Inflation/Deflation

Highlights The Fed: The Fed will formally discuss tapering plans over the course of this summer and fall and announce the slowing of asset purchases before the end of 2021. Its labor market objectives will also be achieved in time to lift rates in 2022. Non-US Developed Markets: The central banks outside the US most likely to deliver tapering and/or outright rate hikes over the next 1-2 years are those facing housing bubbles – the Bank of Canada and Reserve Bank of New Zealand. The ECB will do nothing on rates while adjusting asset purchase programs to preserve the size of its balance sheet, while the Reserve Bank of Australia will also sit on their hands for longer. Bond Strategy Recommendations: Investors should maintain below-benchmark portfolio duration in US-only and global fixed income portfolios. Global bond investors should also favor exposure in markets where central banks will be more dovish than expected (core Europe, Australia), while limiting exposure to markets where hawkish surprises are more likely (the US, Canada, New Zealand). Feature The recovery from the 2020 COVID recession is now well underway and many investors are getting antsy about when central bankers might respond by removing monetary policy accommodation. Some central banks appear more eager than others. Both the Bank of Canada and Bank of England, for instance, have already started to reduce their rates of bond buying. Meanwhile, the US Federal Reserve is only just now starting to talk about the timing of its own tapering. This Special Report lays out a timeline for what central bank actions we should expect during the next two years. The first section focuses exclusively on the US Federal Reserve and the second section incorporates likely announcements from other central banks. Based on a comparison of our expected central bank timeline with current market prices, we conclude that investors should maintain below-benchmark portfolio duration in US-only and global fixed income portfolios. Global bond investors should also favor government bonds in countries where central banks are likely to be less hawkish than markets expect (core Europe, Australia) versus bonds from countries where hawkish surprises are more likely (US, Canada, New Zealand and, potentially, the UK and Sweden).   The Federal Reserve’s Timeline Chart 1 shows our anticipated timeline for when the Federal Reserve will make specific policy announcements between now and the start of 2024. Chart 1The Federal Reserve’s Timeline A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years First, over the course of this summer, the Fed will initiate discussions about when to taper its asset purchases. Then, asset purchase tapering will be announced at the December 2021 FOMC meeting with purchases set to decline as of the beginning of 2022. We expect that net Fed purchases will fall to zero by the end of Q3 2022. That is, by that time the Fed will no longer be adding to its securities holdings. Rather, it will keep the size of its balance sheet constant. Then, with its balance sheet no longer growing, the Fed will begin the process of lifting interest rates. We expect the first rate hike to occur at the December 2022 FOMC meeting. Finally, some time after the fed funds rate is well above the zero bound, the Fed will try to reduce the size of its securities portfolio. How do we arrive at this timeline? Table 1A Checklist For Liftoff A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years We start with the Fed’s forward guidance about the timing of the first rate hike (Table 1). The Fed has told us that it will lift rates off the zero bound once (i) PCE inflation is above 2%, (ii) the labor market is at “maximum employment” and (iii) inflation is expected to remain above 2% for some time. The first item on the Fed’s liftoff checklist has already been met and the third item logically follows from the other two. That is, if inflation is above 2% and the labor market is at “maximum employment” then the Fed will certainly expect inflation to remain high. This means that the second item on the Fed’s checklist is the most critical for assessing the timing of liftoff. In assessing the US labor market’s progress toward “maximum employment” we first have to define what “maximum employment” means. Based on the Fed’s communications, we infer that “maximum employment” means an unemployment rate between 3.5% and 4.5% - a range consistent with the Fed’s NAIRU estimates – and a labor force participation rate that has recovered back to pre-pandemic levels (Chart 2). Table 2 presents the average monthly growth in nonfarm payrolls that is required to reach that definition of maximum employment by specific future dates. For example, we calculate that average monthly payroll growth of 698k to 830k will cause the labor market to reach maximum employment by the end of this year. Average monthly payroll growth of 412k to 493k is required to hit the Fed’s target by the end of 2022. Chart 2Defining "Maximum Employment" Defining "Maximum Employment" Defining "Maximum Employment" Table 2Average Monthly Nonfarm Payroll Growth Required To Reach Maximum Employment By The Given Date A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years The most recent issue of the Bank Credit Analyst posits several reasons why US employment growth will pick up steam in the coming months.1 We agree with this view and note that indicators of labor demand such as job openings, the NFIB “jobs hard to get” survey and the Conference Board’s “jobs plentiful” survey also point to accelerating employment gains.2 All told, we think that average monthly payroll growth of 412k to 493k is eminently achievable (Chart 3). This means that the Fed will hit its three liftoff criteria in time to hike rates before the end of 2022. Chart 3Max Employment By The End of 2022 Max Employment By The End of 2022 Max Employment By The End of 2022 Working backwards from the expected liftoff date, the Fed has said that it needs to see “substantial progress” toward the criteria listed in Table 1 before it will taper its pace of asset purchases. The definition of “substantial progress” remains somewhat unclear, but a few recent Fed communications provide some clues. First, Fed Chair Jay Powell said that he wants to see a “string of months” like the strong March employment report before it will be appropriate to reduce the pace of asset purchases. The question of how many months constitutes a “string” remains unclear, but it certainly seems plausible that we could see two or three more strong employment reports over the course of the summer. Other Fed Governors appear to agree with this timeline. Governor Randal Quarles: If my expectations about economic growth, employment, and inflation over the coming months are borne out, however, and especially if they come in stronger than I expect, then, as noted in the minutes of the last FOMC meeting, it will become important for the FOMC to begin discussing our plans to adjust the pace of asset purchases at upcoming meetings.3 Fed Vice-Chair Richard Clarida: I myself think that the pace of labor market improvement will pick up. […] It may well be the time that – there will come a time in upcoming meetings we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases …4 Fed Governor Christopher Waller: The May and June jobs report[s] may reveal that April was an outlier, but we need to see that first before we start thinking about adjusting our policy stance.5 Our takeaway from these comments is that two or three more strong employment reports, say 500k or higher, would be sufficient for the Fed to more formally discuss tapering plans. Further, several Fed Governors seem to agree with our forecast that nonfarm payroll growth will accelerate in the coming months. With that in mind, it seems reasonable to expect that the Fed will discuss tapering plans over the course of the summer and fall, and that it will have seen sufficient labor market gains to announce a formal plan before the end of this year. Assuming that a tapering announcement occurs before the end of this year and that asset purchases actually start declining as of Jan 1st 2022, we estimate that the tapering process will conclude by the end of Q3 2022. That is, the Fed will hold the size of its balance sheet constant as of that date. Chart 4Balance Sheet Growth Will End Before The First Rate Hike Balance Sheet Growth Will End Before The First Rate Hike Balance Sheet Growth Will End Before The First Rate Hike At the very least, the Fed will certainly bring its net purchases to zero before it lifts rates. This is because it would be incoherent for the Fed to be tightening policy through its interest rate actions while it eases policy with its balance sheet strategy. Indeed, this is the roadmap that the Fed followed leading up to the 2015 rate hike cycle (Chart 4). Finally, we note that the Fed will try to reduce the size of its balance sheet only after the process of rate hikes is well underway. This will be consistent with the last tightening cycle when the Fed waited until the funds rate was 1.5% before it pared the size of its securities portfolio (Chart 4). We also want to stress that the Fed will only try to reduce the size of its balance sheet. In fact, we doubt that this process will get very far. The main reason for our skepticism is that there is an ongoing structural issue in the Treasury market where the supply of securities keeps growing while stricter regulations make it more costly for primary dealers to intermediate trades.6 In this environment, there are strong odds that Treasury market liquidity will evaporate whenever there is a significant shock to financial markets. When that happens, the Fed will be forced to support Treasury market liquidity through large-scale purchases, as was the case during last March’s market turmoil (Chart 5). In essence, the likelihood of future shocks that will necessitate Fed intervention in the Treasury market makes it unlikely that the Fed will make much progress reducing the size of its balance sheet. Chart 5Fed Had To Support Treasury Market In March 2020 Fed Had To Support Treasury Market In March 2020 Fed Had To Support Treasury Market In March 2020 Market Expectations And Investment Implications We can get a sense of how our Fed timeline compares to consensus expectations by looking at the New York Fed’s Surveys of Market Participants and Primary Dealers (Tables 3A & 3B). Respondents to these surveys expect tapering to start in early 2022, in line with our expectations, though they generally see it taking longer for net purchases to fall to zero. Respondents also expect a later Fed liftoff date than we do and don’t see the Fed trying to reduce the size of its balance sheet until well after rate hikes have begun. Table 3ASurvey of Market Participants Expected Fed Timeline A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years Table 3BSurvey Of Primary Dealers Expected Fed Timeline A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years But more important for investors than survey results is what is currently priced into the yield curve. In that regard, the overnight index swap curve is priced for Fed liftoff in February 2023 and a total of 75 bps of rate hikes by the end of 2023 (Chart 6). We expect rate hikes to start earlier and proceed more quickly than that, and therefore recommend running below-benchmark duration in US bond portfolios. Chart 6Market Rate Expectations Market Rate Expectations Market Rate Expectations The Timelines For Other Central Banks Policymakers outside the US are facing many of the same issues that the Fed is – rapidly recovering economies coming out of the pandemic, inflation overshoots, and surging asset prices. However, not every central bank will respond at the same time, or same pace, as the Fed. In Charts 7a and 7b, we show additional timelines for two of the most important non-Fed central banks: the European Central Bank (ECB) and the BoE. We see the likely dates and policy decisions playing out as follows. Chart 7AThe ECB’s Timeline A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years Chart 7BThe Bank Of England’s Timeline A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years European Central Bank For the ECB, the timing of its upcoming inflation strategy review is the most critical element. That report is due to be delivered in the latter half of this year, most likely in September or October (no firm release date has been announced by the ECB). It is highly unlikely that any meaningful policy changes will be implemented before that strategic review is completed. Some ECB officials have hinted that a move to a Fed-like interpretation of the ECB inflation target, tolerating overshoots of the target to make up for past undershoots, could result from the strategy review. The more likely option will be a move to an inflation target range, perhaps a 1-3% tolerance band, that offers more policy flexibility than the current target of just below 2%. This will potentially “move the goalposts” for the ECB in a way that will make monetary tightening even less likely compared to previous cycles. Looking at past ECB tightening episodes dating back to the central bank’s inception in 1998, it is clear that a majority of countries within the euro area must be seeing inflation that is high enough, with unemployment low enough, before any policy tightening can take place. Chart 8 illustrates this point, by showing “breadth” measures for unemployment and inflation across the euro area.7 Chart 8The ECB Usually Tightens When Growth AND Inflation Are Broad Based The ECB Usually Tightens When Growth AND Inflation Are Broad Based The ECB Usually Tightens When Growth AND Inflation Are Broad Based Specifically, the chart shows the percentage of euro area countries with an unemployment rate below the OECD’s estimate of full employment (second panel), the percentage of euro area countries with headline inflation higher than one year earlier (third panel) and the percentage of euro area countries with headline inflation above the ECB’s 2% target (bottom panel). We compare those breadth measures to the actual path of policy interest rates and the size of the ECB’s balance sheet (top panel). The conclusion from the chart is that the euro area is still a long way from having the sort of broad-based rise in inflation or fall in unemployment necessary to trigger a reduction in the size of its balance sheet or actual interest rate hikes. Chart 9The ECB Is Under No Pressure To Tighten Pre-Emptively The ECB Is Under No Pressure To Tighten Pre-Emptively The ECB Is Under No Pressure To Tighten Pre-Emptively Nonetheless, our expectation is that the ECB will want to begin preparing the markets for the end of the Pandemic Emergency Purchase Program (PEPP) - which has been buying government bonds since March 2020 in a less constrained fashion than previous asset purchase programs - shortly after the inflation strategy review is concluded. Much of the euro area economy is already showing signs of rapid recovery from pandemic induced lockdowns, amid an accelerating pace of vaccinations. On top of that, the Next Generation European Union (NGEU) recovery fund is set to begin distributing funds in the final quarter of 2021, providing a meaningful lift to government investment and expected growth in 2022. It will be difficult for the ECB to justify the need for an “emergency” program like the PEPP to continue against such a growth backdrop, especially with euro area inflation no longer at the depressed levels seen in 2020. We expect the ECB to begin preparing the market for the end of PEPP heading into the December 2021 ECB policy meeting, when it will be announced that the program will not be renewed when it expires in March 2022 (Chart 9). As always for such major policy announcements, the ECB will wish to do so when there is a new set of economic forecasts used to justify any changes. This is why December – the first meeting after the strategic review is completed that will also have new forecasts – is the earliest realistic date for an announcement on the PEPP. The communication around the PEPP announcement will need to be delicate, as the PEPP has significantly increased the ECB’s footprint in European bond markets. The share of government bonds owned by the ECB has increased by anywhere from five to ten percentage points since the PEPP began (Chart 10). We expect the ECB will be forced to expand its existing Public Sector Purchase Program (PSPP) to make up for the eventual disappearance of the PEPP. This means that the PEPP will be effectively “rolled into” the PSPP, to limit the damage from a likely post-PEPP surge in bond yields in the more fragile markets like Italy, Spain and even Greece – especially with the euro now trading close to pre-2008 highs on a trade-weighted basis (Chart 11). Chart 10The PEPP Can Expire, But Cannot Disappear A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years Chart 11ECB Must Avoid A 'PEPP Taper Tantrum' ECB Must Avoid A 'PEPP Taper Tantrum' ECB Must Avoid A 'PEPP Taper Tantrum' There is a chance that the ECB will want to avoid any “PEPP taper tantrum” in Peripheral European yields (and spreads versus Germany) by making an announcement on PEPP expiry and PSPP expansion at the same meeting. If that happens, we suspect it would happen in December of this year rather than sometime in the first quarter of 2022. Beyond that, the ECB will likely seek to keep financial conditions as accommodative as possible by keeping policy interest rates unchanged well into 2023, with an actual rate hike not likely until mid-2024 at the earliest. The ECB could deliver a more modest form of “tightening” before then by letting some of the cheap bank funding programs (TLTROs) expire. Although we suspect that even those programs will need to be renewed, perhaps at less attractive financing terms, to prevent an unwanted tightening of credit conditions in the euro area banking system. Bank Of England Chart 12BoE Forecasts Are Conservative BoE Forecasts Are Conservative BoE Forecasts Are Conservative Having already announced a tapering of the pace of its bond buying in early May, the BoE is likely to continue along that path over the next year. We expect the BoE, like the ECB, to make any future taper announcements when new sets of economic forecasts are published in Monetary Policy Reports. Thus, the next taper announcements are expected in August 2021, November 2021 and February 2022, with a full tapering down to zero net purchases (new buying only replacing maturing bonds) by May 2022 at the latest. The first rate hike will occur between 6-12 months after the end of tapering, possibly as early as November 2022 but, more likely in our view, sometime closer to mid-2023. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 12). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. The BoE has been one of the least active central banks in the developed world since the 2008 financial crisis. The BoE main policy rate, the Bank Rate, has been no higher than 0.75% since then, even with the BoE threatening to lift rates to higher levels many times under the leadership of former Governor Mark Carney when inflation was overshooting the bank’s 2% target. Of course, the Brexit uncertainty since mid-2016 effectively tied the hands of the central bank and prevented any possible policy tightening. Now that Brexit has actually happened, however, the BoE has more flexibility to respond to developments with UK economic growth and inflation, as needed. A possible path for the UK Cash Rate was laid out in a recent speech by BoE Monetary Policy Committee (MPC) member Gertjan Vlieghe.8 He triggered a selloff across the Gilt market with his comment that a BoE rate hike could occur as early as Q2 2022 – with the Bank Rate rising to 1.25% from the current 0.1% by 2024 - under more optimistic scenarios for UK growth and employment. His base case, however, was that the coming uptick in UK inflation will prove to be temporary, but that a move towards full employment will make the first hike more likely toward the end of 2022 with modest rate increases in 2023 and 2024 that will take the Bank Rate to 0.75% (Chart 13). Chart 13Gilts Are Vulnerable To A Hawkish Surprise Gilts Are Vulnerable To A Hawkish Surprise Gilts Are Vulnerable To A Hawkish Surprise Vlighe’s base case scenario on growth and interest rates is in line with the BoE’s current forecasts that call for spare capacity in the UK economy to be fully eliminated by mid-2022, with rate hikes to begin in mid-2023. That is broadly in line with our projected BoE timeline and with current pricing in the UK OIS curve, although we see risks tilted towards faster growth and inflation – and the BoE moving more aggressively than projected – over the next 12-18 months. Other Major Developed Market Central Banks Looking beyond the “Big Three” of the Fed, ECB and BoE, central bank timelines have become increasingly dependent on a single factor – the strength of domestic housing markets. House prices are booming in Canada, New Zealand and Sweden, with valuation measures like the ratio of median house prices to median incomes soaring to historical extremes according to the OECD (Chart 14). House prices are also climbing fast in the US and UK, but the valuation measures have not surpassed the peaks seen during the mid-2000s housing bubble. The housing boom has already motivated some central banks to respond by turning less dovish sooner than expected, even with unemployment rates still above pre-pandemic peaks (Chart 15).9 The BoC noted that soaring Canadian housing values motivated the taper announcement in April. The Reserve Bank of New Zealand (RBNZ) has come under political pressure over the growing unaffordability of New Zealand homes, with the government changing the central bank’s remit earlier this year to force the RBNZ to explicitly consider house price inflation when setting monetary policy. Chart 14Surging House Prices Can Turn Doves Into Hawks Surging House Prices Can Turn Doves Into Hawks Surging House Prices Can Turn Doves Into Hawks Chart 15These CBs Could Turn More Hawkish Before Reaching Full Employment These CBs Could Turn More Hawkish Before Reaching Full Employment These CBs Could Turn More Hawkish Before Reaching Full Employment We expect more tapering announcements from the BoC over the latter half of 2021, with a first rate hike likely sometime in the first quarter of 2022. We see the RBNZ moving aggressively, as well, tapering over the remainder of 2021 before lifting rates by the spring of 2022 at the latest. Sweden’s Riksbank will be the next central bank to turn more hawkish because of surging home values, although they will lag the pace of the BoC and RBNZ with Sweden only now beginning to emerge from lockdowns associated with a third wave of COVID-19 cases. Importantly, Australia – a country that has dealt with house price surges in the past – has seen house price valuations retreat over the past few years, even with the Reserve Bank of Australia (RBA) slashing policy rates to historic lows. The RBA also introduced yield curve control in 2020 to anchor the level of short-term bond yields, while also engaging in outright bond purchases to mitigate the rise in longer-term bond yields. With Australian inflation still remaining well below target in a year of rising global inflation, and with subdued labor costs likely to keep price pressures moderate over the next 12-18 months, we expect the RBA to move very slowly on both tapering and rate hikes. Finally, for completeness, we should note that we do not expect any policy changes from the Bank of Japan (BoJ) over the next two years, with inflation likely to remain far below the central bank’s 2% target. Non-US Investment Implications In Table 4, we show the timing of the first rate hike (i.e. “liftoff”), and the subsequent amount of total rate hikes to the end of 2024, as currently discounted in the OIS curves of the eight countries discussed in this report. We rank the countries in the table in order of liftoff dates, starting with the closest to today. Table 4The “Pecking Order” Of Central Bank Rate Hikes A Central Bank Timeline For The Next Two Years A Central Bank Timeline For The Next Two Years The RBNZ is expected to hike first in May 2022, followed by the BoC (September 2022), the Fed (February 2023), the RBA (April 2023), the Riksbank (May 2023), the BoE (May 2023), the ECB (June 2023) and the BoJ (October 2025). The cumulative amount of rate hikes discounted to the end of 2024 rank similarly: more rate increases are expected in New Zealand (167bps), Canada (150bps), the US (137bps) and Australia (113bps); while fewer rate increases are expected in the Sweden (63bps), the UK (61bps), the euro area (31bps) and Japan (7bps). According to our various central bank timelines discussed in this report, we see the risks of a rate hike coming sooner than discounted by markets in the US, Canada and New Zealand. We see central banks moving slower than markets expect in the euro area and Australia, while we see Sweden and UK priced in line with our base case views (although we see risks tilted towards a more hawkish turn faster than expected in the latter two). The story is the same in terms of cumulative rate hikes discounted in OIS curves, with markets not pricing in enough rate hikes in New Zealand, Canada and the US – and, possibly, Sweden and the UK – while pricing too many hikes in Australia and the euro area. This leads us to recommend the following country allocations in a global government bond portfolio: Underweight the US, Canada and New Zealand Overweight Australia and core Europe (and Japan) Neutral Sweden and the UK, but with a bias to downgrade. Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst June 2021 Monthly Report, "Global House Prices: A New Threat For Policymakers", dated May 27, 2021. 2 Please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 3 https://www.federalreserve.gov/newsevents/speech/quarles20210526b.htm 4 https://ca.news.yahoo.com/federal-reserve-vice-chair-richard-clarida-yahoo-finance-transcript-may-2021-173007192.html 5 https://www.federalreserve.gov/newsevents/speech/waller20210513a.htm 6 For a longer discussion of Treasury market liquidity issues please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup 2: Shocked And Awed”, dated July 28, 2020. 7 For more details, please see Global Fixed Income Strategy Report, “ECB Outlook: Walking On Eggshells”, dated May 19, 2021. 8 The full speech can be found here: https://www.bankofengland.co.uk/speech/2021/may/gertjan-vlieghe-speech-hosted-by-the-department-of-economics-and-the-ipr 9 For more details on the global housing boom, see Global Fixed Income Strategy Special Report, “Global House Prices: A New Threat For Policymakers”, dated May 28, 2021. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights A first Fed funds rate hike by early 2023 is cloud cuckoo land – because it will take years to meet the Fed’s pre-condition of full employment. More likely, the first rate hike will happen after mid-2024, and even this is a coin toss which assumes no further shock(s). Buy the March 2024 US interest rate future contract. An alternative expression is to buy the 5-year T-bond, or to go long the 5-year T-bond versus the 5-year German bund. For equity investors, the current overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Bitcoin has support at $32500, and then at $22750. The latest correction in cryptocurrencies is a good entry point into a diversified basket that includes ‘proof of stake’ coins, such as ethereum. Fragile iron ore prices confirm the onset of a commodity correction. Feature Chart of the WeekAfter A Recession, It Takes Many Years To Reabsorb The Unemployed After A Recession, It Takes Many Years To Reabsorb The Unemployed After A Recession, It Takes Many Years To Reabsorb The Unemployed After a recession, an economy takes years to reabsorb the unemployed. Here’s how long it took in the US after each of the last five recessions.1 1974-75 recession: 4 years Early-1980s recession: 6 years Early-1990s recession: 5 years Dot com bust: 3 years Global financial crisis: 8 years After the pandemic recession, reabsorbing the unemployed (that are not just on ‘temporary layoff’) will also take many years (Chart I-1). Full Employment Is Many Years Away There is a remarkable consistency in employment recoveries. The last five recessions were different in their severities and durations, and therefore in their peak unemployment rates. Yet in the recoveries that followed each of the last five recessions, the unemployment rate declined at a consistent pace of 0.4-0.5 percent per year. After the mild recessions of the early-1990s and the dot com bust, the pace of recovery in the unemployment rate was at the lower end of 0.4 percent per year. Whereas after the global financial crisis and its surge in permanent unemployment, the pace of recovery was at the upper end of 0.5 percent per year. But the difference in the pace of the five employment recovery was marginal (Table I-1). Table 1After Every Recession, The Pace Of Recovery In The Jobs Market Is Near-Identical A Fed Rate Hike By Early 2023 Is Pie In The Sky A Fed Rate Hike By Early 2023 Is Pie In The Sky Another near-constant through the past fifty years is the definition of ‘full employment’. It is achieved when the (permanent) unemployment rate reaches 1.5 percent. Combining the latest (permanent) unemployment rate of 2.7 percent, the unemployment rate at full employment, and the remarkably consistent recovery paces, we can deduce that: The US economy will reach full employment between September 2023 and June 2024. The Federal Reserve has promised that it will not raise the Fed funds rate until the economy has reached full employment. Based on the remarkably consistent pace of the past five employment recoveries, it means September 2023 at the earliest, but more likely closer to June 2024. Yet US interest rate futures are pricing the first Fed funds rate hike through December 2022-March 2023 (Chart I-2). Chart I-2Cloud Cuckoo Land: A First Rate Hike In Dec 22-Mar 23 Cloud Cuckoo Land: A First Rate Hike In Dec 22-Mar 23 Cloud Cuckoo Land: A First Rate Hike In Dec 22-Mar 23 This makes US interest rate future contracts from December 2022 to June 2024 a compelling buy (Chart I-3). Chart I-3Cloud Cuckoo Land: 4 Rate Hikes By June 24 Cloud Cuckoo Land: 4 Rate Hikes By June 24 Cloud Cuckoo Land: 4 Rate Hikes By June 24 Buy The March 2024 US Interest Rate Future The post-pandemic jobs market recovery will likely be at the lower end of its 0.4-0.5 percent a year pace, for two reasons. First, reducing the unemployment rate doesn’t only mean creating jobs for the currently unemployed. It also means creating jobs for those that have left the labour force but plan on re-joining. When these so-called ‘inactive’ people re-join the labour force they add to the number that are counted as unemployed. As the millions of inactives re-join the labour market, it will weigh on the pace of the recovery in the unemployment rate. During the pandemic, the number of inactive people surged by an unprecedented 8 million. Even now, the excess inactive stands at 5 million (Chart I-4). As these millions gradually re-join the labour market, it will weigh on the pace of the recovery in the unemployment rate. Chart I-4Massive Slack In The US Labour Market Massive Slack In The US Labour Market Massive Slack In The US Labour Market Second, after every recession, there is a surge in productivity (Chart I-5). This is because the period immediately after a recession is when the economy experiences the most intensive clearing out of dead wood, restructuring of capital and labour, and absorption of new technologies and ways of working. Chart I-5The Post-Pandemic Productivity Boom Will Be A Super-Boom The Post-Pandemic Productivity Boom Will Be A Super-Boom The Post-Pandemic Productivity Boom Will Be A Super-Boom If anything, the post-pandemic productivity boom will be even larger than normal. Whereas most recessions upend one or two sectors of the economy, the pandemic has forced all of us to adopt new technologies and ways of working and living. The unfortunate corollary of this post-pandemic productivity super-boom is that the pace of absorption of the excess unemployed and inactive will be slower. Moreover, even achieving full employment by June 2024 assumes blue skies through the next few years, which is to say no further shocks. Yet as we explained in The Shock Theory Of Bond Yields, deflationary shocks tend to come once every three years, meaning there is an evens chance that dark clouds ruin the blue skies. One complication is that the Fed will start tapering its asset purchases much sooner, and that this will be interpreted as the precursor of a rate hike. However, in the last cycle the taper of asset purchases in early 2014 preceded the first rate hike by two years (Chart I-6). On a similar timeframe, a taper at the end of 2021 would imply the first rate hike at the end of 2023, and not the start of 2023 as is implied by the interest rate futures. Chart I-6The First Rate Hike Came Two Years After The Taper The First Rate Hike Came Two Years After The Taper The First Rate Hike Came Two Years After The Taper Pulling all of this together, a first Fed funds rate hike by early 2023 is cloud cuckoo land. More likely it will happen after mid-2024, and even this is a coin toss which assumes no further shock(s) in the interim. The investment conclusion is to buy any of the US interest rate futures that expire from December 2022 out to June 2024. The earlier contracts have the higher probabilities of expiring in profit while the later contracts have the greater upside if the Fed stays pat. Our choice is the March 2024 contract. An alternative expression is to buy the 5-year T-bond, or to go long the 5-year T-bond versus the 5-year German bund. For equity investors, the current overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. The 419th Time That Cryptos Have ‘Died’ Rumours of crypto’s death have been greatly exaggerated. Apparently, last week was the 419th time that cryptocurrencies have died. Get used to it. As we pointed out in Why Cryptocurrencies Are Here To Stay… cryptocurrencies can suffer deep corrections from which they fully resurrect. Since 2013, the bitcoin price has suffered 17 drawdowns of more than 50 percent and an additional 11 drawdowns of 25-50 percent.2  Rumours of crypto’s death have been greatly exaggerated. We will not repeat the arguments why cryptos are here to stay, which were detailed in our Special Report, but we will discuss the recent price action. Why did cryptos correct? The simple answer is that their fractal structure had become extremely fragile, making the price extremely vulnerable to the slightest negative catalyst (Chart I-7). Chart I-7The Fractal Structure Of Cryptos Had Become Very Fragile The Fractal Structure Of Cryptos Had Become Very Fragile The Fractal Structure Of Cryptos Had Become Very Fragile A fragile fractal structure signifies that longer-term investors have disappeared from the price setting process. This means that price evolution is the result of more and more short-term traders joining the trend. Eventually though, there are no more short-term traders left to buy at the current price. So, when somebody wants to sell – perhaps on some negative news – a longer-term investor must step in as the buyer. But the longer-term investor will only buy at a much lower price, meaning that the price suffers a deep correction. Empirically and theoretically, the price correction meets support at successive Fibonacci retracements of the preceding momentum-fuelled rally, because a new cohort of buyers enters at each retracement level. Hence, the key support levels in the current correction are the 23.6 percent and 38.2 percent retracements of the preceding rally. In the case of bitcoin, this equates to support at $32500 and $22750. Which of these support level will prevail? Our bias is the higher level, because successive crypto corrections are becoming less and less extreme – possibly because more and more institutional investors are now involved in the asset class (Chart I-8). Chart I-8Crypto Corrections Are Becoming Less Extreme Crypto Corrections Are Becoming Less Extreme Crypto Corrections Are Becoming Less Extreme Hence, the latest correction in cryptos offers a good entry point. Albeit it is important to own a diversified basket that includes ‘proof of stake’ coins, such as ethereum. The Onset Of A Commodity Correction Finally this week, we highlight that iron ore prices are at the same level of fractal fragility that has marked previous major turning points in 2015 and 2019 (Chart I-9). Chart I-9Iron Ore Is Very Fragile Iron Ore Is Very Fragile Iron Ore Is Very Fragile Combined with the fragility we have recently highlighted in lumber, agricultural commodities, industrial metals, and DRAM prices, it confirms the onset of a commodity correction. We have already discussed this theme in Don’t Panic About US Inflation and are exposed to it through short positions in PKB, CAD, and inflation expectations. Hence, there are no new trades this week.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Throughout this analysis, the unemployment rate is based on the unemployed that are ‘not on temporary layoff’. Full employment is defined as this unemployment rate reaching 1.5 percent, or the cycle low, whichever is the higher. 2 The drawdown is calculated versus the highest price in the preceding 6 months. 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Highlights Monetary Policy: The Fed will not immediately change its policy stance in response to rising inflation and inflation expectations. Rather, it will follow its current forward guidance and only lift rates off zero once the labor market has reached “maximum employment”. However, once the first rate hike has occurred, the Fed will shift its focus toward inflation and inflation expectations. Duration: The overnight index swap curve is priced for a total of 77 bps of rate hikes by the end of 2023. We see strong odds that more hikes will be delivered and therefore continue to recommend a below-benchmark portfolio duration stance. Corporate Bonds: High and rising inflation expectations will eventually pose a risk to credit spreads, but only once the Fed tightens policy in response. For now, we remain overweight spread product versus Treasuries, though we maintain a preference for high-yield corporates, USD-denominated EM Sovereigns and municipal bonds over investment grade corporate bonds. Feature Recent inflationary trends are making the Fed’s job more difficult. Not only was April’s increase in core CPI the largest since 1981, but measures of long-term inflation expectations have also jumped. The 5-year/5-year TIPS breakeven inflation rate has quickly risen to levels that are consistent with the Fed’s 2% inflation target (Chart 1). What’s more, survey measures of inflation expectations have also moved up, in many cases to uncomfortably high levels (Chart 2). Chart 1Back To Target Back To Target Back To Target Chart 2Inflation Expectations Have Jumped Inflation Expectations Have Jumped Inflation Expectations Have Jumped All of this makes the Fed’s zero-lower-bound interest rate policy look increasingly untenable. Can the Fed really just sit on the sidelines as inflation and inflation expectations rise to above-target levels? Our expectation is that the Fed will ignore rising inflation until the labor market is fully recovered, but it may then need to move quickly to contain inflationary pressures. The result could very well be a rate hike cycle that takes a long time to start, but then proceeds at a rapid pace. The Fed’s Liftoff Criteria Are Different Than Its Criteria For Pace A crucial point about the Fed’s forward guidance is that the criteria that will determine the timing of the first rate hike are different than the criteria that will determine the post-liftoff pace of rate hikes. Liftoff Criteria Table 1A Checklist For Liftoff Lower For Longer, Then Faster Than You Think Lower For Longer, Then Faster Than You Think For liftoff, the Fed has been very explicit that three conditions must be met before it will raise rates off the zero bound (Table 1). Of the three conditions listed in Table 1, the timing of when the labor market will reach “maximum employment” is the most uncertain. We have written extensively about how the Fed defines “maximum employment” and about the pace of employment growth that’s necessary to achieve that goal by specific future dates.1 To summarize, we calculate that average monthly nonfarm payroll growth of at least 698k is required to reach “maximum employment” by the end of this year and average monthly payroll growth of at least 412k is required to hit that target by the end of 2022 (Chart 3). Chart 3Employment Growth Employment Growth Employment Growth Chart 4Labor Demand Is Strong Labor Demand Is Strong Labor Demand Is Strong Our assessment is that “maximum employment” will be achieved in time for the Fed to lift rates in 2022, largely because employment growth must rise quickly in order to catch up with skyrocketing indicators of labor demand (Chart 4). The risk, of course, is that inflation continues to run hot as the Fed waits for its “maximum employment” condition to be met. If this occurs, we believe that the Fed will stick to its current forward guidance. It will ignore rising inflation until its liftoff criteria are met. Only then, will Fed policy turn toward containing inflation. Pace Criteria In a recent speech, Fed Vice-Chair Richard Clarida laid out three indicators that he will track to guide the pace of policy tightening post Fed liftoff.2 First, he pointed to inflation expectations. In particular, the Fed’s index of Common Inflation Expectations (CIE):3 Other things being equal, my desired pace of policy normalization post-liftoff to return inflation to 2 percent […] would be somewhat slower than otherwise if the CIE index is, at time of liftoff, below the pre-ELB level. [ELB = effective lower bound]. Chart 2 shows that the CIE index has already broken above its 2018 peak. It stands to reason that, all else equal, an elevated CIE index would speed up the post-liftoff pace of rate hikes. Chart 5Inflation Since August 2020 Inflation Since August 2020 Inflation Since August 2020 Second, Clarida noted that: Another factor I will consider in calibrating the pace of policy normalization post-liftoff is the average rate of PCE inflation since the new framework was adopted in August 2020. The annualized rate of change in core PCE since August 2020 is almost at the Fed’s 2% target already, and it will certainly rise to above-target levels when the April data are released, as was the case with core CPI (Chart 5). Finally, Clarida offered up a detailed Taylor-type monetary policy rule that he says he will consult once the conditions for liftoff are met: Consistent with our new framework, the relevant policy rule benchmark I will consult once the conditions for liftoff have been met is an inertial Taylor-type rule with a coefficient of zero on the unemployment gap, a coefficient of 1.5 on the gap between core PCE inflation and the 2 percent longer-run goal, and a neutral real policy rate equal to my SEP forecast of long-run r*. Chart 6Balanced Approach (Shortfalls) Rule* Recommendations Lower For Longer, Then Faster Than You Think Lower For Longer, Then Faster Than You Think Chart 6 shows the results of a very similar policy rule using median FOMC estimates for r*, NAIRU and the path of inflation. We use a slightly more pessimistic forecast for the unemployment rate and assume that it reaches 4.5% by the end of 2022 and 4% by the end of 2023. Even with those conservative assumptions, the rule still recommends a policy rate of 1.5% by the end of 2022 and 2.65% by the end of 2023. This is not to say that the Fed will immediately lift rates to those levels once it is ready to hike, only that the Fed will have a strong incentive to pursue a rapid pace of rate hikes once it finally lifts rates off the zero bound. Investment Implications For investors, the bottom line is that the Fed will not immediately change its policy stance in response to rising inflation and inflation expectations. Rather, it will follow its current forward guidance and only lift rates off zero once the labor market has reached “maximum employment”. However, once the first rate hike has occurred, the Fed will shift its focus toward inflation and inflation expectations. If inflation and inflation expectations rise further, or even remain sticky near current levels, the Fed will lift rates more quickly than many anticipate. At present, the overnight index swap curve is priced for a total of 77 bps of rate hikes by the end of 2023. We see strong odds that more hikes will be delivered and therefore continue to recommend a below-benchmark portfolio duration stance. Is Inflation A Risk For Spread Product? Yes it is, but not just yet. In past reports, we’ve often pointed to 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5% as a reason to turn more cautious on spread product (see Chart 1), and the recent rise in inflation expectations certainly does set off some alarm bells. High inflation expectations pose a risk to credit spreads because of what they signal about the future course of Fed policy. If the Fed responds to high inflation expectations by tightening policy into restrictive territory, then economic growth and credit spreads are at risk. All this remains true, but the Fed’s willingness to ignore rising inflation expectations – at least until “maximum employment” and fed funds liftoff are achieved – gives spread product a little more runway than usual. One way to illustrate this dynamic is with the slope of the yield curve (Chart 7). Historically, corporate bond (both investment grade and junk) excess returns are strong at least until the 3-year/10-year Treasury slope flattens to below 50 bps (Table 2). Currently, the 3-year/10-year Treasury slope is well above 100 bps and has shown few signs of rolling over. If the Fed was still following its old forward-looking policy framework, then the yield curve would likely be much flatter today. That is, the curve would be pricing-in some policy tightening in response to high and rising inflation expectations. However, as discussed above, inflation expectations are not currently the Fed’s primary concern and they will only become the Fed’s primary concern once “maximum employment” has been achieved and the funds rate has been lifted off the zero bound. Chart 7Spread Product Returns Are Strong When The Curve Is Steep Spread Product Returns Are Strong When The Curve Is Steep Spread Product Returns Are Strong When The Curve Is Steep Table 2Corporate Bond Performance In Different Phases Of The Cycle Lower For Longer, Then Faster Than You Think Lower For Longer, Then Faster Than You Think All in all, we are concerned that, if inflation expectations remain elevated, the Fed may quickly ramp up its post-liftoff pace of rate hikes, sending credit spreads wider. But we are reluctant to position for that outcome when we are still many months away from Fed liftoff and the slope of the yield curve remains so steep. Chart 8Low Expected Returns In IG Low Expected Returns in IG Low Expected Returns in IG Another factor to consider is that value in spread product is extremely tight. In fact, our measure of the 12-month breakeven spread for the quality-adjusted investment grade corporate bond index is almost at its most expensive level since 1995 (Chart 8). This doesn’t change our assessment of when restrictive Fed policy will cause spreads to widen, but it does reduce our return expectations in the interim. All else equal, since the rewards from being overweight spread product versus Treasuries are low, we will be quicker to reduce our recommended spread product allocation when our indicators start to point toward the end of the credit cycle. Though, at the very least, we will still want to see the 3-year/10-year Treasury slope start to flatten and approach 50 bps before we get too pessimistic on spread product. The bottom line is that high and rising inflation expectations will eventually pose a risk to credit spreads, but only once the Fed tightens policy in response. For now, we remain overweight spread product versus Treasuries, though we maintain a preference for high-yield corporates, USD-denominated EM Sovereigns and municipal bonds over investment grade corporate bonds.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Overshoot Territory”, dated April 13, 2021. 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm 3 The CIE is a composite measure of different market-based and survey-based indicators of inflation expectations. https://www.federalreserve.gov/econres/notes/feds-notes/index-of-common-inflation-expectations-20200902.htm  Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Inflation is on everyone’s mind, … : Inflation has been a hot topic in our meetings with clients and in internal BCA discussions, but it has lately broken out among businesses and the general public. … but investors are mainly concerned with what it means for markets, … : When clients ask if and when inflation could become a problem, they really want to know if and when they should be repositioning their portfolios to prepare for it. … which ultimately brings the discussion back to the Fed: Inflation sensitivities vary among (and within) asset classes, but risk assets as a whole fare much worse when monetary policy settings are tight than when they are easy. If rising inflation drives the Fed to impose restrictive monetary policy, it will bring the curtain down on the equity bull market. Feature Inflation has been a hot topic with clients, for the internet-equipped public (Chart 1) and within BCA, where our latest monthly view meeting was entirely devoted to it. Client questions have addressed three broad themes: Chart 1Trending Trending Trending What constitutes too much inflation? How will you know too much inflation is on the way? How soon could too much inflation arrive? Economists have yet to establish exactly where inflation comes from and their attempts to build models that anticipate it have been woefully unsuccessful. The problem may be that prices are set at the micro level by a confluence of innumerable individual interactions. Just as Hayek pointed out that no top-down committee could determine how to allocate resources efficiently without the signals provided by prices, it’s fiendishly difficult to try to divine their aggregate future direction from macroeconomic inputs. Even if we can’t build an airtight model predicting consumer price moves, however, we can systematically assess several known contributors to inflation to try to gain some advance notice into its movements. Obtaining that advance notice is of great practical significance in the current market environment. In a Goldilocks-and-the-two-tails world where widespread vaccinations have rendered the too-cold left-tail outcome increasingly unlikely, overheating is the only obstacle to the potent-growth/easy-policy backdrop that would be just right for equities and other risk assets over the next twelve months. Troublesome inflation seems to be the only factor that could get the Fed to back off of its pledge to maintain ultra-easy monetary policy for an extended period and we see it as the biggest threat to the equity bull market. We are therefore introducing our inflation checklist and expect to revisit it regularly over the rest of the year and into 2022. It reveals what we’re watching to monitor inflation and how, with some interpretive discretion, we’ll know if it’s poised to break out. It will also allow US Investment Strategy readers to follow along with our thinking in real time. As long as the checklist does not point to a meaningful, persistent move higher in consumer prices, we will likely continue to be constructive on the prospects for financial markets and the economy. Checklist Design Table 1Inflation Checklist Tracking Inflation Tracking Inflation Our inflation checklist (Table 1) tracks price pressures in five broad categories: Labor Market Indicators, Price Indexes, Pipeline Pressures, Inflation Expectations and the Fed’s Reaction Function. We do not have a hard-and-fast scale of the categories’ relative importance, but we are especially alert to signals from the labor market and changes in inflation expectations. It will be hard to achieve persistently uncomfortable inflation readings without an upward inflection in the pace of wage growth and we do not see wage growth getting traction until inflation expectations rise enough to push workers to agitate for it. As we have previously stated, we do not think that core US inflation measures can break out of the range that has held them in check for three decades unless workers, households and businesses adopt a new inflation mindset (Chart 2). Chart 2Volcker's Gift Volcker's Gift Volcker's Gift We do not have a pre-determined rule for how many X’s it will take to signal that policy-altering inflation is on the way. Nor do we have pre-conceived notions about the various combinations of red flags that would herald the onset of a new inflation regime. The purpose of the checklist is to establish a consistent analytical framework for assessing the future direction of inflation and its impact on monetary policy settings. Interpreting the output of that framework will require judgment and we mean to maintain our flexibility in exercising it. The State Of The Labor Market The Phillips Curve, which posits an inverse relationship between unemployment and inflation, has fallen into disrepute with investors. Even the Fed has distanced itself from it, announcing last summer that it would no longer pursue a strategy of pre-emptively tightening policy when the labor market begins to heat up. Asserting that wage growth is inversely related to the unemployment rate simply applies the law of supply and demand to the labor market, and we have no problem with it, although it should be noted that the relationship is not linear. Wages only reliably rise once unemployment breaks below a minimum threshold level, such as NAIRU, the natural rate of unemployment (Chart 3). Chart 3The Unemployment Gap Matters For Wage Growth The Unemployment Gap Matters For Wage Growth The Unemployment Gap Matters For Wage Growth With that empirical relationship in mind, the category's components consider the available supply and utilization of labor inputs; demand for labor; and wage growth, which should reveal something about the current supply-demand balance. The 61.7% labor force participation rate remains far short of its 63.4% pre-pandemic level (Chart 4, top panel) while the prime-age employment-to-population ratio remains below its trough level of the two recessions that preceded the global financial crisis (Chart 4, bottom panel), making it clear that labor supply is still constrained. Chart 4A Lot Of Workers Are Still Idle ... A Lot Of Workers Are Still Idle ... A Lot Of Workers Are Still Idle ... Labor demand, on the other hand, is at levels topping the cyclical peaks of the last 20 years, according to the share of small businesses reporting job openings in the NFIB survey (Chart 5, solid line) and job openings as a share of total employment as reported by the Department of Labor’s Job Openings and Labor Turnover Survey (Chart 5, dashed line). One would expect that the combination of raging demand and constrained supply to lead to higher wages, yet the top wage measures remain quiet (Chart 6). We expect they will until the prime-age employment-to-population ratio starts to make a run at recovering its pre-pandemic level (Chart 7). Chart 5... Even Though Employers Are Looking For Help ... Even Though Employers Are Looking For Help ... Even Though Employers Are Looking For Help Chart 6Wage Growth Remains Subdued Wage Growth Remains Subdued Wage Growth Remains Subdued Chart 7The Labor Market Still Has A Lot Of Slack Tracking Inflation Tracking Inflation The bottom line is that the labor market is starkly bifurcated as vividly illustrated by the Atlanta Fed’s Labor Market Distributions spider chart (Chart 8). On the demand dimensions on the right side of the chart, the labor market is far ahead of where it was at the end of the last two expansions, but far behind on the supply dimensions at the top and bottom left and wages in the middle left. For now, we tick only the Labor Demand box, as it is the only element of the labor market that is back to full health. We expect that shadow supply, which will likely be released in earnest upon next term’s return of in-person instruction in schools across the country and the expiration of unusually generous unemployment insurance benefits, will keep wages from rising much higher until it is fully absorbed. Chart 8A Tale Of Two Markets Tracking Inflation Tracking Inflation Price Indexes The Fed’s preferred core PCE index remains in check, along with the headline PCE index (Chart 9, top panel), but the more widely followed CPI surprised to the upside in April (Chart 9, bottom panel), especially in month-over-month terms, with the headline index rising 0.8% and the core index rising 0.9% for its largest gain in 39 years. Last week’s report dove into the details of the core CPI print and concluded that it was driven by extreme outliers in a handful of categories that are unlikely to be sustained.1 The magnitude of the upside surprise nonetheless leaves us no choice but to check the Marquee Indexes box until the sequential increases settle down. Chart 9CPI Took Off In April CPI Took Off In April CPI Took Off In April The message from more refined measures like trimmed-mean CPI and PCE is more encouraging (Chart 10). Trimmed-mean indexes are akin to the Olympic judging method in which the top and bottom scores are discarded, and their proponents argue that they provide a truer measure of core inflation than the static series which exclude every food and energy category every month. The trimmed-mean CPI and PCE series are well behaved and suggest that the inflation genie has not yet gotten out of the bottle. Chart 10Outliers May Be Skewing The Core Indexes ... Outliers May Be Skewing The Core Indexes ... Outliers May Be Skewing The Core Indexes ... Pipeline Pressures Price increases across the commodity complex have drawn inflation watchers’ attention. Prices at the pump loom large in consumers’ perceptions of inflation and commodities are inputs in a range of manufactured goods; if manufacturers are able to pass price increases onto end users, commodity price increases may find their way into end-product prices. The BCA pipeline inflation indicator rolls the CRB raw industrials index, the ISM survey’s prices paid and supplier delivery time components, overtime hours worked and capacity utilization into a single measure that has moved in step with CPI. It is currently at its highest level in two decades (Chart 11). Chart 11... But Bottlenecks Are Inflicting Near-Term Upward Pressure ... But Bottlenecks Are Inflicting Near-Term Upward Pressure ... But Bottlenecks Are Inflicting Near-Term Upward Pressure Exchange rate moves are not as important for US inflation as they are in economies that are more reliant on trade, but they still matter at the margin. When the dollar weakens, the price of imports rises and when it strengthens, the price of imports falls. Trade-weighted indexes are our go-to series for gauging the dollar’s course (Chart 12, top panel), but the DXY index draws a lot of attention from market professionals and it is currently testing a multi-year technical support level (Chart 12, bottom panel). A break below 90 would presage a further fall and may push inflation expectations higher. Chart 12A Weaker Dollar Could Push US Import Prices Higher ... A Weaker Dollar Could Push US Import Prices Higher ... A Weaker Dollar Could Push US Import Prices Higher ... Services inflation is mainly a domestic phenomenon, but goods prices are globally determined. Inflation measures in major international economies can therefore provide some insight into the path of goods prices and the path of US inflation at the margin. Headline and core consumer prices in the Eurozone have yet to stir from their slumber (Chart 13, top panel) while consumer prices in China briefly deflated (Chart 13, bottom panel). The rest of the world is not yet exerting upward pressure on US consumer prices. Chart 13... But There Isn't Much Inflationary Pressure Outside The US ... But There Isn't Much Inflationary Pressure Outside The US ... But There Isn't Much Inflationary Pressure Outside The US Inflation Expectations Chart 14Investors Vote For Transitory Investors Vote For Transitory Investors Vote For Transitory Expectations inform behavior. If a widespread belief that troublesome inflation is going to return takes hold, individual workers and unions will demand higher wages to maintain their purchasing power, businesses up and down the supply chain will insist on price hikes to protect their margins and consumers may accelerate their big-ticket purchase decisions. Each of these actions adds fuel to the fire, and if economic participants come to believe that a new inflation regime has arrived, it could initiate a self-reinforcing dynamic in which higher prices beget higher prices. Think of it as the flip side of the deflation mindset that has left Japan with relentless disinflation in consumer prices and a relative plunge in asset prices. We are monitoring the inflation expectations curve very closely with the aim of detecting the arrival of a new inflation mindset. If the curve were to shift out – inflation expectations were higher across all time periods – and steepen, with inflation expectations rising across the entire time horizon, participants in the real economy might be on the cusp of changing their behavior to align with expectations. For now, we are encouraged that the inflation expectations curves as derived from the difference in TIPS and nominal Treasury yields (Chart 14, top two panels), and from the CPI swaps market (Chart 14, bottom two panels) suggest that investors agree that inflation pressures are likely to dissipate. We come to that conclusion from the fact that the 2-to-5-year and 5-to-10-year segments of the curve are inverted, which is to say that investors expect near-term inflation will exceed longer-term inflation. Inversion in both segments shows that investors expect a steady decline, with the inflation rate over the next two years exceeding the inflation rate over the next five years and the inflation rate over the next five years exceeding the inflation rate over the next ten years. We place greater reliance on market-determined measures of inflation expectations than survey measures, but we are monitoring a range of consumer and business surveys. The University of Michigan’s consumer sentiment survey shows that households also expect that near-term inflation pressures will not persist. Its respondents see inflation soaring over the next twelve months (Chart 15, top panel) but rising much more modestly over the next five years (Chart 15, bottom panel). Chart 15Households Also Think Acute Inflation Pressures Will Be Short Lived Households Also Think Acute Inflation Pressures Will Be Short Lived Households Also Think Acute Inflation Pressures Will Be Short Lived Fed Reaction Function The investment implications of higher inflation come down to how the Fed reacts to it. For now, the Fed is sticking to its pledge that it has reduced its propensity to tighten policy. It remains outwardly committed to pursuing an average inflation target and to eschewing proactive policy tightening when the labor market appears to be firming. Though we expect that markets will periodically test the Fed when inflation seems to be gathering momentum, we do not yet see any reason to doubt its resolve. We will only check either of the Fed boxes in the event that Fed speakers begin to telegraph a change of direction or if the summary of economic projections (“the dots”) indicates that the bias toward accommodative policy is shifting. We see that bias as nearly fixed in the near term, given that the Fed has gone to considerable lengths to outline its policy goals for participants in the financial markets and the economy. It is not etched in stone, but we don’t foresee a material change in the next few months. Until we do, or until we become convinced that the Fed has allowed itself to get helplessly behind the inflation curve, we expect to stick to our recommendation to overweight risk assets at the expense of Treasuries over the twelve-month cyclical timeframe.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the May 17, 2021 US Investment Strategy report, "The Data That Cried Wolf," available at www.bcaresearch.com.

Dear client, In addition to this weekly report, we also sent you a Special Report on cryptocurrencies, authored by my colleagues Guy Russell and Matt Gertken. The conclusion is that government authorities are likely to lean against the proliferation of cryptocurrencies, something we suspected in our most recent report on the topic. Regards, Chester Highlights Net foreign inflows into US assets probably peaked in March. Meanwhile, there are strong reasons to believe outflows from US securities will accelerate in the coming months. As such, the 12-18-month outlook for the US dollar remains negative. Cryptocurrencies are correcting sharply amidst a crackdown in China, a risk we warned investors about in our Special Report last month. We are increasingly favoring the yen. Lower the limit-sell on USD/JPY to 109. Hold long CHF/NZD positions recommended last week. Feature Chart I-1Current Account Deficit = Capital Account Surplus Current Account Deficit = Capital Account Surplus Current Account Deficit = Capital Account Surplus The US runs a sizeable trade deficit. As such, it must import capital to finance this deficit (Chart I-1). Over the last year, this has been driven by equity and agency bond purchases by foreigners. However, we might be at the apex of a shift, where foreign appetite for US securities starts a meaningful decline. Financing The US Deficit TIC data is usually a lagging indicator for FX markets, but still holds valuable insights into foreign appetite for US assets. On this front, the March data was particularly instructive: There were strong inflows into US Treasury notes and bonds, to the tune of almost $120 bn. This was the greatest driver of monthly inflows. This was also the largest monthly increase since the global financial crisis. Net inflows into US equities stood at $32.2 bn in March. This is on par with the three-month average, but a sharp deceleration from December inflows of $78.3 bn. Corporate bonds commanded particularly strong inflows in March to the tune of $43.1 bn. It appears that foreign private concerns swapped their agency bond purchases with corporate bonds. US residents repatriated $54.1 bn back home in March. Official concerns were big buyers of long-term US Treasury bonds, but this was offset by a large sale of US T-bills. Net foreign official purchases of overall US securities were just $6.5 bn. With the dollar down since March, it is a fair assumption that the strong inflows we saw since then have somewhat reversed. The question going forward is whether there has been a regime shift in US purchases, specifically the purchase of equities (and agency bonds). And if so, can the purchase of US Treasurys pick up the slack (Chart I-2). Foreign inflows into the US equity market tend to be driven by expected rates of return, either from an expected rerating of the multiple or from profit growth. A rerating of the US equity multiple, relative to the rest of the world, has inversely tracked interest rates (Chart I-3). This is due to the higher weighting of defensive sectors in the US equity market. Concurrently, we showed in a recent report that profit growth on an aggregate level also tends to move in sync with relative economic momentum.1  Chart I-2Equity Inflows Have Financed ##br##The US Deficit Equity Inflows Have Financed The US Deficit Equity Inflows Have Financed The US Deficit Chart I-3Rising Bond Yields Would Curtail Equity Inflows Rising Bond Yields Would Curtail Equity Inflows Rising Bond Yields Would Curtail Equity Inflows If growth is rotating away from the US, and global bond yields still have upside, this will curtail foreign appetite for US equities. This appears to be the story since March, as non-US bourses have outperformed (Chart I-4). Chart I-4ANon-US Markets Are Bottoming Non-US Markets Are Bottoming Non-US Markets Are Bottoming Chart I-4BNon-US Markets Are Bottoming Non-US Markets Are Bottoming Non-US Markets Are Bottoming In terms of fixed income flows, the rise in US bond yields towards a peak of circa 180bps in March undoubtedly triggered strong inflows into the US Treasury market. Since then, yields outside the US have been moving somewhat higher, especially in Germany. This should curtail bond inflows, and also fits with a growth rotation away from the US. While foreign central banks were net buyers of US Treasurys in March, the “other reportables” category from the CFTC data show a huge short position in US 10-year futures. Foreign central banks are usually grouped in this category. This will suggest the accumulation of Treasurys should reverse in the coming months (Chart I-5). Chart I-5Did Central Banks Hedge Their March Purchases? Did Central Banks Hedge Their March Purchases? Did Central Banks Hedge Their March Purchases? A rotation of growth from the US towards other parts of the world would also make it more difficult to finance the US current account deficit. This is because it will compress real interest rate spreads between the US and the rest of the world. From a historical perspective, inflows into US Treasury assets only tend to accelerate when real rates in the US are at least 50-100 bps above that in other G10 economies (Chart I-6). That could explain why despite a positive Treasury-JGB spread of 165 basis points, Japanese investors were very much absent buyers in March (Chart I-7). Chart I-6Real Rate Differentials And Bond Capital Flows Real Rate Differentials And Bond Capital Flows Real Rate Differentials And Bond Capital Flows Chart I-7The Big Boys Did Not Buy Much Treasurys In March The Big Boys Did Not Buy Much Treasurys In March The Big Boys Did Not Buy Much Treasurys In March Critical to this view is the outlook for US inflation. On this front, we note the following: First, the output gap in the US should close faster than most other economies, at least according to the OECD (Chart I-8). Ceteris paribus, US inflation should outpace that in other countries in the near term and put downward pressure on real rates. Chart I-8The US Should Generate Higher Inflation The US Should Generate Higher Inflation The US Should Generate Higher Inflation Fiscal spending has been more pronounced in the US compared to other countries, which will further fan the inflationary flames. The Fed is the only central bank in the G10 committed to an inflation overshoot. In a nutshell, there is compelling evidence to suggest US inflows peaked in March from both foreign equity and bond investors. Upside surprises in inflation are more likely in the US in the very near term compared to other economies, which will depress real rates. Meanwhile, higher global yields are also a negative for the US equity market. There Is No Alternative Chart I-9A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys My colleague, Mathieu Savary, has made the case that there is no alternative to US Treasurys. The treasury market is the most liquid and the deepest safe haven pool in the capital market universe (Chart I-9). Ergo, a flight to safety will always bid up Treasurys, as we saw in March 2020. We do agree that Treasurys will continue to act as the world’s safe haven benchmark for now. However, that privilege is fraying at the edges, and it is the marginal changes that matter for dollar investors. Competition for safe haven assets continues to intensify as the narrative switches from 40 years of disinflationary forces to the rising prospect of an inflation overshoot. Inflation is anathema to fiat currencies, including the dollar. For investors, precious metals have been a preferred habitat for anti-fiat holdings. That said, cryptocurrencies are also rising in the ranks as an alternative. In our Special Report2 released a month ago, we suggested government regulation was a huge risk for cryptocurrencies. But more specifically, the degree to which cryptocurrencies can benefit from a shift away from dollars will depend on whether private investors or central banks drive the outflows. Since the peak in the DXY index in 2020, the biggest sellers of US Treasurys have been private investors. Cryptocurrencies benefited from this diversification. That has changed since March, which partly explains the big drawdown in crypto prices. In general, you always want to align yourself with strong buyers who are price indiscriminate. Foreign central banks (the biggest holders of US Treasurys) prefer gold as their anti-dollar asset. This puts an solid footing under gold prices, compared to cryptocurrencies or other anti-fiat assets. It is worth noting that competition between the dollar and gold often run in long cycles. In the 1970s, as inflation took hold in the US, the dollar depreciated and gold soared. In the 1980s, the dollar took off and gold fell sharply, as the Federal Reserve was able to bring down inflation. The 1990s were relatively disinflationary, which supported the dollar (Chart I-10). A whiff of rising inflation in the early 2000s hurt the dollar, while the 2010s were characterized by very low inflation, supporting the dollar. More recently, the dollar is weakening as inflationary trends accelerate faster in the US (Chart I-11). Chart I-10The Dollar And Inflation Move Opposite Ways (1) The Dollar And Inflation Move Opposite Ways (1) The Dollar And Inflation Move Opposite Ways (1) Chart I-11The Dollar And Inflation Move Opposite Ways (2) The Dollar And Inflation Move Opposite Ways (2) The Dollar And Inflation Move Opposite Ways (2) One of our favorite indicators for gauging ultimate downside in the dollar is the bond-to-gold ratio. The rationale is that the bond-to-gold ratio should capture investor preference at the margin for either US Treasurys or gold. This in turn has been a good measure of investor confidence in the greenback. On this basis, the bond-to-gold ratio (TLT-to-GLD ETF) is breaking down to fresh cycle lows (Chart I-12). This has historically pointed towards a lower US dollar. Chart I-12The Dollar And The Bond-To-Gold Ratio The Dollar And The Bond-To-Gold Ratio The Dollar And The Bond-To-Gold Ratio Within precious metals, we like gold but love silver. As such, we are short the gold-to-silver ratio since an entry point of 68. Our bias is that initial support for this ratio is 60. Meanwhile, we also like platinum, and will go long versus palladium at current levels. A Few Other Indicators A few other market developments are pointing to a lower dollar in the coming months. The dollar tends to decline in the second half of the year. This has been true since the 1970s (Chart I-13). Importantly, even during the Paul Volcker years in the 80s when the dollar staged a meaningful rally, it often fell in the second half of the year. The winner in the second half of the year has usually been the Swiss franc and the Japanese yen (Chart I-14).  Chart I-13The Dollar Usually Strengthens In H1 A Peak In US Inflows? A Peak In US Inflows? Chart I-14The Dollar Usually Weakens In H2 A Peak In US Inflows? A Peak In US Inflows? The OECD leading economic indicators still suggest US growth remains robust relative to the rest of the G10. However, our expectation is that this gap will decrease sharply in the second half of this year. That said, the current reading is a risk to our dollar bearish view (Chart I-15). Chart I-15US Exceptionalism Is A Risk For Dollar Bears US Exceptionalism Is A Risk For Dollar Bears US Exceptionalism Is A Risk For Dollar Bears Lumber has started to underperform Dr. Copper. Lumber benefits from solid US housing activity, while copper is more tied to global growth and the emerging investment in green technology. As a counter-cyclical currency, the dollar also tends to underperform higher beta currencies when lumber is underperforming copper (Chart I-16). The copper-to-gold ratio has also bottomed, suggesting ample liquidity is now fueling growth (Chart I-17). We suggested last week that the velocity of money across countries was a key variable to watch in getting the dollar call right. So far, the collapse in money velocity is least acute in China, explaining the rise in the copper-to-gold ratio and the improvement in non-US yields compared to the US. Chart I-16Lumber/Copper Prices And The Dollar Lumber/Copper Prices And The Dollar Lumber/Copper Prices And The Dollar Chart I-17Copper/Gold Prices And Bond Yields Copper/Gold Prices And Bond Yields Copper/Gold Prices And Bond Yields In summary, many cyclical indicators still point to a lower dollar. The key risk to this view is an equity market correction, and/or persistent relative strength in US growth.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Report, "Trading Currencies Using Equity Signals," dated May 7, 2021. 2 Please see Foreign Exchange Special Report, "Will Cryptocurrencies Displace Fiat," dated April 23, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The reason to own stocks is not profit growth. The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will be lacklustre, at best. The reason to own stocks is that the ultimate low in the T-bond yield is yet to come. This ultimate low in the T-bond yield will define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks… …and tilt towards long-duration growth sectors and growth-heavy stock markets such as the S&P500 that will benefit most from the final collapse in yields. The correction in DRAM, corn, and lumber prices suggests that the recent mania in inflation expectations is about to end. Fractal trade shortlist: copper and tin are fragile, go long T-bonds versus TIPS. Feature Chart of the WeekGlobal Profits Surged During The Credit Boom, But Have Gone Nowhere Since Global Profits Surged During The Credit Boom, But Have Gone Nowhere Since Global Profits Surged During The Credit Boom, But Have Gone Nowhere Since The main reason to own stocks is not what you think. The usual long-term argument to own stocks is based on profit growth – specifically, that an uptrend in profits drives up stock prices. Except that since 2008, this is not true (Chart of the Week and Chart I-2). Profits have barely grown, yet the global stock market has doubled.1 Chart I-2Since The Credit Boom Ended, Global Profits Have Barely Grown Since The Credit Boom Ended, Global Profits Have Barely Grown Since The Credit Boom Ended, Global Profits Have Barely Grown As profits have barely grown since 2008, the main reason that the global stock market has doubled is that the valuation paid for those profits has surged. Looking ahead, we expect this to remain the main reason to own stocks. The Reason To Own Stocks Is Not Profit Growth Profits are the product of sales and the profit margin on those sales. During the credit boom of the nineties and noughties, the strong tailwind of credit creation supercharged sales growth. At the same time, the profit margin on those sales trended higher (Chart I-3). Chart I-3Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Hence, in the decade leading up to 2008, global stock market profits surged, outstripping both sales and world GDP. Then the credit boom ended, and profits languished, because: Absent the tailwind from the credit boom, sales growth moderated. The profit margin trended lower. In the post-pandemic years, we expect both trends to persist. The credit boom is not coming back. Furthermore, as the pandemic recession was not protracted, sales are not at a depressed level from which they can play a sharp catch-up, as they did after the 2008 recession and the 2015 emerging markets recession. The structural downtrend in the profit margin will continue. Meanwhile, the structural downtrend in the profit margin will continue. Governments are desperate to mitigate – or at least, contain – the ballooning deficits that have paid for their pandemic stimuluses. Raising corporate taxes from structurally depressed levels is an easy and politically expedient response, as we have already seen from both the Biden administration in the US, and the Johnson administration in the UK. Higher corporate taxes will weigh on structural profit margins (Chart I-4). Chart I-4Corporate Taxes Will Rise From Structurally Depressed Levels Corporate Taxes Will Rise From Structurally Depressed Levels Corporate Taxes Will Rise From Structurally Depressed Levels The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will continue to be lacklustre, at best. The Reason To Own Stocks Is That The Ultimate High In Valuations Is Yet To Come To repeat, the main reason that the global stock market has doubled since 2008 is that its valuation has surged (Chart I-5). Chart I-5The Main Driver Of The Stock Market Has Been Valuation Expansion The Main Driver Of The Stock Market Has Been Valuation Expansion The Main Driver Of The Stock Market Has Been Valuation Expansion In turn, the stock market’s valuation has surged because bond yields have plummeted. Empirically, the valuation of the global stock market is tightly connected with the simple average of the (inverted) yields on the safest sovereign bond, the US T-bond, and the riskier sovereign bond, the Italian BTP. The main reason that the global stock market has doubled since 2008 is that its valuation has surged. Through 2012-13, the decline in the Italian BTP yield, by signifying the fading of euro break-up risk, boosted stock valuations. In more recent years though, it has been the US T-bond yield that has been more influential in driving the global stock market’s valuation (Chart I-6). Chart I-6The Stock Market's Valuation Expansion Is Due To Lower Bond Yields The Stock Market's Valuation Expansion Is Due To Lower Bond Yields The Stock Market's Valuation Expansion Is Due To Lower Bond Yields But the crucial point to grasp is that the relationship between the declining bond yield and stock market valuation becomes exponential. This is because as bond yields approach their lower bound, bond prices have less additional upside but considerably more downside. This extra riskiness of bonds means that investors demand a diminishing risk premium on equities versus bonds. So, as bond yields decline, the required return on equities – which equals the bond yield plus the risk premium – collapses. And as valuation is just the inverse of required return, valuations soar. Chart I-7 and Chart I-8 demonstrate this exponential relationship in practice. Note that the bond yield is on the logarithmic left scale while the stock market’s valuation is on the linear right scale. The logarithmic versus linear scale visually demonstrates that at a lower bond yield, a given change in the bond yield has a much greater impact on the stock market’s valuation. Chart I-7The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential Chart I-8When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge Specifically, if the 30-year yield in the US reached the recent low achieved in the UK, it would boost the stock market’s valuation by nearly 50 percent. We fully expect this to happen at some point in the coming years because of The Shock Theory Of Bond Yields which we introduced in last week’s report. In a nutshell, the shock theory of bond yields states that each successive deflationary shock takes the bond yield to a lower structural level, until it can go no lower. Although it is impossible to predict the timing and nature of individual shocks such as the pandemic, it is easy to predict the statistical distribution of shocks. On this basis, the likelihood of a net deflationary shock is 50 percent within the next three years, and 81 percent within the next five years. Whatever that deflationary shock is, and whenever it arrives, it will mark the ultimate low in the 30-year T-bond yield – at a level close to the recent low in the UK. This ultimate low in the T-bond yield will also define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks. And tilt towards long-duration growth sectors that will benefit most from the final collapse in yields. Growth sectors and growth-heavy stock markets such as the S&P500 will continue to outperform, as they have done consistently since 2008. The Inflation Bubble Is Bursting   The last couple of months has seen a mania in inflation expectations. As industries reconfigured for the end of lockdowns, supply bottlenecks in some commodities led to understandable spikes in their prices. These commodity price increases then unleashed fears about inflation. As investors sought inflation hedges, it drove up commodity prices more broadly … which added to the inflation fears…which added further fuel to the mania in inflation expectations. And so, the indiscriminate rally in commodities continued. The inflation bubble is bursting. But now it seems that the indiscriminate rally is over. DRAM prices have rolled over, belying the thesis that there is widespread shortage in semiconductors (Chart I-9). More spectacularly in the past week, the corn price has tumbled by 12 percent while the lumber price has slumped by 25 percent (Chart I-10). Chart I-9DRAM Prices Have ##br##Rolled Over DRAM Prices Have Rolled Over DRAM Prices Have Rolled Over Chart I-10Lumber Prices Are Correcting, Will Other Commodities Follow? Lumber Prices Are Correcting, Will Other Commodities Follow? Lumber Prices Are Correcting, Will Other Commodities Follow? Given that the commodity rally was indiscriminate, there is a danger that any correction will spread into other commodities like the industrial metals, copper and tin – especially as their fractal structures are at a level of fragility that has identified previous turning points in 2008, 2011, 2015, 2017 and 2020 (Chart I-11 and Chart I-12). Chart I-11Copper's Fractal Structure Is Fragile Copper's Fractal Structure Is Fragile Copper's Fractal Structure Is Fragile Chart I-12Tin's Fractal Structure Is Fragile Tin's Fractal Structure Is Fragile Tin's Fractal Structure Is Fragile In any case, the mania in inflation expectations is about to end. An excellent way to play this is to expect compression in the market implied inflation rate in T-bond yields versus TIPS yields (Chart I-13). Chart I-13The Mania In Inflation Expectations Is About To End The Mania In Inflation Expectations Is About To End The Mania In Inflation Expectations Is About To End Hence, this week’s recommended trade is to go long the 10-year T-bond versus the 10-year TIPS, setting a profit target and symmetrical stop-loss at 3.6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  To clarify, Chart 2 shows world stock market earnings per share, both 12-month forward and 12-month trailing. Whereas Charts 1 and 3 show sales and net profits (not per share). Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators 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 Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators 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 Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights ECB Tapering?: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. Euro Area Bond Strategy: We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. We also suggest a new tactical trade to fade the current market pricing of ECB rate hikes by going long the December 2023 euribor interest rate futures contract. Feature Dear Client, Next week, we will be jointly publishing a Special Report, discussing the investment implications of the current global housing boom, with our colleagues at the monthly Bank Credit Analyst. You will be receiving that report on Friday, May 28. We will return to regular weekly publishing schedule on Tuesday, June 1. - Rob Robis Chart of the WeekAn Underwhelming Rise In European Bond Yields An Underwhelming Rise In European Bond Yields An Underwhelming Rise In European Bond Yields For next month’s monetary policy meeting, European Central Bank (ECB) President Christine Lagarde reportedly plans to invite the Governing Council members to meet in person for the first time since the start of the pandemic. That provides an interesting subtext to a meeting that will surely involve a debate over how much monetary support is still necessary for an increasingly vaccinated Europe that is emerging from the depths of COVID-19. Some ECB officials have already noted that the risks to economic growth and inflation expectations were now “tilted to the upside”, according to the minutes of the last ECB meeting in April. With European economic confidence improving, European bond yields have moved higher in response (Chart of the Week). The benchmark 10-year German bund yield now sits at -0.11%, up 46bps year-to-date but with half of that move occurring over the past month. The pickup up in yields has not been contained to the core countries of Germany and France – the 10-year Italian government bond yield is now up to 1.11%, over twice the level that began 2021 (0.52%). Inflation expectations have picked up sharply, with the 5-year/5-year forward euro CPI swap now up to 1.63%, a level last seen in December 2018. These yield increases have lagged the big moves seen in other countries; 10-year government bond yields in the US and Canada have seen year-to-date increases of 72bps and 90bps, respectively. In those countries, yields have surged because of rising inflation expectations and worries about a tapering of central bank bond buying – concerns that turned out to be accurate in the case of Canada, where the Bank of Canada did indeed announce a slower pace of bond buying last month. In our view, it is still too soon for the ECB to contemplate such a shift to a less dovish policy stance. This message is corroborated by our ECB Monitor that has risen but is still not signaling a need for tighter monetary policy. The bond selloff in Europe looks like a case of "too much, too fast". The ECB Now Has A Lot To Think About Recent euro area economic data has not only caught up to the earlier strength visible in the US, but in some cases is back to levels not seen for many years. The expectations component of the German ZEW survey surged nearly 14 points in May and is now up to levels last seen in 2000. The Markit PMI for manufacturing reached an all-time high of 62.9 in April. The European Commission’s consumer confidence index for the euro area is nearly back to pre-pandemic levels (Chart 2), which bodes well for a continued recovery of the Markit PMI for services. More positive news on the pandemic is driving the surge in growth expectations. The pace of new COVID-19 cases has fallen steadily, with Italy – one of the hardest-stricken regions during the initial months of the pandemic – now seeing the lowest rate of new cases since October (on a rolling 7-day basis). Meanwhile, the pace of vaccinations has accelerated after a slow initial rollout; the number of daily jabs administered (per 100 people) is now greater in Germany, France and Italy than in the US (Chart 3). Chart 2European Growth Is Recovering European Growth Is Recovering European Growth Is Recovering Chart 3Inoculation Acceleration In Europe Inoculation Acceleration In Europe Inoculation Acceleration In Europe Chart 4How Much Spare Capacity Is There In Europe? How Much Spare Capacity Is There In Europe? How Much Spare Capacity Is There In Europe? The rapid increase in inoculations is setting Europe up for a solid recovery from the lockdown-driven double-dip recession of Q4/2020 and Q1/2021. The European Commission upgraded its growth forecasts for the euro area last week, with real GDP now expected to expand by 4.3% in 2021 and 4.4% in 2022, compared with previous forecasts of 3.8% in both years. All euro area countries are now expected to see a return to the pre-pandemic level of economic output by the end of 2022 – a number boosted by a pickup in public investment through the Next Generation EU (NGEU) package, which is expected to begin paying out funds later this summer. The ECB will surely raise its own forecasts at the June meeting, both for economic growth and inflation. The outlook for the latter will likely turn into the biggest source of debate within the ECB Governing Council. Despite the fairly coordinated recovery of survey-based data like the manufacturing PMIs, there remains a wide divergence of unemployment rates - and measures of spare capacity, more generally - within the euro area (Chart 4). This will make it difficult for the ECB to determine if the current surge in realized inflation, which has pushed the annual growth of headline HICP inflation towards the 2% level in many euro zone nations, can persist with countries like Italy and Spain still suffering from very high unemployment. The wide dispersion of unemployment rates within the euro zone also suggests that the current level of policy rates (at or below 0%) is appropriate. One simple metric to measure the “breadth” of European labor market strength is to look at the percentage of euro area countries that have an unemployment rate below the OECD’s estimate of the full employment NAIRU.1 That metric correlates well with an estimate of the appropriate level of euro area short-term interest rates generated by a basic Taylor Rule. Currently, only 43% of euro zone countries are beyond full employment, which is consistent with an ECB policy rate round 0% (Chart 5). Chart 5Policy Rates Near 0% Are Still Appropriate Policy Rates Near 0% Are Still Appropriate Policy Rates Near 0% Are Still Appropriate A slightly larger share of countries (47%) is witnessing an acceleration in wage growth (bottom panel). This could mean that some of the NAIRU estimates for the individual countries are too low, which would fit with the acceleration in overall euro area wage growth seen since 2015. With so many euro area countries still working off the rise in unemployment generated by the pandemic, however, it will take some time for the ECB to get a clear enough read on labor market dynamics to determine if any necessary monetary policy adjustments should be made. The “breadth” of data trends do not only correlate to theoretical interest rate measures like the Taylor Rule. Actual ECB policy decisions are motivated by the degree to which higher growth and inflation is evident across the euro area. In Chart 6, we show a similar metric to the labor market breadth measures from Chart 5, but using other economic and inflation data. Specifically, we show the percentage of euro area countries that are seeing: Chart 6ECB Typically Tightens When Growth AND Inflation Are Broad Based ECB Typically Tightens When Growth AND Inflation Are Broad Based ECB Typically Tightens When Growth AND Inflation Are Broad Based a) Accelerating growth momentum, indicated by an OECD leading economic indicator that is higher than the level of one year earlier; b) Accelerating inflation momentum, comparing the latest reading on headline HICP inflation to that of one year earlier; c) Relatively high inflation, measured by headline HICP inflation being above the ECB’s “just below 2%” target. Looking at all previous periods of ECB monetary tightening since the inception of the euro in 1998 – taking the form of actual policy rate hikes or a flat-to-declining trend in the ECB’s balance sheet – it is clear that the ECB does not tighten without at least 75% of euro area countries seeing both economic growth and inflation accelerate. Actual rate hikes occur when at least 75% of countries had inflation above 2%, as occurred during the hiking cycles of 2000, 2005-2007 and 2011. More recently, the ECB paused the expansion of its balance sheet in 2017 when growth and inflation accelerated, but did not make any policy rate adjustments as only 50% of countries had inflation above 2%. Today, essentially all euro area countries are seeing accelerating growth momentum compared to the pandemic-depressed levels of a year ago. 59% of the euro area is seeing faster inflation, a number that is likely to move higher as more of Europe reopens from lockdown amid a surge in global commodity prices. Yet only 12% of euro area countries have headline inflation above 2%, suggesting that realized inflation is not yet strong enough to trigger even an ECB balance sheet adjustment, based on the 2017 experience. Don’t Bet On A June ECB Taper So judging by past ECB behavior, an announcement to taper bond buying at the June policy meeting would be highly premature. A more likely scenario is that an upgrade of the ECB’s growth and inflation forecast prompts a discussion of what to do with all the varying parts of the ECB’s monetary stimulus – quantitative easing, bank funding programs like TLTROs, as well as policy interest rates. Yet it will be impossible for the ECB Governing Council to reach any conclusions on their next step(s) at the June meeting because the very nature of the ECB's inflation target might soon change. The ECB is currently conducting a review of its monetary policy strategy – the first since 2003 – that is scheduled for completion later this year. Some adjustment to the ECB inflation target is expected to allow more flexibility, but it is not yet clear what that change will look like. Could the ECB follow the lead of the Federal Reserve and move to an “average inflation target” regime, tolerating overshoots of the inflation target after periods of below-target inflation? ECB Chief Economist Philip Lane noted back in March that “there was a very strong logic” to the Fed’s new approach. He also said that the “very different histories of inflation” in some European countries may make it difficult to reach an agreement on any system that allows even temporary periods of higher inflation.2 More recently, Bank of Finland Governor Olli Rehn – a moderate member of the Governing Council who was considered a candidate for the current ECB presidency – came out in favor of the ECB shifting to a Fed-like average inflation target for Europe in a recent Financial Times interview.3 Rehn noted that a Fed-like focus on aiming for maximum unemployment “makes sense in the current context of a lower natural rate of interest.” Rehn went on to describe the ECB’s current wording of its inflation target as having “generated a perception of asymmetry” such that “2 per cent is perceived as a ceiling and that is dampening inflation expectations.” We imagine that Jens Weidmann from the Bundesbank would vehemently oppose any move to change the ECB inflation target to tolerate even a temporary period of inflation above 2%. German headline HICP inflation already reached 2.1% in April, with more increases likely as the German economy reopens from extended pandemic lockdowns. Yet even if Weidmann were to not dig in his heels against any “loosening” of the ECB inflation target, the looming conclusion of the ECB strategy review makes it highly unlikely that any change in policy – like tapering – could credibly be announced before then. If higher inflation will be tolerated, then why bother to taper at all? Looking beyond the inflation strategy review, there are other factors that could weigh on the ECB in its deliberations on the next monetary policy move: China policy tightening: China – Europe’s largest trading partner – has seen its policymakers begin to rein in credit growth, and fiscal spending, after allowing a surge in borrowing in 2020 to help boost growth during the pandemic. Our measure of the China credit impulse leads the annual growth rate of European exports to China by around nine months (Chart 7), and is flagging a dramatic slowing of exports in the latter half of this year. This represents a downside risk to euro area growth, particularly in countries that export more heavily to China like Germany. Slowing loan growth: The annual growth rate of overall euro area bank lending peaked at 12.2% back in February and is now down to 10.9% (Chart 8). Much of the softening has occurred in Germany and France – countries that had seen a big take-up of subsidized bank funding through the ECB’s TLTROs. The pricing incentives set up by the ECB for the latest TLTRO program were highly attractive, and it appears that German and French banks took advantage of the cheap funding to ramp up lending activity. This makes the economic interpretation of the bank lending data more challenging for the ECB, especially with Italian loan growth – and TLTRO usage – now accelerating. Chart 7Warning Signs For European Export Demand Warning Signs For European Export Demand Warning Signs For European Export Demand Chart 8ECB LTROs Are Becoming Italy-Focused ECB LTROs Are Becoming Italy-Focused ECB LTROs Are Becoming Italy-Focused NGEU spending: As mentioned earlier, disbursements from the €750bn NGEU (a.k.a. “recovery fund”) are expected to begin later this year, pending EU approval of government investment proposals. NGEU funds are intended to finance initiatives that can boost future economic growth, like investments in digital and green programs. Most euro area countries have already submitted their proposals, led by Italy’s request for €192bn. Chart 9NGEU Will Give A Big Boost To European Growth Over The Next Five Years ECB Outlook: Walking On Eggshells ECB Outlook: Walking On Eggshells Chart 10NGEU Impact Will Be Front Loaded NGEU Impact Will Be Front Loaded NGEU Impact Will Be Front Loaded A recent study by S&P Global concluded that NGEU investments could boost overall euro area growth by between 1.3 and 3.9 percentage points, cumulatively, between 2021 and 2026 (Chart 9).4 That same study also noted that the impacts of the spending will be front-loaded over the next two years (Chart 10). The Italian government believes that NGEU investment could double Italy’s anemic trend growth rate to 1.5%. Many ECB officials have noted that NGEU is the kind of structural fiscal stimulus that makes it less necessary to maintain highly accommodative monetary policy. Until the NGEU proposals are finalized and the final approved amounts are dispersed, however, the ECB will be unable to adjust its economic forecasts to account for more government investment. Given all of these immediate uncertainties, including how successfully Europe can reopen from pandemic lockdowns, we do not see a plausible scenario where the ECB Governing Council could conclude at the June policy meeting that an immediate change in the current monetary policy tools and guidance was needed. Bottom Line: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. Likely ECB Next Moves & Investment Implications While a June taper announcement from the ECB is unlikely, a hint towards a future move is quite possible. The ECB is notorious for preparing markets well in advance of any policy shifts, thus the official statement following the June meeting – as well as ECB President Lagarde’s press conference – could contain clues as to what the ECB will do next. Chart 11ECB Easing Takes Many Forms ECB Easing Takes Many Forms ECB Easing Takes Many Forms A discussion of what will happen with the Pandemic Emergency Purchase Program (PEPP) – which is scheduled to end next March – could come up in June. We deem it more likely that the topic will be raised at the September policy meeting when there will be more clarity on the success of the reopening of Europe’s economy, and to the final approved size of the NGEU funds, which will determine the need to maintain an asset purchase program introduced because of the COVID-19 shock. There are certainly many policy options available for the ECB to choose from when they do decide to dial back accommodation. There are several policy interest rates that could be adjusted. Although it is likely that when the ECB next tries to hike interest rates, the first rate to move will be the overnight deposit rate which is currently at -0.5% and represents the “floor” for short-term interest rates in Europe (Chart 11). Rate hikes will not occur before the balance sheet tools are reduced or unwound, however, which means asset purchases will be dialed back first. Market participants are well aware of that order of policy choices, as a very flat path for short-term interest rates is currently discounted in the European overnight index swap (OIS) curve. The spread between forward rates in the OIS and CPI swap curves can be used as a proxy for the market forward pricing of real interest rates. Currently, the market-implied real ECB policy rate is expected to stay between -2% and -1% over the next decade (Chart 12). Put another way, the markets are pricing in a very flat path for ECB policy rates that will stay below expected inflation over the next ten years. While the natural real rate of interest in Europe is likely very low given low trend growth, a real rate as low as -2% discounts a lot of bad structural news for the European economy. By comparison, the NY Fed’s last estimate of the natural real rate (r-star) for Europe – calculated in Q2/2020 before the economic volatility surrounding the pandemic made r-star estimation more unreliable – was positive at +0.6%. The prolonged path of negative expected real interest rates in Europe goes a long way in explaining the persistence of negative real bond yields in the benchmark German government yield curve. Simply put, there is little belief that the ECB will ever be able to engineer a full-blown rate hike cycle – an outcome that Japanese fixed income investors are quite familiar with. Given the ECB’s constant worry about the level of the euro, and its role in impacting European growth and inflation expectations, markets are correct in thinking that it will be difficult for the ECB to lift rates much without triggering unwanted currency appreciation. It is no coincidence that the euro has been consistently undervalued on a purchasing power parity (PPP) basis ever since the ECB moved to a negative interest rate policy back in 2014 (Chart 13). Chart 12Markets Expect Negative European Real Rates For The Next Decade Markets Expect Negative European Real Rates For The Next Decade Markets Expect Negative European Real Rates For The Next Decade Looking ahead, the ECB will need to be careful about signaling any changes in monetary policy, including tapering, that would force markets to revise up the future path of European interest rates and give the euro a large boost. Chart 13Low ECB Rates Keeping The Euro Undervalued Low ECB Rates Keeping The Euro Undervalued Low ECB Rates Keeping The Euro Undervalued That means that European real bond yields are likely to stay deeply negative over at least the latter half of 2021, with any additional nominal yield increases coming from higher inflation expectations (Chart 14). This will limit how much more European bond yields can rise from current levels. Chart 14European Bond Strategy Summary European Bond Strategy Summary European Bond Strategy Summary We continue to believe that core European bond yields will trade with a “low yield beta” to US Treasury yields over at least the second half of 2021 and likely into 2022 when we expect the Fed to begin tapering its bond buying. Thus, we are sticking with our strategic recommendation to overweight core European government bonds versus US Treasuries in global bond portfolios. We simply see greater odds of a taper occurring in the US than in Europe, with the Fed more likely to deliver subsequent post-taper rate hikes than the ECB. We still recommend a moderately below-benchmark duration stance within dedicated European bond portfolios, although if the 10-year German bund yield rises significantly into positive territory, we would likely look to raise our suggested European duration exposure. We are also maintaining our recommended overweight on European inflation-linked bonds, as breakeven spreads in Germany, France and Italy are the only ones that remain below fair value in our suite of global valuation models. On European credit, we continue to recommend overweighting spread product versus sovereign bonds. That includes Italian and Spanish government bonds, as well as both investment grade and high-yield corporate debt. The time to turn more bearish on those markets will be when the ECB does begin to taper its asset purchases, as credit spreads have tended to widen during periods when the growth of the ECB’s balance sheet has been decelerating (Chart 15). We expect that when the ECB does finally decide to taper, the net amount of TLTROs will likely be maintained near current levels (by introducing new TLTROs to replace expiring ones). This will ensure that borrowing costs in the more fragile countries like Italy do not spike higher from the double-whammy of reduced ECB buying of Italian bonds and diminished access to cheap ECB bank funding. One final note – we are introducing a new trade in our Tactical Overlay portfolio on page 19 this week, as a way to fade the markets pricing in a more hawkish ECB outlook. A 10bp rate hike – the most likely size of any first attempt for the ECB to lift rates – is now priced in the OIS curve around mid-2023. By the end of 2023, nearly 25bps of hikes are discounted in forward rate curves. We do not expect the ECB to lift rates at all in 2023, but even if rates were increased, a cumulative 25bps of hikes within six months is unlikely to be delivered. Thus, we recommend going long the December 2023 3-month Euribor interest rate futures contract at an entry price of 100.27 (Chart 16). Chart 15ECB Tapering Would Be Bad News For European Credit ECB Tapering Would Be Bad News For European Credit ECB Tapering Would Be Bad News For European Credit Chart 16Go Long Dec/2023 Euribor Futures Go Long Dec/2023 Euribor Futures Go Long Dec/2023 Euribor Futures Bottom Line: The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 NAIRU is an acronym for the Non-Accelerating Inflation Rate of Unemployment. 2 Lane’s comments came from a wide-ranging interview with the Financial Times published on March 16, 2021, which can be found here: https://www.ft.com/content/2aa6750d-48b7-441e-9e84-7cb6467c5366 3 Rehn’s comments were published earlier this month on May 9 and can be found here: https://www.ft.com/content/05a12645-ceb2-4cd5-938e-974b778e16e0 4 The S&P Global report, titled “Next Generation EU Will Shift European Growth Into A Higher Gear”, can be found here: https://www.spglobal.com/ratings/en/research/articles/210427-next-generation-eu-will-shift-european-growth-into-a-higher-gear-1192994 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ECB Outlook: Walking On Eggshells ECB Outlook: Walking On Eggshells Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 19 at 10:00 AM EDT, 3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT). 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 US growth has likely peaked. Economic momentum will slow over the coming quarters as the tailwind from stimulus fades and the vaccination campaign winds down. Historically, a slowdown in US growth, as proxied by a decline in the ISM manufacturing index, has been associated with lower overall equity returns, the outperformance of defensive stocks over cyclicals, large caps over small caps, and US equities over their overseas peers. A falling ISM has also been associated with a strengthening dollar, lower Treasury yields, wider credit spreads, a decline in the US Treasury/German bund spreads, falling oil prices, and an increase in the gold-to-copper price ratio. Compared to past episodes, there are three reasons to expect the coming US slowdown to be relatively benign: First, growth is slowing from exceptionally strong levels; second, growth in many other parts of the world is still speeding up; and third, monetary policy will remain highly accommodative in the face of what is likely to be a transitory increase in inflation. We continue to maintain a positive 12-month view on global equities. Nevertheless, with global growth momentum likely to slow later this year, investors who are maximally overweight risk should pare back cyclical exposure. Crypto update: We warned that “Bitcoin is on a collision course with ESG” two weeks ago. Elon Musk’s flip-flop on allowing customers to pay for Teslas in Bitcoin is yet another piece of evidence that ESG concerns will win out. With that in mind, we are going short Bitcoin. Beware The Second Derivative US growth has likely peaked. Economic momentum will slow over the coming quarters as the tailwind from fiscal stimulus fades and the vaccination campaign winds down. According to the Brookings Institution, fiscal easing contributed nearly seven percentage points to US growth in the first quarter (Chart 1). However, fiscal policy is set to detract from growth in the remainder of the year, reflecting the one-off nature of some of the stimulus measures. Chart 1After A Strong Boost, Fiscal Thrust Is Turning Negative Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation On the pandemic front, the number of new cases continues to trend lower in the US, thanks mainly to a successful vaccination campaign. A falling infection rate has allowed states to dismantle lockdown measures. Conceptually, it is the change in social distancing measures that correlates with economic growth. While some restrictions remain in place (especially in the educational sector), we are now well past the point of maximum loosening. How have financial markets performed during episodes of slowing US economic growth? To answer this question, we looked at the performance of various assets during periods when the ISM manufacturing index was falling and when it was rising. To add a bit more granularity to the analysis, we also looked at cases when the ISM was trending up and above 50, trending down and above 50, trending down and below 50, and trending up and below 50. As summarized in Table 1 and the Appendix Charts, the key results are as follows: Stocks tend to do best when the ISM is rising. Since 1950, the S&P 500 has risen on average by 1.51% during months when the ISM was trending higher, compared to 0.49% during months when the ISM was trending lower. The results were virtually the same if one restricts the sample to the post-1995 period. While the change in the ISM generally matters more for the S&P 500, absolute levels matter too. Since 1995, the best period for the S&P 500 was when the ISM was below 50 but trending higher (S&P 500 up 2.07%), while the worst period was when the ISM was below 50 and trending lower (S&P 500 up 0.03%). This suggests that swings in the ISM have a bigger effect on the stock market during periods of economic contraction. During periods where the ISM was falling but still above 50, the S&P 500 has delivered a positive – though far from stellar – monthly return of 0.69%. US defensively-geared equities outperformed cyclicals when the ISM was trending lower. During periods when the ISM was falling but still above 50, defensives beat cyclicals by 0.45%. Defensives outperformed cyclicals by 0.84% during periods when the ISM was below 50 and trending lower. US small caps underperformed large caps during periods when the ISM was falling. Non-US stocks also underperformed their US counterparts in a falling ISM environment. The relationship between the ISM and value/growth performance is more ambiguous. To the extent that there is one, value generally outperforms growth when the ISM is below 50. Treasury yields tend to increase, while the yield curve tends to steepen, when the ISM is trending higher. Reflecting the higher beta that Treasuries have to the global business cycle, Treasury yields generally rise more than Germany bund yields when the ISM is on the upswing. Corporate credit spreads tend to widen when the ISM is falling. Spreads narrow the most when the ISM is below 50 but rising. As a countercyclical currency, the US dollar tends to weaken when the ISM is rising and strengthen when the ISM is falling. The prices of cyclically-sensitive commodities such as oil and copper normally decline when the ISM is trending lower, although in general, the bulk of the decline in commodity prices usually occurs only when the ISM has dipped below 50. There is not much of a relationship between gold prices and the ISM. Table 1The Economic Cycle And Financial Assets Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Implications For Today Assuming that the ISM has peaked but remains above 50, the analysis above suggests that the S&P 500 will rise modestly over the coming months; US stocks will edge out non-US stocks; defensives will outperform cyclicals; and large caps will perform slightly better than small caps. The analysis also suggests that Treasury yields will move lower; the Treasury-bund spread will narrow; corporate credit spreads will be flat-to-wider; the dollar will strengthen modestly; and commodities will move broadly sideways. Our own 12-month view is more pro-risk than implied by the ISM analysis. There are three reasons for this: First, US growth is slowing from exceptionally strong levels; second, growth in many other parts of the world is still accelerating; and third, monetary policy remains highly accommodative. Let’s examine each assumption in turn. Reason #1: US growth is slowing from exceptionally strong levels While payroll growth surprised sharply on the downside in April, we suspect this was mainly due to pandemic-induced distortions to the seasonal adjustment mechanism used by the Bureau of Labor Statistics. Seasonally unadjusted payrolls rose by 1.1 million in April, which is broadly consistent with the strong pace of GDP growth tracking estimates. The Atlanta Fed GDPNow model points to growth of 11% in Q2. Bloomberg consensus estimates have US real GDP rising by 8.1% in the second quarter. Growth will decline to 7% in Q3 and 4.7% in Q4, but still average 4% in 2022 (Table 2). Table 2Growth Is Peaking, But At A Very High Level Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Chart 2Firms Will Need To Rebuild Inventories Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation US households were sitting on $2.2 trillion in excess savings as of the end of April. This is money they would not have had in absence of the pandemic. Slightly less than half of that stockpile can be attributed to transfer payments, mainly in the form of stimulus checks and unemployment benefits. The rest stems from decreased spending during the pandemic. Not all of this money will be spent immediately. However, given the large sums involved – $2.2 trillion is equivalent to 15% of annual personal consumption – even a partial depletion of these excess savings will be enough to power consumption for the foreseeable future. Meanwhile, firms will have to boost production in order to restore depleted inventories. The inventory-to-sales ratio stands at record low levels (Chart 2). The decline in inventories pushed up the ISM new orders-to-inventory ratio in April, even as the overall ISM index slid from 64.7 in March to 60.7. The new orders-to-inventory ratio tends to lead the ISM index, which suggests that any decline in the ISM index over the coming months will be gradual.    An easing of supply-side constraints should also support growth. Even though overall employment was still 5.2% below pre-pandemic levels in April, a record share of small firms surveyed by the NFIB reported difficulty in filling vacant positions (Chart 3). Enhanced unemployment benefits have eroded the incentive to find work. In addition, many schools remain partially shuttered. Chart 4 shows that mothers with young children have seen a much larger decline in labor force participation than other groups. Chart 3Firms Are Struggling To Find Workers Firms Are Struggling To Find Workers Firms Are Struggling To Find Workers Chart 4Mothers With Children Had To Leave The Labor Force Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Enhanced unemployment benefits will expire in September. As schools resume normal operations, more workers will flow back into the labor market. At the same time, some of the bottlenecks currently gripping the global supply chain should abate, allowing for increased output.   Reason #2: Growth in many other parts of the world is still accelerating Chart 5Over 40% Of S&P 500 Revenues Come From Abroad Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Chart 6Euro Area Data Has Surprised On The Upside Euro Area Data Has Surprised On The Upside Euro Area Data Has Surprised On The Upside S&P 500 constituent firms derive 43% of their revenues from abroad (Chart 5). While Bloomberg estimates suggest that US growth will peak in the second quarter, growth in the euro area is not expected to peak until the third quarter. Mathieu Savary, who heads BCA’s European Investment Strategy service, sees upside risks to European growth estimates for the second half of this year. Consistent with Mathieu’s observations, recent economic data has been surprising to the upside in the euro area (Chart 6). Just this week, economic expectations for both Germany and the wider euro area leaped to the highest level in more than 20 years, according to the ZEW economic research institute. Growth in Japan should also pick up in the remainder of the year. Japan’s vaccination campaign has gotten off to a very slow start, with less than 3% of the population being inoculated to date. The government imposed its third state of emergency on April 25 in response to rising viral case counts. It subsequently extended those restrictions on May 11. The authorities intend to vaccinate the country’s 36 million elderly people by July, when the Olympics are set to begin. This should permit some easing in lockdown measures. Investors are worried that the Chinese economy will slow this year. The Chinese PMIs peaked in November 2020, about the same time as the combined credit/fiscal impulse reached an apex (Chart 7). Jing Sima, BCA’s chief China strategist, expects the general government budget deficit to remain at a still-ample 8% of GDP this year, similar to where it was last year. She expects credit growth to slow by 2%-to-3%, converging towards the pace of nominal GDP growth. Keep in mind that China’s credit-to-GDP ratio stands at 270%. Thus, if credit grows in line with nominal GDP growth of about 10%, this would still leave the stock of credit roughly 27% of GDP higher at the end of 2021 compared to the end of 2020. This hardly constitutes “deleveraging”. A resilient Chinese economy should buoy other emerging markets. Progress on the pandemic front should also help. The UN estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population (Chart 8). The shortages of vaccines in emerging markets could turn into a surfeit by the end of this year, something that market participants do not seem to fully appreciate. Chart 7China: Peak Stimulus And Peak Growth China: Peak Stimulus And Peak Growth China: Peak Stimulus And Peak Growth The rotation in growth momentum from the US to the rest of the world should put downward pressure on the US dollar. A weaker dollar, in turn, has usually coincided with the outperformance of non-US stock markets (Chart 9). Chart 8Vaccine Production Set To Ramp Up Further Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Chart 9A Weaker Dollar Has Coincided With The Outperformance Of Non-US Stock Markets A Weaker Dollar Has Coincided With The Outperformance Of Non-US Stock Markets A Weaker Dollar Has Coincided With The Outperformance Of Non-US Stock Markets   Reason #3: Monetary policy remains highly accommodative The slowdown in US growth is coming at a time when inflation is rising. The core CPI increased by 0.9% month-over-month in April. This was the biggest monthly jump since August 1981. The year-over-year rate climbed to 3.0%, the highest in 25 years. The “whiff of stagflation” helped push the S&P 500 down this week. As we discussed last week, we are very much in the camp that expects inflation to rise significantly over the long haul. Over the next one or two years, however, we would fade inflationary fears. As the example of the 1960s illustrates, a long period of overheating is often necessary to push up inflation in a sustained manner. The US unemployment rate reached its full employment level in 1962. However, it was not until 1966 – when the unemployment rate was two full percentage points below equilibrium – that inflation finally took off (Chart 10). The official core CPI likely overstates underlying inflationary pressures. The pandemic threw all sorts of prices out of whack. Stripping out volatile food and energy prices from inflation is not enough. One needs more refined measures of inflation. Luckily, they exist. Chart 11 shows that median CPI, trimmed-mean CPI, and sticky price CPI all remain well contained. Similarly, relatively clean measures of wage growth, such as the Atlanta Fed Wage Tracker, do not point to an imminent wage-price spiral (Chart 12). Chart 10Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 11Cleaner Measures Of Inflation Are Telling A Different Story Cleaner Measures Of Inflation Are Telling A Different Story Cleaner Measures Of Inflation Are Telling A Different Story Chart 12Wage Growth Is Still Lackluster Wage Growth Is Still Lackluster Wage Growth Is Still Lackluster All this means that the Fed can afford to sustain exceptionally easy monetary policy. That should keep growth at an above-trend pace and continue to support to equity valuations.   Investment Conclusions My “golden rule” for investing is to stay bullish on stocks unless one thinks there is a recession around the corner (Chart 13). Seeing around the corner is not easy, of course, but it is not impossible either. Chart 13Recessions And Bear Markets Tend To Overlap Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Last year’s recession was caused by a true exogenous shock – the pandemic. Most recessions are endogenous in nature, however. They result from growing imbalances that are usually laid bare by tighter monetary policy. One can debate the extent to which the global economy is plagued by imbalances of one form or another. But one thing is clear, monetary policy is unlikely to turn contractionary any time soon. In this environment, one should remain positive on equities and other risk assets over a 12-month horizon. Nevertheless, with global growth momentum likely to slow later this year, investors who are maximally overweight risk should pare back cyclical exposure. Go Short Bitcoin We warned that “Bitcoin is on a collision course with ESG” two weeks ago in a report entitled “How To Short Bitcoin, Or Anything Else, Without Losing Your Shorts.” Elon Musk’s flip-flop on allowing Tesla customers to pay for Teslas in Bitcoin is yet another piece of evidence that ESG concerns will win out. News that Colonial Pipeline paid hackers 75 bitcoin (nearly $5 million) in ransom further cements Bitcoin’s status as the currency of choice for criminals around the world. With all that in mind, we are going short Bitcoin as of midnight Eastern Daylight Time (EDT) using the shorting technique described in that report. The technique flips the usual risk-reward from shorting on its head. Normally, when you short a stock, your gain is capped at 100% of the initial position whereas your potential loss is unlimited. With our shorting technique, your potential loss is capped at 100% while your potential gain is unlimited. This makes shorting as an investment strategy a lot safer. APPENDIX The Economic Cycle And Financial Assets APPENDIX CHART 1A Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation APPENDIX CHART 1B Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Appendix Chart 1C Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Appendix Chart 1D Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Special Trade Recommendations Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Current MacroQuant Model Scores   Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation