Monetary

Highlights Q2/2021 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -6bps during the second quarter of the year. Winners & Losers: The government bond side of the portfolio underperformed by -21bps, led overwhelmingly by our underweight to US Treasuries (-18bps). Spread product allocations outperformed by +15bps, primarily due to overweights on US high-yield (+11bps) and US CMBS (+3bps). Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Feature The trend in global bond yields so far in 2021 has been a tale of two quarters. The first three months of the year saw a surge in yields worldwide on the back of rapidly improving economic data, the rollout of COVID-19 vaccines and supply squeezes triggering rapid increases in inflation. During the second three months of the year, however, global yields drifted a bit lower in response to more mixed economic data, the spread of the Delta variant and slightly hawkish shifts from a few key central banks – most notably, the Fed – even with economic confidence measures remaining upbeat across the developed economies. The decline in yields has not been seen across the maturity spectrum, though. The yield-to-maturity of the Bloomberg Barclays Global and US Treasury 10+ year indices fell by -12bps and -30bps, respectively, from recent peaks. At the same time, shorter term bond yields have been relatively stable as central banks continue to signal that interest rate hikes are still well off into the future. In contrast to government bonds, credit markets have remained calm with spreads tight for developed market corporates and emerging market (EM) debt. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the second quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. The latter half of 2021 should prove to be even more challenging for bond investors, who must disentangle less consistent messages across countries on the Delta variant, vaccinations, inflation and the outlook for both monetary and fiscal policy. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2021 Model Bond Portfolio Performance: Mixed Returns Chart 1Q2/2021 Performance: Credit Gains & Duration Losses The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was +1.13%, slightly underperformed the custom benchmark index by -6bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -21bps of underperformance versus our custom benchmark index while the latter outperformed by +15bps. We have remained significantly underweight US Treasuries and positioned for a bearish steepening of the US Treasury curve since just before last year's US presidential election. That tilt was a big contributor to the excess return of the portfolio in Q1 (+63bps) that was partially given back (-18bps) in Q2 as longer maturity Treasury yields fell during the quarter. Our inflation-linked bond allocations in the US and Europe (+5bps) helped mitigate the loss on the government bond side from our below-benchmark duration stance and general curve steepening bias in most countries in the portfolio (Table 2). Table 2GFIS Model Bond Portfolio Q2/2021 Overall Return Attribution The sum of excess returns during the quarter from countries that we overweighted (Germany, France, Italy, Spain, and Japan) was zero. Improving growth momentum and stronger economic confidence helped push yields higher in those countries. Therefore, those positions could not offset the losses from the underweight to US Treasuries. We did make two shifts in the country allocation within the government bond portion of the portfolio during Q2, downgrading Canada to underweight on April 20 and upgrading Australia to overweight on June 9. Neither change meaningfully contributed to the return of the portfolio. Meanwhile, our moderate overall overweight tilt on spread product versus government bonds fueled the outperformance from the credit side of the portfolio, led by US high-yield (+11bps) and US CMBS (+3bps). Overall gains from spread product were impressive in both USD-hedged total return terms (+95bps) and relative to our custom benchmark (+15bps), despite spreads entering Q2 at fairly tight levels. In the second quarter, improving economic confidence and easing credit conditions allowed spreads to narrow even further for corporate debt in the US and Europe, as well as for EM USD-denominated credit. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2021 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q2/2021 Spread Product Performance Attribution By Sector Biggest Outperformers: Overweight US high-yield: Ba-rated (+5bps), B-rated (+4bps), and Caa-rated (+3bps) Overweight US TIPS (+4bps) Overweight US CMBS (+3bps) Overweight Euro Area high-yield (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10 years (-17bps), Underweight US Treasuries with a maturity between 7 and 10 years (-3bps) Underweight US Treasuries with a maturity between 5 and 7 years (-2bps) Underweight EM USD sovereigns (-1bps) Underweight UK GIlts with a maturity greater than 10 years (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2021 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. In Q2, the picture on that front was mixed. We were only neutral some of the biggest outperformers like UK Gilts (+312bps in USD-hedged duration-matched total return terms) and investment grade credit in the US (+430bps) and UK (+231bps). Our relative value allocation within EM, overweight corporates (+430bps) versus sovereigns (+527bps), also underperformed during Q2. We remained overweight government debt markets in the euro area which were the worst performers during the quarter (Germany: -25bps, Spain: -59bps, Italy: -67bps, and France: -83bps). The news was better on the credit side, where our significant overweight to US high-yield (+146bps) was a big positive contributor, as were overweights to US CMBS (+137bps) and euro area high-yield (+92bps). Bottom Line: Our model bond portfolio slightly underperformed its benchmark index in the second quarter of the year by -6bps – a negative result mainly driven by our underweight allocation to the US Treasury market but with an overweight to US high-yield providing a meaningful offset. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by swings in global government bond yields, most notably US Treasuries. Our most favored cyclical indicators for global bond yields are still, in aggregate, signaling more upside potential over at least the next six months, although the nature of the signal is changing (Chart 5). Our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, remains elevated but appears to have peaked. At the same time, the global manufacturing PMI, which typically leads global real bond yields by around six months, continues to climb to new cyclical highs. This suggests that the recent downdraft in global real bond yields could prove to be short-lived. Our Global Central Bank Monitor is climbing steadily, indicating greater upward pressure on bond yields from the combination of strong growth, rising inflation and loose financial conditions. Admittedly, bond yields are lagging the upward trajectory implied by the Monitor with central banks deliberately responding far more slowly to the cyclical pressures that would have triggered bond-bearish monetary tightening in the past. Nonetheless, the Monitor, the Global Duration Indicator and the global manufacturing PMI and all sending the same message – global bond yields remain too low, suggesting a below-benchmark overall portfolio duration stance remains appropriate. With regards to country allocation within the government bond side of our model portfolio, we continue to overweight countries where central banks are less likely to begin normalizing pandemic-era monetary policy quickly (Germany, France, Italy, Spain, Japan, Australia), while underweighting countries where normalization is expected to begin within the next 6-12 months (the US and Canada). We remain neutral the UK, although we have them on “downgrade watch” until there is greater clarity on how severely the spread of the Delta variant is impacting UK growth. The US remains the biggest underweight. The modestly hawkish turn by the Fed at the June FOMC meeting likely marked the end of the cyclical bear-steepening trend of the US Treasury curve. A full-blown turn to a bear-flattening of the US curve will be slow to develop, but we fully expect the cyclical pressures that drove the underperformance of longer-maturity US Treasuries over the past year to begin leaking into shorter-maturity bonds. That trend already appears to be underway with 5-year US yields starting to drift upward at a faster pace compared to other developed market peers (Chart 6). Chart 5Cyclical Indicators Suggest Global Yields Still Have More Upside Chart 6UST Underperformance Will Shift To Shorter Maturities This leads us to make a change to our model portfolio allocations this week, reducing the exposure to the belly of the US Treasury curve (the 3-5 year and 5-7 year maturity buckets), while modestly increasing the allocation to the 7-10 year bucket. To neutralize the duration-extending implication of that marginal shift, we added a new allocation to US Treasury bills, thus turning this US Treasury shift into a “butterfly” trade, essentially selling the 5-year bullet for a cash/10-year barbell. Longer-term Treasury yields, however, are still in the process of working off an oversold condition that developed in Q1 (Chart 7). Duration positioning remains quite short, according to the JP Morgan survey of bond investors, while speculators are still working off a huge net short position in 30-year Treasury futures according to data from the CFTC. We anticipate that it will take another month or two to work off such an extreme oversold condition for US Treasuries, based on similar episodes over the past two decades. After that, longer-maturity Treasury yields will begin to begin climbing again, to the benefit of the US underweight (and below-benchmark duration stance) in our model portfolio. Chart 7Longer-Maturity USTs Working Off Oversold Condition Chart 8A Sharply Diminished Impulse From Global QE Outside the US, the bond-friendly impact of quantitative easing programs is fading, on the margin, with the growth of central bank balance sheets slowing (Chart 8). While outright tapering of bond buying has only occurred in Canada and the UK (within our model bond portfolio universe), we expect the Fed to begin tapering in early 2022. Financial stability concerns are expected to play an increasingly important role in future tapering decisions, with house prices booming in many countries, most notably Canada which supports our underweight stance on Canadian government debt. Australia is the notable exception to this trend towards slowing balance sheet growth, with the Reserve Bank of Australia (RBA) maintaining a healthy pace of bond buying given underwhelming realized inflation. The recent wave of COVID-19 cases, which has left half of Australia under lockdowns that were largely avoided in 2020, will ensure that the RBA stays dovish for longer, to the benefit of our overweight stance on Australian government bonds. We continue to see the overall dovish stance of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt. However, inflation breakevens in most countries have largely completed the rebound from the depressed levels reached during the 2020 COVID-19 global recession. Our Comprehensive Breakeven Indicators combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. Those indicators suggest that the most attractive markets to position for further upside potential for breakevens are in Italy and France, with breakevens looking more stretched in the US, Canada and Australia (Chart 9). On the back of this, we are maintaining our allocations to inflation-linked bonds in the euro area in our model portfolio. Chart 9Less Scope For Wider Global Inflation Breakevens Chart 10Fading Support For Credit Markets From Global QE Moving our attention to the credit side of our model portfolio, we feel that a moderate overweight stance on overall global corporates versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets, as an indicator of the incremental shift away from the COVID-era monetary policies from 2020, is flashing a warning sign for the performance of global spread product. The annual growth rate of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has been an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond excess returns around February 2022 Although given the current tight level of global corporate bond spreads, both for investment grade and high-yield, we expect future return outperformance from corporates versus government debt to come from carry rather than spread compression. Our preferred measure of the attractiveness of credit spreads is the historical percentile ranking of 12-month breakeven spreads, which measure how much spreads would need to widen to eliminate the carry advantage over duration-matched government bonds on a one-year horizon. Currently, only the lower-rated high-yield credit tiers in the US and euro area offer 12-month breakeven spreads above the bottom quartile of their history, within the credit sectors of our model portfolio (Chart 11). Chart 11Lower-Rated High-Yield Offers Relatively Attractive Spreads Given the sharply reduced default risks on both sides of the Atlantic, and with nominal growth in good shape amid low borrowing rates, we are maintaining our overweights to high-yield bonds in both the US and euro area. At the same time, we are sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce the overall corporate bond exposure later this year, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that signals about the future path for global monetary policy. Within the euro area, we continue to prefer owning Italian government bonds (and to a lesser extent, Spanish government debt) over investment grade corporates, given the more explicit support for the sovereigns through ECB quantitative easing (Chart 12). We expect the ECB to be the most accommodative central bank within our model portfolio universe over at least the next year, with even tapering of any kind unlikely in 2022. Chart 12Favor Italian BTPs Over Euro Area Investment Grade One area of the spread product universe where we are starting to reduce risk in the model portfolio is EM USD-denominated credit. EM debt has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices over the past year. We have positioned for that in our model portfolio through an overall overweight stance on EM USD-denominated debt, but one that favors investment grade corporates over sovereigns. Now, all of those supportive factors for EM credit are fading. Chinese policymakers have reigned in both credit stimulus and fiscal stimulus this year, with the combined impulse suggesting a slower pace of Chinese economic growth in the latter half of 2021 (Chart 13). Given China’s huge share of the global consumption of industrial commodities, slowing Chinese growth should cool the momentum of commodity prices over the next few quarters. A slowing liquidity impulse from global central bank asset purchases is also a negative for EM debt performance, on the margin. The same can be said for the US dollar, which is no longer depreciating as markets start to pull forward the expected future path for US interest rates (Chart 14). A stronger US dollar typically correlates with softer commodity prices and wider EM credit spreads. Chart 13Major EM Risks: China Tightening & Global QE Tapering Chart 14EM Supportive USD Weakness Is Fading In response to these growing risks to the bullish EM backdrop - including the rapid spread of the Delta variant made worse by the less-effective vaccines available in those countries - we are downgrading our overall EM USD credit exposure in the model bond portfolio to underweight from neutral. We are doing this by cutting the EM corporate exposure from overweight to neutral, while maintaining an underweight tilt on EM USD sovereigns. We expect to further cut the EM exposure in the coming months by moving to a full underweight on EM corporates. Summing it all up, our overall allocations and risks in our model portfolio leading into Q3/2021 look like this: An overall below-benchmark stance on global duration, equal to nearly one full year versus the custom index (Chart 15) A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 16). This overweight comes almost entirely from overweight allocations to US and euro area high-yield corporate debt. Chart 15Overall Portfolio Duration: Stay Below Benchmark Chart 16Overall Portfolio Allocation: Small Spread Product Overweight After the changes made to our US Treasury and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 34bps (Chart 17). The main reason for this is that our positioning remains focused heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral or largely offsetting other positions in a relative value sense (overweight Australia vs underweight Canada, overweight US CMBS versus underweight US Agency MBS). This fits with our desire to maintain only a moderate level of overall portfolio risk. The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry”, hedged into USD, of 13bps (Chart 18). Chart 17Overall Portfolio Risk: Moderate Chart 18Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the US and EM, we now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. We see global growth momentum and the Fed monetary policy outlook as the two most important factors for fixed income markets in the second half of 2021, thus our scenarios are defined along those lines. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries Base Case Global growth stays above-trend in both Q3 and Q4, putting downward pressure on unemployment rates and keeping realized inflation elevated. Ongoing global vaccinations lead to more of the global economy fully reopening, with the Delta variant not having serious widespread impact on economic confidence outside of parts of the emerging world. Excess savings built up during the pandemic are run down by both consumers and businesses as optimism stays ebullient within the developed economies. China credit tightening slows growth enough to cool off upward commodity price momentum. At the same time, falling US unemployment and surprisingly “sticky” domestic US realized inflation embolden the Fed to signal a move to begin tapering its bond purchases starting in January 2022. Real bond yields globally bottom out, while inflation expectations recover some of the pullback seen in Q2/2021. The entire US Treasury curve shifts higher, led by the 10-year reaching 1.65% and a modest bear-flattening of the 5-year/30-year curve. The VIX stays near 15, the US dollar rises +3%, the Brent oil price goes nowhere and the fed funds rate is unchanged at 0% Upside Growth Surprise The Delta variant proves to be far less deadly than feared. A rapid pace of global vaccinations leads to booming growth led by the US but including a fully reopened euro area. Chinese policymakers begin to reverse some of the H1/2021 credit tightening. Unemployment rates rapidly fall worldwide, while supply bottlenecks persist, keeping upward pressure on realized inflation. Markets pull forward the timing and pace of future central bank interest rate hikes, most notably in the US when the Fed begins tapering bond purchases sooner than expected before year-end. Real bond yields drift higher globally, but inflation breakevens stay elevated with the earlier surge in realized inflation proving not to be “transitory”. The US Treasury curve modestly bear-flattens, with the 10-year reaching 1.9% and the 5-year/30-year spread narrowing by 25bps. The VIX rises to 25 as risk assets struggle in response to rising bond yields even with faster growth. The US dollar falls -5% on the back of improving global growth expectations, the Brent oil price climbs +5% and the fed funds rate stays unchanged. Downside Growth Surprise The global economy gets hit on multiple fronts: the rapid spread of the Delta variant overwhelms the positive momentum on vaccinations, most notably in EM countries; Europe struggles to fully reopen; China policy tightening results in a larger-than-expected drag on global growth; and US households are reluctant to draw down on excess savings after government income support measures expire in September. Diminished economic optimism leads to a pullback in global equity values, lower government bond yields and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.25% alongside lower inflation breakevens. The VIX rises to 30, the safe-haven US dollar rises +5%, the Brent oil price falls -10% and the fed funds rate stays at 0%. Chart 19Risk Factor Assumptions For The Scenario Analysis Chart 20US Treasury Yield Assumptions For The Scenario Analysis The inputs into the scenario analysis are shown in Chart 19 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 20. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The model bond portfolio is expected to deliver a positive excess return over the next six months of +46bps in the base case scenario and +28bps in the optimistic growth scenario, but is projected to underperform by -36bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Economy – The endpoint of easier-for-longer monetary policy may be coming into view: Elevated inflation readings and discomfort among more hawkish FOMC members may signal that a monetary policy inflection is on the way. Markets – Volatility should pick up as investors reprice financial assets to reflect the end of emergency accommodation: The rumblings in bond, currency and precious metals markets that followed the June FOMC meeting are likely to spread as investors pull their liftoff date expectations forward. Strategy – Maintain below-benchmark duration positioning and ensure that portfolios can withstand increased volatility: Don’t be lulled to sleep by the 10-year Treasury yield’s backing and filling or by the VIX’s foray into the low teens. It is a more auspicious time to be buying insurance than selling it. Feature After fourteen years, investors may be weary of focusing so much attention on the Fed, but there’s been no avoiding its impact since the global financial crisis (GFC) emerged. Zero interest rate policy (ZIRP), large-scale asset purchases and other emergency measures have exerted a strong pull on financial markets as they have been switched on and off. The extended turn of rushing to the rescue appears to be weighing on the Fed as well. Last August’s revisions to its Statement on Longer-Run Goals and Monetary Policy Strategy explicitly acknowledged the challenges of operating in a ZIRP world in which its ability to deploy its primary tool for countering economic weakness – cutting the fed funds rate – is constrained by the zero lower bound. The Fed responded by adjusting its approach to each element of its dual mandate. It adopted an average-inflation-targeting framework that seeks to remediate past inflation shortfalls and indicated that it would only intervene to mitigate shortfalls from its maximum employment estimate. The latter move marked a break with the previous four decades, when the Fed, unwilling to give inflation pressures a chance to take root, proactively tightened policy when it judged that the labor market might be getting too strong. Taken together, the changes amounted to a significant break from doing whatever it took to keep inflation from gaining a foothold to making sure it didn’t completely vanish from households’, businesses’ and investors’ consciousness. If the changes were implemented as outlined, the effects could be wide-ranging. Inflation would be able to gain more traction, all else equal, leading to higher bond yields as markets anticipated that a higher terminal fed funds rate would be required to bring it to heel. A higher terminal fed funds rate might lead to a deeper economic slowdown, ushering in lower bond yields than otherwise would have prevailed. By inducing higher highs and lower lows in Treasury yields, the revisions to the Fed’s framework could promote increased financial market volatility, depending on FOMC members’ ongoing commitment to them and the way that commitment interacted with investors’ expectations. Although the revised framework is eleven months old, it is freshly relevant as the interaction between its implementation and investors’ expectations may be approaching an inflection point. When the FOMC announced the framework revisions last August, it didn’t have any immediate monetary policy implications and investors and committee members could reasonably have figured they would cross the new-framework bridge when they came to it. Elevated inflation readings and some differences in views within the FOMC suggest the bridge might now have to be crossed soon enough to fit within most institutional investors’ time horizons. Volatility may well rise as markets attempt to reprice assets against the backdrop of a novel monetary policy approach. End Of An Era The aforementioned changes that the FOMC made to its monetary policy strategy represented a watershed moment for US monetary policy. Beginning with Paul Volcker’s tenure as Fed chair near the end of the high-inflation ‘70s, the Fed has kept a sharp lookout for inflation pressures (Chart 1). Though it only introduced an annual inflation target in the aftermath of the GFC, its one-way view of inflation was well established. Signs that it might be emerging could be grounds for tighter monetary conditions while dormant readings were nothing to worry about. Chart 1Upholding Volcker's Mantle The average inflation target indicates that inflation shortfalls will henceforth be as much of a concern as inflation overshoots and the Fed will attempt to remediate them with an eye towards keeping inflation expectations from slipping below 2%. On the other hand, the new framework shifts from a two-way to a one-way perspective on employment. Where the committee had previously attempted to conduct policy in a way that mitigated any deviations from its maximum-employment assessment, the new framework seeks only to mitigate shortfalls. Citing the post-crisis experience, when inflation remained in check despite a half-century low in the unemployment rate, and a desire to see expansion gains spread more widely across households, Chair Powell has repeatedly emphasized that too much employment is not a concern. Easier Said Than Done When the Fed announced the changes to its approach, we noted that they would be significant for investors provided it were to follow through on them. It is one thing to promise wide-reaching changes in the indefinite future but quite another to execute them in real time under duress. Financial markets seemed to be aware that turning on a dime would be easier said than done and did not bother to adjust their fed funds rate expectations (Chart 2) or reprice assets that might be most affected by the new policy framework. Among investors with a time frame of a year or less, the talk was all theoretical, anyway – of course policy was going to remain extremely easy when the US and the rest of the world were still knee-deep in a once-in-a-century pandemic and the development of an effective vaccine was a ways off. Chart 2Until Recently, Markets Saw Little Chance Of Rate Hikes On A Two-Year Horizon In other words, talk was cheap when the FOMC unveiled its new framework. Its plans would only matter once the pandemic’s grip eased and central banks regained some discretion. The committee’s resolve to adhere to the new framework would only be tested in the face of uncomfortably high inflation prints and/or inflation expectations that threatened to anchor at levels above its target range. Investors wouldn’t bother to reprice financial assets in line with the new framework until they were certain it would apply. Inoculating Against Deflation As it turned out, effective vaccines appeared on the horizon sooner than anticipated. Pfizer and BioNTech announced the enormously encouraging results from their vaccine’s Phase III trials before the New York open on November 9th, and the Moderna vaccine’s similar clinical successes followed shortly thereafter. Vaccine distribution would begin in January, and the long end of the Treasury curve would begin to reprice, nudged along by rising inflation expectations. Agita sparked by March CPI data caused expectations to peak ahead of the April release, and 10-year breakevens briefly edged above the levels consistent with the Fed’s goals (Chart 3, top panel). Chart 3Coloring Within The Lines Chart 4Unsustainable Outliers We share the view of most mainstream economists that the upside surprises in the March and April inflation prints resulted from transitory reopening factors and do not mark an inflection point. Increases in used car prices will slow once rental car companies rebuild their fleets to match burgeoning demand and new car production can resume at its intended pace, lumber prices will continue to ease as sawmills ramp up operations to capture outsized profits, and the pace of increases in airfares will settle down once staffing bottlenecks can be resolved and more flights can be added to meet resurgent demand (Chart 4). Easier For How Much Longer? Markets’ collective shrug upon the release of the revisions to the Fed’s monetary policy framework reflected the view that they did not amount to a meaningful change over most investors’ time horizons. The second wave of COVID-19 infections had peaked a month before, but at least one other was likely in store as students returned to college campuses, and a vaccine was not yet on the horizon. According to Good Judgment’s professional superforecasters, there was roughly an equal 40% probability that 25 million vaccine doses would be available for distribution in the US between October 1st, 2020 and March 31st, 2021 or between April 1st and September 30th, 2021 (Chart 5). The more optimistic estimate turned out to be right, albeit not quite optimistic enough: nearly 25 million doses were administered by the end of February and nearly 50 million by the March 31/April 1 midpoint of the two periods (Chart 6). Chart 5Vaccine Development And Distribution Wound Up Beating August's Expectations ... Chart 6... By A Considerable Margin The vaccine outlook was relevant because it was hard to envision any incremental tightening of monetary policy while the country was still in the throes of the pandemic. Treasury yields at the longer end of the curve weren’t likely to go anywhere in the absence of increases in the fed funds rate (Chart 7) or increases in inflation or real growth expectations. Just as a still-raging virus was likely to keep the FOMC from hiking rates, it would also put a lid on inflation pressures and economic growth. With economic activity sharply limited by social distancing mandates and individuals’ innate reluctance to risk exposure, it was certain that capacity would continue to surpass aggregate demand. Chart 7Treasury Yields Move With Fed Funds Expectations To the extent investors thought about the FOMC’s new framework when it was unveiled, they seem to have taken it as confirmation that monetary policy would remain easier for longer, consistent with the theme that has prevailed since the Bernanke Fed led the charge to counter the GFC. Treasury yields were subdued even after the vaccine news broke in November (Chart 8, top panel), and with the interest rate structure remaining quiet, there was no major repricing in other rate-sensitive markets. Gold, which might have been expected to benefit from more accommodative policy, slipped nearly 15%, from the mid-$1,900s to the high $1,600s, between the release of the new framework and its March trough. After retracing half of its post-August decline, it shed a fresh 5% following the FOMC’s June meeting (Chart 8, second panel). Chart 8Growth Prospects, Not Fed Prospects Commodity currencies had added 10% versus the US dollar before ceding half of those gains in the wake of the June FOMC meeting, but their rally appears to have been driven by the increased global growth expectations that followed the positive vaccine news as they went nowhere in September and October (Chart 8, third panel). Similarly, the DXY Index had taken its post-revision cue from global growth prospects, moving inversely with pandemic news (rising when bad, falling when good), before rallying after the June meeting (Chart 8, bottom panel). The rise in measured inflation has encouraged some committee members to bring forward their anticipated liftoff dates and accelerate their individual dot plots, as disclosed last month. Now that the Fed no longer seems to be of one mind on the easier-for-longer path, investors have begun to reassess the scene. Prices are moving as capital reportedly exits pro-inflation positions and the money markets now call for two-and-a-half rate hikes by mid-2023 (Chart 2). More volatility could be in store amidst a shift in the Fed consensus as markets pull forward or push back their expected liftoff date and the expected pace of hikes speeds up or slows down. Investment Implications With the moves in measured inflation and inflation expectations seeming to have met the FOMC’s first two criteria for hiking rates (Table 1), a return to full employment looms as the final hurdle to liftoff. We reiterate our view that hiring progress is the swing factor that investors should be watching to anticipate the coming shift in monetary policy settings. Net payrolls expanded by 850,000 in June, topping estimates and putting the three-month moving average, 567,000, ahead of the 375-485,000 pace required to return the economy to full employment by the second half of 2022.1 That may sound like an overly ambitious target on its face, but we contend that annualized monthly payroll expansion of 4% for fourteen months or 3.1% for eighteen months is attainable given the magnitude of the pandemic job losses (Chart 9). Table 1A Checklist For Liftoff Chart 9A 2H22 Return To Full Employment Is Entirely Possible Our outlook for sustained net payroll expansion remains near the optimistic end of the expectations continuum, though the money market consensus has lately caught up with our sometime-before-the-end-of-2022 liftoff date view (Chart 10). Given that we expect that the yield curve will steepen as the hiring strength shows itself, we advise maintaining below-benchmark duration in Treasury portfolios. The optimism embedded in our hiring view implies robust growth over the next twelve months and we therefore recommend overweighting spread product within fixed income portfolios via a high-yield overweight, and overweighting equities within multi-asset portfolios. Hot growth will eventually induce the Fed to start pumping the monetary brakes, slowing the economy and investment returns, but the twelve-month outlook remains favorable for risk assets. Chart 10Looking For At Least One Hike By The End Of 2022 Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com   Footnotes 1 Making the simplifying (and overly conservative) assumption that returning to full employment will require recovering February 2020’s level of nonfarm payrolls, the US is currently short 6.8 million jobs. Regaining those jobs by August 2022 (14 months from now) will require a monthly average of 485,000 net job gains; regaining them by December 2022 (18 months hence) will require a 375,000 monthly average.

Highlights Gold is – and always will be – exquisitely sensitive to Fed policy and forward guidance, as last month's "Dot Shock" showed (Chart of the Week). Its price will continue to twitch – sometimes violently – as the widening dispersion of views evident in the Fed dots keeps markets on edge and pushes forward rate expectations in different directions. Fed policy is important but will remain secondary to fundamentals in oil markets. Increasingly inelastic supply will force refiners to draw down inventories, which will keep forward curves backwardated. OPEC 2.0's production-management policy is the key driver here, followed closely by shale-oil's capital discipline. Between these market bookends are base metals, which will remain sensitive to Fed policy, but increasingly will be more responsive to tightening supply-demand fundamentals, as the pace of the global renewables and EV buildout challenges supply. The one thing these markets will share going forward is increasing volatility. Gold volatility will remain elevated as markets are forced to parse sometimes-cacophonous Fed forward guidance; oil volatility will increase with steeper backwardation; and base metals volatility will rise as fundamentals continue to tighten. We remain long commodity-index exposure (S&P GSCI and COMT ETF) and equity exposure (PICK ETF). Feature Gold markets still are processing last month's "Dot Shock" – occasioned by the mid-June move of three more Fed bankers' dots into the raise-rates-in-2022 camp at the Fed – and the sometimes-cacophonous forward guidance of post-FOMC meetings accompanying these projections. Following last month's meeting, seven of the 18 central bankers at the June meeting now favor an earlier rate hike. This dot dispersion fuels policy uncertainty. When policy uncertainty is stoked, demand for the USD typically rises, which generally – but not always – contributes to liquidation of dollar-sensitive positions in assets like commodities. This typically leads to higher price volatility.1 This is most apparent in gold, which is and always will be exquisitely sensitive to Fed guidance and the slightest hint of a change in course (or momentum building internally for such a change). This is what markets got immediately after the June meeting. When this guidance reflects a wide dispersion of views inside the Fed, it should come as no surprise that price volatility increases among assets that are most responsive to monetary policy. This dispersion of market expectations – as a matter of course – is intensified by discordant central-bank forward guidance.2 Fundamentals Reduce Oil's Sensitivity To Fed Policy Fed policy will always be important for the evolution of the USD through time, which makes it extremely important for commodities, since the most widely traded commodities are priced in USD. All else equal, an increase in the value of the USD raises the cost of commodities ex-US, and vice versa. Chart of the WeekGold Still Processing Dot Shock Chart 2Oil Market Remains Tight... The USD's impact is dampened when markets are fundamentally tight – e.g., when the level of demand exceeds supply, as is the case presently for oil (Chart 2).3 When this occurs, refiner inventories have to be drawn down to make up for supply deficits (Chart 3). This leads to a backwardation in the oil forward curves – i.e., prices of prompt-delivery oil are higher than deferred-delivery oil – reflecting the fact that the supply curve is becoming increasingly inelastic (Chart 4). This backwardation benefits OPEC 2.0 member states, as most of them have long-term supply contracts with customers indexed to spot prices, and investors who are long commodity-index exposure, as it is the source of the roll yield for these products.4 Chart 3Forcing Inventories To Draw... Chart 4...And Backwardating Forward Curves Copper's Sensitivity To Fed Policy Declining Supply-demand fundamentals in base metals – particularly in the bellwether copper market – are tightening, which, as the oil market illustrates, will make prices in these markets less sensitive to USD pressures going forward (Chart 5). We expect the copper forward curve to remain backwardated for an extended period (Chart 6), which will distance the evolution of copper prices from Fed policy variables (e.g., interest rates and the USD). Chart 5Copper USD Sensitivity Will Diminish As Balances Tighten Chart 6Expect Persistent Backwardation In Copper Indeed, our modeling suggests this already is occurring in the metals markets, as can be seen from the resilience of copper prices during 1H21, when China's fiscal and monetary stimulus was waning and, recently, during the USD's recent rally, which was an unexpected headwind generated by the Fed's June meeting. If, as appears likely, China re-engages in fiscal and monetary stimulus in 2H21, the global demand resurgence for metals, copper in particular, will receive an additional fillip. Like oil, copper inventories will have to be drawn down over the next two years to make up for physical deficits, which have been a persistent problem for years (Chart 7). Capex in copper markets has yet to be incentivized by higher prices, which means these physical deficits likely will widen as the world gears up for expanded renewables generation and the grids required to support them, not to mention higher electric vehicle (EV) demand. If, as we expect, copper miners do not invest in new greenfield mine projects – choosing instead to stay with their brownfield expansion strategies – the market will tighten significantly as the world ramps up its demand for renewable energy. This means copper's supply curve will, like oil's, become increasingly inelastic. At the limit – i.e., if new mining capex is not incentivized – price will be forced to allocate limited supply, and may even have to get to the point of destroying demand to accommodate the renewables buildout. Chart 7Supply-Demand Balance Tightening In Copper A Word On Spec Positioning We revisited our modeling of speculative influence on these markets over the past couple of weeks, in anticipation of the volatility we expect and the almost-certain outcry from public officials that will ensue. Our modeling continues to support our earlier work, which found fundamentals are determinant to the evolution of industrial commodity prices. Using Granger-Causality and econometric analysis, we find prices mostly explain spec positioning in oil and copper, and not the other way around.5 We do find spec positioning – via Working's T Index – to be important to the evolution of volatility in WTI crude oil options, along with other key variables (Chart 8).6 That said, other variables are equally important to this evolution, including the St. Louis Fed's Financial Stress Index, EM equity volatility, VIX volatility and USD volatility. These variables are not useful in modeling copper volatility, where it appears fundamental and financial variables are driving the evolution of prices and, by extension, price volatility. We will continue to research this issue, and will continue to subject our results to repeated trials in an attempt to disprove them, as any researcher would do. Chart 8Oil Volatility Drivers Investment Implications Gold will remain hostage to Fed policy, but oil and base metals increasingly will be charting a path that is independent of policy-related variables, chiefly the USD. There is no escaping the fact that gold volatility will increasingly be in the thrall of US monetary policy – particularly during the next two years as the Fed attempts to guide markets toward something resembling normalization of that policy.7 However, as the events of the most recent FOMC meeting illustrate, gold price volatility will remain elevated as markets are forced to parse oftentimes-cacophonous Fed forward guidance. This would argue in favor of using low-volatility episodes as buying opportunities in gold options – particularly calls, as we continue to expect gold prices to end the year at $2,000/oz. We also favor silver exposure via calls, expecting price to go to $30/oz this year. In oil and base metals, we continue to expect supply-demand fundamentals in these markets to tighten, which predisposes us to favor commodity index products. For this reason, we remain long commodity-index exposure – specifically the S&P GSCI index, which is up 6.8% since inception, and the COMT ETF, which is up 8.7% since inception. We expect the base metals markets to remain very well bid going forward, and remain long equity exposure in these markets via the PICK ETF, which we re-entered after a trailing stop was elected that left us with a 24% gain since inception at the end of last year.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil stocks (ex SPR) fell 6.7mm barrels in the week ended 25 June 2021, according to the US EIA. Total crude and product stocks were down 4.6mm barrels. Domestic crude oil production was unchanged at 11.1mm b/d over the reporting week. Total refined-product demand surpassed the comparable 2019 reporting period, led by higher distillate consumption (4.2mm b/d vs 3.8mm b/d). Gasoline consumption remains a laggard (9.2mm b/d vs 9.5mm b/d), as does jet fuel (1.4mm b/d vs 1.9mm b/d). Propane and propylene demand surged over the period, likely on the back of petchem demand (993k b/d vs 863k b/d). Base Metals: Bullish Base metals prices are moving higher in anticipation of tariffs being imposed by Russia to discourage exports beyond the Eurasian Economic Union, according to argusmedia.com. In addition to export tariffs on copper, aluminum and nickel, steel exports also will face levies to discourage material from leaving the EAEU (Chart 9). The tariffs are expected to remain in place from August through December 2021. Separately, premiums paid for high-quality iron ore in China (65% Fe) reached record highs earlier this week, as steelmakers scramble for supply, according to reuters.com. The premium iron ore traded close to $36/MT over benchmark material (62% Fe) this week. Precious Metals: Bullish Gold prices continue to move lower following the FOMC meeting on June 16. The yellow metal was down 0.6% y-o-y at $1762.80/oz as of Tuesday’s close after being up a little more than 13% y-o-y before the FOMC meeting earlier this month (Chart 10). We believe the USD rally, which, based on earlier research we have done, could be benefitting from safe-haven demand arising from global concern over the so-called Delta variant of COVID-19, which has spread to at least 85 countries. Public-health officials are fearful this could cause a resurgence in COVID-19 cases and additional mutations in the virus if vaccine distribution in EM states is not increased. Ags/Softs: Neutral Widely disparate weather conditions in the US west and east crop regions – drought vs cooler and wetter weather – appear to be on track to produce average crop yields for corn and beans this year, according to agriculture.com's Successful Farming. In regions where hard red spring wheat is grown, states experiencing low rainfall likely will have poor crops this year. Chart 9 Chart 10   Footnotes 1     We model gold prices as a function of financial variables sensitive to Fed policy – e.g., real rates and the broad trade-weighted USD – and uncertainty, which is conveyed via the Global Economic Policy Uncertainty (GEPU) index published by Baker, Bloom & Davis.  2     Please see Lustenberger, Thomas and Enzo Rossib (2017), "Does Central Bank Transparency and Communication Affect Financial and Macroeconomic Forecasts?" SNB Working Papers, 12/2017. The Swiss central bank researchers find "… the verdict about the frequency of central bank communication is unambiguous. More communication produces forecast errors and increases their dispersion. … Stated differently, a central bank that speaks with a cacophony of voices may, in effect, have no voice at all. Thus, speaking less may be beneficial for central banks that want to raise predictability and homogeneity among financial and macroeconomic forecasts. We provide some evidence that this may be particularly true for central banks whose transparency level is already high." (p. 26) 3    Please see OPEC 2.0 Vs. The Fed, published on February 8, 2018, for additional discussion. 4    Please see The Case For A Strategic Allocation To Commodities As An Asset Class, a Special Report we published on March 11, 2021 on commodity-index investing.  It is available at ces.bcaresearch.com. 5    The one outlier we found was Brent prices, for which non-commercial short positioning does Granger-Cause price.  Otherwise, price was found to Granger-Cause spec positioning on the long and short sides of the market. 6   Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published on April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. 7     Please see How To Re-Shape The Yield Curve Without Really Trying published by our US Bond Strategy group on June 22 for a deeper discussion of the outlook for Fed policy.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights The US dollar will reach its ultimate high in the next deflationary shock. The swing factor for dollar demand is portfolio flows. In the next shock, portfolio flows will surge into US investments, driving up the US dollar to its ultimate high. One reason is that the US T-bond is the only major bond that can act as a haven-asset, now that most other bond yields are close to the effective lower bound. For US investors, international stocks will create a double-jeopardy. Not only will non-US stocks underperform US stocks, but non-US currencies will underperform the dollar. For non-US investors, the US 30-year T-bond will create a double-win from price surge and dollar surge, leading to a potential doubling of your money. Fractal trade shortlist: stocks versus bonds, tin, and US REITS versus US utilities. Feature Chart of the WeekSuccessive Shocks Take The Dollar To New Highs In our recent report The Shock Theory Of Bond Yields we explained that the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that an economy has endured. Each successive deflationary shock takes the bond yield to a lower low. Until it can go no lower (Chart 2). Chart I-2Successive Shocks Take The T-Bond Yield To New Lows Today’s report explains an important corollary. Each major deflationary shock has taken the US dollar to a new high, led by strong rallies against cyclical currencies such as the pound and the Canadian dollar (Chart of the Week, Chart I-3 and Chart I-4). We conclude that the US dollar will reach its ultimate high in the next deflationary shock. Chart I-3USD/GBP Surges In Shocks Chart I-4USD/CAD Surges In Shocks   Investors Must Build Shocks Into Their Strategy Most strategists claim that shocks, such as the pandemic, are inherently unpredictable. They argue that shocks are exogenous events that investors cannot plan for. We disagree. Granted, the timing and source of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the likelihood of suffering a shock is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or to slump by at least 25 percent.1 Using this definition through the past five decades, shocks have arrived with a remarkable predictability (Chart I-5). As a statistical distribution, the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). Chart I-5A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years Hence, in any three-year period, the likelihood of suffering a shock is 50 percent; in a five-year period, it is 81 percent; and in a ten-year period, it is a near-certain 96 percent (Chart I-6). Chart I-6On A Multi-Year Horizon, A Shock Is A Near-Certainty Yet, to repeat, the precise source and timing of the near-certain shock is unknown. This creates a dissonance for our narrative-focused minds. Absent a narrative for the certain shock, we do not plan for it. But we should. For long-term investors one crucial takeaway is that the ultimate low in the T-bond yield is yet to come. Another crucial takeaway is that the ultimate high in the US dollar is also yet to come. In A Shock, The US Dollar Surges The net demand for dollars comes from four sources: To fund the demand for goods and services denominated in dollars. (In fact, the structural US deficit in goods and services means that this source generates a persistent supply of dollars.) To fund the demand for long-term investments denominated in dollars, also known as foreign direct investment (FDI). To fund the demand for shorter-term financial investments like bonds and equities denominated in dollars, also known as portfolio flows.2 To fund the demand for currency reserves denominated in dollars. Of these four sources of dollar demand, the US deficit in goods and services is not particularly volatile. FDI flows also change relatively slowly. Meanwhile, demand for dollar reserves is a residual factor, except at the rare moment that a currency peg starts or ends.3  The largest quarterly swings in portfolio flows swamp the largest quarterly swings in the trade balance and FDI. This means that the swing factor for dollar demand is portfolio flows. Chart I-7 and Chart I-8 show that the largest quarterly swings in portfolio flows, at over $1.5 trillion (annualised rate) swamp the largest quarterly swings in the trade balance and FDI, at just $0.5 trillion. Chart I-7The Swing Factor For Dollar Demand Is Portfolio Flows Chart I-8The Swing Factor For Dollar Demand Is Portfolio Flows All of which brings us to the main point of this report. In a shock, portfolio flows surge into US investments, which drives up the US dollar. In a shock, portfolio flows surge into US investments, which drives up the US dollar. There are two reasons for this. First, the US stock market is one of the most defensive in the world. Hence, in a shock, equity flows flood into the US (Chart I-9). Chart I-9The US Stock Market Is One Of The Most Defensive In The World But even more important now, the US T-bond is the only major bond that can act as a haven-asset. With most other bond yields already close to the effective lower bound, the US T-bond is the only mainstream asset which still has substantial scope to rally when other asset prices are collapsing. Hence, in recent years, the dollar is just tracking the performance of bonds versus stocks (Chart I-10). It follows that in the next deflationary shock, when bonds surge versus stocks, the dollar will surge to its ultimate high. Chart I-10The Dollar Is Just Tracking Bonds Versus Stocks An Inflationary Shock Will Quickly Morph Into A Deflationary Shock But what if the next shock is a dollar crisis? Such a crisis, caused by a loss of faith in the greenback as a store of value, would start off inflationary – to the detriment of the dollar. However, our high-conviction view is that even if the shock started as inflationary, it would quickly morph into deflationary. The simple reason is that the initial backup in bond yields that would come from such an inflationary shock would collapse the value of $500 trillion worth of global real estate, equities, and other risk-assets, and thereby unleash a massive deflationary impulse. Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. Investors demand a massive risk premium when inflation is out of control. The starting valuation needed to generate a given real return during an inflationary shock collapses because investors demand a massive risk premium when inflation is out of control. For example, in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But to generate the same real return of 10 percent during the inflationary 1970s, the starting multiple had to halve to 7 (Chart I-11). Chart I-11In An Inflationary Shock, Valuations Collapse Suffice to say, if the valuation of $500 trillion of global risk-assets were to halve, we would not have to worry about inflation. So, to sum up: On a timeframe of a few years, a shock is a near-certainty even if we do not know its precise source or its precise timing. Furthermore, the shock will be net deflationary. Hence, investors must build such a net deflationary shock or shocks into their long-term investment strategy. Specifically, in the next shock: US equities will outperform non-US equities. The 10-year T-bond yield will reach zero, and the 30-year T-bond yield will reach 0.5 percent. The US dollar will reach its ultimate high. This leads to two very important messages, one for US investors, one for non-US investors. For US investors, international stocks will create a double-jeopardy. In the next shock, not only will non-US stocks underperform US stocks, but non-US currencies will underperform the dollar. The corollary for non-US investors is that the US 30-year T-bond will create a double-win. Not only will the T-bond price surge, but the dollar will also reach a new high. The combination will lead to a potential doubling of your money. H1 2021 Win Ratio Reaches A Magnificent 71 Percent Last Thursday’s 16 percent rally in Nike shares on a brighter sales outlook means that our long Nike versus L’Oréal trade quickly achieved its 9 percent profit target. Long USD/HUF also quickly achieved its 3 percent profit target. Combined with other ‘wins’, this has boosted the fractal trades win ratio for H1 2021 to a magnificent 71 percent – comprising 12.1 wins versus just 4.9 losses. A fragile fractal structure is a warning that the investors setting the investment’s price has become dangerously biased to short-term traders. As longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. This creates an excellent countertrend investment opportunity because once the longer-term investors re-enter the price setting process, the recent trend will reverse. This week we highlight three fragile fractal structures. The fractal structure of stocks versus bonds (MSCI All Country World versus 30-year T-bond) remains fragile, suggesting that a neutral stance, at best, for stocks versus bonds through the summer (Chart I-12). Chart I-12The Fractal Structure Of Stocks Versus Bonds Is Fragile The fractal structure of tin is also fragile (Chart I-13). Given that most commodity prices have begun corrections, tin is vulnerable – especially versus other commodities. Chart I-13The Fractal Structure Of Tin Is Fragile Finally, comparing two high-yielding sectors, the fractal structure of US REITS versus US utilities is at a point of fragility that has reliably presaged countertrend moves (Chart I-14). Accordingly, this week’s recommended trade is to short US REITS versus US utilities, setting the profit target and symmetrical stop-loss at 5 percent. Chart I-14Short US REITS Versus US Utilities   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 In this discussion, portfolio flows include short-term speculative flows. 3For example, if a currency broke its peg with the dollar it would stop buying the dollar reserves needed to maintain the peg. 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 Chart I-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields - Asia Chart I-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations