which is at a decade-high level of 180 basis points. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary The recent 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a downturn. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. As the 30-year T-bond rallies, so too will other long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the S&P 500 versus short-duration stock markets such as the FTSE 100. Fractal trading watchlist: We focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? Bottom Line: As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, and long-duration stock markets such as the US versus non-US. Feature My colleague Peter Berezin recently wrote that recessions tend to happen when: “1) the build-up of imbalances makes the economy vulnerable to downturn; 2) a catalyst exposes these imbalances; and 3) amplifiers exacerbate the slump.” Peter is spot on. Using this checklist, I would argue that right now: There is a massive imbalance that makes the economy vulnerable to a downturn. Specifically, a 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history – the 26 percent overspend on durables refers to the US, but other advanced economies have experienced similar binges on goods. The catalyst that exposes this massive imbalance is the realisation that durables are, well, durable. They last a long time. So, if you front-end loaded many of this year’s purchases into last year, then you will not buy them this year. If you overspent by 26 percent in 2021, then the risk is that you symmetrically underspend by 26 percent in 2022. If central banks hike rates into this demand downturn, they will amplify and exacerbate the slump. A Massive Imbalance In Spending Makes The Economy Vulnerable To A Downturn Much of the recent overspend on goods was spending displaced from the underspend on services which became unavailable in the pandemic – such as eating out, going to the movies, and going to in-person doctor’s appointments. Raising the obvious question, can a future underspend on goods be countered by a future overspend on services? The answer is no. The consumption of services is constrained by time, opportunity, and biology. For example, there is a limit on how often you can eat out, go to the movies, or go to the doctor. If you are used to eating out and going to the movies once a week, and the pandemic prevented you from doing so for a year, that does not mean you will eat out and go to the movies an extra 52 times for the 52 times you missed! Rather, you will quickly revert to your previous pattern of going out once a week. This constraint on services spending means that the underspend will not become a symmetric overspend. In fact, the underspend on certain services will persist. This is because we have made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping and online medical care. Additionally, a small but significant minority of people have changed their behaviour, shunning services that require close contact with strangers. To repeat the crucial asymmetry, an overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend (Chart I-1 and Chart I-2). Therefore, the recent massive overspend on goods at the expense of services makes the economy vulnerable to a downturn, and the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. These hikes will prove to be overkill, because inflation is set to cool of its own accord. Chart I-1An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An Overspend On Goods Can Be Corrected By A Subsequent Underspend...   Chart I-2...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend   Durables Are Driving Inflation, And Inflation Is Driving The 30-Year T-Bond The recent binge on goods really comprises three mini-binges, which peaked in May 2020, January-March 2021, and October 2021. With a couple of months lag, these three mini-binges have caused three mini-waves in core inflation. To see the cause and effect, it is best to examine the evolution of inflation granularly – on a month-on-month basis – which removes the distorting ‘base effects.’ The mini-binges in goods lifted the core monthly inflation rate to an (annualised) 7 percent in July 2020, 10 percent in April-June 2021, and 7 percent in January 2022 (Chart I-3). Chart I-3Spending On Durables Is Driving Inflation Spending On Durables Is Driving Inflation Spending On Durables Is Driving Inflation Worryingly, the sensitivity of inflation has increased in each new mini-binge in goods spending, possibly reflecting more pressure on already-creaking supply chains as well as more secondary effects. Nevertheless, the key driver of the mini-waves in core inflation is the demand for durables, and as that demand wanes, so will core inflation. As monthly core inflation eases back, so too will the 30-year T-bond yield. What about the 30-year T-bond yield? Although it is a long-duration asset, its yield has recently been tracking the short-term contours of core inflation. So, when monthly inflation reached an (annualised) 10 percent last year, the 30-year T-bond yield reached 2.5 percent. At the more recent 7 percent inflation rate, the yield has reached 2.35 percent. It follows that as monthly core inflation eases back, so too will the 30-year T-bond yield (Chart I-4). Chart I-4Inflation Is Driving The 30-Year T-Bond Inflation Is Driving The 30-Year T-Bond Inflation Is Driving The 30-Year T-Bond Get The 30-Year T-Bond Right, And You’ll Get Most Things Right For the past year, the story of stocks has been the story of bonds. Or to be more precise, the story of long-duration stocks has been the story of the 30-year T-bond. Through this period, the worry du jour has changed – from the Omicron mutation of SARS-CoV-2 to an Evergrande default to Facebook subscriber losses and now to Russia/Ukraine tensions. Yet the overarching story through all of this is that the long-duration Nasdaq index has tracked the 30-year T-bond price one-for-one (Chart I-5). And the connection between S&P 500 and the 30-year T-bond price is almost as good (Chart I-6). Chart I-5Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Chart I-6Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right The tight short-term connection between long-duration stocks and the 30-year T-bond makes perfect sense. The cashflows of any investment can be simplified into a ‘lump-sum’ payment in the future, and the ‘present value’ of this payment will move in line with the present value of an equal-duration bond. So, all else being equal, a long-duration stock will move one-for-one in line with a long-duration bond. The story of long-duration stocks has been the story of the 30-year T-bond. ‘Value’ stocks and non-US stock markets which are over-weighted to value have a shorter-duration. Therefore, they have a much weaker connection with the 30-year T-bond. It follows that if you get the 30-year T-bond right, you’ll get most things right: The performance of other long-duration bonds (Chart I-7). The performance of long-duration growth stocks (Chart I-8). The performance of ‘growth’ versus ‘value’ (Chart I-9). The performance of growth-heavy stock markets like the S&P 500 versus value-heavy stock markets like the FTSE100 (Chart I-10). Of course, the corollary is that if you get the 30-year T-bond wrong, you’ll get most things wrong. Observe that the 1-year charts of long-duration bonds, growth stocks, growth versus value, and S&P 500 versus FTSE100 are indistinguishable. Proving once again that investment is complex, but it is not complicated! Chart I-7Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Chart I-8Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right   Chart I-9Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Chart I-10Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Our expectation is that as the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the US versus non-US. Fractal Trading Watchlist This week we focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. Emerging markets (EM) have been a big underperformer through the past year, but it may be time to dip in again, at least relative to value-heavy developed market (DM) indexes. Specifically, MSCI Emerging Markets versus MSCI UK has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2018, and 2020 (Chart I-11). Accordingly, this week’s recommended trade is to go long MSCI EM versus UK (dollar indexes), setting the profit-target and symmetrical stop-loss at 10 percent.  Chart I-11Time To Dip Into EM Again, Selectively Time To Dip Into EM Again, Selectively Time To Dip Into EM Again, Selectively Financials Versus Industrials Is Approaching A Turning-Point Financials Versus Industrials Is Approaching A Turning-Point Financials Versus Industrials Is Approaching A Turning-Point Image CAD/SEK At A Top CAD/SEK At A Top CAD/SEK At A Top Awaiting A Major Entry-Point Into Biotech Awaiting A Major Entry-Point Into Biotech Awaiting A Major Entry-Point Into Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations I Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Image   Indicators To Watch - Interest Rate Expectations III A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face Image    

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (February 15 at 10:00 AM EST, 15:00 PM GMT, 16:00 PM CET). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Highlights A feedback loop has emerged in European markets. Tightening financial conditions will preempt the European Central Bank from hiking rates as much as the money market is pricing in. The widening in peripheral and credit spreads is overdone. Investors already long should maintain their positions. Investors without exposure will soon find an attractive entry point. Despite these near-term gyrations, the ECB is still on track to hike interest rates once in Q4 2022 and lift them aggressively in 2023. Feature Last week’s hawkish pivot by the European Central Bank (ECB) continues to affect markets. We take the words of the ECB at their face value; we anticipate the Governing Council (GC) to begin lifting interest rates at the end of 2022 and to continue to do so steadily over 2023 and 2024. However, as the shock filters through financial asset prices, we become more confident that the ECB will not lift rates five times in 2022 as the Euro Short Term Rate (ESTR) curve currently anticipates. Chart 1Growing Tensions In The Periphery... Growing Tensions In The Periphery... Growing Tensions In The Periphery... First, the behavior of Italian and Greek bond markets constitutes a major support to our view. Italian and Greek 10-year spreads have widened by respectively 46 and 65 basis points over the past six trading days (Chart 1). This tension highlights that investors still view these economies as continental trouble spots. Meanwhile, the ECB’s communication continues to highlight the need for flexibility to maintain order in the sovereign debt market. The GC does not want inadvertently to engineer a severe tightening in financial conditions in the already fragile periphery. In this context, it is highly unlikely that the ECB will rush to terminate the Asset Purchase Program (APP), an end on which rate hikes depend. Second, the corporate bond market is also going through a significant period of ruction. Both investment grade and high-yield bond yields have risen rapidly in recent days, and they are now retesting their late-2018 levels (Chart 2, top two panels). Spreads too are widening meaningfully, even though they remain further away from their 2018 highs (Chart 2, bottom two panels) The ECB is unwilling to let a liquidity shock morph into a solvency problem for European firms. For now, the behavior of the European credit market remains consistent with a liquidity shock. Funding markets are experiencing a violent adjustment, which is bleeding into the overall level of spreads. However, investors are not differentiating based on credit risk. Chart 3 shows that CCC credit (the lowest rated HY bonds) is not selling off relative to the overall high-yield index, which we would anticipate if investors were worried about underlying default risk. Chart 3No Distinction On Credit Risk No Distinction On Credit Risk No Distinction On Credit Risk Chart 2...And In European Corporates ...And In European Corporates ...And In European Corporates If the liquidity shock were to deepen further and last long enough, the resilience of the corporate sector would fritter away. However, the GC has tried to resist a deflationary shock for more than ten years now, and a solvency problem would undo all the progress made toward escaping the European liquidity trap, especially because wages have yet to recover. Third, members of the ECB’s GC are already trying to talk down the market. President Christine Lagarde displayed a more dovish tone when she spoke in front of the EU Parliament on February 7, 2022. ECB Chief Economist Philippe Lane remains steadfast that wages are not yet a problem. The Governor of the Bank of France, François Villeroy de Galhau still sees an imminent peak in CPI, and Olli Rehn, Governor of the Bank of Finland, recently lectured about the need for a gradual normalization of policy. Even hawks like the Bundesbank’s Joachim Nagel or the DNB’s Klaas Knot have gestured toward higher rates, but only toward the end of the year. In this context, we expect credit spreads to begin to narrow again; however, it will likely first require an easing in funding pressures. This is unlikely to happen until US yields form an interim peak. However, as Chart 4 highlights, the Treasury market is becoming extremely oversold. Moreover, a JP Morgan survey shows that its clients are massively short duration. The risk of a pullback in Treasury yields is growing, even if rising inflation and fears of a tighter Fed prevail for now. If US yields were to decline Bunds would likely follow the Treasury market because the ECB is becoming louder that it does not want to tighten financial conditions abruptly. Hence, a pullback in global risk-free yields will be the key to a period of calm in credit spreads, since valuations have improved materially, with the breakeven spreads on investment grade and high-yield bonds moving back to their 43rd and 44th percentiles, respectively (Chart 5). A stabilization in global yields and European spreads should also percolate to the peripheral sovereign bond market and limit the upside to Italian and Greek spreads. Chart 4Oversold Treasurys Oversold Treasurys Oversold Treasurys Chart 5Restoring Value In Corporates Restoring Value In Corporates Restoring Value In Corporates Bottom Line: The tightening in financial conditions taking place in Europe indicates that money market curves are pricing in the path for European policy rates too aggressively. The ECB has changed since 2011. It will not let peripheral borrowing costs threaten the recovery in Southern European economies, nor will it allow a liquidity shock in the corporate bond market to become a solvency issue that will damage growth prospects. European peripheral and corporate spreads will narrow once global risk-free rates peak.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com

Executive Summary The End Of The Negative Bond Yield Era Europe Joins The Global Bond Bear Market Europe Joins The Global Bond Bear Market Recent price action in developed market government bond markets confirms a backdrop that has been in place for the past several years - movements in US Treasuries define the trend in global yields, but Europe sets the effective floor. Higher core European bond yields are also pushing up non-European yields, in the context of the current global monetary policy tightening cycle. The hawkish market pricing for the ECB this year has gone a bit too far, as the start of European rate hikes this year is more likely in Q4 than in the summer – and only after ECB asset purchases begin to formally wind down. In the UK, the Bank of England appears to be trying to front load policy tightening, both rate hikes and balance sheet runoff, in response to overshooting UK inflation. A shorter, sharper policy tightening cycle means that the UK Gilt curve will continue to bear-flatten.  Bottom Line: Within the “Big 3” developed market central banks, the Fed and Bank of England are more likely to deliver discounted rate hikes than the ECB over the next 6-12 months. Remain underweight US Treasuries and UK Gilts versus German Bunds in global bond portfolios. Feature Chart 1A Global Repricing Of Interest Rate Expectations A Global Repricing Of Interest Rate Expectations A Global Repricing Of Interest Rate Expectations Persistent elevated inflation readings are forcing policymakers to move up the timetable of expected cyclical interest rate increases, but without signaling any change to longer-term interest rate expectations. The result has been an upward move in bond yields led by a repricing of shorter-term yields, leading to bearish yield curve flattening pressure across the developed markets (Chart 1). As the global bond bear market has intensified and broadened across countries and fixed income sectors, the amount of bonds worldwide with negative yields has been slashed by $9 trillion since December (Chart 2). Some notable examples: the 10-year German Bund yield is now up to +0.26%, the 30-year US real TIPS yield is now at +0.04% and even the 5-year Japanese government bond yield climbed to +0.02% for the first time since 2016. Last week, bond markets had to digest both a 25bp Bank of England (BoE) rate hike - that was almost a 50bp move - and a huge upside surprise in the January US employment report. However, it was the more hawkish-than-expected messaging from the European Central Bank (ECB) that really rattled fixed income markets. At the February monetary policy meeting, ECB President Christine Lagarde opened the door to potential ECB rate hikes this year, a notable change from the previous forward guidance that rates would stay unchanged in 2022. This not only triggered a major decline in European government bond prices, but also notable jumps in bond volatility for both longer-term and, especially, shorter-term yields. Implied volatilities for swaptions on 2-year European swap rates now sit at the highest levels since the depths of the European Debt Crisis in 2011 (Chart 3). Chart 2The End Of The Negative Bond Yield Era The End Of The Negative Bond Yield Era The End Of The Negative Bond Yield Era ​​​​​ Chart 3The Front-Ends Of Yield Curves Awaken The Front-Ends Of Yield Curves Awaken The Front-Ends Of Yield Curves Awaken ​​​​​​ Overnight index swap (OIS) curves are now discounting multiple rate hikes from the Fed (+127bps), BoE (+125bps) and ECB (+46bps) this year. Tighter monetary policy is the inevitable consequence of the current combination of steady above-trend growth, tight labor markets and very high inflation in those countries. This mix will continue to put upward pressure on global bond yields through a blend of steady inflation expectations and higher real yields as pandemic era monetary stimulus is removed – a process that is already underway in the US and Europe (Chart 4). Our Central Bank Monitors – designed to measure the cyclical pressure to change monetary policy – are all indicating the need for tightening in the US, UK and euro area. However, the risk is that tightening perceived to be too aggressive or too rapid will be received poorly by financial markets that have grown accustomed to easy money policies during the pandemic. Given the current starting point of high equity valuations and relatively tight corporate credit spreads in the US, financial conditions are no impediment to additional Fed rate hikes in 2022 (Chart 5). The same cannot be said in the UK, where the steady appreciation of the trade-weighted pound is tightening financial conditions, on the margin. In the euro area, financial conditions remain relatively stimulative, as the euro is undervalued on a trade-weighted basis. Chart 4A Recipe For Even Higher Bond Yields A Recipe For Even Higher Bond Yields A Recipe For Even Higher Bond Yields Given high realized inflation, financial stability concerns are playing a secondary role in the policy deliberations of central banks facing an inflation-fighting credibility crisis. In the absence of a big fall in inflation, it will take much larger selloffs in equity and corporate credit markets than what has occurred so far in 2022 before policymakers would step back from interest rate increases over the next year. Chart 5Financial Conditions Are No Impediment To Rate Hikes Financial Conditions Are No Impediment To Rate Hikes Financial Conditions Are No Impediment To Rate Hikes ​​​​​​ The ECB Will Lag The Fed On Rate Hikes Chart 6Faster Growth & Slower Inflation Expected In 2022 Faster Growth & Slower Inflation Expected In 2022 Faster Growth & Slower Inflation Expected In 2022 One of our highest conviction bond market views to begin 2022 called for US Treasuries to underperform German Bunds. Our view was based on the likelihood that the Fed would lift the fed funds rate multiple times this year and the ECB was likely to hold off on rate hikes until the first half of 2023 at the earliest. Last week’s shift in the ECB’s tone does not change that relative call. The Fed is still under far greater pressure to hike rates than the ECB, even if there is now a greater chance that the ECB could begin to tighten by the end of 2022. From an economic growth perspective, both central banks have good reasons to consider withdrawing monetary accommodation. The economic expectations in both the US and euro area have started to recover, according to the ZEW survey of financial market professionals, with a bigger bounce seen in the latter since the trough of last October (Chart 6). The fading Omicron wave is likely playing a large role in lifting economic expectations, as the variant has proven to be less lethal than previous waves of the virus. The ZEW survey also asks respondents about their views on future inflation and interest rate changes. The ZEW Inflation Expectations index has fallen back to pre-pandemic lows in both the US and euro area, indicating that a majority expect lower inflation in the US and Europe over the next year. Both the Fed and ECB also expect inflation to fall from current elevated levels this year. However, there is still a much stronger case for tightening in the US given the tight labor market that is pushing up wages. Last week’s January US payrolls data was a shocker, with employment rising +476,000 on the month when some forecasters were calling for an outright contraction in jobs due to the impact of the Omicron variant. Wage growth accelerated smartly, with average hourly earnings up 0.7% on the month and 5.7% on a year-over-year basis (Chart 7). This continues the trend of wage acceleration seen in other data series like the Employment Cost Index, confirming that the US labor market is tight enough to elicit a strong policy response from the Fed. In the euro area, the recent economic data has been a bit more mixed. The Markit manufacturing PMI rose to a five-month high of 59.0 in January, beating expectations. However, the services PMI fell to a nine-month low of 51.2 as renewed COVID lockdowns weighed on consumer confidence and spending (Chart 8). With Omicron numbers now slowing, some recovery in consumer spending is likely over the next few months as euro area governments reduce restrictions. However, the manufacturing recovery will struggle to gain significant upside momentum without stronger demand for European exports – an outcome that is not currently heralded by an upturn in reliable indicators like the global leading economic indicator or the China credit impulse (Chart 9). Chart 7Persistent US Labor Market Strength Persistent US Labor Market Strength Persistent US Labor Market Strength ​​​​​​ Chart 8A Mixed Picture On European Growth A Mixed Picture On European Growth A Mixed Picture On European Growth ​​​​​​ Even within the euro area inflation data, there are mixed trends that make it less clear that a major tightening cycle is necessary. Headline euro area HICP inflation hit a 37-year high of 5.1% in January, which was heavily influenced by a 28.6% rise in the energy component of the index (Chart 10). Goods price inflation reached 6.8%, its highest level since 1991, fueled by global supply chain disruptions and greater consumer demand for goods versus services during the pandemic. For the latter, services inflation reached a much more subdued 2.4% in January, in line with core HICP inflation of 2.3%. We expect goods price inflation to slow substantially, on a global basis and not just in Europe, as supply chain disruptions ease over the course of 2022 and consumers shift spending back towards services from durable goods as economies reopen post-Omicron. Chart 9A Gloomy Picture For European Exports A Gloomy Picture For European Exports A Gloomy Picture For European Exports ​​​​​ Chart 10European Inflation Surge Focused On Energy & Goods European Inflation Surge Focused On Energy & Goods European Inflation Surge Focused On Energy & Goods ​​​​​ Surging oil and natural gas prices will keep the energy component elevated over the next few months, particularly if geopolitical tensions over Ukraine result in Russia withholding natural gas supplies to Europe. Yet it is not clear how much of this will pass through to core inflation, which actually decelerated in January from the 2.6% pace seen in December 2021 despite surging energy prices. What does a typical ECB liftoff look like? Should the ECB focus more on the headline or core inflation numbers when deciding if rate hikes are necessary later this year? The answer may lie more in the breadth across countries, rather than depth across sectors, of euro area inflation pressures. In the relatively short history of the ECB, dating back to the inception of the euro in 1998, there have been only three monetary tightening episodes that involved interest rate increases: 1999-00, 2006-08 and 2011. In Chart 11, we show the percentage share of individual euro area countries that have accelerating growth momentum (measured as a leading economic indicator above the level of a year earlier), and with headline/core inflation above the ECB’s 2% target. In all three of those past ECB tightening episodes, essentially all euro area countries had to see strong growth or inflation at or above the ECB target before the ECB would hike rates. Chart 11The Growth & Inflation Conditions For An ECB Rate Hike Are In Place The Growth & Inflation Conditions For An ECB Rate Hike Are In Place The Growth & Inflation Conditions For An ECB Rate Hike Are In Place Chart 12Watch European Wages To Determine The ECB's Next Move(s) Watch European Wages To Determine The ECB's Next Move(s) Watch European Wages To Determine The ECB's Next Move(s) A similar story can be told looking at the state of the euro area labor market. The 1999-00 and 2006-08 tightening cycles occurred when nearly all euro area countries had an unemployment rate below the OECD’s estimate of the full employment NAIRU (Chart 12). Only in 2011, which was widely regarded as a major policy error, did the ECB hike rates without widespread labor market strength across the euro area. Right now, the breadth of the growth and inflation data across the euro area would indicate that the ECB will soon begin to tighten policy, if history is any guide. The one missing piece of the puzzle is faster wage growth. Euro area wage growth is severely lagging compared to other developed economies. For the last known data point in Q3/2021, wages were only growing at a 1.5% year-over-year rate. Wage growth has very likely accelerated since then, with the overall euro area unemployment rate now down to an all-time low of 7.0%, well below the OECD NAIRU estimate of 7.7%. The ECB will need to see confirmation of that faster wage growth in the data, however, before embarking on a path of rate hikes. Since last week’s ECB meeting, numerous ECB officials – including President Lagarde - have stated that asset purchases must stop before rate hikes can begin. While the ECB’s pandemic emergency bond buying program is set to end next month, the existing Asset Purchase Program is set to continue with no expiry date. If the ECB officials are to be taken at their word, it is very difficult to imagine a scenario where asset purchases would be fully wound down (i.e. net purchases of zero, with buying only to replace maturing bonds held by the ECB) before the July liftoff date now priced into the Euro OIS curve. Such a rapid removal of the ECB bid would be very disruptive to the riskier parts of European fixed income markets, like Italian and Greek sovereign debt, that have benefited from heavy ECB buying under the pandemic bond buying program. European bond strategy implications While an ECB rate hike in 2022 is now a more probable scenario, it is not yet a done deal. The European growth picture remains mixed, and inflation readings outside of supply-constrained energy and durable goods – including wages - are far less threatening than headline inflation. At the moment, underlying inflation pressures are far more intense in the US. Durable goods inflation in the US reached 16.8% on a year-over-year basis last month, but climbed to “only” 3.8% in Europe (Chart 13). The Cleveland Fed’s trimmed mean CPI index accelerated to 4.8% in January, compared to 3.0% for the euro area trimmed mean CPI inflation gauge constructed by our colleagues at BCA Research European Investment Strategy. Chart 13Stay Positioned For A Wider UST-Bund Spread Stay Positioned For A Wider UST-Bund Spread Stay Positioned For A Wider UST-Bund Spread The Fed has a lot more work ahead of it in terms of tightening monetary policy to rein in inflation pressures (and inflation expectations) than the ECB. This will lead to a faster pace of rate hikes in the US than in Europe and renewed widening of the US Treasury-German Bund yield spread. Financial conditions in Europe will also play a role in limiting when, and how much, the ECB can eventually tighten monetary policy. Yields and spreads on the riskier parts of the European fixed income markets like Italian government bonds have already widened substantially in response to the more hawkish guidance from the ECB (Chart 14). The euro has also stabilized after the steady depreciation seen since the May 2021 peak. Markets are obviously pricing in an end to ECB asset purchases – the precursor to rate hikes – which would force the private sector to absorb a greater share of Italian bond issuance than has been the case over the past few years. It will likely take higher yields to entice those buyers compared to the price-insensitive ECB that has been buying Italian debt as a monetary policy tool. The speed of the adjustment in Italian bond yields has no doubt alerted the ECB Governing Council to the financial stability risks of moving too fast on tightening monetary conditions. We must acknowledge that most the recent trends in the Treasury-Bund spread (narrower) and Italian bond yields/spreads (higher) go against our current strategic recommendations to overweight European fixed income. Markets have moved to price in a far more aggressive move from the ECB than we had envisioned for 2022. However, as highlighted above, it is not clear that the ECB needs to dial back monetary accommodation as rapidly as markets now expect. Thus, we are sticking with our strategic recommendations to overweight euro area government bonds, both in the core and periphery, in global bond portfolios. At the same time, we continue to recommend a below-benchmark duration stance within dedicated European portfolios, even with the 10-year German Bund yield having already reached our end-2022 yield target of 0.25% (Chart 15). European bond yields will remain under upward pressure until euro area inflation finally peaks and the ECB will be under less pressure to tighten. Chart 14ECB Facing An "Italy-vs-Inflation" Tradeoff ECB Facing An "Italy-vs-Inflation" Tradeoff ECB Facing An "Italy-vs-Inflation" Tradeoff ​​​​​ Chart 15Too Much, Too Soon Priced Into Bund Yields Too Much, Too Soon Priced Into Bund Yields Too Much, Too Soon Priced Into Bund Yields ​​​​​ Bottom Line: Markets are overestimating how quickly the ECB can begin to tighten European monetary policy. An initial rate hike can occur in Q4 of this year, at the earliest, which is later than the current mid-summer liftoff date discounted in interest rate forwards. Ride out the current European rates volatility and stay overweight European government debt versus the US. UK Update: The BoE Wants To Tighten Fast At last week's policy meeting, the BoE Monetary Policy Committee (MPC) voted 5-4 to raise Bank Rate by 25bps to 0.5%. That close vote is less dovish than it appears, though, as the four “dissenting” MPC members wanted to raise rates by 50bps instead! This was a hawkish surprise that resulted in bearish flattening of the UK Gilt yield curve. Chart 16UK Gilts: Volatile, But Underperforming UK Gilts: Volatile, But Underperforming UK Gilts: Volatile, But Underperforming We have maintained a below-benchmark strategic recommendation on Gilts since August of last year. The relative performance of Gilts versus the Bloomberg Global Treasury benchmark index has seen tremendous volatility since then, particular after the BoE delayed the expected initial rate hike last November (Chart 16) Gilts began to underperform again after the BoE hiked in December and have continued to be one of the worst performing G10 bond markets, validating our bearish call. After last week’s BoE hike, we still see value in betting on additional Gilt underperformance, as markets may still be underestimating how high the BoE will have to raise rates in the current tightening cycle. In the new set of economic projections from the BoE’s Monetary Policy Report published last week, the central bank raised its expectation for the April peak in UK inflation to 7.25% (Chart 17). This compares to the latest inflation rate of 5.4%. Higher energy and goods prices account for three-quarters of that expected inflation increase, according to the BoE. UK inflation is projected to fall rapidly from that April peak, in response to an expected deceleration of energy and goods prices and slower UK economic growth. However, the Monetary Policy Report also highlighted that domestic UK cost pressures are intensifying in response to a very tight UK labor market. The BoE’s Agents’ survey of UK businesses reported that UK firms continue to have difficulty filling job openings, while also having success in passing on rising labor costs into selling prices. Thus, the UK labor market is now the critical variable to watch to determine how many more rate hikes the BoE will need to deliver in the current cycle. On that note, the BoE expects UK wage growth to accelerate to just under 5% over the next year, which is well above the central bank’s estimate of “underlying” pre-pandemic wage growth around 3.5%. Inflation expectations in the UK remain elevated. The YouGov/Citigroup survey shows that UK consumers expect inflation to be 4.8% on year from now and 3.8% 5-10 years ahead (Chart 18, top panel). Market-based inflation expectations have been more volatile of late but CPI swaps are pricing in inflation of 5.0% in two years and 4.2% in ten years.1 Thus, by any measure – realized inflation, expected inflation or wage growth – UK inflation is too high, which justifies tighter monetary policy. The UK OIS curve now discounts a peak in Bank Rate of 1.85% in April 2023, but this is immediately followed by rate cuts that take Bank Rate to 1.5% by the end of 2024. That path over the next year is a bit more hawkish than the results from the BoE’s new Market Participants Survey of bond investors, which showed an expected peak in Bank Rate of 1.5% sometime in the latter half of 2023. In both cases, Bank Rate is expected to settle below the BoE’s 2% inflation target, or below current inflation expectations. Suggesting an implied belief that the BoE will not be able to raise real interest rates into positive territory. In terms of forward guidance, several BoE officials have noted that they expect that only a few more hikes will be needed to help bring UK inflation back down to the 2% target. Yet the OIS curve is pricing in a “policy error” scenario where the BoE pushes up rates too rapidly and is then forced to cut rates soon afterward. We see both the BoE guidance and the OIS pricing as far too cautious on the eventual peak in Bank Rate, which leads us to maintain our underweight recommendation on UK Gilt exposure, both in terms of duration and country allocation in global bond portfolios. Chart 17BoE Sees A Short, Sharp Shock From Inflation & Rates BoE Sees A Short, Sharp Shock From Inflation & Rates BoE Sees A Short, Sharp Shock From Inflation & Rates We have also been recommending a Gilt curve steepening trade in our Tactical Overlay portfolio on page 20 since last October. This trade went long a 10-year Gilt bullet versus a barbell combination of a 7-year and 30-year Gilt. Chart 18Stay Underweight UK Gilts Stay Underweight UK Gilts Stay Underweight UK Gilts ​​​​​ Our view at the time of trade inception was that a Gilt steepener would benefit from a scenario where the market would be forced to reassess how high rates would go in the next BoE tightening cycle. However, the BoE now appears to be “front loading” the tightening cycle by moving rates sooner and more aggressively, as evidenced by the near 50bp rate hike last week, while also moving to an accelerated runoff of bonds accumulated during quantitative easing operations. The Gilt yield curve has flattened considerably in response to increasing BoE hawkishness, with the yield spread between the 10-year and 2-yield Gilt now down to a mere +17bps. While we still see the potential for the longer-end of the Gilt curve to rise in response to an eventual repricing of terminal rate expectations that appear too low, the BoE’s acceleration of its hiking timetable will make it difficult for the curve to bearishly steepen in the near term. Thus, we are closing out our tactical Gilt curve steepener at a small gain of +23bps.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      UK CPI swaps, and inflation breakevens on index-linked Gilts, reference the UK Retail Price Index (RPI) which typically runs higher than the UK Consumer Price Index (CPI). This imparts an upward bias to UK inflation expectations when compared to CPI swaps and breakevens in other countries. Currently, RPI inflation is running at 7.5% compared to CPI inflation of 5.4%. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Europe Joins The Global Bond Bear Market Europe Joins The Global Bond Bear Market The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Cyclical Recommendations (6-18 Months) Europe Joins The Global Bond Bear Market Europe Joins The Global Bond Bear Market Tactical Overlay Trades

Highlights Chart 1Most Sectors Have Fully Recovered Most Sectors Have Fully Recovered Most Sectors Have Fully Recovered Last week’s January employment report shocked markets by showing much greater job gains than had been anticipated. More important than the headline number, however, were the revisions to prior months that reveal a much different picture of the post-COVID labor market. In overall terms, the revised data show that employment is still significantly below where it was prior to the pandemic. Specifically, the economy is still missing about 2.9 million jobs. However, the data now reveal that more than 60% of the missing jobs come from the Leisure & Hospitality sector and that the Health Care and State & Local Government sectors account for the rest. In other words, except for the few sectors that have been most impacted by the pandemic, the US labor market has made a full recovery (Chart 1). The new data justify the Fed’s recent push toward tightening. This is because there is no longer any evidence of labor market slack beyond what we see in the select few close-contact service industries that have been most impacted by COVID. Investors should maintain below-benchmark portfolio duration as the Fed moves toward rate hikes. Feature Table 1Recommended Portfolio Specification The COVID Labor Market The COVID Labor Market Table 2Fixed Income Sector Performance The COVID Labor Market The COVID Labor Market Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 115 basis points in January. The index option-adjusted spread widened 14 bps on the month to reach 108 bps, and our quality-adjusted 12-month breakeven spread moved up to its 15th percentile since 1995 (Chart 2). This indicates that, despite the recent selloff, corporate bonds remain expensive. We discussed the intermediate-term outlook for corporate bonds in a recent report.1  Specifically, we analyzed the performance of both investment grade and high-yield corporate bonds during previous Fed tightening cycles. Our conclusion is that it will soon be appropriate to reduce our cyclical exposure to corporate credit. For investment grade corporates, this will mean reducing our recommended allocation from neutral (3 out of 5) to underweight (2 out of 5). Our analysis of past cycles suggests that the slope of the yield curve is a critical indicator of corporate bond performance. Excess corporate bond returns are generally strong when the 3-year/10-year Treasury slope is above 50 bps but take a step down when the slope shifts into a range of 0 – 50 bps. The 3/10 slope has just recently dipped below 50 bps (bottom panel). Though our fair value estimates can’t rule out a near-term bounce back above 50 bps, this will become less and less likely as Fed rate hikes approach. We maintain our current recommended allocation for now but expect to downgrade within the next few weeks. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The COVID Labor Market The COVID Labor Market Table 3BCorporate Sector Risk Vs. Reward* The COVID Labor Market The COVID Labor Market High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 158 basis points in January. The index option-adjusted spread widened 59 bps in January to reach 342 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also moved up to 4% (Chart 3). The odds are good that defaults will come in below 4% during the next 12 months, which should coincide with the outperformance of high-yield bonds versus Treasuries. For context, the high-yield default rate came in at 1.24% in 2021 and we showed in a recent report that corporate balance sheets are in excellent shape.2 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). While high-yield valuations are more favorable than for investment grade, the bonds will still have to contend with a more challenging monetary environment this year as the Fed lifts rates and the yield curve flattens. For this reason, we expect to reduce our recommended allocation to high-yield corporates in the coming weeks – from overweight (4 out of 5) to neutral (3 out of 5) – though we will retain our preference for high-yield over investment grade. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in January. The zero-volatility spread for conventional 30-year agency MBS tightened 7 bps on the month, split between a 17 bps tightening of the option-adjusted spread (OAS) and a 10 bps increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.3 This valuation picture is starting to change. The option cost is now up to 36 bps, its highest level since March 2020, and refi activity is slowing as the Fed moves toward rate hikes. At 23 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS. We continue to recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Emerging Market Bonds (USD): Overweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview This week we officially initiate coverage of USD-denominated Emerging Market (EM) bonds. To start, we will focus on investment grade rated Sovereigns, Corporates and Quasi-Sovereigns. We plan to expand our coverage to include high-yield in the coming months. This EM section replaces the previous Government-Related section in our monthly summary. We will continue to cover Government-Related securities from time to time, but that sub-index will no longer be regularly included in our recommended portfolio allocation. Emerging Market bonds underperformed the duration-equivalent Treasury index by 88 basis points in January. EM Sovereigns underperformed the Treasury benchmark by 134 bps on the month and the EM Corporate & Quasi-Sovereign Index underperformed by 58 bps. After strong relative performance in the back-half of 2021, the EM Sovereign index eked out just 4 bps of outperformance versus the duration-equivalent US corporate bond index in January (Chart 5). Meanwhile, the EM Corporate & Quasi-Sovereign index outperformed the duration-matched US corporate index by 24 bps on the month. Yield differentials for EM sovereigns and corporates remain attractive relative to US corporates (panel 4). Additionally, EM currencies are hanging in there versus the dollar even as the Fed moves toward tightening (bottom panel). We recommend an overweight allocation to USD-denominated EM bonds in US bond portfolios, and we maintain our preference for EM sovereign and corporate bonds relative to US corporates with the same credit rating and duration. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 121 basis points in January (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.4 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 19% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk as bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened dramatically in January, and yields continued their sharp rise through the first week of February – though in a more parallel fashion. All in all, the 2-year/10-year Treasury slope has flattened 17 bps since the end of December, bringing it to 62 bps. The 5-year/30-year slope has flattened 19 bps since the end of December, bringing it to 45 bps. The aggressive flattening of the curve has occurred alongside the Fed’s increased near-term hawkishness. Our 12-month discounter has risen from 77 bps at the end of last year to 149 bps today (Chart 7). In other words, the market has gone from anticipating just over three 25 basis point rate hikes during the next 12 months to nearly six! Last week’s report argued that the most recent move to discount more than four 25 basis point rate hikes in 2022 is overdone.5  We contend that tightening financial conditions and falling inflation expectations will cause the Fed to moderate its pace of rate hikes in the second half of this year. We still see the Fed lifting rates three or four times in 2022, but this is now significantly below what’s priced in the market. Given our view, we recommend a position long the 2-year Treasury note versus a barbell consisting of cash and the 10-year note. This trade will profit as a more moderate expected pace of near-term rate hikes limits the upward pressure on the 2-year yield. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 23 basis points in January. The 10-year TIPS breakeven inflation rate has declined by 16 bps since the end of December while the 2-year TIPS breakeven inflation rate has fallen by 1 bp. The 10-year and 2-year rates currently sit at 2.43% and 3.21%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate is down 22 bps since the end of December. It currently sits at 2.05%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given how the market has reacted to the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in January. Aaa-rated ABS outperformed by 19 bps on the month and non-Aaa ABS outperformed by 20 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in January. Aaa Non-Agency CMBS underperformed Treasuries by 3 bps in January, but non-Aaa Non-Agency CMBS outperformed by 2 bps (Chart 10). Though returns have been strong and spreads remain relatively wide, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in January. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.     Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 31, 2022) The COVID Labor Market The COVID Labor Market Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 31, 2022) The COVID Labor Market The COVID Labor Market Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -53 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 53 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The COVID Labor Market The COVID Labor Market Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of January 31, 2022) The COVID Labor Market The COVID Labor Market Recommended Portfolio Specification The COVID Labor Market The COVID Labor Market Other Recommendations The COVID Labor Market The COVID Labor Market Ryan Swift US Bond Strategist rswift@bcaresearch.com    Footnotes 1 Please see US Bond Strategy Weekly Report, “Positioning For Rate Hikes In The Corporate Bond Market”, dated January 25, 2022. 2 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 5 Please see US Bond Strategy Weekly Report, “The Best Laid Plans”, dated February 1, 2022.

Executive Summary The European Central Bank (ECB) has engaged in a decisive pivot toward higher policy rates. Markets are pricing in a first interest-rate hike in July and three more increases thereafter in 2022. This is too much for one year. Limited domestic inflationary pressures, weakness in long-term inflation expectations, economic slack, and vulnerability in the periphery will limit the ECB to one hike in December. Nonetheless, the ECB will increase interest rates more than the market anticipates beyond 2022. The UK is setting up for a dangerous latter half of 2022. Too Much Now, Not Enough Later Too Much Now, Not Enough Later Too Much Now, Not Enough Later Bottom Line: Bet on a steepening of the euro short-term rate (€STR) curve. Current pricing for 2022 is too aggressive; however, it is too timid beyond the yearend. European financials will be the prime beneficiary of this tilt. Feature On Thursday, February 3, ECB President Christine Lagarde announced a decidedly hawkish pivot at the ECB press conference. The Frankfurt-based institution, worried by higher-than-anticipated inflation, no longer excludes rate hikes for 2022. In a context in which the BoE is resolutely hiking rates and the Fed is ready to initiate a sustained tightening campaign, investors are pricing in a 10bp ECB rate hike as early as July 2022. They also foresee three additional increases by the end of the year. We agree that the ECB will start lifting the deposit rate this year; however, we expect the tightening to begin in December. Nonetheless, we expect the ECB to lift policy rates more aggressively than the €STR prices in subsequent years. European Inflation Is Different Chart 1Surprise! Surprise! Surprise! The knee-jerk reaction of investors to price in a sudden, sustained campaign of ECB rate hikes this year similar to that of the Fed is natural in light of elevated Eurozone inflation and inflation surprises (Chart 1). However, we continue to view European inflation as distinct from US inflation. European inflation remains dominated by dynamics in the energy market. While headline inflation increased from 5% to 5.1% in January, the core Consumer Price Index (CPI) declined modestly to 2.3% from 2.6%. Crucially, the variance of headline CPI is still almost fully explained by the variance of its energy component (Chart 2, top panel). However, it is concerning that there is also evident pass-through from energy prices to core CPI taking place today (Chart 2, bottom panel). Naturally, natural gas prices play a particularly important role in this energy-driven inflation spike (Chart 3). Chart 2Energy Still Drives Inflation Energy Still Drives Inflation Energy Still Drives Inflation Chart 3Natural Gas Remains Key Natural Gas Remains Key Natural Gas Remains Key Imported inflation is another key driver of European inflation. Chart 4 highlights that there is a robust relationship between the level of headline Harmonized Index of Consumer Prices (HICP) across EU nations and their import prices. This confirms that a large proportion of the European inflationary outburst has taken root outside of the continent’s borders. Chart 4Imported Inflation? The ECB Is Not the Fed—Not Yet The ECB Is Not the Fed—Not Yet Despite this energy-driven, imported inflation, domestic pressures are still much more muted than those in the US. VAT increases played an important role in pushing core CPI higher. Without this contribution, CPI excluding food and energy would be 50 bps lower (Chart 5). Meanwhile, rent inflation remains a modest 1.1%, which is significantly lower than that in the US (Chart 6, top panel), whereas used car CPI is not nearly as extreme as across the Atlantic (Chart 6, bottom panel). Chart 5Elevated Contribution From Taxes Elevated Contribution From Taxes Elevated Contribution From Taxes Chart 6Comparatively Muted Domestic Inflation Drivers Comparatively Muted Domestic Inflation Drivers Comparatively Muted Domestic Inflation Drivers Wage dynamics too are not yet as concerning in the Eurozone as they are in the US. Negotiated wages remain near a record low of 1.4%, and unit labor costs at 0.9% are still inconsistent with strong underlying inflationary pressures (Chart 7, top and second panel). The labor market is tightening and the Euro Area unemployment rate fell to a new low at 7%. However, the total hours worked have not yet reached their pre-pandemic levels (Chart 7, third panel), which suggests that it could take a few more months before the dislocation caused by the pandemic has been fully absorbed and wages become a risk. That being said, it is only a matter of time, as job vacancies are skyrocketing (Chart 7, bottom panel). Chart 8Plentiful Slack Plentiful Slack Plentiful Slack Chart 7The Labor Market Will Heat Up... Later The Labor Market Will Heat Up... Later The Labor Market Will Heat Up... Later The European output gap also limits a repetition of the wage-price spiral taking hold in the US. The OECD’s Weekly Tracker of GDP, a proxy for the overall Eurozone comprised of Germany, France, Italy, and Spain, reveals that, as of mid-January, aggregate output was still 4.9% below its pre-pandemic trend (Chart 8, top panel). Looking at the actual GDP of European countries individually, only France stands above its pre-pandemic trend, whereas Germany, Italy, and Spain still linger well below the average economic path that prevailed from 2012 to 2019 (Chart 8, bottom panels). Chart 9The Inflationary Role Of Bottlenecks The Inflationary Role Of Bottlenecks The Inflationary Role Of Bottlenecks Bottlenecks have also played an important role in relation to higher inflation. Goods inflation is much more elevated than services inflation (Chart 9, top panel), and industrial companies rank the ability to procure equipment and materials as their most important production constraint (Chart 9, second panel). However, production bottlenecks are dissipating. A recent Ifo survey highlights that the proportion of retailers with procurement issues declined from 82% in December 2021 to 57% in January 2022. Moreover, the supplier deliveries indexes of the PMIs are improving across the world. In fact, our simple Supply Disruption Index has begun to rollover, which points toward an imminent end to the wave of inflation surprises (Chart 9, bottom panel). European inflation expectations bear the imprint of those more modest domestic inflationary pressures, which explains the comparatively more limited wage-price spiral on the continent. The inflation expectations of Eurozone households are rising, but they are still within the norm of the past 20 years. In the US, they are breaking out. Moreover, our Index of Common Inflation Expectations, designed to mimic the New York Fed’s measure, remains well contained and is tentatively rolling over (Chart 10). Collectively, these forces explain the radically different inflation profiles of the Euro Area and the US. On the western shore of the Atlantic, the two-year annualized rate of change of the core CPI has completely shattered its highs of the past 20 years, indicating that more than simple base-effects are contributing to inflation (Chart 11, top panel). Meanwhile, the two-year annualized rate of change of the European core CPI is higher than the past deflationary eight years, but it is still low compared to the rates that prevailed prior to the European sovereign debt crisis (Chart 11, bottom panel). Chart 10Inflation Expectations: Unlike The US Inflation Expectations: Unlike The US Inflation Expectations: Unlike The US Chart 11Realized Inflation: Unlike The US Realized Inflation: Unlike The US Realized Inflation: Unlike The US Chart 12The Coming CPI Peak? The Coming CPI Peak? The Coming CPI Peak? Going forward, there remains a high likelihood that Eurozone inflation will soon peak. The impact of the German VAT increases will soon dissipate from the data, energy inflation will diminish as the annual rate of change of oil and natural gas prices peaks, and the growth in monetary aggregates has normalized sharply. Most importantly, in the absence of significant domestic inflationary pressures, the sharp decline in the ZEW Inflation Expectations components point toward a deceleration in headline HICP (Chart 12). Nonetheless, we cannot be too sanguine. The European output gap is likely to close this year and wages pressures will emerge before the end of 2022. As a result, inflation will not fall below 2% anytime soon. Moreover, as we wrote last week, any long-lasting crisis in Ukraine will prevent energy inflation from declining, and thus, there remains significant upside risk to our inflation view in the coming months.  Bottom Line: European inflation remains dominated by energy prices and imported price pressures. For now, domestic inflation dynamics are still mild, which explains why Europe’s inflation profile is much shallower than that of the US. Moreover, the near-term picture suggests that the imported inflation will peak, giving a respite to the HICP. Nonetheless, toward the yearend, domestic inflationary forces will pick up as wages gain traction. ECB Pricing: Too Much And Too Little ECB President Christine Lagarde delivered a message that was loud and clear: The ECB is abandoning its ultra-dovish stance. Despite this policy pivot, investors are pricing in too many hikes this year, whereas we only expect one rate increase toward yearend. True, if energy prices spike anew, risks to this forecast will be skewed to the upside. Nonetheless, we are inclined to fade the number of rate hikes priced in for 2022 and bet for more hikes in 2023 and 2024 (Chart 13). Chart 13Too Much Now, Not Enough Later Too Much Now, Not Enough Later Too Much Now, Not Enough Later Why does our base case only include one rate hike in December? First, we are considering the entirety of the inflation picture. As we argued above, inflationary dynamics in Europe are much tamer than those in the US, especially in terms of domestic inflation, which the ECB can influence. Moreover, the ECB is still reeling from its infamous 2011 policy mistake, which accentuated underlying deflationary pressures and caused the ECB to undershoot its mandate for eight years in a row (Chart 14). Inflation expectations also offer some leeway to the ECB. Predictions by professional forecasters continue to track below two percent for the medium term. Importantly, market-based inflation expectations remain consistent with a temporary inflation shock, and do not meet yet the ECB’s criteria of being above the 2% target durably. 10-year CPI swaps hover around 2%, driven by the jump in 2-year CPI swaps to 2.7%. Long-dated expectations approximated by the 5-year/5-year forward CPI swap remain below 2% and the inflation curve is its most inverted on record (Chart 15). Chart 15Inflation Swaps Don't Fit The ECB's Criteria Inflation Swaps Don't Fit The ECB's Criteria Inflation Swaps Don't Fit The ECB's Criteria Chart 14The Legacy Of The 2011 Mistake The Legacy Of The 2011 Mistake The Legacy Of The 2011 Mistake In the end, President Lagarde did mention in the press conference that inflation is finally moving toward its target after years of undershoot. In the context described above, it is likely that the ECB will continue to tolerate some higher inflation in the near term if it represses the deflationary mentality that had engulfed the Eurozone last decade and caused a progressive Japanification of the region. This is a small price to pay to exit at last the lower bound of interest rates on a durable basis. Second comes the sequencing of policy. President Lagarde reiterated the importance of the order of events. First, the ECB will have to bring asset purchases to a net zero before lifting rates. It has yet to curtail purchases. The March meeting will be of paramount importance, since it will feature the tapering schedule of the central bank. We continue to see a progressive pace of declining assets purchases that will likely end in September 2022. Moreover, the ECB will want to see how the European economy and markets will absorb the TLTRO cliff this June, when EUR1.3 trillion of facility expire. Chart 16The Italian Constraint The Italian Constraint The Italian Constraint Third, the ECB remains hamstrung by financial dynamics in the periphery. On Thursday, as Bund yields rose 10 basis points, BTP yields rose 21 basis points, bringing the Italian-German spread to 150bps, its highest level since September 2020 (Chart 16). Simply put, the periphery remains fragile because Italy and Spain sport some of the most negative output gaps in the region. Waiting for a stronger position out of those countries would let the ECB increase rates further down the road, allowing for a cleaner exit from negative policy rates in Europe. While these factors continue to favor a cautious posture by the ECB in 2022 and, therefore, support our base view of only one 10bps hike in December to be flagged when net purchases end in September, they will evolve and allow for many more hikes in 2023 and 2024. We expect the following developments to unfold: The output gaps across the region will close this year, which will put the economy in a position of strength and generate stronger domestic inflationary pressures down the road. Salaries will begin to accelerate meaningfully by the summer. This force will accentuate domestic inflationary pressures in late 2022 and 2023, and will contribute to higher household inflation expectations. The periphery will grow increasingly stronger as the Next Generation EU (NGEU) disbursements accelerate in 2022 and 2023. These disbursements are primarily geared toward infrastructure/capex spending (Chart 17) and will therefore sport elevated fiscal multipliers. The resulting strength will provide more resilience to the periphery and limit the tightening of financial conditions caused by higher interest rates. Chart 17The NGEU Will Matter… A Lot The ECB Is Not the Fed—Not Yet The ECB Is Not the Fed—Not Yet Chart 18Terminal Rates Are Too Low Terminal Rates Are Too Low Terminal Rates Are Too Low In the longer term, we also believe that markets still understate the ability of the ECB to lift rates. The market-derived terminal rate proxy for Europe is in the vicinity of the levels recorded in the wake of the European sovereign debt crisis last decade (Chart 18). Fiscal policy is more generous, however, and thus domestic demand is stronger. As a corollary, the accelerator model implies that capex will be more robust than it was last decade. Finally, the European Union is not as politically divided as it once was, which creates a stronger block. Together, these developments suggest that the r-star or the neutral rate of interest in the Euro Area is higher than last decade. Bottom Line: The €STR curve is pricing in the potential path of the ECB this year too aggressively. The ECB is likely to start raising rates in December, not in July. Domestic inflation and inflation expectations remain too modest, while the periphery remains fragile. Moreover, the ECB will stick to the previously decided sequence that calls for an end to net asset purchases ahead of hikes. Beyond 2022, we expect the ECB to increase rates more than what is priced into the €STR curve. Investment Implications The first implication of our view is that the European yield curve is likely to steepen further in the coming year. This is true in absolute terms but also relative to the US. We remain long European steepeners relative to US ones. Second, we continue to favor European financials. European banks are a direct equity play on higher yields and on a steeper yield curve (Chart 19). Moreover, European financials have upside relative to their US competitors. They are cheap, and they will benefit from the relative steepening in the European yield curve (Chart 20). Additionally, European monetary conditions will remain easier this year than US ones, whereas European growth will continue to catch up to the US. Chart 20Roll Over XLF Roll Over XLF Roll Over XLF Chart 19Banks Will Shine More Banks Will Shine More Banks Will Shine More Chart 21A Bit More Stress A Bit More Stress A Bit More Stress Third, the equity market correction might have a little more to run. In the near term, equities had become very oversold. This week’s bounce makes sense after the S&P 500’s RSI plunged below 30. However, hedge funds are not shorting the market as violently as they did in 2018, yet all the major global central banks (apart from the BoJ) are abandoning their pandemic-driven policy. As a result of the prospect of a global decline in liquidity, a retest of the 2018-lows in net exposure is likely as we approach the March Fed meeting, especially as credit spreads are still too low to cause a meaningful change in tone by the Fed (Chart 21). Thus, European stocks could experience another wave of selling in the coming weeks, especially when the risks surrounding Ukraine have yet to clear. Keep some protections in place. Finally, the euro has surged this week. With looming Ukrainian risk, the potential for a repricing downward of the near-term European policy rates and the risk of a last sell-off in equities, the euro could give up some of its recent gains and remain in a churning pattern, in place since December 2021. The uncertainty is therefore elevated for near-term traders. However, considering last week’s ECB pivot and the likelihood of an upward revision of the €STR curve for 2024 rates, long-term investors should use a pull back in the euro in the coming weeks to gain exposure to long EUR/USD. What About The BoE? Last week, the Bank of England increased rates by 25bps to 0.5%, which was a widely expected move. The BoE is naturally ahead of the ECB because inflation swaps stand at 4.3% and are even higher than those in the US. The BoE is forced to be more aggressive because inflation expectations are becoming unmoored, which raises the risk of a wage-price spiral north of the Channel. This is a legacy of years of higher inflation and of the labor-supply problems created by Brexit. Additionally, the UK is exiting Omicron lockdowns faster than the Euro Area, which accentuates its near-term economic strength. The UK is not, however, out of the woods. A perfect storm is brewing for the remainder of the year. Interest rates are set to rise sharply, energy price caps will disappear in two months, and the budget is anticipating a significant tightening in the coming quarters after taxes rise in April. This will hurt economic activity in the latter half of the year and will cause tensions in the domestic market. The tax hikes are not guaranteed and a reversal is still possible. PM Boris Johnson is currently embroiled in the so-called “Partygate” scandal and Rishi Sunak, Chancellor of the Exchequer, is seen as the most likely candidate within the Conservative Party to replace Johnson if he were to be pushed out of power by the 1922 Committee. As a colleague observed, it remains to be seen whether Sunak’s political ambitions will scuttle his fiscal rectitude. Nonetheless, the threats to UK small-cap stocks are increasing, warranting a cautious stance if the tax increases are not revoked in the coming weeks.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades