Monetary

Highlights The latest “dot plot” from the Fed reaffirmed the FOMC’s intention to keep rates near zero for at least the next two years, despite evidence that the US economy will recover from the pandemic much faster than expected. The Fed’s reluctance to telegraph any rate hikes stems in part from its conviction that the neutral rate of interest has declined. A lower neutral rate implies that monetary policy may not be as accommodative as widely believed. Whereas Fed officials have argued that the neutral rate has fallen due to structural factors outside their control, critics insist that the Fed’s own actions have painted it into a corner.  By cutting rates at every opportunity, so the argument goes, the Fed has inflated a massive asset bubble. Moreover, low rates have encouraged governments and the private sector to take on more debt. All this has locked the Fed into a low interest-rate trap: Any attempt to tighten monetary policy would cause asset prices to plunge and debt-servicing costs to rise. This would result in financial distress and rising unemployment – the exact two things the Fed wants to avoid. While we disagree with the view that easier monetary policy has made things worse, we do agree that elevated asset prices and high debt levels limit the Fed’s room for maneuver. In this week’s report, we contend that the low interest-rate trap will likely be resolved through an extended period of easy money, ultimately culminating in significantly higher inflation starting by the middle of this decade. Growth Dots Up, Rate Dots Not The FOMC released its latest Summary of Economic Projections (aka the “dot plot”) this week. As widely anticipated, the Fed upgraded its view on growth following the passage of the $1.9 trillion American Rescue Plan Act. The Fed now expects real GDP to rise by 6.5% in the fourth quarter of 2021 from a year ago, up from its December 2020 estimate of 4.2%. The Fed also sees the unemployment rate falling to 4.5% by the fourth quarter of this year. Back in December, the Fed thought the unemployment rate would end this year at 5% (Chart 1). Chart 1The Fed Sees Faster Recovery, Same Rate Path Chart 2The Fed Has Been Lowering Its Estimate Of The Neutral Rate The Fed’s unemployment rate projection of 3.9% for 2022 is slightly below the “longer run” estimate of 4.0%. This suggests that the Fed believes the US will have reached full employment by the end of next year. Yet, despite the Fed’s sanguine view on the pace of the economic recovery, the median dot for the expected fed funds rate in 2023 remained at 0.1% (although seven members did pencil in a hike for that year, up from five last December). The median “longer run” dot stayed at 2.5%, with not a single Fed member putting in an estimate above 3%. The Fed regards this longer-run dot as its estimate of the neutral rate of interest – the interest rate consistent with full employment and stable inflation. When the Fed introduced the “dots” back in early 2012, its estimate of the neutral rate stood at 4.3%. It has been trending lower ever since (Chart 2). Explanations For The Falling Neutral Rate What accounts for the steady decline in the Fed’s estimate of the neutral rate in recent years? Fed officials have generally argued that structural forces have dragged down the equilibrium interest rate for the economy. These forces include slower trend growth, an aging population, the shift to a capital-lite economy, high levels of overseas savings, and as we recently discussed, increased income inequality. There is another interpretation, however. Rather than casting the Fed as a helpless observer responding to structural forces beyond its control, some commentators have argued that the Fed’s own actions explain why rates are so chronically low today. By cutting interest rates at every opportunity, so the argument goes, the Fed has inflated a massive asset bubble, stretching from equities to commercial real estate to cryptocurrencies. Moreover, low rates have encouraged governments and the private sector to take on more debt. Chart 3The Correlation Between Swings In Mortgage Rates And Housing Activity All this has locked the Fed into a low interest-rate trap: Any attempt to tighten monetary policy would cause asset prices to plunge and debt-servicing costs to rise. This would result in financial distress and rising unemployment – the exact two things the Fed wants to avoid. The Fed Is Not The Culprit It is a provocative argument, but is the Fed really to blame? For the most part, the answer is “’no.” To see why, consider the counterfactual: Suppose the Fed did not cut rates. If rates had stayed elevated, the recovery in the cyclical sectors of the economy following the Global Financial Crisis would have been even slower. Housing, in particular, would have remained in the doldrums. Chart 3 shows that there is a strong correlation between housing activity and the 30-year mortgage rate. Lower home prices would have reduced spending via the wealth effect channel, while making it more difficult for banks to recapitalize their balance sheets. In addition, relatively high US rates would have put upward pressure on the dollar, leading to a larger trade deficit (Chart 4). All of this would have reduced aggregate demand. Chart 4The Dollar And The Trade Balance Chart 5Rising Labor Share Of Income Occurring Alongside Labor Market Tightening The share of national income flowing to workers tends to rise when the labor market tightens (Chart 5). A chronic shortfall in aggregate demand would have exacerbated income inequality. Since the poor spend more of every dollar of disposable income than the rich, this would have further dampened overall spending. The Fed has been like a doctor administering a life-saving medicine that comes with some notable side effects. These side effects include increased sensitivity of asset prices to changes in interest rates.1 They also include higher debt levels, at least in those sectors of the economy that had the ability to lever up in response to lower interest rates. Side Effect Triage How dangerous are these side effects? To the extent that today’s low policy rates stem from the fact that structural forces have depressed the neutral rate of interest, they are not especially dangerous at the moment. Yes, debt-servicing costs would balloon, and asset prices would tumble, if the Fed raised rates significantly. However, there’s no reason for the Fed to do that in a setting where the neutral rate is very low. The problem is that the neutral rate may rise over time. Baby boomers are leaving the labor force en masse. They accumulated a lot of wealth while working. According to the Federal Reserve, they currently own more than half of all US wealth (Chart 6). In fact, Americans over the age of 55 controlled 70% of household wealth as of the third quarter of 2020, up from 54% in 1989. As baby boomers retire, their consumption will no longer be backed by income. The resulting depletion of savings will push up the equilibrium rate of interest. Chart 6Baby Boomers Have Accumulated A Lot Of Wealth While US fiscal policy will tighten next year, it will remain highly pro-cyclical by historic standards. BCA’s geopolitical strategists expect Congress to pass a $4 trillion spending bill this fall focusing on infrastructure, health care, and clean energy. They anticipate that only half of the bill will be financed through higher taxes. Big budget deficits will drain private-sector savings. There Will Be Political Pressure To Keep Rates Low Debt is not a major problem for governments when the interest rate they pay is below the growth rate of the economy. As we have discussed before, when trend GDP growth exceeds the borrowing rate, the more debt a government carries, the more fiscal support it can provide without putting the debt-to-GDP ratio on a runaway trajectory. If interest rates were to rise meaningfully, however, what had previously been a virtuous fiscal circle would become a vicious one. Needless to say, governments would resist such an outcome. Faced with the prospect of having to reallocate tax revenue from social programs to bondholders, politicians would put political pressure on central banks to refrain from raising rates. Central banks would probably oblige, at least initially. By keeping interest rates below their equilibrium level, central banks could engineer higher inflation – something they have been striving to do for quite some time. Higher inflation, in turn, could pave the way for an exit from the low interest-rate trap. Rising prices would lift nominal GDP, thereby reducing the debt-to-GDP ratio. As inflation rose, real rates would fall. This would provide relief to overextended private-sector borrowers. Once enough debt had been inflated away, central banks could bring interest rates to their equilibrium level. In the end, bondholders would suffer while borrowers would prosper. This leads us to our key macroeconomic conclusion: Today’s low interest-rate trap will likely be resolved through an extended period of easy money, ultimately culminating in significantly higher inflation. Investment Implications Equities face some near-term risks stemming from the recent rise in bond yields. Nevertheless, as we have argued in past reports, stocks will shrug off their losses provided that bond yields do not rise to a level that chokes off economic growth. With the Fed still on hold, we do not expect that to happen anytime soon. As such, our best bet is that the Goldilocks environment for risk assets – where growth is strong, inflation is contained, and monetary policy is accommodative – will last another two years. Investors operating on a 12-month horizon should continue to favor stocks over bonds. Within the fixed-income category, investors should overweight spread product relative to safer government bonds. Value stocks will lead the equity market higher over the next 12 months. The pandemic benefited growth names, especially in the tech realm. The cessation of lockdown measures will favor value names. Not only is value still exceptionally cheap in relation to growth, but traditional value sectors such as banks and energy companies have seen stronger upward earnings revisions than tech stocks since the start of the year (Chart 7). Chart 7 Earnings Revisions And Valuations Favor Value Stocks (I) Chart 7Earnings Revisions And Valuations Favor Value Stocks (II) Recent upgrades to economic growth forecasts have favored the US, which could help the dollar in the near term. Nevertheless, we expect the greenback to fall modestly over a 12-month horizon. The US trade deficit has ballooned in recent quarters, while the dollar remains overvalued on a purchasing power parity basis (Chart 8). Despite improving US growth prospects, real yield differentials have not moved significantly in favor of the dollar (Chart 9). Chart 8The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (I) Chart 8The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (II) Chart 9Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (I) Chart 9Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (II) Moreover, the growth outlook outside the US should improve later this year as more countries ramp up their vaccination campaigns. US growth should also come down from its highs due to the expiration of various stimulus measures. Meanwhile, China will continue to stimulate its economy, albeit at a slower pace. Jing Sima, BCA’s chief China strategist, expects the rate of credit expansion to fall by only 2-to-3 percentage points in 2021. The general government deficit should remain broadly stable at 8% of GDP this year, ensuring adequate fiscal support for growth. A strong Chinese economy will bolster the RMB and other EM currencies. Looking further ahead, the cyclical bull market in stocks will end when inflation rises so high that central banks are forced to tighten monetary policy. While this is not a near-term risk, it is a major danger for the middle of the decade and beyond. As we discussed last week, inflation is often slow to rise in response to an overheated economy, but when it does rise, it can do so precipitously. Investors looking to hedge long-term inflation risk should reduce duration exposure in fixed-income portfolios while favoring inflation-protected securities over nominal bonds. In addition to gold, they should own some property. The best inflation hedge is simply to buy a nice house financed with a high loan-to-value fixed-rate mortgage. In a few decades you will still own the nice house, but the value of the mortgage will be greatly reduced in real terms.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 For example, suppose the earnings yield is 4% – as it approximately is now for global equities – and the real bond yield is zero, implying an equity risk premium (ERP) of 4%. A one percentage-point increase in real bond yields would require that stock prices fall by 20% in order to keep the ERP unchanged (e.g., the earnings yield would have to rise from 4/100=4% to 4/80=5%). In contrast, if the earnings yield were initially 7% and the real bond yield were 3%, stock prices would need to fall by only 12.5%, taking the earnings yield from 7/100=7% to 7/87.5=8%.   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Dear client, Next week, in lieu of our weekly report, I will be hosting a webcast on Thursday, March 25 at 10:00 am EDT and Friday March 26 at 9:00 am HKT. I look forward to your comments and questions during the webcast. Best regards, Chester Highlights During bear markets, counter-trend rallies in the dollar are capped around 4%. This time should be no different. Meanwhile, unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real short rates will drop. The relative equity performance of the US is critical for the dollar. Reserve diversification out of dollars has also started to place a natural ceiling against other developed market currencies. An attractive opportunity is emerging to short the AUD/CAD cross. Feature The 1.7% rise in the US dollar this year is reinvigorating the bull case. When presenting our key views last year, we highlighted that the DXY index was at risk of a 2-4% bounce.1 We reaffirmed this view in our January report: Sizing A Potential Dollar Bounce. At the time, the DXY index was at the 90 level, suggesting the rally should fizzle around 94. Therefore, the key question is whether the nascent rise in the DXY will punch through this level, or fade as we originally expected. The short-term case for the dollar remains bullish. The currency is much oversold. Meanwhile, real interest rates are moving in favor of the US, vis-à-vis a few countries. Third and interrelated, economic momentum in the US is quite strong, compared to other G10 countries. With the rising specter of a market correction, the dollar could also benefit from safe haven flows towards the US. The Federal Reserve’s meeting yesterday certainly reaffirmed that short-term rates will remain anchored near zero, at least until 2023. The Fed does not see inflation much above 2% a couple of years out. Nevertheless, a lot can change in the coming months. Cycles, Positioning And Interest Rates The dollar tends to move in long cycles, with the latest bull and bear markets lasting about a decade or so. In other words, the dollar is a momentum currency. As such, determining which regime you are in is critical to assessing the magnitude of any rally. This is certainly the case when sentiment remains overly dollar bearish, as now. During bear markets, counter-trend rallies in the dollar are capped around 4-6%. This was what happened in the early 2000s. In bull markets, such as after the financial crisis, the dollar achieves escape velocity, with more durable rallies well into the teens (Chart I-1). So far, the current rise still fits within the narrative of a healthy reset in a longer-term bear market. Chart I-1The Dollar Rally Is Still Benign Long interest rates have also been moving in favor of the dollar, especially relative to the euro area, Japan, and even Sweden. Currencies are driven by real interest rate differentials, and higher US yields are bullish. With the Fed giving no indication it will prevent the curve from steepening further, US interest rates could keep gaping higher. However, currencies are about relative rate differentials, and the rise in US interest rates has not been in isolation. Rates in the UK, Australia and New Zealand, countries that have managed the COVID-19 crisis pretty well, are beginning to rise faster than in the US (Chart I-2). Chart I-2A Synchronized Rise In Global Yields US Versus World Growth The rise in US interest rates has been justified by better economic performance. Whether looking at purchasing managers’ indices, economic surprise indices, or even GDP growth expectations, the US has had the upper hand (Chart I-3). The Fed expects US growth to hit 6.5% this year. This is well above what other central banks expect for their domestic economies. The ECB expects 4%, the BoJ expects 3.9%, and the BoC expects 4.6% (Table I-1). Chart I-3AThe US Leads In Growth This Year Chart I-3BThe US Leads In Growth This Year Table I-1The US Leads In Growth And Inflation This Year However, economic dominance can be transient, especially in a world of flexible exchange rates.  For one, a higher dollar will sap US growth via the export channel. This is especially the case since the starting point is an expensive currency. On a real effective exchange rate basis, the dollar is above its long-term mean (Chart I-4). Meanwhile, we expect the rest of the world to perform better as economies reopen. The services PMI in the US is already close to a cyclical high, similar to Sweden (Chart I-5). These are among the countries with the least stringent COVID-19 measures in the western hemisphere. This suggests that other economies, even manufacturing-centric ones, could see a coiled-spring rebound in growth as we put this pandemic behind us. Chart I-4The Dollar Is Expensive Chart I-5The US Service PMI Is At A Cyclical High The sweet spot for most economies is when growth is rising but inflation is low, allowing the resident central bank to keep policy dovish. However, it is an open question if the US can continue to boost spending, without a commensurate rise in inflation. The OECD estimates that the US output gap will close by 2022, with the $1.9-trillion fiscal package. This will put the US well ahead of any G10 country (Chart I-6). Unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real rates will drop (Chart I-7). Rising nominal rates and falling real yields will be anathema to the dollar. Chart I-6The US Output Gap Will Soon Close Chart I-7Wages And Inflation Should Inch Higher Equity Rotation And The Dollar A currency manager once noted that the most important variable to pay attention to when making FX allocations is relative equity performance. This might seem bizarre at first blush, but stands at the center of what an exchange rate is – a mechanism that equalizes rates of return across countries. As such while bond flows are important for exchange rates, equity flows matter as well. The relative equity performance of the US is critical for two reasons. First, the US equity market tends to do relatively better during bear markets. This was the case last year and during the 2008 crisis. Second, the outperformance of the US over the last decade has dovetailed with a dollar bull market (Chart I-8). It is rare to find a currency that has performed well both during equity bull and bear markets. If past is prologue, the near-term risks for the dollar are to the upside, especially if the market rally encounters turbulence as yields rise. The put/call ratio in the US is at a 5-year nadir. A move towards parity could violently pull up the DXY index (Chart I-9). However, a garden-variety 5-10% correction in the SPX should correspond to a shallow bounce in the DXY. This will also fit the pattern of bear market USD rallies, as we already highlighted in Chart I-1. Chart I-8US Equity Relative Performance And The Dollar Chart I-9The Dollar Could Rise In ##br##A Market Reset At the same time, any correction could usher in a violent rotation from cyclicals to defensives, especially if underpinned by higher interest rates. The performance of energy and financials are a leap ahead of other sectors in the S&P 500 this year. Importantly, they also massively outperformed during the February drawdown. Meanwhile, valuations are heavily elevated in the US compared to the rest of the world. This is true for growth sectors compared to value, and cyclicals compared to defensives. Throughout history, both exchange rates and valuations have tended to mean revert. Long-Term Dollar Outlook The 2020 pandemic was a one-in-a-hundred-year event. Coordinated fiscal and monetary stimuli have ushered in a new economic cycle. As a counter-cyclical currency, the dollar tends to do poorly (Chart I-10). This is because monetary stimulus provides more torque to economies levered to the global cycle. Once growth achieves escape velocity, the currencies of these more pro-cyclical economies benefit. The IMF projects that non-US growth should outpace US growth after 2021. Meanwhile, it is an open question that any rally in the dollar will be durable. The key driver behind the dollar increase in 2020 was a global shortage. Not only has the Fed extended its liquidity provisions to foreign central banks until September this year, the share of offshore US dollar debt issuance has fallen by a full 9 percentage points (Chart I-11). Simply put, the Fed is flooding the system with dollar liquidity at the same time that foreign entities are weaning themselves off it Chart I-10The IMF Expects Faster Growth Outside The US After 2021 Chart I-11Share Of US Dollar Debt ##br##Rolling Over The reason behind this is balance-of-payment dynamics. The market has realized that ballooning twin deficits in the US come at a cost. For foreign issuers, it is the prospect of rolling over US-denominated debt at a much higher coupon rate. For bond investors, it is currency depreciation, especially if fiscal largesse becomes too “sticky,” and stokes inflation. As such, bond investors continue to avoid the US, despite rising rates (Chart I-12). Finally, reserve diversification out of dollars has started to place a natural ceiling on the US dollar, especially against other developed market currencies. Ever since the trend began to accelerate in 2015, the DXY has been unable to sustainably punch through the 100 level (Chart I-13). This will place a durable floor under developed market currencies in general and gold in particular. The Chinese RMB has also been gaining traction in global FX reserves. Chart I-12Little Appetite For US ##br##Treasurys Chart I-13Reserve Diversification Has Been A Headwind For The Dollar More specifically, the role of the USD/CNY exchange rate as a key anchor for emerging market currencies will rise, especially if the RMB remains structurally strong.2 The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. Swap agreements entail no exchange of currency, but are about confidence. The PBoC can instill this confidence in countries that have low and/or falling foreign exchange reserves. The dollar will remain the global reserve currency for years to come. However, a slow pivot towards reserve diversification will act as a structural headwind for the dollar. Housekeeping Chart I-14AUD/CAD Is Correlated To The VIX We were stopped out of our CAD/NOK trade for a profit of 3.1%. The resilience of the US economy is benefiting the CAD more than the NOK for now. However, the Norges Bank confirmed it might be one of the first central banks to lift rates, as early as this year. We are both short USD/NOK and EUR/NOK and recommend sticking with these positions. Second, the growing spat between the EU and the UK could lead to more volatility in our short EUR/GBP position. Our target remains 0.8, but we are tightening stops to 0.865 to protect profits. The BoE left interest rates unchanged, but struck a constructive tone. This will bode well for cable, beyond near-term volatility. Third, our short USD/JPY position was stopped out amid the dollar rally. We are standing aside for now, but will reopen this trade later. Finally, a rise in volatility will boost the dollar, but also benefit short AUD/CAD positions. We are already short the AUD/MXN, but short AUD/CAD could be more profitable should market turmoil persist (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see the Foreign Exchange Strategy Special Report, titled “2021 Key Views: Tradeable Themes,” dated December 4, 2020. 2 Please see Foreign Exchange Strategy Currency In-Depth Report, titled “Will The RMB Continue To Appreciate?,” dated February 26, 2021. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Most data out of the US has been robust: Both PPI, import and export prices were in line with expectations for February. The PPI ex food and energy came in at 2.5% year-on-year. Empire manufacturing was robust at 17.4 in March, versus 12.1 last month. Housing starts and building permits came in a nudge below expectations in February, at 1421K and 1682K. The one disappointment was retail sales, which fell 3.3% year-on-year in February. The DXY index rose slightly this week. The FOMC remained dovish, without any revision to its median path of interest rate hikes. The markets disliked its reticence on rising long-bond yields. As such, equities are rolling over as yields continue to creep higher. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area are mending: The ZEW expectations survey rose to 74 in March, from 69.6. For Germany, the improvement was better at 76.6 from 71.2. The trade balance remained at a healthy €24.2bn euro surplus in January. The euro fell by 0.6% amidst broad dollar strength. With the ECB committed to cap the rise in yields and rise in peripheral spreads, relative interest rates will move against the euro. Sentiment remains elevated, and so a healthy reset is necessary to wash out stale longs. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been mixed: Core machinery orders grew 1.5% year-on-year in January. Exports fell by 4.5% in January, while imports rose by 11.8%. This has shifted the adjusted trade balance to a deficit of ¥38.7bn yen. The Japanese yen fell by 0.4% against the US dollar this week, and remains the weakest G10 currency this year. Rising yields have seen Japanese investors stampede into overseas markets such as the UK, while pushing down the yen. We remain yen bulls, but will stand aside for now since it could still go lower in the short term. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been weak: Industrial production and construction output fell by 4.9% and 3% year-on-year in January. Monthly GDP growth fell by 2.9% in January. Rightmove house prices rose 2.7% year-on-year in March. The pound fell by 0.4% against the dollar this week. It however remains the best performing currency this year. The BoE kept monetary policy on hold, but struck a hawkish tone as vaccination progresses, giving way to higher mobility in the summer. We remain long sterling via the euro. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: Home prices rose by 3.6% in the fourth quarter. Modest home appreciation is welcome news by the RBA, given high-flying prices in its antipodean neighbor. The employment report was solid. There were 88.7K new jobs in February, all full-time. This pushed down the unemployment rate to 5.8% from 6.4%. The Aussie fell by 0.4% this week. The Australian recovery is fast approaching escape velocity, forcing the RBA to contain a more pronounced rise in long-bond yields. We remain long AUD/NZD. In the very near term, a market shakeout could pull the Aussie lower, favoring short AUD/CAD positions.  Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data out of New Zealand was weak: Credit card spending fell by 10.6% year-on-year in January. Q4 GDP contracted by 1% both year-on-year and quarter-on-quarter. The current account remains in deficit at NZ$-2.7bn for Q4. The New Zealand dollar fell by 0.9% against the US dollar this week. The new rule to include house prices in setting monetary policy will be a logistical nightmare for the RBNZ. In trying to achieve financial stability, the RBNZ will have to forego some economic stability, especially if the country still requires accommodative settings. Confused messaging could also introduce currency volatility. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 There was a data dump in Canada this week: The economy added 259.2K jobs in February. This pushed down the unemployment rate from 9.4% to 8.2%. Wages also increased by 4.3% in February. The Nanos confidence index rose from 60.5 to 62.7 in the week of March 12. Housing starts rose by 246K in February, as expected. The BoC’s preferred measures of CPI came in close to the 2% target. Headline CPI was weaker at 1.1% in February. The Canadian dollar rose by 0.3% against the US dollar this week. The correction in oil prices could set the tone for the near-term performance of the loonie, despite robust domestic conditions. However, at the crosses, CAD should have upside. We took profits on our short CAD/NOK position this week. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: Producer and import prices fell by 1.1% year-on-year in February. February CPI releases also suggest the economy remains in deflation. The Swiss franc fell by 0.4% against the US dollar this week. Safe-haven currencies continue to be sold as yields rise, making the Swiss franc the worst performing currency this year after the yen. This is welcome news for the SNB.  We have been long EUR/CHF on this expectation, and recommend investors to stick with this trade. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The trade balance remained in surplus of NOK 25.1bn in February. The Norges bank kept interest rates on hold at 0%. The NOK fell by 1.2% against the dollar this week. The trigger was the selloff in oil prices. However, with the Norges bank signaling a rate hike later this year, placing it ahead of its G10 peers, there is little scope for the NOK to fall durably. Inflation in Norway is above target, and higher mobility later this year will benefit oil-rich Norway. We are long the Norwegian krone as a high-conviction bet against both the dollar and the euro. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data releases were a slight miss: Headline CPI came in at 1.4% in February. Core CPI came in at 1.2%. The unemployment rate remained at 8.9% in February. The Swedish krona fell by 0.8% against US dollar this week. Sweden is struggling to contain another wave of the pandemic and this has weighed on the currency this year. The saving grace for the economy has been a global manufacturing cycle that continues humming. Until Sweden is able to get past the pandemic, the currency will continue trading in a stop-and-go pattern. We remain long the SEK on cheap valuations and as a play on the global industrial cycle. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The Federal Reserve’s ultra-dovish stance is not the only reason for markets to cheer. The US is booming, China is unlikely to overtighten monetary and fiscal policy, and Europe remains a source of positive political surprises. Still, the cornerstone of this cycle’s wall of worry has been laid: Biden faces a series of foreign policy challenges, the US is raising taxes, China is tightening policy, and Europe’s stimulus is not large enough to qualify as a game changer for potential GDP growth. Stay the course by maintaining strategic pro-cyclical trades yet building up tactical hedges and safe-haven plays. Feature Chart 1US Stimulus, Chinese Tightening, German Vaccine Hiccups The US is turning to tax hikes, China is returning to structural reforms, and Europe is bungling its vaccine rollout. Yet synchronized global debt monetization is nothing to underrate. Especially not in the context of a Great Power struggle that features a green energy race as well as a high-tech race. Governments are generating a cyclical growth boom and it is conceivably that their simultaneous pump-priming combined with a new capex cycle and private innovation could generate a productivity breakthrough. This upside risk is keeping global equity markets bullish even as it becomes apparent that construction has begun on this cycle’s wall of worry. The US dollar bounce should be watched closely in this context (Chart 1). After passing the $1.9 trillion American Rescue Plan Act, which consists largely but not entirely of short-term cash handouts (Chart 2), President Joe Biden’s policy agenda will now turn to tax hikes. Thus far the tax hike proposals are in line with Biden’s campaign literature (Table 1). It remains to be seen whether the market will “sell the news” that Biden is pivoting to tax hikes. After all, Biden was the most moderate of the Democratic candidates and his tax proposals only partially reverse President Trump’s tax cuts. Chart 2American Rescue Plan Act Table 1Biden’s Tax Hike Proposals On The Campaign Trail Nevertheless higher taxes symbolize a regime change in the US – it is very unlikely tax rates will go down anytime soon but they could go easily higher than expected in the coming decade – and the drafting process will bring negative surprises, as Treasury Secretary Janet Yellen highlighted by courting Europe to cooperate on a 12% minimum corporate tax and halt the global race to the bottom in taxes on multinational corporations. At the same time Biden’s foreign policy challenges are rising across the board: China is demanding a rollback of Trump’s policies: If Biden says yes, he will sacrifice hard-won American leverage on matters of national interest. If he says no, the Phase One trade deal will be null and void, as will sanctions on Iran and North Korea, and the new economic sanctions on Taiwan will expand beyond mere pineapples.1 Russia is recalling its US ambassador: Biden vowed to make Russia pay for alleged interference in the 2020 US election and sanctions are forthcoming.2 The real way to make Russia pay is to halt the construction of the Nordstream II natural gas pipeline, which reduces the leverage of eastern European democracies while increasing Germany’s energy dependence on Russia. But Germany is dead-set on that pipeline. If Biden levies sanctions the centerpiece of his diplomatic outreach to Europe will be further encouraged to chart an independent course from Washington (though the rest of Europe might cheer). North Korea is threatening to restart missile tests: North Korea is pouring scorn on the Biden administration for trying to restart negotiations.3 The North wants sanctions relief and it knows that Biden is willing to offer it but it may need to create an atmosphere of crisis first. China would be happy were that to happen as it could offer the US its good services on North Korea instead of concrete trade concessions. Iran is refusing to rejoin negotiations over the 2015 nuclear deal: Biden has about five months to arrange for the US and Iran to rejoin the 2015 nuclear deal. Beyond that he will enter into another long negotiation with the master negotiators, the Persians. But unlike President Obama from 2009-15, he will not have support from Russia and China … unless he sacrifices his doctrine of “extreme competition” from the get-go. It is not clear which of these challenges will be relevant to financial markets, or when. However, with US and global equities skyrocketing, it must be said that the geopolitical backdrop is not nearly as reassuring as the Federal Reserve, which announced on Saint Patrick’s Day that it will not hike interest rates until 2024 even in the face of a 6.5% growth rate and the prospect of an additional, yet-to-be passed $2 trillion in US deficit spending. Herein lies Biden’s first victory. He has stressed that boosting the American economy and middle class is critical to his foreign policy. He envisions the US regaining its global standing by defeating the virus, super-charging the economy, and then orchestrating a grand alliance of European and Asian democracies to write new global rules that will put pressure on China to reform its economy. “I say it to foreign leaders and domestic alike. It's never, ever a good bet to bet against the American people. America is coming back. The development, manufacturing, and distribution of vaccines in record time is a true miracle of science.”4 The pandemic and economic part of this agenda are effectively done and now comes the hard part: creating a grand alliance while China and Russia demonstrate to their neighbors the hard consequences of joining any new US crusade. The contradiction of Biden’s foreign policy is his desire to act multilaterally and yet also get a great deal done. The Europeans are averse to conflict with China and Russia. The Russians and Chinese are not inclined to do any great favors on Iran or North Korea. Nobody is opening up their economy – Biden himself is coopting Trump’s protectionism, if less brashly. Cooperation with Presidents Xi Jinping and Vladimir Putin on nuclear proliferation is possible – as long as Biden aborts his democracy agenda and his trade agenda. We continue with our pro-cyclical investment stance but have started building up hedges as we are convinced that geopolitical risk will deliver a rude awakening. This awakening will be a buying opportunity given the ultra-stimulating backdrop … unless it portends war in continental Europe or the Taiwan Strait. In the remainder of this report we highlight the takeaways from China’s National People’s Congress as well as recent developments in Germany. Our key views remain the same: China will not overtighten monetary/fiscal policy; Biden will be hawkish on China; Germany’s election may see an upset but that would be market-positive. China: No Overtightening So Far China concluded its National People’s Congress – the “Two Sessions” of legislation every year – and issued its 2021 Government Work Report. It also officially released the fourteenth five-year plan covering economic development for 2021-25. Table 2 shows the new plan’s targets as compared to the just expired thirteenth five-year plan that covered 2016-20. Table 2China’s Fourteenth Five Year Plan (2021-25) For a full run-down of the National People’s Congress we recommend clients peruse BCA’s latest China Investment Strategy report. From a geopolitical point of view we would highlight the following takeaways: The Tech Race: China added a new target for strategic emerging industry value added as percent of GDP – it wants this number to reach 17% by 2025 but there is nothing solid to benchmark this against. The point is that by including such a target China is putting more emphasis on emerging industries, including: information technology, robotics, green energy, electric vehicles, 5G networks, new materials, power equipment, aerospace and aviation equipment, and others. China’s technological “Great Leap Forward” continues, with a focus on domestic production and upgrading the manufacturing sector that is bound to stiffen the competition with the United States. China’s removal of a target for service industry growth suggests that Beijing does not want de-industrialization to occur any faster – another reason for global trade tensions to stay high. Research and Development: For R&D spending, previous five-year plans set targets for the desired level. For example, over the last five years China vowed to increase annual R&D spending to 2.5% of GDP. A reasonable expectation for the coming five years would have been a 3% target of GDP. However, this time the government set a target of an annual growth rate of no less than 7% during 2021-2025. The point is that China is continuing to ascend the ranks in R&D spending relative to the US and West in coordination with the overarching goal of forging an innovative and high-tech economy. Unemployment: China has restored an unemployment rate target. In its twelfth five-year plan Beijing aimed to keep the urban surveyed unemployment rate below 5% but over the past five years this target vanished. Now China restored the target and bumped it up slightly to 5.5%. This target should not be hard to meet given the reported sharp decline in urban unemployment to 5.2% already. However, China’s unemployment statistics are notoriously unreliable. The real takeaway is that unemployment will be higher as trend growth slows, while social stability remains the Communist Party’s ultimate prize – and any reform or deleveraging process will occur within that context. The Green Energy Race: China re-emphasized its pledge to tackle climate change, aiming for peak carbon emissions by 2030 and carbon neutrality by 2060. However, no detailed action plans were mentioned. Presumably China will not loosen its enforcement of existing environmental targets. Most of these were kept the same as over the past five years, except for pollution (PM2.5 concentration). Previously the government sought to reduce PM2.5 concentration by 18%. Now the target is set at 10% aggregate reduction, which is lower, though further reduction will be difficult after a 43% drop since 2014. Overall, China has not loosened up its environmental targets – if anything, enforcement will strengthen, resulting in an ongoing regulatory headwind to “Old China” industries. Military Power: Last week we noted that the government’s goals for the military have changed in a way that reinforces themes of persistently high geopolitical tensions. The info-tech upgrades to the People’s Liberation Army were supposed to be met by 2020, with full “modernization” achieved by 2035. However, last October the government created a new deadline, the one-hundredth anniversary of the PLA in 2027 (“military centenary goal”). No specific measures or targets are given but the point is that there is a new deadline of serious importance – an importance that matches the party’s much-ballyhooed centennial on July 1 of 2021 and the People’s Republic’s centennial in 2049. The fact that this deadline is only six years away suggests that a rapid program of military reform and upgrade is beginning. The official defense spending growth target of 6.8% is only slightly bigger than last year’s 6.6% but these targets mask the significance of the announcement. The takeaway is that the Chinese military is preparing for an earlier-than-expected contingency with the United States and its allies. What about China’s all-important monetary, fiscal, and quasi-fiscal credit targets? There is no doubt that China is tightening policy, as we highlight in our updated China Policy Tightening Checklist (Table 3). But will China overtighten? Probably not, at least not judging by the Two Sessions, but the risk is not negligible. Table 3A Checklist For Chinese Policy Tightening The government reiterated that money and credit growth should remain in a reasonable range in 2021, with “reasonable range” referring to nominal economic growth. Chinese economists estimate that the nominal growth rate will be around 8%-9% in 2021. The IMF projection is 8.1%, while latest OECD forecast is at 7.8%.5 Because China’s total private credit (total social financing) growth is inherently higher than M2 growth, we would use pre-pandemic levels as our benchmark for whether the government will tighten policy excessively: If total social financing growth plunges below 12%, then our view is disproved and Beijing is over-tightening (Chart 3). If M2 growth plunges below 8%, we can call it over-tightening. Anything above these benchmarks should be seen as reasonable and expected tightening, anything below as excessive. However, the Chinese and global financial markets could grow jittery at any time over the perennial risk of a policy mistake whenever governments try to prevent excessive leverage and bubbles. As for fiscal policy, the new quotas for local government net new bond issuance point to expected rather than excessive tightening. New bonds can be used to finance capital investment projects. The quota for total new bond issuance is 4.47 trillion CNY, down by 5.5% from last year. Though local governments may not use up all of the quota, the reduction is small. In fact, total local government bond issuance will be a whisker higher in 2021 than in 2020. The quota for net new bonds is only slightly below the 2020 level and much higher than the 2019 level. Therefore the chance of fiscal overtightening is small – and smaller than monetary overtightening. Chart 3China Policy Overtightening Benchmark Chart 4China’s Real Budget Deficit Is Huge China’s official budget balance is a fiction so we look at the IMF’s augmented net lending and borrowing, which reached a whopping -18.2 % of GDP in 2020. It is expected to decrease gradually to -13.8% by 2025. That level will be slightly higher than the pre-pandemic level from 2017-2019 (Chart 4).6 By contrast, China’s total augmented debt is expected to keep rising in the coming years and reach double the 2015 level by 2025. Efforts to constrain debt could lead to a larger debt-to-GDP ratio if growth suffers as a consequence, as our Global Investment Strategy points out. So China will tighten cautiously – especially given falling productivity, higher unemployment, and the threat of sustained pressure from the US and its allies. US-China: Biden As Trump-Lite Chinese and US officials will convene in Alaska on March 18-19. This is the first major US-China meeting under the Biden administration and global investors will watch closely to see whether tensions will drop. So far tensions have not fallen, highlighting a persistent and once again underrated risk to the global equity rally. Biden’s foreign policy team has not completed its review of China policy and Presidents Biden and Xi Jinping are trying to schedule a bilateral summit in April – so nothing concrete will be decided before then. Chart 5US-China: Beijing's Standing Offer The Biden administration is setting up a pragmatic policy, offering areas to engage with China while warning that it will not compromise on democratic values or national interests. China would welcome the opportunity to work with the Americans on nuclear non-proliferation, namely North Korea and Iran, as this would expend US leverage on an area of shared interest while leaving China a free hand over its economic and technological policies. China at least partially enforced sanctions on these countries in response to President Trump’s demands during the trade war and official statistics suggest it continues to do so. Oil imports from Iran remain extremely low while Chinese business with North Korea is, on paper, nil (Chart 5). If this data is accurate then North Korea’s economy has not benefited from China’s stimulus and snapback. If true, then Pyongyang will offer partial concessions on its nuclear program in exchange for sanctions relief. At the moment, instead of staging any major provocations to object to US-Korean military drills, the North is using fiery language and threatening to restart missile tests. This suggests a diplomatic opening. But investors should be prepared for Pyongyang to stage much bigger provocations than missile tests. In March 2010, while the world focused on the financial crisis, the North Koreans torpedoed a South Korean corvette, the Chonan, and shelled some islands, at the risk of a war. The problem under the Trump administration was that Trump wanted a verifiable and durable deal of economic opening for denuclearization whereas the North Koreans wanted to play for time, reduce sanctions, study the data from their flurry of missile tests during the Obama and early Trump years, and see if Trump would get reelected before offering any concrete concessions. Trump’s stance was not really different from Bill Clinton’s but he tried to accelerate the timeline and go for a big win. By Trump’s losing the election North Korea bought four more years on the clock. Chart 6US-China: Biden Lukewarm On China The Biden administration is willing to play for time if it gets concrete results in phases. This would keep North Korea at bay and retain a line of pragmatic engagement with Beijing. But if North Korea stages a giant provocation Biden will not hesitate to use threats of destruction like Clinton and Trump did. The American public is not much concerned about North Korea (or Iran) but is increasingly concerned about China, with a recent Gallup opinion poll showing that nearly 50% view China as America’s greatest enemy and Americans consistently overrate China’s economic power (Chart 6). Biden will not let grassroots nationalism run his policy. But it is true that he has little to gain politically from appearing to appease China. With progress at hand on the pandemic and economic recovery, Biden will devote more attention to courting the allies and attempting to construct his alliance of democracies to meet global challenges and to “stand up” to China and Russia. The allies, however, are risk-averse when it comes to confronting China. This is as true for the Europeans as it is for China’s Asian neighbors, who stand directly in its firing line. In fact, Europe’s total trade with China is equivalent to that of the US (Chart 7). The Europeans have said that they will pursue tougher trade enforcement through the World Trade Organization, which would tie the Biden administration’s hands. Biden and his cabinet officials insist that they will use the “full array” of tools at their disposal (e.g. tariffs and sanctions) to punish China for mercantilist trade policies. Chinese negotiators are said to be asking explicitly for Biden to roll back Trump’s policies. Some of these policies relate to trade and tech acquisition, others to strategic disputes. We doubt that Biden will compromise on the trade issues to get cooperation on North Korea and Iran. But he will have to offer major concessions if he wants durable denuclearization agreements on these rogue states. Otherwise it will be clear that his administration is mostly focused on competition with China itself and willing to sideline the minor nuclear aspirants. Our expectation is that Americans care about the China threat and the smaller threats will be used as pretexts with which to increase pressure and sanctions on China. Asian equities have corrected after going vertical, as expected. But contrary to our expectations geopolitics was not the cause (Chart 8). This selloff could eventually create a buying opportunity if the Biden administration is revealed to take a more dovish line on China, trade, and tech in exchange for progress on strategic disputes like North Korea. Any discount due to North Korean provocations in particular would be a buy. On Taiwan, however, China’s new 2027 military target underscores our oft-recited red flag. Chart 7EU Risk Averse On China Chart 8Asian Equity Correction And GeoRisk Indicators Bottom Line: Investors should stay focused on the US-China relationship. What matters is Biden’s first actions on tariffs and high-tech exports. So far Biden is hawkish as we anticipated. Investors should fade rumors of big new US-China cooperation prior to the first Biden-Xi summit. Any major North Korean aggression will create a buy-on-the-dips opportunity. Unless it triggers a war, that is – and the threshold for war is high given the Chonan incident in 2010. Germany: Markets Wake Up To Election Risk – And Smile This week’s election in the Netherlands delivered a fully expected victory to Prime Minister Mark Rutte’s liberal coalition. The German leadership ranks next to the Dutch in terms of governments that received an increase in popular support as a result of the COVID-19 crisis (Chart 9). However, in Germany’s case the election outcome is not a foregone conclusion. Chart 9German Leadership Saw Popularity Bounce As we highlighted in our annual forecast, an upset in which a left-wing bloc forms the government for the first time since 2005 is likelier than the market expects. This scenario presents an upside risk for equities and bund yields since Germany would become even more pro-Europe, pro-integration, and proactive in its fiscal spending. In the current context that would be greeted warmly by financial markets as it would reinforce the cyclical rotation into the euro, industrials, and European peripheral debt. Incidentally, it would also reduce tensions with Russia and China – even as the Biden administration is courting Germany. Recent state elections confirm that the electorate is moving to the left rather than the right. In Baden-Wurttemberg, the third largest state by population and economic output, and a southern state, the Christian Democrats slipped from the last election (-2.9%), the Social Democrats slipped by less (-1.7%), the Free Democrats gained (2.2%), the Greens gained (2.3%), and the far-right Alternative for Germany saw a big drop (-5.4%). In the smaller state of Rhineland-Palatinate the results were largely the same although the Greens did even better (Tables 4A & 4B).7 In both cases the Christian Democrats saw the worst result since prior to the financial crisis while the Greens tripled their support in Baden and doubled their support in the Palatinate over the same time frame. Table 4AGerman State Elections Show Voters’ Leftward Drift Continues Table 4BGerman State Elections Show Voters’ Leftward Drift Continues To put this into perspective: Outgoing Chancellor Angela Merkel and her coalition have seen a net 6% increase in popular support since COVID-19. The coalition, led by the Christian Democratic Union and its Bavarian sister party, the Christian Social Union, still leads national opinion polling. What we are highlighting are chinks in the armor. The gap with the combined left-leaning bloc is less than 10% points (Chart 10). Chart 10German Party Polling Merkel is a lame duck whose party has been in power for 17 years. She is struggling to find an adequate successor. Her current frontrunner for chancellor-candidate, Armin Laschet, is suffering in public opinion, especially after the state election defeats, while her previous successor was ousted last year. Other chancellor-candidates, like Friedrich Merz, Markus Söder, and Norbert Röttgen may find themselves to the right of the median voter, which has been shifting to the left. Merkel’s party’s handling of COVID-19 first received praise and now, in the year of the vote, is falling under pressure due to difficulties rolling out the vaccine. Even as conditions improve over the course of the year her party may struggle to recover from the damage, since the underlying reality is that Germany has suffered a recession and is beset by global challenges. While the Christian Democrats performed relatively well in the 2009 election, in the teeth of the global financial crisis, times have changed. Today the Social Democrats are no longer in free fall – ever since their Finance Minister Olaf Scholz led the charge for fiscal stimulus in 2019 – while third parties like the Free Democrats, Greens, and Die Linke all gained in 2009 and look to gain this year (Table 5). In today’s context it is even more likely that other parties will rise at the ruling party’s expense. Still, the Christian Democrats have stout support in polls and do not have to split votes with the far-right, which is in collapse. Table 5German Federal Election Results Show 2021 Could Throw Curveball For Ruling Party Therein lies the real market takeaway: right-wing populism has flopped in Germany. The risk to the consensus view that Merkel will hand off the baton seamlessly to a successor and secure her party another term in leadership is that the establishment left will take power (the Greens in Germany are essentially an establishment party). Chart 11German Bunds Respond To Macro Shifts, State Elections Near-term pandemic and economic problems have caused bund yields to fall and the yield curve to flatten so far this year (Chart 11). But that trend is unlikely to continue given the global and national outlook. Election uncertainty should work against this trend since the only possible uncertainty gives more upside to the fiscal outlook and bond yields. If the consensus view indeed comes to pass and the Christian Democrats remain in power, the election holds out policy continuity – at least on economic policy. Fiscal tightening would happen sooner under the Christian Democrats but it would not be aggressive or premature, at least not in the 2021-22 period. It is the current coalition that first loosened Germany’s belt – and it did so in 2019, prior to COVID-19. Germany’s and the EU’s proactive fiscal turn will have a major positive impact on growth prospects, at least cyclically, though it is probably too small thus far to create a structural improvement in potential growth. Fiscal thrust is negative over next two years even with the EU’s Next Generation Recovery Fund being distributed. A structural increase in growth is possible given that all of the major countries are simultaneously pursuing monetary and fiscal stimulus as well as big investments in technology and renewable energy that will help engender a new private capex cycle. But productivity has been on a long, multi-decade decline so it remains to be seen if this can be reversed. Geopolitically speaking, Germany’s and the EU’s policy shift arrived in the nick of time to deepen European integration before divisions revive. Integration is broadly driven by European states’ need to compete on a grand scale with the US, Russia, and China. But Putin, Brexit, and Mario Draghi demonstrate the more tactical pressures: Brexit discourages states from exiting, especially with ongoing trade disputes and the risk of a new Scottish independence referendum; Putin’s aggressive foreign policy drives eastern Europeans into the arms of the West; and the formation of a unity government in Italy encourages European solidarity and improves Italian growth prospects. The outlook for structural reforms is not hopeless. Prime Minister Draghi’s government has a good chance of succeeding at some structural reforms where his predecessors have failed. Meanwhile French President Emmanuel Macron is still favored to win the French election in 2022, which is good for French structural reform. The fact that the EU tied its recovery fund to reform is positive. Most importantly the green energy agenda is replacing budget cutting for the time being, which, again, is positive for capex and could create positive long-term productivity surprises. Of course, structural reform intensity slowed just prior to COVID, in Spain, France, and Italy. Once the recovery funds are spent the desire to persist with reform will wane. This is clear in Spain, which has rolled back some reforms and has a weak government that could dissolve any time, and Italy, where the Draghi coalition may not last long after funds are spent. If the global upswing persists and Chinese/EM growth improves, then Europe will benefit from a macro backdrop that enables it to persist with some structural reforms and crawl out of its liquidity trap. But if China/EM growth relapses then Europe will fall back into a slump. Thus it is a very good thing for Europe, the euro, and European equities that the US is engaged in an epic fiscal blowout and that China’s Two Sessions dampened the risk of overtightening. Incidentally, if the German government does shift, relations with Russia would improve on the margin. While US-Russia tensions will remain hot, German mediation could reduce Russia’s insecurity and lower geopolitical risks for both Russia and emerging Europe, which are very cheaply valued at present in part because they face a persistent geopolitical risk premium. Bottom Line: German politics will drive further EU integration whether the Christian Democrats stay in power or whether the left-wing parties manage a surprise victory. Europe will have to provide more fiscal stimulus but otherwise the global context is favorable for Europe. Investors should not be too pessimistic about short-term hiccups with the vaccine rollout. Investment Takeaways The US is stimulating, China is not overtightening, and German’s election risk is actually an upside risk for European and global risk assets. These points reaffirm a bullish cyclical outlook on global stocks and commodities and a bearish outlook on government bonds. It is especially positive for global beneficiaries of US stimulus excluding China, such as Canada and Mexico. It is also beneficial for industrial metals and emerging markets exposed to China over the medium term, after frenzied buying suffers a healthy correction. Any premium in European equities should be snapped up. However, the cornerstone has been laid for the wall of worry in this global economic cycle: the US is raising taxes, China is tightening policy, and Europe’s fiscal stimulus will probably fall short. Moreover a consensus outcome from the German election would be a harbinger of earlier-than-expected fiscal normalization. There is not yet a clear green light in US-China relations – on the contrary, our view that Biden would be hawkish is coming to pass. Biden faces foreign policy tests across the board and now is a good time to hedge against the inevitable return of downside risks given the remorseless increase in tensions between the Great Powers. Housekeeping A number of clients have written to ask follow-up questions about our contrarian report last week taking a positive view on cybersecurity stocks despite the tech selloff and a positive view on global defense stocks, especially in relation to cybersecurity. The main request is, Which companies offer the best value? So we teamed up with BCA’s new Equity Analyzer to highlight the companies that receive the best BCA scores utilizing a range of factors including value, safety, payout, quality, technicals, sentiment, and macro context – all relative to a universe of global stocks with a minimum market cap of $1 billion. The results are shown in the Appendix, which we hope will come in handy. Separately our tactical hedge, long US health care equipment versus the broad market, has stopped out at -5%. This makes sense in light of the pro-cyclical rotation. Health care equipment is still likely to outperform the rest of the US health care sector amid a policy onslaught of higher taxes, government-provided insurance, and pharmaceutical price caps.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Appendix Appendix Table ABCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Appendix Table BBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Appendix Table CBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Footnotes 1 China is asking for export controls that have hamstrung Huawei and SMIC to be removed as well as for sanctions and travel bans on Communist Party members and students to be lifted. See Lingling Wei and Bob Davis, "China Plans To Ask U.S. To Roll Back Trump Policies In Alaska Meeting," Wall Street Journal, March 17, 2021, wsj.com; Helen Davidson, "Taiwanese urged to eat ‘freedom pineapples’ after China import ban," The Guardian, March 2, 2021, theguardian.com. 2 "Putin on Biden: Russian President Reacts To US Leader’s Criticism," BBC, March 18, 2021, bbc.com. 3 Pyongyang is likely to test a new, longer range intercontinental ballistic missile for the first time since its self-imposed missile test moratorium began in 2018 after President Trump’s summit with leader Kim Jong Un. See Lara Seligman and Natasha Bertrand, "U.S. ‘On Watch’ For New North Korean Missile Tests," Politico, March 16, 2021, politico.com. 4 See ABC News, "Transcript: Joe Biden delivers remarks on 1-year anniversary of pandemic", ABC News, Mar. 11, 2021, abcnews.com. 5 Please see IMF Staff, "World Economic Outlook Reports", IMF, Jan. 2021, imf.org and OECD Staff, "OECD Economic Outlook, Interim Report March 2021", OECD, March 9, 2021, oecd.org. 6 Please see IMF Asia and Pacific Dept, "People’s Republic of China : 2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China", IMF, Jan. 8, 2021, imf.org. 7 The other state elections coming up this year will coincide with the federal election on September 26, with one minor exception (Saxony-Anhalt). Opinion polls show the Christian Democrats slipping below the Greens in Berlin and the Social Democrats in Mecklenburg-Vorpommern. The Alternative for Germany is falling in all regions.

Highlights The report from last week’s National People’s Congress (NPC) indicates a gradual pullback in policy support this year. Fiscal thrust will be neutral in 2021, whereas the rate of credit expansion will be slightly lower compared with last year. China’s economy should run on its own momentum in the first half, before slowing to a benign and managed rate. Nonetheless, the risk of policy overtightening is nontrivial and could threaten the cyclical outlook on China’s economy and corporate profits. The recent price correction in Chinese stocks has not yet run its course. Moreover, equity prices in both onshore and offshore markets are breaching their technical resistance. We are downgrading our tactical (0 to 3 months) and cyclical (6 to 12 months) positions on Chinese stocks to underweight relative to global benchmarks. Feature China’s budget and key economic initiatives unveiled at last week’s NPC indicate that policy tightening will be gradual this year. Overall, maintaining stability, both socially and economically, remains the focal point of Premier Li Keqiang’s work plan presented at the NPC’s annual plenary session in Beijing. However, investors have centered on the government’s plan to have a smaller policy push on growth in its budget compared with last year, fearing that economic and corporate profit rebound will disappoint. The Shanghai Composite Index dropped by 6% during the week when the NPC took place. In our view, the risks of a policy over-tightening in the next six months are high. As such, with this report we are downgrading our cyclical call on Chinese stocks to underweight within a global equity portfolio.      Reading Policy Tea Leaves China's growth trajectory since the middle of 2020 has given the government comfort in staying the course on policy normalization. The question is how much Chinese policymakers are willing to pull back support for the economy this year. Overall, the central government plans a smaller policy push in this year's budget and intends to let the economy run on its own steam. Further policy reflation is not in the cards unless a relapse in the economy threatens job creation. The NPC outlined a growth target “above 6%” for 2021 and did not set a numerical goal for the 14th Five-Year Plan from 2021 to 2025. However, de-emphasizing growth does not mean China has abandoned its GDP targets (Table 1). Indeed, in most years in the past two decades, China’s expansion in GDP has overshot objectives set at the NPC (Chart 1). Our baseline estimate is that real GDP will increase by 8% in 2021. Table 12021 Economic And Policy Targets Chart 1Actual Econ Growth Rates Have Overshot Targets In Most Years   We also maintain our view that the rate of credit expansion will be reduced by 2 to 3 percentage points this year to about 11% annually, which is in line with nominal GDP growth (Chart 2). On the fiscal front, the target for a budget deficit was cut by less than half percentage point compared with last year. When taking into account both the government’s budgetary and fund expenditures, the broad-measure fiscal deficit will probably be around 8% of GDP (about the same as last year), which implies there will not be any fresh fiscal thrust in 2021 (Chart 3) Chart 2Credit Growth Will Decelerate From Last Year Chart 3Neutral Fiscal Thrust The pullback in fiscal impulse is larger than in 2010, 2014, and 2017, following the previous three fiscal expansionary cycles. However, the government's eased budget deficit target this year does not mean government expenditure growth will slow. Government revenues climbed sharply by the end of 2020 and will continue to improve this year (Chart 4). Higher revenues will allow more government spending while keeping the fiscal deficit within its objectives. Chart 4Gov Revenue Is On The mend But Spending Has Yet To Pick Up Chart 5A Small Reduction In ##br##LG Bond Quota Furthermore, the quota for local government special purpose bonds was reduced by only 2% from last year.  It should help to support a steady growth in China’s infrastructure investment (Chart 5). The data from January and February total social financing shows a noticeable improvement in corporate demand for bank loans, as well as the composition of bank loans. Corporate demand for medium- and long-term loans remains on a strong uptrend, which reflects an ongoing recovery in corporate profits and supports an optimistic view on capital investment in the months ahead (Chart 6). Chart 6More Demand For Longer-Term Loans Reflects Better Investment Propensity Bottom Line: The growth and budget targets set at this year’s NPC suggest only a modest pullback in policy support. Downside Risks To The Economy Chart 7Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Despite a relatively dovish tone from the NPC, investors should not be complacent about the risk of a policy-tightening overshoot, which could lead to disappointing economic and profit growth this year.  In most of the previous policy tightening cycles, China’s economic activities remained resilient in the first 6 to 9 months (Chart 7). One exception was 2014, when nominal GDP growth dropped sharply as soon as credit growth slowed. The reason is that Chinese authorities kept a very disciplined fiscal stance and aggressively tightened monetary policy, while allowing the RMB to soft peg to a rising USD. In other words, macroeconomic policies were too restrictive during the 2013/14 cycle. Although messages from the NPC do not suggest that Chinese authorities are on such an aggressive tightening path this year, investors should watch the following signs that could threaten China's cyclical economic health: Policymakers may keep monetary conditions too tight, by allowing the RMB to rise too fast while lifting bank lending and policy rates. Currently rates are maintained at historically low levels, much lower than in previous policy tightening cycles (Chart 8). However, the trade-weighted RMB has appreciated by 6% since its trough in July last year and has returned to its pre US-China trade war level (Chart 9).  The Chairman of China’s Banking and Insurance Regulatory Commission recently signaled that bank lending rates would climb. Although we do not expect the rate to return to its 2014 or 2017 level, China is much more indebted than in previous cycles. Even a small bump in interest rates will place a burden on corporates and local governments’ debt servicing cost, dampening their propensity to invest (Chart 10).  Chart 8Aggressive Rate Hikes Are ##br##Unlikely This Year Chart 9Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Chart 10Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chart 11Bank Lending To Property Sector Has Become Increasingly Restrictive   Policies could become too restrictive in key old-economy industries. Chinese authorities have reiterated their determination to contain price bubbles in the property sector. For the first time since 2017, bank lending to real estate developers grew at a pace far below overall bank loans and continued to trend downward in February this year (Chart 11). Moreover, household mortgage loans have reached their slowest expansion rate since 2013.  At 22% of China’s total bank lending, a sharp setback in the property sector’s loan growth will be a significant drag on total credit and the economy.   A worsened imbalance in supply and demand could lead to too much buildup in industrial inventory. Manufacturing inventories recovered sharply following last year’s massive stimulus and many sectors have surpassed their pre-pandemic levels (Chart 12). Strong external demand helped to boost China’s production and propensity to restock on raw materials. However, both China’s core CPI and producer prices for consumer goods remain in the doldrums, which indicates that domestic final demand has yet to fully recover (Chart 13).  As discussed in last week’s report, reopening the world economy in 2H21 should benefit the service sector more than tradeable goods. China’s inventory buildup, particularly in the upstream industries, could turn excessive when export growth slows and domestic demand fails to pick up the slack. Chart 12How Far Can Chinas Inventory Restocking Cycle Go? Chart 13Final Demand Remains ##br##Weak The service sector could take longer than expected to recuperate, even though China’s domestic COVID-19 situation is under control. China’s services sector has flourished in recent years and accounted for 54% of the nation’s pre-pandemic economic output. However, about half of the service sector output is tied to real estate and financial services. Increasing pressures from tighter policy regulations targeting both the property and online financial service sectors could dampen their support to the economy more than policymakers anticipated. At the same time, wage and household income growth could remain tame by China’s standards (Chart 14).   The NPC’s targeted 7% annual increase in spending for national research and development – far below the 12% annual average reached during the past five years – will not be enough to offset the slowdowns in real estate and financial services (Chart 15). Chart 14Household Income Growth Has Yet To Recover Chart 15Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Bottom Line: The downside risks to China’s cyclical growth trajectory are nontrivial. A tug-of-war between policy tightening and growth support will likely persist throughout this year. Investment Implications We recommend investors to underweight Chinese stocks within a global equity portfolio, in the next 0 to 9 months (Chart 16A and 16B). Chart 16AChinese Stocks Are At Their Technical Resistance Chart 16BChinese Stocks Are At Their Technical Resistance On January 13, we tactically downgraded Chinese stocks from overweight to neutral, anticipating that China’s equity markets are sensitive to rising expectations of policy tightening, due to higher corporate debt-servicing costs and lofty valuations.  Chinese stock prices peaked in mid-February, but in our view the correction has not yet run its course. In terms of the economy, we maintain our baseline view that China's overall policy environment this year will be more accommodative than in 2017/18. The growth momentum carried over from last year's stimulus should prevent China's economy and corporate profits from slumping by too much this year. However, as policy supports are scaled back, investors will increasingly focus on the intensity of China’s domestic policy tightening and the uncertainties surrounding it. Downside risks are nontrivial and will continue to weigh on investors' sentiment. For investors that are mainly exposed to the Chinese domestic equity market, the near-term setbacks in the A-share market are taking some air out of Chinese equities' frothy valuations, and may pave the way for a more optimistic cyclical outlook beyond the next 9 to 12 months. We recommend domestic investors to stay on the sidelines for now, but will start recommending sector rotations in the next few months when opportunities arise. Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to beat expectations. Corporates: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & TIPS: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Expect Some Pushback From The Fed The continuing bond market selloff will be the top item on the agenda at this week’s FOMC meeting. Meeting participants will debate whether the sharp rise in long-maturity bond yields represents a threat to the economic recovery and Chair Powell will no doubt be peppered with questions on the topic at his post-meeting press conference, as he was when he sat down with a Wall Street Journal reporter two weeks ago.1 But for our part, we’ll be focused more on the front-end of the yield curve this week. Specifically, we’ll be looking to see whether the Fed revises up its funds rate forecasts by enough to justify current market pricing or whether it uses its forecasts to push back against the bond bears. The market’s fed funds rate expectations have moved a lot since the Fed last published its own forecasts in December (Chart 1on page 1). In December, the market was priced for fed funds liftoff in December 2023 and then only one more 25 basis point rate hike through the end of 2024. Now, the market is looking for liftoff in January 2023, followed by two more rate hikes before the end of that year. Chart 1Market Priced For 3 Rate Hikes Before The End Of 2023 As for the Fed, at last December’s meeting only 5 out of 17 FOMC participants anticipated raising rates before the end of 2023. It’s logical to expect the Fed to increase its rate expectations this week as the economic outlook is much brighter than it was at the time of the December FOMC meeting. Back in December, we still didn’t know whether the Democrats would win control of the Senate, enabling passage of President Biden’s $1.9 trillion stimulus bill. Doubts also remained about how quickly COVID vaccination would occur. Chart 2The Data Can't Disappoint The Fed will probably respond to these pro-growth developments by revising up its interest rate expectations, but we doubt that these revisions will bridge all of the gap with the market. Employment and inflation both remain far from where the Fed would like them to be, and the Fed will want to send the message that its policy stance remains highly accommodative. We could see the Fed’s median fed funds rate forecast shifting to call for one rate hike by the end of 2023, but not the three currently priced into the yield curve. In this scenario, the Fed’s pushback could prompt some near-term downside in bond yields. The question is how long the Fed’s messaging will impact the market in the current environment of surging economic growth. The Economic Surprise Index shows that the economic data can’t even manage to disappoint expectations, a development that usually coincides with rising yields (Chart 2). Bottom Line: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to surpass expectations. We maintain below-benchmark portfolio duration and we will continue to use our Checklist (see last week’s report)2 to determine an appropriate time to increase duration.   The Spread Buffer In Corporate Credit Treasury yields troughed last August, and since then returns have been hard to come by in the US bond market. This is not too surprising. Fixed income is hardly the ideal asset class for a reflationary economic environment. However, there are steps a bond portfolio manager can take to maximize profits in an economic environment that is characterized by (i) rapid economic growth, (ii) rising inflation expectations and (iii) monetary policy that remains accommodative. Specifically, bond investors should minimize their exposure to interest rate risk (i.e. duration) and maximize exposure to credit risk. That is, shy away from long duration assets with little-to-no credit spread and favor shorter duration assets where the credit spread makes up a large proportion of the yield. This sort of strategy has worked well since the August trough in Treasury yields. The Investment Grade Corporate Bond Index – an index with relatively long duration and a small credit spread – is down 4.08% since August 4th (Chart 3). Notably the worst returns have come from the highest rated credit tiers where the credit spread makes up a smaller proportion of the yield. Notice that Aaa-rated Corporates have lost 9% while Baa-rated bonds are only down 2.52% (Table 1). In contrast, total returns from the High-Yield Index – an index with lower duration where the credit spread makes up a much larger proportion of the yield – have held up nicely. The overall index has returned 6.65% since August 4th with the lowest credit tiers once again performing best. Chart 3Move Down In ##br##Quality Table 1Corporate Bond Returns Since The Aug. 4 2020 Trough In Treasury Yields Performance for both the Investment Grade and High-Yield indexes improves if we look at excess returns relative to a duration-matched position in Treasury securities. That is, if we hedge out the interest rate risk and focus purely on spread movements. Though even here, we find that the lowest rated credits with the widest spreads deliver the best returns. If we assume that this reflationary economic environment persists for the next 12 months, can we expect the same low rate risk/high credit risk strategy to succeed? One way to investigate this question is to look at the 12-month breakeven yields and spreads for different segments of the corporate bond market (Table 2). The 12-month breakeven yield is the yield increase that the index can tolerate over the next 12 months before it delivers negative total returns. Similarly, the 12-month breakeven spread is the spread widening that an index can tolerate over the next 12 months before it delivers negative excess returns (where excess returns are measured versus a duration-matched position in Treasury securities). Table 2Corporate Bond 12-Month Breakeven Yields And Spreads The overall Investment Grade Corporate Index, for example, has an average maturity of 12 years and a 12-month breakeven yield of 27 bps. This means that, if we assume that the investment grade corporate bond spread holds steady, then the odds of the index delivering negative total returns over the next 12 months are the same as the odds of a 12-year Treasury yield rising by more than 27 bps. An assumption of flat investment grade corporate bond spreads seems reasonable given that spreads are already historically tight (Chart 4). Moving down in quality within investment grade helps a bit, the Baa credit tier has a 12-month breakeven yield of 30 bps compared to a 12-month breakeven yield of 21 bps for the Aa credit tier. A similar benefit is observed if we look at the 12-month breakeven spread: 14 bps for Baa and only 6 bps for Aa. However, the real improvement comes when we move out of investment grade entirely and into high-yield. To calculate fair breakeven yields and spreads for high-yield bonds we need to incorporate default loss expectations. The current macro environment of strong growth and accommodative monetary policy should lead to relatively low default losses. That being the case, we assume a base case of a 2.5% default rate and 40% recovery rate for the next 12 months. Using this assumption, we calculate a 12-month breakeven yield of 75 bps for the High-Yield Index and a 12-month breakeven spread of 46 bps. This represents a significant extra buffer compared to what is offered by even the lowest investment grade credit tier. Not only that, but the 75 bps 12-month breakeven yield from the High-Yield Index looks even better when we consider that high-yield spreads are not as overvalued relative to history as investment grade spreads, and have more room to tighten as the economic recovery progresses (Chart 5). Chart 4Investment Grade Valuation Chart 5High-Yield Valuation Table 2 also presents two other default loss scenarios, and it shows that we need fairly pessimistic default loss expectations to make high-yield breakeven yields and spreads comparable to what is offered by investment grade bonds. Even if we assume a 4.5% default rate and 30% recovery rate for the next 12 months, we still get a 32 bps breakeven yield from the High-Yield Index, comparable to what we get from the Baa credit tier. Bottom Line: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense.                           Inflation & The Inverted TIPS Curve Chart 6Inflation Will Peak In April February’s Consumer Price Index was released last week, and it showed that core CPI managed only a 0.1% increase on the month. This caught some off guard given that “rising inflation” has become a popular market narrative during the past few months. Our view is that core inflation will rise significantly between now and the end of the year, and that 12-month core PCE inflation will end the year close to the Fed’s 2% target. We arrive at this view for three reasons. First, base effects will lead to a large jump in 12-month inflation measures in March and April. Chart 6 illustrates the paths for both 12-month core PCE and core CPI assuming modest 0.15% monthly gains between now and the end of the year. Because the severely negative inflation prints from last March and April are about to fall out of the rolling 12-month sample, 12-month core inflation is on the cusp of rising to levels considerably above the Fed’s target. This means that after 12-month inflation peaks in April, the question will be how much it declines during the remainder of the year. One reason why we think it might not fall that dramatically is that bottlenecks are already emerging in both the goods and services sectors, and prices will come under upward pressure as the economy re-opens and consumers are encouraged to deploy some of the excess savings they’ve built up during the pandemic. Producer prices are currently surging, as are survey responses about price pressures from the NFIB Small Business Survey and the ISM Manufacturing and Non-Manufacturing Surveys (Chart 7). Finally, shelter is the largest component of core inflation (accounting for almost 40% of core CPI). It would be difficult for overall core inflation to rise significantly without at least some participation from shelter. With that in mind, we now see evidence that shelter inflation will soon put in a trough (Chart 8). Chart 7Price Pressures Are Building Chart 8Shelter Inflation About To Bottom The permanent unemployment rate and Apartment Market Tightness Index are both tightly correlated with shelter inflation. The permanent unemployment rate has stopped climbing and will move lower during the next few months as increased vaccination rates allow for more of the economy to re-open (Chart 8, panel 2). The Apartment Market Tightness Index is also well off its lows, and it will soon jump above the 50 line, joining the Sales Volume Index (Chart 8, panel 3). Consumers are also increasingly seeing signs of rental inflation. A question from the New York Fed’s Survey of Consumer Expectations showed a very sharp increase in expected rents in February (Chart 8, bottom panel). Chart 9Stay Long TIPS As for TIPS strategy, we are hesitant to back away from our overweight TIPS/underweight nominal Treasuries position with inflation on the cusp of a such a significant move higher, especially with the 5-year/5-year forward TIPS breakeven inflation rate still below where the Fed would like it to be (Chart 9). We are also not yet willing to exit the inflation curve flattening and real yield curve steepening positions that we have been recommending since last April, even though the 5/10 TIPS breakeven inflation slope has become inverted (Chart 9, bottom panel).3  With the Fed targeting an overshoot of its 2% inflation target, an inverted inflation curve is more natural than a positively sloped one. This is because the Fed will be trying to hit its inflation target from above, rather than from below. Further, the short-end of the inflation curve is more sensitive to the actual inflation data than the long-end. This means that the curve could flatten even more as inflation rises in the coming months. Bottom Line: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the implications of what Powell said in this interview please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Duration: Markets are correctly interpreting the $1.9 trillion US fiscal stimulus package as a factor justifying higher global growth expectations and bond yields. Maintain a below-benchmark stance on overall global duration. Yield Betas & Country Allocation: Within government bond portfolios, overweighting the “lower-beta” countries that have bond yields less sensitive to changes in US yields (Germany, France, Japan) versus the higher-beta markets (Canada, Australia, UK) remains the appropriate strategy during the current bond bear market. Underweights should remain concentrated in the US, though, as it is highly unlikely that any central bank will begin to tighten policy before the Fed. UK Follow-Up: The conclusions from our UK Special Report published last week do not change after adjusting for the difference in the inflation indices used to calculate UK inflation-linked bond yields compared to those of other countries. UK real interest rates are the lowest in the developed economies, while inflation breakevens are the highest. NOTE: There will be no Global Fixed Income Strategy report published next week. Instead, BCA Chief Global Fixed Income Strategist Rob Robis will do a webcast discussing his latest thoughts on global bond markets. Yields Rising Around The World Chart of the WeekPolicy Mix Is Bond-Bearish The path of least resistance for global bond yields remains biased upward. Optimism on future economic growth remains ebullient with consumer and business confidence indices surging in much of the developed world. The epicenter of the global bond bear market remains the US, where pandemic related economic restrictions are being unwound with 21.4% of the US population now having received at least one dose of a vaccine. Fiscal policy in the US is also supporting the positive vibes on future growth after the $1.9 trillion stimulus package was signed into law by President Biden last week. The 10-year US Treasury yield climbed back to the 2021 high of 1.63% on the back of that announcement. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget (Chart of the Week). This, combined with ongoing quantitative easing from global central banks eager to keep bond yields as low as possible until inflation expectations sustainably return to policymaker targets, is providing a bond-bearish lift to both inflation expectations and real yields – most notably in the US. Central bankers can try to fight back against the speed of the increase in bond yields by maintaining their commitment to current policy settings, as the European Central Bank (ECB) and Bank of Canada (BoC) did last week. The Fed, Bank of England (BoE) and Bank of Japan (BoJ) will all get the chance to do the same this at this week’s policy meetings. The likely message from all will be one of staying the course and not reflexively responding to higher bond yields, which have not triggered a broad-based selloff in global risk assets that would pre-emptively tighten financial conditions. The S&P 500 index hit an all-time high last week, while equity markets in Europe and Japan have returned to pre-pandemic levels (Chart 2). Global corporate credit spreads have remained calm, consistent with a positive growth backdrop that diminishes the potential for credit downgrades and defaults. The US dollar has gotten a lift from improving US growth expectations and relatively higher US Treasury yields, which has had some negative spillover effect into emerging market equities and currencies. The dollar rebound has been relatively modest to date, however, with the DXY index up only 3% from the early 2021 lows. A major reason why global equity and credit markets have absorbed higher bond yields so well is because the sheer scope of the new US fiscal stimulus will have a major impact on growth momentum both in the US and outside the US. This comes on top of the boost to optimism from the speed of the US and UK vaccine rollouts. In an update to its December 2020 economic outlook published last week, the OECD estimated that the $1.9 trillion US stimulus will boost US real GDP growth by 3.8 percentage points versus its original forecast over the next year (Chart 3). Other countries will also benefit from the implied surge in US demand spilling over from that stimulus package, with the OECD projecting a 1.1 percentage point increase to world real GDP growth. Chart 2Risk Assets Ignoring Rising Global Bond Yields Chart 3Big Growth Spillovers From US Fiscal Stimulus Countries that have the greater exposure to US demand, like Canada and Mexico, are expected to benefit a bit more than the rest of the world, but the expected boost to growth is consistent (around one half of a percentage point) from China to Europe to Japan to major emerging market countries like Brazil. That US-fueled pickup in global economic activity will help absorb some of the spare capacity that opened up during the COVID-19 pandemic. In Chart 4 and Chart 5, we show the estimates taken from the December 2020 OECD Economic Outlook for the output gaps in the US, euro area, UK, Japan, Canada and Australia for 2021 and 2022. We adjust those projections by the OECD’s estimate of the impact of the US fiscal stimulus in 2021, as well as by the additional upward revisions to the OECD growth projections in 2021 and 2022 that were published last week. Chart 4The $1.9 Trillion Stimulus Will Close The US Output Gap … Chart 5… And Help Narrow Output Gaps Elsewhere Chart 6Maintain Below-Benchmark Duration The conclusion is that the US output gap will be eliminated in 2022, while output gaps will still be negative, but diminished, in the other countries after factoring in the impact of the latest US fiscal package. This suggests that the maximum upward pressure on global bond yields should still be centered in the US, where inflation pressures will be more evident and the Fed will likely begin signaling a shift to a less dovish stance sooner than other central banks (although not likely until much later in 2021). Our Global Duration Indicator continues to flag pressure for higher bond yields ahead for the major developed economies (Chart 6). The improving growth momentum means that rising real yields should increasingly become the more important driver of higher nominal bond yields. Persistent central bank dovishness in the face of that growth surge, however, means that it is still too soon to position for narrowing global inflation expectations or any bearish flattening of government bond yield curves - even in the US. Bottom Line: Markets are correctly interpreting the $1.9 trillion US fiscal stimulus package as a factor justifying higher global growth expectations and bond yields. Maintain a below-benchmark stance on overall global duration. Using Yield Betas For Bond Country Allocation, One More Time Over the past two months, we have published Special Reports that delved into the outlook for bond yields and currencies in Australia, Canada and the UK. We selected those three countries as they represented the most likely downgrade candidates within our recommended government bond country allocation given their status as “higher beta” bond markets that are more correlated to US Treasury yields. We estimate US Treasury yield betas from a rolling regression (over a three-year window) of changes in 10-year non-US government bond yields to changes in 10-year US Treasury yields (Chart 7). This allows us to assess which markets are more or less sensitive to the ups and downs of US bond yields. We have used this framework to help guide our country allocation strategy during the pandemic and, for the most part, it has been successful. Chart 7Government Bond Yield Sensitivities To USTs Are Shifting Fast So far in 2021, the markets with higher US Treasury yield betas (Canada, Australia and New Zealand) have underperformed the lower beta markets (Germany, France and Japan). We show that in the top panel of Chart 8, which plots the yield betas at the start of the year versus the year-to-date relative return of each country’s government bond market to that of the overall Bloomberg Barclays Global Treasury index. The returns are adjusted to reflect any differences in the durations of each country versus that of the overall index, and are shown in USD-hedged terms to allow for a common currency comparison. The bottom panel of Chart 8 shows the same relationship for the all of 2020. This is a mirror image of what has occurred so far in 2021, with the countries with higher yield betas outperforming the lower beta markets. The obvious difference between the two years is the direction of Treasury yields, which fell in 2020 and have been rising this year. So far in 2020, the differences between the returns of the higher beta markets have been quite similar. New Zealand has had the biggest negative performance (-2.8% versus the global benchmark), but this has only been moderately worse than Australia (-2.6%) and Canada (-2.4%). These are all just slightly worse than the return of US Treasuries relative to the Global Treasury index (-2.3%). Our estimated yield betas have changed rapidly over the past few months. For example, the rolling three-year yield beta of Australia has shot up from 0.61 at the beginning of the year to 0.78, while Canada has seen a similar move (0.81 to 0.88). This reflects the rapid repricing of interest rate expectations in both countries as current growth momentum and growth expectations improve. While not a perfect relationship, yield betas do show some correlation to our Central Bank Monitors – designed to measure the pressure on central banks to tighten of ease monetary policy (Chart 9). The latest increases in the yield betas of Australia, New Zealand and Canada have occurred alongside a rising trend in our Central Bank Monitors for each nation. The implication is that the relative underperformance of government bonds in those countries is related to the cyclical pressure for the RBA, RBNZ and BoC to tighten monetary policy. Chart 8An Intuitive Link Between Yield Betas & Bond Market Performance Chart 9Cyclical Pressures & Yield Betas Are Linked At the same time, the yield betas of government bonds in Germany and the UK have remained low despite the cyclical upturn in our ECB and BoE Monitors. The lingering impact of COVID-19 lockdowns on economic growth and inflation in the euro area and UK is likely weighing on bond yields in both regions. This limits any challenge to the dovish forward guidance of the ECB and BoE, in contrast to the repricing of interest rate expectations seen in other countries. The market-implied path of policy interest rates extracted from OIS forward curves does show a much more aggressive expected path of policy rates in the higher beta markets versus the lower beta markets (Chart 10). Chart 10More Rate Hikes Expected In The Higher Yield Beta Countries​​​​​​​ The “liftoff” date for each central bank shown, representing when the first full interest rate hike is priced into the OIS forwards, is shown in Table 1. We rank the countries in the table by the amount of time until the discounted liftoff date, from shortest to longest. The first rate hike is expected in New Zealand in June 2022, with the BoC expected to lift rates in Canada two months later. The market is not pricing a full rate hike by the Fed until January 2023, while liftoff in the UK and Australia are expected during the summer of 2023. Table 1The "Pecking Order" Of Global Liftoff We treat the countries with perpetually low interest rates, the euro area and Japan, differently in Table 1, as both the ECB and BoJ would most likely move slowly if and when they ever decided to raise rates again. Thus, we define liftoff as only a 10bp increase in policy interest rates for those two regions, while for all the other central banks we assume the size of the first rate hike will be 25bps. On that reduced basis, the market is priced for “liftoff” by the ECB and BoJ in September 2023 and February 2025, respectively. In terms of that “order of liftoff” shown in Table 1, we generally agree with current market pricing except for New Zealand and Canada. We fully expect the Fed to be the first central bank to begin signaling the path towards monetary policy normalization, largely due to the impact of the fiscal stimulus, starting with a move to begin tapering the Fed’s asset purchases at the start of 2022. The Fed will also be the first to begin rate hikes after tapering. We do not anticipate the BoC or Reserve Bank of New Zealand (RBNZ) to make any hawkish moves (reduced asset purchases or rate hikes) before the Fed does the same, as this would put unwanted appreciation pressures on the New Zealand and Canadian dollars. We expect the BoC and RBNZ to move soon after the Fed begins to shift, followed by the BoE and RBA a bit later after that in line with the current liftoff ordering. The pace of rate hikes after liftoff also appears to be a bit too aggressively priced in the countries with higher yield betas. The cumulative amount of interest rate increases to the end of 2024 currently priced in OIS curves is larger in Canada (175bps) and Australia (156bps) than the US (139bps) and New Zealand (140bps). The relative differences are not huge, however, but we think the odds favor the Fed delivering the greater amount of rate hikes over the next three years. More generally, when looking at what is more important for each central bank in determining the timing of liftoff, we can boil it down to a couple of the most important measures for the higher beta countries (Chart 11): US: The Fed will continue to focus on both inflation expectations and broad measures of labor market utilization before signaling any policy shift. On that basis, there is still some way to go before TIPS breakevens return to the 2.3-2.5% level we believe to be consistent with the Fed sustainably hitting its 2% inflation goal on the PCE deflator. Also, there is still a lot of ground to cover before the US labor market fully returns to pre-pandemic health, as the employment/population ratio is four percentage points below the pre-COVID peak. New Zealand: The RBNZ is now under a lot more pressure to tighten policy after the New Zealand government changed the central bank’s remit to include stabilizing house prices, which have soured to unaffordable levels that have exacerbated income inequality. With house prices now rising at a 19% annual rate, the highest since 2004, the RBNZ will be under pressure to hike sooner, although any associated rise in the New Zealand dollar will likely be of equal concern. Canada: The BoC has been very candid that its current policy mix of aggressive asset purchases and 0% policy rates will be altered if the Canadian economy improves. We believe that the current trends of booming house price inflation, recovering business investment prospects and a rapidly recovering labor market will all make the BoC more willing to signal tighter monetary policy fairly soon after the Fed does the same. Australia: The RBA is likely to continue surprising bond markets with its dovishness in the face of a rapidly recovering economy, given underwhelming inflation. In a recent speech, RBA Governor Philip Lowe noted that Australian inflation will not return to the RBA’s 2-3% target band without wage growth rising from the current 1.4% pace up to 3%. The RBA does not expect the labor market to tighten enough to generate that kind of wage growth until at least 2024, suggesting no eagerness to begin normalizing monetary policy. Among the lower-beta markets, the most important things that will dictate future policy moves are the following (Chart 12): Chart 11What To Watch In The Higher Yield Beta Countries Chart 12What To Watch In The Lower Yield Beta Countries UK: The BoE’s current focus is on how fast the UK economy recovers from the pandemic shock, with inflation expectations remaining elevated (see the next section of this report). The degree of strength in business investment and consumer spending will thus dictate the timing of any BoE shift to a less accommodative policy stance. Euro Area: The latest set of ECB projections call for inflation to only reach 1.4% by 2023. As long as inflation (both realized and expected) stays well below the 2% ECB target, the central bank will focus more on supporting easy financial conditions (lower corporate bond yields, tighter Italy-Germany yield spreads and resisting euro currency strength). Japan: Inflation continues to underwhelm in Japan, and the BoJ is a long way from contemplating any tightening measures. Summing it all up, we still see value in using yield betas to dictate our recommended fixed income country allocations. Although these should be complemented with assessments of the relative likelihood of central banks moving before others to further refine country allocations. Bottom Line: Within government bond portfolios, overweighting the “lower-beta” countries that have bond yields less sensitive to changes in US yields (Germany, France, Japan) versus the higher-beta markets (Canada, Australia, UK) remains the appropriate strategy during the current bond bear market. Underweights should remain concentrated in the US, though, as it is highly unlikely that any central bank will begin to tighten policy before the Fed. A Brief Follow-Up To Our UK Special Report In our Special Report on the UK published last week, we noted that the UK had the lowest real bond yields and highest inflation expectations among the developed market countries with inflation-linked bonds.1 Some astute clients pointed out that we neglected to discuss how the UK inflation-linked bonds are priced off the UK Retail Price Index (RPI) which typically runs with a faster inflation rate than the UK Consumer Price Index (CPI). This creates a downward bias to UK real yields in comparison to other countries that use domestic CPI indices in inflation-linked bond pricing. We did not ignore the RPI-CPI differential in our report, we just did not think it to be relevant to the conclusions of our report. The UK still has the lowest real rates and highest inflation expectations even after adjusting both by the RPI-CPI gap (Chart 13). Furthermore, survey-based measures of UK inflation expectations are broadly in line with the RPI-based inflation breakevens, confirming the message from the RPI-based real yields and inflation expectations. Chart 13UK Real Yields Are Too Low, Using RPI Or CPI Looking ahead, the RPI-CPI gap is likely to stay in a much narrower range compared to its longer run history. Chart 14A Less Active BoE Has Narrowed The RPI-CPI Gap For example, between 2000 and 2007, the RPI-CPI gap averaged a full percentage point but with very large fluctuations (Chart 14). This is because mortgage interest costs are included in the RPI but are not part of the CPI. Thus, RPI inflation tends to be more volatile when the BoE is more active in adjusting interest rates. After the 2008 financial crisis, the BoE has kept policy rates at very low levels with very few changes. The RPI-CPI gap has narrowed as a result, averaging only one-half of a percentage point between 2009 to today. Thus, our conclusion on UK bond yields remains the same – Gilt yields are too low and are likely to rise further over the next 6-12 months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Why Are UK Interest Rates Still So Low?",dated March 10, 2021, available at gfis.bcaresearch.com and fes.bcaresearch.com. 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 With the vaccination campaign in full gear and plenty of fiscal support in the pipeline, investors have swung from worrying that the US economy will grow too slowly to worrying that it will grow too fast. Thanks to the latest stimulus bill, US households will have $2 trillion in excess savings at their disposal by April. This money will seep into the economy as lockdown measures end. There is still scope for US interest rate expectations to rise beyond 2023. However, the Fed is unlikely to raise rates in the next two years even if the economy does begin to overheat. This should keep rate expectations at the short end of the curve well anchored near zero, allowing the curve to further steepen. Investors should continue to overweight equities on a 12-month horizon. Historically, stocks have been able to shrug off rising bond yields, provided borrowing costs did not rise so high as to tip the economy into recession. A faster start to the vaccination campaign in the US and accommodative fiscal policy should support the dollar over the next few months. Nevertheless, the greenback will still decline modestly over a 12-month horizon. Too Hot For Comfort? With the vaccination campaign in full gear and plenty of fiscal support in the pipeline, investors have swung from worrying that the US economy will grow too slowly to worrying that it will grow too fast. Chart 1 illustrates these concerns in a nutshell. Point A on the aggregate demand schedule corresponds to a situation where the economy is operating below capacity and interest rates are stuck at zero. An outward shift in the demand curve from AD1 to AD2 would eliminate the output gap without necessitating higher interest rates (Point B). Such an outcome would be good news for equity investors because it would lead to more output and increased corporate profits without any tightening in monetary policy. Chart 1Where Will Fiscal And Monetary Policy Take Us? If the demand curve were to shift further out to AD3, however, the Fed might be forced to take away the punch bowl. The result would be higher interest rates rather than higher output (Point C). This would be bad news for equity investors. Two Questions Analyzing the current debate about where bond yields are going through the lens of this simple chart, two questions arise: How likely is the US economy to run out of excess capacity over the next few quarters? How would the Fed respond to evidence that the US economy is overheating? On the first question, the honest answer is that no one knows. According to the Congressional Budget Office, the output gap stood at 3% of GDP in the fourth quarter of 2020. The true number is probably closer to 5% of GDP since the CBO implausibly assumes that GDP was 1% above potential prior to the pandemic. As of February, payroll employment was down 5.3% from its pre-pandemic level, suggesting that there is still a fair amount of slack in the economy. Employment had fallen even more among low-income workers, women, and certain ethnic minority groups – an important consideration given the Fed’s heightened focus on “inclusive growth” (Chart 2). Chart 2Some Have Suffered More Job Losses Than Others Slack Will Shrink Chart 3Lower Spending And Higher Income Led To Mounting Excess Savings US households were sitting on around $1.7 trillion in excess savings as of the end of January. Households generated about two-thirds of those excess savings by cutting back on spending during the pandemic, with the remaining one-third stemming from increased transfer payments (Chart 3). We estimate that the stimulus bill that President Biden signed into law earlier today will boost household savings by an additional $300 billion, bringing the stock of excess savings to $2 trillion by April. As lockdown measures ease, it is reasonable to assume that households will spend a portion of this cash cushion. Unlike President Trump’s Tax Cuts and Jobs Act, Biden’s American Rescue Plan Act will raise the incomes of the poor much more than the rich (Chart 4). Since the poor tend to spend a greater share of each dollar of disposable income than the rich, aggregate demand could rise meaningfully. Chart 4Biden’s Package Will Boost The Income Of The Poor Meanwhile, the supply side of the economy could face a temporary setback. Under the legislation, about 40% of jobless workers will receive more income from extended unemployment benefits than they did from working. While these additional benefits will expire in early September, they could temporarily curtail labor supply at a time when firms are trying to step up the pace of hiring. Putting it all together, there is a high probability that the US economy will heat up this summer, stoking fears of higher inflation. Door C, D, Or E? For investors, how the Fed reacts to any potential overheating will be critical. If the market prices in an earlier liftoff date for the fed funds rate, the economy will move towards Point C. However, there is another possibility: Rather than fretting about an overheated economy, the Fed could welcome it, stressing its commitment to maintain very easy monetary policy. In that case, the economy would find itself closer to Point D. In fact, Point D could turn out to be a waystation to Point E. An overheated economy could lift inflation. In the absence of any rate hikes, real interest rates would fall. Lower real rates would further stoke spending, causing the aggregate demand curve to shift to AD4. What point will the US end up reaching? As we discuss below, our guess is “eventually Point C,” but with a temporary detour towards Points D/E. The Long-Term Case For C Chart 5Real Yields Have Recovered But Are Still Low The 5-year/5-year forward US TIPS yield currently stands at 0.18%. This is well above the trough of -0.84% reached last August, but still below the average of 0.7% that prevailed in 2017-19 (Chart 5). One can make a case that real bond yields will eventually rise above where they were before the pandemic. Even though the US budget deficit will decline next year due to the expiration of most stimulus measures, fiscal policy will remain looser than it was for most of the post-GFC period. Notably, BCA’s geopolitical strategists expect Congress to pass a $4 trillion 10-year infrastructure bill by this fall, only half of which will be financed through tax hikes. They also anticipate increased spending on health care and other social programs. Chronically easier fiscal policy will lift the neutral rate of interest. Recall that the neutral rate – also known as the “equilibrium rate” –  is simply the interest rate that equalizes aggregate demand with aggregate supply. To the extent that looser fiscal policy raises aggregate demand, a higher interest rate will be necessary to bring aggregate demand back down so that it matches aggregate supply. Temporary Detour Towards D/E That journey to higher real bond yields is likely to be prolonged, however. As noted above, the Fed has no desire to validate market expectations of tighter monetary policy anytime soon. Chart 6 shows that yields rarely rise significantly when the Fed is on hold. Chart 6Treasurys Tend To Underperform When The Fed Delivers Hawkish Surprises Currently, investors expect the Fed to start hiking rates in November 2022, with a second rate hike delivered in May 2023, and a third in November 2023 (Chart 7). This is considerably more hawkish than the Fed’s own forecast from December, which called for no rate hikes until at least 2024. Chart 7The Market Expects Liftoff In Late 2022 While the Fed is likely to bring forward its dots during this month’s FOMC meeting, our US bond strategists still expect the revised dots to signal a later liftoff than what the market is pricing in. On balance, we expect the 10-year Treasury yield to finish the year at about 1.7% – broadly in line with market expectations – but to rise more than expected over a longer-term horizon of 2-to-5 years. Is Inflation A Short-Term Or Long-Term Risk? A sizeable gap has opened up between US 5-year and 10-year inflation breakevens (Chart 8). Investors believe that inflation will accelerate over the next few years but then settle down to a lower level by the middle of the decade.  We think the opposite is more likely to transpire. Economies can often operate above potential for a while before inflation expectations become unmoored. For example, in the 1960s, the unemployment rate spent over two years below NAIRU before inflation finally burst onto the scene. However, as the sixties also revealed, when inflation does rise, it can rise quickly. Core CPI inflation doubled within the span of nine months in 1966. Inflation continued rising all the way to 6% in 1969 (Chart 9). Chart 8Breakeven Curve Inversion Chart 9Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s   As we discussed in February, there are numerous similarities between the present environment and the mid-1960s. This suggests that inflation could surprise significantly to the upside in the middle of the decade, even if it is slow to get off the ground over the next few years. Remain Overweight Stocks Over A 12-Month Horizon Stocks usually rise when growth is strong and monetary policy is accommodative (Chart 10). While bond yields in the US and most other economies will trend higher, they will remain below their equilibrium level for at least the next two years. Chart 10Stocks Do Well When The Economy Does Well In fact, fiscal largesse may have boosted the US neutral rate of interest by more than bond yields have risen, implying that monetary policy has become more, not less, stimulative over the past few months. Historically, stocks have been able to shrug off rising bond yields, provided borrowing costs did not rise so high as to tip the economy into recession (Chart 11 and Table 1). Chart 11What Happens To Equities When Treasury Yields Rise?   Table 1As Long As Bond Yields Don't Rise Into Restrictive Territory, Stocks Will Recover Mixed Picture For The US Dollar The OECD estimates that GDP in the rest of the world will receive a modest lift from US fiscal stimulus (Chart 12). Nevertheless, the US economy will be the primary beneficiary. This has important implications for the direction of the dollar. Chart 12The Benefits Of US Fiscal Stimulus Will Spill Over To Other Countries The dollar is normally a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle. One key reason for this is that the US economy, with its relatively small manufacturing base and large service sector, is less cyclical than most other economies. Thus, when global growth rises, the US often lags behind. The pattern has been different this year, however. Chart 13 shows that growth expectations have risen more in the US than abroad. This is partly because US fiscal policy has been more stimulative than elsewhere. In addition, the US has been faster out of the gate in vaccinating its population (Chart 14). Chart 13US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US growth outperformance should support the greenback over the next few months. Nevertheless, we are not ready to abandon our bearish 12-month dollar view. For one thing, growth revisions should shift back in favor of other developed economies later this year as they catch up to the US in their vaccination campaigns. The prospect of negative fiscal thrust in 2022 due to the expiration of various stimulus measures will also weigh on the US growth outlook. Lastly, the Fed’s reticence to signal a tighter monetary stance will prevent US 2-year real yields – which are already quite low compared to other developed markets – from rising very much (Chart 15). We have found that shorter-dated yields help explain currency movements better than longer-dated yields. Chart 14US Is Among The Vaccination Leaders   Chart 15Real Rate Differentials Are A Headwind For The Dollar A modestly softer dollar should, in turn, support cyclical equity sectors and value stocks over the next 12 months.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Please note that we will be presenting a webcast on Thursday March 11 at 10:00 AM EST for the Americas and EMEA regions and on March 12 at 9:00 HKT/12:00 AEDT for APAC clients. We will be discussing macro themes and investment strategies. Highlights EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were in 2013. Yet better does not mean they will be unscathed. The combination of rising US bond yields and a firming US currency will suffocate EM risk assets in the near-term. A neutral allocation is warranted in EM stocks and credit markets within global equity and credit portfolios, respectively. Feature Ever since the US elections concluded in January with a Blue Sweep, we have been warning that rising US bond yields could trigger a setback in global markets in general, and in EM markets in particular. EM equities, currencies and fixed-income markets have recently experienced a correction (Chart 1). The question now is: Is the market rout over? Or is there more to come? We are inclined to believe that the correction is not over. Rising US Treasury yields have been the culprit of the shakeout in global growth stocks, EM equities, as well as EM currencies. Therefore, taking a stance on US bond yields and on the US dollar is critical for assessing the outlook for EM financial markets. Odds are that the selloff in US long-term bonds and the rebound in the US dollar are not yet over because: Positioning and sentiment on US long-dated Treasuries is neutral, as illustrated in Chart 2. Chart 1Rising US Real Yields Have Caused A Shakeout In EM Chart 2Investor Sentiment And Positioning In US Treasurys Are Neutral   Typically, US bond yields do not reverse their ascent until investor sentiment becomes downbeat and bond portfolios are of materially short duration. These conditions for a top in bond yields are not yet present. US government bond yields would have been much higher if it were not for the Federal Reserve and US commercial banks’ massive bond-buying spree. The Fed has bought $2.8 trillion and US commercial banks have purchased about $300 billion of Treasurys in the past 12 months (Chart 3). One of the main motives for commercial banks to buy US Treasurys has been the SLR relief initiative which commenced on April 1, 2020.1 This SLR relief is due to terminate on March 31, 2021. Unless it is extended, commercial banks will drastically curtail their net government bond purchases. This will exert upward pressure on Treasury yields. Regarding the greenback, investor sentiment remains quite bearish (Chart 4). From a contrarian perspective, this heralds further strength in the US dollar. Chart 3Surging Purchases Of US Treasurys By The Fed And Commercial Banks Chart 4Investors Are Still Bearish On The US Dollar   From a cyclical perspective, US growth will be stronger relative to its potential, and vis-à-vis other DMs, EMs and China. Growth differentials moving in favor of the US foreshadows near-term strengthening of the dollar. Structurally, the bearish case for the US currency hinges on both the Federal Reserve falling behind the inflation curve and ballooning US twin deficits. In our view, this will ultimately be the case. Hence, the long-term outlook for the US dollar remains troublesome. That said, twin deficits alone are insufficient to produce a continuous currency depreciation. The twin deficits must also be accompanied with low/falling real interest rates – in order to generate sufficient conditions for currency depreciation. As long as US real rates continue rising, the dollar’s rebound will be extended. The USD/EUR exchange rate has been correlated with the 10-year real yield differential and this relationship will persist (Chart 5).  Bottom Line: US government bonds will continue selling off. Rising bond yields (including rising real yields) will support the dollar in the near-term. The combination of rising US bond yields and a firming US currency will cause global macro volatility to rise (Chart 6). This will suffocate EM risk assets and EM currencies. Chart 5US Real Yields (TIPS) Will Continue Driving The US Dollar Chart 6Aggregate Financial Market Volatility: Higher Lows   Impact On EM: 2013 Versus Now Are we entering another Taper Tantrum episode as in the spring of 2013 when many EMs were devastated? There are both similarities and differences between the current period of rising US bond yields and the 2013 episode. Similarities: Today, as in early 2013, investor sentiment on EM is very bullish and investors are long EM (Chart 7). Chart 7Investor Sentiment On EM Stocks Was At A Record High In January In early 2013, as is the case today, EM local currency bond yields were very low and EM credit spreads were too tight. When US Treasury yields spiked in the spring of 2013, EM assets tanked. Many commentators blamed it on the Fed. We disagree with that interpretation. Remarkably, the rise in US TIPS yields in 2013 had little impact on equity indices such as the S&P 500 and Nasdaq, or on US corporate spreads (Chart 8). The correction in the US equity market lasted about a week. Yet, EM equities, fixed income markets and currencies experienced a prolonged slump, and in many cases, a bear market. There is no basis to believe that the Fed’s policy and US bond yields are more important to EM than they are to US credit and equity markets. The core rationale for the EM bear market in 2013 was poor domestic fundamentals. The Fed’s tapering was the trigger, not the cause. Differences: The key difference between the current episode and the 2013 Taper Tantrum is EM macro fundamentals. Specifically: EM economies (ex-China, Korea and Taiwan) entered 2013 with booming bank loans and strong domestic demand as well as high inflation (Chart 9). Chart 8US Markets Were Not Hit By The Taper Tantrum In 2013 Chart 9EM (ex-China, Korea And Taiwan): 2013 Vs Now Chart 10EM (ex-China, Korea And Taiwan): 2013 Vs Now Presently, EM bank credit is subdued, domestic demand is dismal, and inflation is tame. Besides, EMs (ex-China, Korea and Taiwan) had a very large trade deficits in 2013 and were financing them via foreign borrowing, which was roaring prior to 2013 (Chart 10). Presently, their trade balances are in surplus and foreign indebtedness has not increased in recent years. Bottom Line: In 2013, EM economies (ex-China, Korea and Taiwan) were overheating and were addicted to foreign funding. These were the reasons why EM currencies and fixed income markets teetered when US bond yields spiked in 2013. Presently, the majority of EM economies (ex-China, Korea and Taiwan) have different types of malaises: domestic bank loan origination is too timid, consumer spending and capital expenditures are moribund, inflation is low and fiscal policy is tight. Consequently, EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were back in 2013. Yet better does not mean they will be unscathed. Investment Strategy Equities: The key variable to watch to assess the vulnerability of both US and EM equity markets is their respective corporate bond yields. Historically, rising corporate bond yields (shown inverted in both panels of Chart 11) heralds lower share prices. Chart 11Rising Corporate Bond Yields Are Bad For Share Prices Given that both EM and US corporate credit spreads are too tight, they are unlikely to narrow further to offset rising US Treasury yields. Instead, EM and US corporate bond yields are likely to rise with US Treasury yields. This will trigger more weakness in share prices. Besides, rising EM local currency government bond yields also point towards more downside in EM equities (yields are shown inverted on the chart) (Chart 12). Chart 12Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Concerning equity style, global growth stocks have peaked versus global value stocks. In the EM equity space, we have less conviction on growth versus value. As to regional allocation in a global equity portfolio, we continue recommending a neutral allocation to EM, underweighting US and overweighting Europe and Japan. Commodities: Investors’ net long positions in commodities are very elevated (Chart 13). As US bond yields rise and the US dollar continues rebounding, there will be a de-risking in the commodities space resulting in a pullback in commodities prices. Currencies: We continue shorting a basket of EM currencies – including BRL, CLP, ZAR, TRY and KRW versus the euro, CHF and JPY. Several EM currencies have failed to break above their technical resistance levels, suggesting that a pullback could be non-trivial (Chart 14). Chart 13Investors Are Record Long Commodities Chart 14Asian Currencies Hit Technical Resistances   In central Europe, we are closing the long CZK/short USD trade with a 3.8% gain. Continue holding the long CZK/short PLN and HUF position. Local fixed income markets: EM local bond yields have risen in response to rising US treasury real yields and the setback in EM currencies. This might persist in the near-term, but we continue to recommend receiving 10-year swap rates in selected countries where inflation risks are low and monetary and fiscal policies are tight. These countries include Mexico, Colombia, Russia, China, India and Malaysia. A further rise in their swap rates would represent an overshoot and hence, should not be chased. EM currencies are more vulnerable to a selloff than local rates are. We continue to wait for a better entry point in currencies to recommend buying cash domestic bonds instead of receiving swap rates. EM Credit: A neutral allocation to EM sovereign and corporate bonds is warranted in a global credit portfolio. Our sovereign credit overweights are Mexico, Russia, Malaysia, Peru, Colombia, the Philippines and Indonesia, while our sovereign credit underweights are Brazil, South Africa and Turkey. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The Supplementary Leverage Ratio (SLR) is equivalent to Basel III Tier-1 leverage ratio and varies from 3-5% for US banks. Under the relief program last April, the Fed allowed US banks to exclude holdings of US Treasury Bonds and cash kept in reserves at the Fed from their assets when calculating this ratio. The SLR relief is planned to end March 31, 2021. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights UK Interest Rates: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Implications for Gilts & GBP: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Maintain below-benchmark duration on Gilts, while downgrading UK allocations within dedicated global fixed income portfolios to neutral. The pound has upside in this environment, especially if depressed UK productivity starts to recover. Feature Chart 1UK Real Yields: Deeply Negative The UK has become one of the more peculiar corners of the global fixed income universe. The outright level of longer-term Gilt yields is in the middle of the pack among the major advanced economies. The story is much different, however, when breaking those nominal UK yields into the real and inflation expectations components. The deeply negative real yields on UK inflation-linked Gilts are the lowest among the majors, even in a world where sub-0% real yields are prevalent in most countries (Chart 1). The flipside of that deeply negative real yield is a high level of inflation expectations. The breakeven inflation rate derived from the difference between the nominal and real 10-year Gilt yields is 3.3%, the highest in the developed “linkers” universe. Inflation expectations in UK consumer surveys are at similar levels, well above the 2% inflation target of the Bank of England (BoE), suggesting little confidence in the central bank’s ability or willingness to hit its own inflation goals. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy and Foreign Exchange Strategy, we investigate why UK real interest rates have remained so persistently negative and assess the possibility of a shift in the low interest rate regime in a post-Brexit, post-pandemic UK – a move that could be quite bearish for UK fixed income markets and bullish for the British pound. Can The BoE Ignore Cyclical Upward Pressure On UK Bond Yields? The UK has suffered from a series of shocks, starting with the 2008 crisis, that have limited the ability of the BoE to attempt to tighten monetary policy. The 2011/12 European debt crisis hurt the UK’s most important trading partners, while the 2016 Brexit vote began a multi-year process of uncertainty over the future of those trading relationships. The COVID-19 pandemic is the latest shock, triggering a recession of historic proportions. The UK economy contracted by -10% in 2020, the largest decline since “The Great Frost” downturn of 1709. UK bond yields collapsed in response as the BoE cut rates to near-0% and reinforced that easy stance with aggressive quantitative easing and promises to keep rates unchanged over at the next few years. Today, UK financial markets are waking up to a world beyond the current COVID-19 lockdowns. The UK is running one of the world’s most successful vaccination rollouts, with 23 million jabs, or 35 per 100 people, already having been administered. UK Prime Minister Boris Johnson recently unveiled a bold plan to fully reopen the UK economy from the current severe lockdowns by mid-year. The UK government’s latest budget called for additional spending measures over the next year, including maintaining the work furlough scheme that has supported household incomes during the pandemic. As a result, UK growth expectations have exploded higher. According to the Bloomberg consensus economics survey, UK nominal GDP growth is expected to surge to 8.4% over calendar year 2021, an annual pace not seen since 1990 (Chart 2). Nominal Gilt yields have begun to reprice higher to reflect those surging growth expectations, with the 5-year/5-year forward Gilt yield climbing 67bps so far in 2021. Real Gilt yields are also moving higher with the 10-year inflation-linked Gilt climbing 38bps year to date, providing additional interest rate support that has fueled a surge in the pound versus the dollar (bottom panel). Our own BoE Monitor - containing growth, inflation and financial variables that typically lead to pressure on the central bank to adjust monetary policy – is signaling a reduced need for additional policy easing (Chart 3). The momentum of changes in longer-maturity UK Gilts and the trade-weighted UK currency index are usually correlated to the ebbs and flows of the BoE Monitor. The latest surge higher in yields and the currency suggests that the markets are anticipating the type of recovery that will put pressure on the BoE to tighten. Chart 2A Growth-Driven Repricing Of Gilts & GBP Chart 3Gilts & GBP Sniffing Out A Less Dovish BoE? It may take a while to see the BoE turn more hawkish, however. The BoE has become one of least active central banks in the world over the past decade. After the BoE cut its official policy interest rate, the Bank Rate, by 500bps during the 2008 financial crisis and 2009 recession, rates were kept in a range between 0.25% and 0.75% for ten consecutive years. The BoE cut rates aggressively in response to the COVID-19 pandemic, lowering the Bank Rate in March 2020 from 0.75% to 0.1%, where it still stands. The BoE has used quantitative easing (QE) and forward guidance to try and limit movements in bond yields whenever cyclical surges in inflation could have justified tighter monetary policy. That has led to an extended period of a negative BoE Bank Rate, something not seen since the inflationary 1970s (Chart 4). Back then, the BoE was lagging the surge in UK inflation, but still hiking nominal interest rates. Today, the central bank is keeping nominal rates near 0% with much lower levels of inflation. Chart 4Over A Decade Of Negative Real UK Interest Rates Short-term interest rate markets are still pricing in a very slow response from the BoE to the current growth optimism. Only 36bps of rate hikes over the next two years are discounted in the UK overnight index swap (OIS) curve. This go-slow response is in line with the BoE’s guidance on future rate hikes which, similar to the language used by other central banks like the Fed, calls for no pre-emptive rate hikes before inflation has sustainably returned to the BoE target. That combination would be consistent with current forward market pricing on both short-term interest rates and inflation. Chart 5BoE Keeping Real Rates Well Below R* In Chart 5, we show the real BoE Bank Rate, constructed by subtracting UK core CPI inflation from the Bank Rate. We also show a forward real rate calculated using the forward UK OIS and CPI swap curves. The market-implied path of the real Bank Rate shows very little change over the next decade, with the real Bank Rate expected to average around -2.5%. This is far below the estimates of a neutral UK real rate (or “r-star”) of just under 2%, as calculated by the New York Fed or recent academic studies. The neutral UK real rate has likely dipped because of the pandemic. The UK Office For Budget Responsibility (OBR) estimates that there has been a long-term “scarring” of the UK economy from COVID-19 through supply-side factors like weaker investment spending, lower productivity growth and diminished labor force participation – equal to three percentage points of the level of potential GDP.1 The BoE estimates a smaller “scarring” of 1.75 percentage points of potential output, but coming with a 6.5% reduction in the size of the UK capital stock. While these are significant reductions in the supply-side of the UK economy, they are not enough to account for the 4.5 percentage point difference between pre-pandemic estimates of the UK r-star and the market-implied path of the real BoE Bank Rate over the next decade. The implication is that the markets are not expecting the BoE to deviate from its strategy of doing very little with interest rates, even as growth recovers from the pandemic shock. That can be seen in the recent upturn in UK inflation expectations that is evident in both market-implied and survey-based measures. Chart 6UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation The 5-year/5-year forward UK CPI swap rate now sits at 3.6%, not far off the 3.3% level of 5-10 year consumer inflation expectations from the latest YouGov/Citigroup survey (Chart 6). The fact that inflation expectations can remain so elevated at a time when headline CPI inflation is struggling to avoid deflation is striking. This indicates a belief that the BoE will do very little in the future to stop a booming UK economy that is expected to put sustained downward pressure on the UK unemployment rate over the next few years (bottom panel). This is from a relatively low starting point of the unemployment rate given the massive government support programs that have limited the amount of pandemic-related layoffs over the past year. The BoE should have reasons to be more concerned about a resurgence of UK inflation. In its latest Monetary Policy Report, the BoE published estimates showing that the entire collapse in UK inflation in 2020 was attributable to weaker demand for goods and services – especially the latter (Chart 7). This suggests that UK inflation could rebound by a similar amount as the UK economy reopens from pandemic lockdowns. According to the UK OBR, 21% of UK household spending is on items described as “social consumption”, like restaurants and hotels (Chart 8). This is a much larger proportion than seen in other major developed economies (excluding Spain) and explains why consumer spending plunged so much more dramatically in the UK during 2020 than in other countries. Chart 7Only A Temporary Drag On UK Inflation From COVID-19 Chart 8UK Households More Focused On “Social Consumption” If the UK pandemic-related restrictions are eased as planned over the next few months, the potential for a sharp snapback in UK consumer spending is significant. The BoE estimates that UK households now have £125bn of “excess” savings thanks to government income support and reduced spending on discretionary items like dining out and vacations. This is the fuel to support a rapid recovery in consumption over the next 6-12 months, especially as personal income growth will get a boost as furloughed workers begin returning to work (Chart 9). Chart 9UK Economy On The Mend Chart 10Big Boost To UK Growth From Housing & Government Spending A similar argument can be made for investment spending – the BoE estimates that UK businesses have amassed £100bn pounds of excess cash, and the latest reading on the BoE’s Agents' Survey of UK firms shows a slight increase after months of decline (bottom panel). With a Brexit deal with the EU finally reached at the start of 2021, UK businesses can also look to increase investment spending that had been delayed because of the years of Brexit uncertainty. The UK economy is already getting a boost from a recovery in the housing market fueled by low interest rates, high household savings and improving consumer confidence. Mortgage approvals have soared to the highest level since 2007, while house prices are now expanding at a 6.4% annual rate (Chart 10). Add it all up, and the economic momentum in the UK is positive and likely to accelerate further in the coming months as a greater share of the population becomes vaccinated. The BoE’s dovish policy stance is likely to appear increasingly inappropriate relative to accelerating UK growth and inflation trends over the next several months. Thus, on a cyclical basis, UK bond yields, both nominal and real, have more upside potential even after the recent increase. Bottom Line: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Structural Forces Keeping UK Interest Rates Low Are Fading Looking beyond the cyclical drivers, the structural factors that have held down UK interest rates in recent years are also starting to fade. The supply side of the UK economy has suffered because of Brexit uncertainty. The OECD’s estimate of potential UK GDP growth fell from 1.75% in 2015 to 1.0% in 2020 (Chart 11). This was mostly due to declining productivity growth – a consequence of years of very weak business investment. The 5-year annualized growth rate of real UK investment spending fell to -3% in 2020, a contraction only matched during the past 30 years after the 1992 ERM crisis and 2008 financial crisis. That plunge in investment coincided with almost no growth in UK labor productivity over that same 5-year window. Chart 11The Road To Faster Potential UK Growth Starts With Investment Slowing population growth also weighed on UK potential growth, slowing to the lowest level in 15 years in 2019 as immigration from EU countries to the UK fell sharply. COVID-19 also hurt immigration flows into the UK last year. The UK Office for National Statistics estimated that the non-UK born population in the UK fell by 2.7% between June 2019 and June 2020. Diminished potential GDP growth is a factor that would structurally reduce the equilibrium real UK interest rate. We are likely past the worst for that downward pressure on potential growth and real rates. Population growth should also stabilize as the UK borders open up again and pandemic travel restrictions are loosened. Measured productivity is already starting to see a cyclical recovery, while investment spending is likely to improve as cash-rich UK companies began to ramp up capital spending plans deferred by Brexit and COVID-19. While the process leading from faster investment spending into speedier productivity growth is typically slow, the key point is that the worst of downtrend is likely over. This is an important development that has implications for UK fixed income markets. When looking at an international comparison of real central bank policy rates within the developed economies, the UK has fallen into the grouping of countries with persistently negative policy rates, namely Japan, the euro area, Switzerland, Sweden and Norway (Chart 12). We have dubbed that group the “Secular Stagnation 5”, after the term made famous by former US Treasury Secretary Lawrence Summers describing a state where the “natural” real rate of interest (r-star) that equates savings with investment is structurally negative. Chart 12Does The UK Belong In The 'Secular Stagnation 5'? Does the UK belong in the “Secular Stagnation 5”? As a way to assess this, we made some comparisons of selected UK data with the same data for those five countries. When looking at potential GDP growth and population growth, the UK sits right in the middle of the range of those growth rates for the five countries (Chart 13). UK productivity growth has underperformed the others recently but, prior to the 2016 Brexit shock, UK productivity was also in the middle of the Secular Stagnation 5 range. Chart 13Brexit Became A Major Hit To UK Potential Growth Chart 14UK Economy Less Focused On Investment & Exports On other measures, the UK is nothing like those other countries. The UK’s economy is far less geared towards exports and investment (Chart 14) and is more tilted towards consumer spending. That can be seen most clearly when looking at the data on savings/investment balances. The UK continuously runs a current account deficit, as opposed to the persistent surpluses seen in the Secular Stagnation 5 (Chart 15). Put another way, the UK is not a “surplus” country that saves more than it invests on a structural basis, a condition that typically depresses real interest rates. Chart 15The UK Is Not A Surplus Country Chart 16Gilts Will Not Become A Low-Beta Market Based on these cross-country comparisons, it is unusual for the UK to have such persistently low real interest rates. This has implications for UK bond yields. Over the past few years, Gilts have been transitioning from a status as a “high yield beta” market – whose yield movements are more correlated to swings in the overall level of global bond yields. The lower beta markets are in countries like Germany, France and Japan – all members of the Secular Stagnation club (Chart 16). The UK does not appear to warrant a permanent membership in that low-yielding group, based on structural factors. That is evident when looking at how Gilt yields are rising even with the BoE absorbing an increasing share of the stock of outstanding Gilts (bottom panel). We conclude that the transition of the UK to a low-beta market is related to the Brexit uncertainty post 2016 and the pandemic shock that has hit the consumer-focused UK economy exceptionally hard – both factors that are set to fade over the next year. Bottom Line: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Investment Conclusions Chart 17Downgrade Gilts To Underweight Our assessment of the cyclical and structural drivers of UK interest rates leads us to the following conclusions on UK fixed income and currency strategy: Duration: Maintain a below-benchmark exposure to UK interest rate movements. Gilt yields will rise by more than is discounted in the forwards over the next 6-12 months (Chart 17), coming more through rising real yields as the UK economy continues its post-Brexit, post-pandemic recovery. Country Allocation: Downgrade strategic allocations to UK Gilts to neutral from overweight in dedicated fixed income portfolios. Our long-standing view that Brexit uncertainty would lead to the outperformance of Gilts versus other developed bond markets is no longer valid. It is still too soon to move to a full underweight stance on Gilts – a better opportunity will develop by mid-year once it is more evident that the current success on UK vaccinations leads to a faster reopening of the UK economy. Yield Curve: Maintain positioning for a bearish steepening of the UK Gilt yield curve. While there is limited scope for more steepening through an even larger increase in inflation breakevens from current elevated levels, the long end of the Gilt curve can move higher by more than the front end as the market re-rates Gilts to a higher-beta status with a higher future trajectory for UK interest rates. Corporate Credit: Downgrade UK investment grade corporate bond exposure to neutral from overweight in dedicated fixed income portfolios. UK corporate spreads have returned to the 2017 lows and, while an improving growth dynamic is not overly bearish for credit, there is no longer a compelling valuation-based case for staying overweight UK investment grade corporates. This move brings our recommended UK allocation in line with our neutral stance on US and euro area investment grade corporates. Chart 18GBP/USD Appears Cheap On A PPP Basis Chart 19Low Productivity Is Weighing On The Pound Currency: A growth-driven path towards interest rate normalization should be positive for the British pound, which remains undervalued versus the US dollar on a purchasing power parity basis (Chart 18).2 A move to 1.45 on GBP/USD is possible within the next six months. A broader move towards pound strength will require an improvement in business investment, as the trade-weighted pound looks fairly valued on our productivity-based model (Chart 19). We do maintain our view that EUR/GBP can approach 0.80 by year-end based on a relatively stronger cyclical improvement in UK growth versus the euro area.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For further details on the OBR estimates of UK growth, inflation and fiscal policy, please see the March 2021 OBR Economic & Financial Outlook, which can be found here: https://obr.uk/ 2 Please see BCA Research Foreign Exchange Strategy Report, "Thoughts On The British Pound", dated December 18, 2020, available at fes.bcaresearch.com.

Highlights Duration: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. The Fed & Financial Conditions: The recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. The Fed & The Labor Market: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Feature Chart 1Bearish Trend Intact The bond bear market rages on. The Bloomberg Barclays Treasury Index returned -1.8% in February, its worst monthly performance since 2016. The sell-off then continued through the first week of March, culminating with the 10-year Treasury yield touching 1.56% as of Friday’s close (Chart 1). The 5-year/5-year forward Treasury yield ended the week at 2.41%, near the top-end of primary dealer estimates of the long-run neutral fed funds rate (Chart 1, bottom panel). We don’t want to catch a falling knife, but eventually, yields will look attractive enough for us to increase our recommended portfolio duration. To help us make that decision, we unveiled a Checklist For Increasing Portfolio Duration in our February Webcast (Table 1).1 Table 1Checklist For Increasing Portfolio Duration This week, we check-in with our Checklist, concluding that it is still too early to increase portfolio duration. Checking-In With Our Duration Checklist Chart 2Cyclical & Valuation Indicators The first item on our Checklist is the 5-year/5-year forward Treasury yield reaching levels consistent with survey estimates of the long-run neutral fed funds rate. As noted above, this condition has been met. Second, we would like to see survey-derived measures of the 10-year term premium reach extended levels. Specifically, we’d like to see them approach their 2018 peaks (Chart 2). Currently, our two measures are sending diverging signals. The term premium derived from the New York Fed’s Survey of Market Participants is 60 bps, only 15 bps off its 2018 peak. However, the term premium derived from the New York Fed’s Survey of Primary Dealers is only 22 bps, 53 bps off its 2018 peak. For now, our assessment is that this condition has not been met. It’s important to note that the surveys used to construct our two term premium measures and to obtain our fair value range for the 5-year/5-year forward Treasury yield have not been updated since January, and that they will be revised ahead of this month’s FOMC meeting. If primary dealers and market participants revise up their fed funds rate expectations, then our valuation measures will give the 10-year yield more room to rise. Third, we continue to track high-frequency cyclical economic indicators like the CRB/Gold ratio (Chart 2, panel 3) and the relative performance of cyclical versus defensive equity sectors (see section titled “The Fed’s Approach To Financial Conditions” below). These measures have yet to show any signs of deterioration, consistent with an environment where bond yields should be rising. Fourth, if current trends continue, we are concerned that US yields may rise too far compared to yields in the rest of the world. This could entice foreign inflows into the US bond market, sending yields back down. Historically, bullish sentiment toward the US dollar is a good indicator of when US yields have risen too far. At present, dollar sentiment remains extremely bearish (Chart 2, bottom panel). This suggests that we are not yet close to the point when foreign purchases will push US yields lower. Finally, we consider the market’s fed funds rate expectations relative to the Fed’s most recent forecast, as inferred from its quarterly “dot plot”. Currently, the market is priced for Fed liftoff to occur in January 2023, with a second rate hike delivered in May 2023 and a third in October 2023 (Chart 3). This is considerably more hawkish than the Fed’s median forecast from December, which called for no rate hikes until at least 2024! Chart 3Market Expects Liftoff In January 2023 We think it’s conceivable that economic conditions could warrant Fed liftoff in late-2022 (see section titled “Tracking Payrolls And The Countdown To Fed Liftoff” below), but the Fed will probably be more cautious about how quickly it brings its expected liftoff date forward. FOMC participants will have an opportunity to push back against the market when they update their funds rate forecasts at this month’s meeting. The Fed will likely bring forward its anticipated liftoff date, but probably not all the way to January 2023. This could halt the uptrend in bond yields, at least for a while. Bottom Line: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. Other surveys used in the construction of our term premium estimates and 5-year/5-year yield targets will also be updated around this time. The Fed’s Approach To Financial Conditions Chart 4Financial Conditions Are Easy Remarks from Fed Chair Jay Powell were a catalyst for higher bond yields last week. Apparently, there had been some expectation in the market that Powell would use his platform to express concern about the recent increase in long-maturity bond yields. In fact, many expected him to foreshadow changes to the Fed’s balance sheet policy, either extending the maturity of its ongoing asset purchases or initiating an Operation Twist, where the Fed sells short-dated securities and buys long-dated ones.2 Powell didn’t announce any of these things. In fact, he didn’t even express concern about the recent rise in long-dated yields despite being given several opportunities to do so. To understand why, we need to understand how the Fed thinks about financial conditions. The Fed only cares about conditions in financial markets to the extent that they are expected to influence the real economy. This means that the Fed takes a broad view of financial conditions, including bond yields, credit spreads and equity prices. From this perspective, financial markets do not currently pose a risk to the economy (Chart 4). Yes, long-dated bond yields have risen, but short-dated yields remain low. Credit spreads also remain very tight and equity prices have only dipped modestly from high levels. The Chicago Fed’s broad index of financial conditions shows that they are extremely accommodative (Chart 4), and thus support continued economic recovery. This financial market back-drop is not one that will cause the Fed to take additional actions to ease policy. Even the recent drop in the stock market appears to be more a reflection of economic optimism than a cause for concern. Looking at the performance of different equity sectors, we find that the sectors that stand to benefit from the end of the pandemic and economic re-opening are surging. Meanwhile, the sectors that are performing poorly are simply giving back some of the huge gains that were realized when the pandemic was raging last year. For example, cyclical sectors (Industrials, Energy and Materials) are soaring while defensive sectors (Healthcare, Communications, Consumer Staples and Utilities) have hooked down (Chart 5A). The ratio between the two remains tightly correlated with the 10-year Treasury yield. Similarly, Bank stocks have exploded higher since bond yields troughed last fall while the Technology sector has had difficulty making further gains (Chart 5B). Last year, the Tech sector benefited from low bond yields and surging demand. This year, Banks stand to profit from higher yields and an improving labor market. Finally, our US Equity Strategy team put together a basket of “COVID-19 Winners” designed to profit from the pandemic and a basket of “Back To Work” stocks designed to benefit from economic re-opening. Not surprisingly, the former is dragging the S&P 500 lower while the latter is on a tear (Chart 5C). Chart 5ASector Rotation: Cyclicals Vs. Defensives Chart 5BSector Rotation: Banks Vs. Tech Chart 5CSector Rotation: COVID Winners Vs. Re-Open Winners The bottom line is that the recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. Other Reasons For The Fed To Change Its Balance Sheet Policy In addition to concerns about a drop in the stock market, several other reasons have been given for why the Fed might consider either increasing its asset purchases or shifting them toward the long end of the curve. 1) Treasury Market Liquidity Chart 6Treasury Market Liquidity First, there is an ongoing tension in the Treasury market between imposing stricter capital regulations on dealer banks and ensuring that they have enough balance sheet capacity to maintain Treasury market liquidity during periods of stress.3 This delicate equilibrium broke down last March when Treasury market liquidity evaporated at a time when both equities and bonds were crashing. The Fed was forced to step into the Treasury market to sustain market functioning. Last week’s Treasury sell-off had a whiff of illiquidity about it as well. One liquidity index that measures the average curve fitting error across all government bond yields increased slightly, but not nearly as much as it did last March (Chart 6). Treasury bid/ask spreads also widened a touch, but unlike last March, Treasury ETFs continued to trade close to their net asset values. A significant deterioration in Treasury liquidity would prompt a quick response from the Fed. That is, the Fed would quickly ramp up purchases to restore market functioning. However, last week’s blip was not nearly severe enough to raise alarm bells. Other periods of Treasury market stress that have prompted the Fed to step in have occurred during periods of extreme economic deterioration and market panic, such as in March 2020 and 2008. With economic growth accelerating rapidly, we place low odds on a major Treasury market liquidity event occurring this year. 2) Expiry Of The SLR Exemption Chart 7Reserve Supply Is Massive A second possible reason for the Fed to change its balance sheet policy is the upcoming expiry of the exemption to the Supplementary Leverage Ratio (SLR). The SLR is a regulation that requires large banks to hold common equity capital totaling at least 5% of assets. Assets are not risk-weighted for the purposes of the SLR. A problem arose with the SLR last March when the Fed bought massive amounts of bonds, flooding the banking system with reserves (Chart 7). The problem is that banks are forced to hold those reserves, and this makes it more difficult for them to meet their SLR requirement. To alleviate the problem, the Fed announced that reserves and Treasury securities would be exempted from the SLR calculation. Today, the issue is that this exemption is scheduled to expire at the end of March and the Fed has yet to announce whether it will be extended or allowed to lapse. Table 2US Bank Supplementary Leverage Ratios If the exemption lapses, then banks may try to unload Treasury securities to remain compliant with the SLR. In theory, this could lead to upward pressure on Treasury yields that the Fed could mitigate by ramping up its asset purchases. However, it’s unclear how much of an impact a lapsing of the SLR exemption would actually have on the Treasury market. Even adjusting for a lapsing of the exemption, all major US banks remain compliant with the 5% SLR (Table 2). Also, banks could always decide to increase their SLRs by reducing share buybacks rather than by shedding Treasuries.   In any event, an increase in Fed asset purchases to lean against rising Treasury yields driven by bank selling would be counterproductive. It would only flood the banking system with more reserves, making the SLR even more difficult to meet. Our view is that a fair compromise would be for the Fed to continue the SLR exemption for bank reserves, but to allow the Treasury security exemption to lapse. But even if the SLR exemption is allowed to lapse completely, we doubt that it will lead to enough market turmoil to prompt a change in the Fed’s balance sheet strategy. 3) Supply/Demand Imbalance In Money Markets Finally, some have noted that the large and growing supply of bank reserves could lead to problems in money markets. Specifically, with the Treasury Department now in the process of paying down its cash account (Chart 7, bottom panel), there is a lot of cash flooding into money markets and coming up against limited T-bill supply. In theory, the Fed could try to mitigate this problem by engaging in an Operation Twist – selling some T-bills and buying some coupon bonds. But we doubt this will occur. The Fed already has tools in place to maintain control over short rates in such circumstances. For example, the same situation arose in 2013 when an over-supply of bank reserves pushed short rates down toward the bottom of the Fed’s target range (Chart 8A). The Fed’s response was to create the Overnight Reverse Repo Facility (ON RRP). This facility allows counterparties to park excess cash at the Fed in exchange for a security off the Fed’s balance sheet. This proved to be an effective floor on repo rates and the fed funds rate, and we expect it will be again (Chart 8B). Chart 8AFed Created ON RRP In 2013... Chart 8B... It Remains A Firm Floor On Rates T-bill yields remained below the ON RRP rate for some time in 2014 and 2015, and the same thing could happen again this year. But this will not be a major concern for the Fed as long as it maintains control over the fed funds rate and the overnight repo rate. Eventually, the Treasury Department can deal with the lack of bill supply by increasing the amount of T-bill issuance. Bottom Line: Treasury market liquidity remains an ongoing concern for the Fed, and the possible expiry of the SLR exemption and lack of T-bill supply present additional near-term technical challenges. We think it’s unlikely that any of these things will prompt the Fed to deviate from its current pace and composition of asset purchases in 2021. Tracking Payrolls And The Countdown To Fed Liftoff Chart 9The Fed's Maximum Employment Targets Employment growth surprised to the upside in February as 379 thousand jobs were added to nonfarm payrolls. This sent bond yields higher, but we caution that even stronger employment growth will be required to keep bond yields rising going forward. The Fed needs to see a return to “maximum employment” before it will lift rates off the zero bound. This means not only that the unemployment rate will have to fall to a range of 3.5% to 4.5%, but also that the labor force participation rate must make a full recovery to pre-pandemic levels (Chart 9). We calculate that average monthly employment growth of 419 thousand will be required to achieve this goal by the end of 2022 (Table 3). In other words, to justify the market’s January 2023 expected liftoff date, we will need to see average monthly payroll growth of at least 419 thousand going forward.   Table 3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date This number seems high, but it may be attainable. With vaccine distribution kicking into high gear, many service sectors of the economy will soon be able to re-open. This already started to happen last month when the Leisure & Hospitality sector added 355 thousand jobs. Even after last month’s gains, Leisure & Hospitality still accounts for 36% of the net job loss since last February (Table 4). This means that there is scope for extremely large employment gains this year if the coronavirus can be contained. Table 4Employment By Industry Bottom Line: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 https://www.bloomberg.com/news/articles/2021-03-01/treasury-curve-dysfunction-ignites-talk-of-federal-reserve-twist?sref=Ij5V3tFi 3 For more details please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup, Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification