Europe

Highlights Duration & Country Allocation: Global bond yields have been driven by growth and inflation expectations over the past year, but shifting policy expectations are now the more important driver. Tighter monetary policies will pressure global bond yields higher over the next 6-12 months, but not equally. Stay underweight countries where tapering and rate hikes are more likely (the US, the UK, Canada, New Zealand) relative to countries where policymakers will move much more slowly (euro area, Australia, Japan). Inflation-Linked Bonds: An update of our Comprehensive Breakeven Indicators shows limited scope for a further widening of breakeven inflation rates between nominal and index-linked government bonds in most developed economies, most notably in Europe. Downgrade strategic (6-18 months) exposure to inflation-linked bonds (vs nominals) to underweight in Germany, France and Italy. Feature Chart of the WeekGlobal Bond Yield Drivers: Inflation Now, Labor Later “Actually, we talked about inflation, inflation, inflation. That has been a topic that has occupied a lot of our time and a lot of our debates.” – ECB President Christine Lagarde Are you tired of talking about inflation? Central bankers likely are. The only problem is that is the job of monetary policymakers to worry about inflation – and the appropriate policy response – when it is rising as fast as been the case in 2021. The current global inflation surge, on the back of supply squeezes for both durable goods and commodity prices, will ease to some degree in 2022. This does not mean, however, that global bond yields have seen their cyclical peak. The driver of higher yields is already starting to transition from high inflation to tightening labor markets and rising wage costs – more enduring sources of potential inflation that will require monetary tightening in many, but not all, countries (Chart of the Week). This week, we discuss the implications of this shift to more policy-driven yields for the country allocation decisions in a government bond portfolio, for both nominal and inflation-linked debt. Shorter-Term Bond Yields Awaken, Longer-Term Yields Take Notice October represented a shift in the relative performance of developed economy government bond markets compared to the previous three months, most notably at the extremes (Chart 2). UK Gilts were the largest underperformer in Q3, down 1.8% versus the Bloomberg Global Treasury index (in USD-hedged terms, duration-matched to the benchmark), while Spain (+0.7%), Australia (+0.4%) and Italy (+0.3%) were the outperformers. In October, that script was flipped with Gilts being the best performer (+2.3%), Australia being the worst performer (-4.2%) and Spain (-0.6%) and Italy (-1.5%) reversing the Q3 gains. Those particular swings in relative performance were a result of shifting market views on policy changes in those countries. The UK Gilt rally was largely contained to a single day, and focused at the long-end of the Gilt curve after the Conservative government announced a smaller-than-expected budget deficit on October 26 - with much less issuance of longer-maturity bonds – which triggered a huge -22bps decline in 30-year Gilt yields. The Australian bond selloff was a triggered by a rapid market reassessment of the next move in monetary policy for the Reserve Bank of Australia (RBA) after an upside surprise on Q3 inflation data. Italian and Spanish debt also sold off on the back of growing fears that even the European Central Bank (ECB) would be forced to tighten policy in response to higher inflation. The backup in Australian and European yields ran counter to the latest policy guidance of from the RBA and ECB, indicating speculation of a bond-bearish hawkish policy shift. In countries where policymakers have been more explicit about the need for monetary tightening, like Canada and New Zealand, government bonds performed poorly in both Q3 and October. While US Treasury returns were “flattish” in both Q3 (0.1%) and October (0.1%), the 2-year Treasury yield doubled from 0.27% to 0.52% during October as the market pulled forward the timing and pace of Fed rate hikes starting next year (Chart 3). Shifting views on monetary policy have not only impacted the relative performance of bond markets, but also the shapes of yield curves. The bigger increases seen in shorter-maturity bond yields have resulted in a fairly synchronized global move towards curve flattening (Chart 4). This would not be unusual during an actual monetary policy tightening cycle involving rate hikes. However, within the developed economies, only Norway and New Zealand have seen an actual rate hike. In other words, yield curves have been flattening on the anticipation of a rate hiking cycle – but one that is expected to be relative mild. Chart 3A Bond-Bearish Repricing Of Global Rate Expectations​​​​​​ Chart 4Some Violent Repricing Of Policy Expectations​​​​​​ Forward interest rates in Overnight Index Swap (OIS) curves are discounting higher rates in 2022 and 2023 across most countries, but with stable rates in 2024 (Chart 5). Yet the cumulative amounts of tightening are very modest, especially when compared to inflation (both realized and expected). Only in New Zealand are policy rates expected to go above 2% by 2023, with the US OIS curve discounting the Fed lifting policy rates to just 1.4%. In the UK, markets are discounting 123bps of hikes by the end of 2022 and a rate cut in 2024 – market pricing that strongly suggests that the Bank of England will make a “policy error” by tightening too much, too quickly, over the next year. Chart 5Markets Still Think Central Banks Will Not Have To Hike Much After the October repricing of rate expectations, and reshaping of yield curves, we see a few conclusions – and investment opportunities – that stand out: US Treasuries With the Fed set to begin tapering asset purchases, the market discussion has moved on to the timing and pace of the post-taper rate hike cycle. The US OIS curve is discounting two Fed hikes in the second half of 2022, starting shortly after the likely end of the Fed taper in June. That timing and pace for 2022 is a bit more aggressive than we are expecting, but a rapidly tightening US labor market and rising wage growth could force the Fed to at least match the market pricing for hikes next year. On that note – the US Employment Cost Index in Q3 rose +1.3%, the fastest quarterly pace since 2001, and +3.7% on a year-over-year basis, the highest since 2004. The greater medium-term risk for the Treasury market is that the Fed starts to signal a need to go higher and faster than the market expects in 2023 and even into 2024. US Treasury yields remain well below levels implied by growth indicators like the ISM index. Thus, there is upside potential as the Fed tightens because of persistent above-trend growth and falling unemployment over the next couple of years (Chart 6). Chart 6Stay Below-Benchmark On US Duration Exposure We continue to recommend a below-benchmark duration strategic stance for dedicated US bond investors, based on our expectation that US bond yields will climb higher over the next 12-18 months. However, our more preferred way to play this for global investors is as a spread trade versus euro area bond yields – specifically, selling 10-year US Treasury versus 10-year German bunds (Chart 7). Chart 7Position For UST Underperformance Vs. Europe​​​​​​ While headline inflation in the euro area has rapidly converged to the pace of US inflation over the past few months, this is overwhelmingly due to surging European energy costs. The pace of underlying inflation, as proxied by measures like the Cleveland Fed trimmed mean CPI and the euro area trimmed mean CPI constructed by our colleagues at BCA Research European Investment Strategy, has diverged sharply with the latter barely above 0%. The ECB will not follow the Fed into a rate hiking cycle next year, which will push US government yields higher versus European equivalents. Australia Government Bonds Chart 8Fade The RBA 'Rate Shock' In Australia The RBA fought back against the sharp repricing of Australian interest rate expectations earlier this week by signaling that no rate hikes are expected until 2023. This is a modest change from the previous forward guidance of 2024 liftoff, but a surprisingly dovish message for markets that had rapidly moved to price in rate hikes next year after the big upside surprise on Q3/2021 Australian inflation With underlying trimmed mean inflation now having crept back into the RBA’s 2-3% target range, although just barely at 2.1%, the RBA would be justified in removing some degree of monetary accommodation. The central bank has already been doing so, on the margin, with some earlier tapering of the pace of asset purchases and last week’s decision to formally abandon its yield control target on shorter-dated government bond yields. Per the RBA’s current forward guidance, however, a move to actual rate hikes would require more evidence of tighter labor markets and faster wage growth – and thus, a more sustainable move to the 2-3% inflation target - that is not yet evident in measures like the Wage Cost Index (Chart 8). We plan on doing a deeper dive into Australia for next week’s report, where we’ll more formally evaluate our strategic view on Australian bond markets. For now, we remain comfortable with our overweight stance on Australian government bonds, as the RBA is still projected to be one of the less hawkish central banks in 2022. UK Gilts The sharp rally in longer-dated UK Gilts seen at the end of October was due to a downside surprise in the expected size of the UK budget deficit next year, and the amount of Gilt issuance that will be needed to finance it. The UK Debt Management Office (DMO) said it planned to issue 194.8 billion pounds ($267.5 billion) of bonds in the current 2021/22 financial year, 57.8 billion pounds less than its previous remit back in March. The pre-budget market expectation was for a far smaller reduction of 33.8 billion pounds. The cut in issuance was most pronounced for longer-dated Gilts, -35% lower than the March budget issuance projection (Chart 9). With longer-maturity Gilts always in high demand from longer-term UK institutional investors, a major “supply shock” of reduced issuance can temporarily boost bond prices and lower yields. This is especially true in the UK where more aggressive rate hike expectations, and more defensive bond market positioning after the August/September selloff, left Gilts vulnerable to a short squeeze. The most important medium-term drivers of Gilt yields are still expectations of growth, inflation and future policy rates. There was very little change in shorter-dated Gilt yields or UK OIS forward rates after last week’s budget announcement – all the price action was the long end of the Gilt yield curve, resulting in an overall bull flattening. As we discussed in last week’s report, we expect the next move in the shape of the Gilt curve will be towards a steeper curve, likely bond-bearishly as long-term yields are still priced too low relative to how high UK policy rates will eventually have to climb in the upcoming BoE hiking cycle. The post-budget flattening has made the valuation of longer-maturity Gilt curve steepeners far more attractive, according to our UK butterfly spread valuation model (Table 1). Table 1UK Butterfly Spread Valuations From Our Curve Models Chart 10A New UK Tactical Trade: Long 10yr Bullet Vs. 7/30 Barbell The trade that stands out as most attractive is to go long the 10-year Gilt bullet versus selling a 7-year/30-year Gilt curve barbell – a butterfly spread that was last priced this attractively in 2013 (Chart 10). We are adding this as a new recommended trade in our Tactical Overlay portfolio, the details of which (specific bonds and weightings for each leg of the trade) can be found on page 17. Bottom Line: Tighter monetary policies will pressure global bond yields higher over the next 6-12 months, but not equally. Stay underweight countries where tapering and rate hikes are more likely (the US, the UK, Canada, New Zealand) relative to countries where policymakers will move much more slowly (euro area, Australia, Japan). Global Breakevens: How Much More Upside? The surge in global inflation this year has helped boost the performance of inflation-linked government bonds versus nominal equivalents. Yet current breakeven inflation rates have reached levels not seen in some time. Last week, the 10-year US TIPS breakeven hit a 15-year high of 2.7%, the 10-year German breakeven reached a 9-year high of 2.1%, while the 10-year UK breakeven climbed to 4.2% - the highest level since 1996 (!). With market-based inflation expectations reaching such historically high levels, how much more can breakevens widen – especially with central banks incrementally moving towards tighter monetary policies? To answer that question, we turn to our Comprehensive Breakeven Indicators (CBIs). The CBIs measure the upside/downside potential for breakevens for the US, Germany, France, Italy, Japan, the UK, Canada and Australia. The CBIs incorporate the following three measures: The residuals from our 10-year breakeven inflation spread fair value models, as a measure of valuation. The spread between 10-year breakevens and survey-based measures of inflation expectations, as a measure of the inflation risk premium embedded in breakevens The gap between headline inflation and the central bank inflation target, as an indication of the existing inflation backdrop and of future monetary policy moves in response to an inflation trend that can help to reverse that trend. Each of the three measures is standardized and added together to produce a single CBI. A higher reading on CBI suggests less potential for additional increases in breakevens, and vice versa. The latest readings from our CBIs are shown in Chart 11. The red diamonds for each country are the actual CBI, while the stacked bars show the individual CBI components. The highest CBI readings are in Germany and the US, while the lowest are in Canada and France. Importantly, no country has a CBI significantly below zero, indicative of the more limited upside potential for breakevens after the big run-up since mid-2020. As a way to assess the usefulness of the CBIs as an indicator of the future breakeven moves, we constructed a simple backtest. We looked at how 10-year breakevens performed in the twelve months after the CBI hit certain thresholds (Chart 12). The backtest results show that the CBIs work as intended, signaling reversals of existing trends once the CBIs climb above +0.5 or below -0.5. The average (mean) size of the breakeven reversal gets larger as the CBI moves further to extremes. Based on the latest reading from the CBIs, we are making significant changes to the recommended allocations (Chart 13) to inflation-linked bonds (ILBs) in our model bond portfolio on pages 14-15: Chart 13No Overweights In Our Revised Allocations To Global Linkers Downgrading ILBs to underweight (versus nominal government bonds) in Germany, France, Italy & Spain from the current overweight allocation. The backtested CBI history for those countries suggests breakevens are more likely to fall over the next twelve months. Furthermore, realized euro area inflation is more likely to fall in 2022, given the lack of underlying euro area inflation described earlier in this report. Downgrade Japan ILBs to neutral from overweight. While the CBI is not at a stretched level, realized Japanese core inflation has struggled to stay in positive territory – even in the current environment of soaring commodity and durable goods prices. Upgrade ILBs in Canada and Australia to neutral from underweight. The former has a CBI that is still below zero, while the latter benefits from the lack of RBA hawkishness compared to other central banks. We are maintaining our other ILB allocations in the UK (underweight vs. nominals) and the US (neutral vs. nominals). In the UK, stretched breakevens are at risk from the hawkish turn by the BoE, which is a clear response to the higher UK inflation expectations. While the US CBI is at a high level, we see better value in playing for narrowing TIPS breakevens at shorter maturity points that are even more exposed to a likely slowing of commodity fueled inflation in 2022 than longer maturity TIPS breakevens. In other words, we see a steeper US breakeven curve, but a flatter real yield curve as the Fed tightens. Bottom Line: An update of our Comprehensive Breakeven Indicators shows limited scope for a further widening of breakeven inflation rates between nominal and index-linked government bonds in most developed economies, most notably in Europe.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.co Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights The market pricing of the ECB is too aggressive. More so than in the US, temporary factors explain the European inflation surge. Energy, taxes, and base effects account for the bulk of the price increases. In contrast to supply shortages, European labor shortages are small and slack will limit wage growth. Despite the lack of near-term inflation risks, European growth prospects are significantly stronger than last decade. As a result, European inflation will settle at a higher level than in the 2010s and will increase durably in the second half of the 2020s. The inflation curve will steepen, as will the yield curve. Banks will continue to outperform, especially compared to the insurance sector. A tactical opportunity to buy European high-yield corporates has emerged. In France, Macron remains the favorite for the 2022 presidential election. Feature Last week’s ECB meeting did nothing to curb the impression among traders that the ECB will start removing monetary accommodation in 2022. The implied policy rate stands at -0.25% one year from now and -0.08% in two years. Meanwhile, Italian 10-year spreads over Germany have increased to 127bps, their highest level since November 2020. This market action rests on the perception that inflationary pressures in the Euro Area are durable. While this line of reasoning may have credence in the US, it is weaker across the Atlantic where the economy shows fewer signs of genuine inflationary pressure. Moreover, the deterioration in peripheral financial conditions further limits the ability of the ECB to withdraw accommodation without a financial accident. Meanwhile, the NGEU program has created a climate where the likelihood of a premature and excessive fiscal tightening is low. Thus, the weak European growth of the past decade will not be repeated. When considering these inflationary and fiscal views, it becomes apparent that the European yield curve has room to steepen further. Consequently, European banks remain attractive and should be bought on dips, especially relative to insurance companies. The EONIA Curve Is Too Aggressive The sudden increase in interest rate hikes priced in the EONIA curve is a consequence of the rapid acceleration in European realized inflation and CPI swaps. Neither are durable. Headline HICP has surged to 4.1% and core CPI towers at 2.1%, their highest reading in 13 and 19 years, respectively. These surges are the reflection of transitory factors: Chart 1The Energy Path-Through Energy prices are lifting HICP and are sipping through to core CPI. Inflation for electricity, gas, and fuel has reached 14.7% and the energy CPI is at 23.5%. Both are moving in line with headline and core CPI (Chart 1). Now that Brent oil and natural gas have increased four and twenty folds since Q2 2020, respectively, their ability to contribute as much to overall inflation has decreased because they are unlikely to appreciate as much again. While oil prices may rise again here, European natural gas will decline meaningfully in the coming months. Tax increases are another important driver of core CPI. Core inflation with constant taxes stand at 1.37%, which is 0.67% below core CPI. In other words, while core CPI is high by the standard of the past decade, once we adjust for tax increases, it stands at normal levels (Chart 2). Base-effects are another dominant ingredient of the surge in European core CPI. The annualized two-year rate of change of the Eurozone’s core CPI stands at 1.11%, which is within the norm of the past seven years and below the rates experienced prior to 2014. In comparison, the annualized two-year core inflation in the US is 2.87%, well outside the range of the past decade (Chart 3). Chart 2Death And Taxes Chart 3Controlling For The Base Effect Inflation remains narrowly based. The Euro Area trimmed-mean CPI stands at 0.22%, or 1.82% below core CPI. Meanwhile, in the US, trimmed-mean CPI has reached 3.5% or 0.5% below core CPI (Chart 4). These figures confirm that the Eurozone inflation increase is more muted and narrower than that of the US. Wages are not experiencing any meaningful shock so far. Negotiated wages are growing at a 1.7% annual rate; meanwhile, the Atlanta Fed Wage Tracker is expanding at 3.6% and is rising even more steadily for low-skill jobs (Chart 5). Chart 4Much More Narrow Than In The US Chart 5Limited Wage Pressures Continental Europe’s more limited inflationary pressures compared to the US are a consequence of policy decisions during the crisis. The Euro Area fiscal stimulus in 2020 and 2021 amounted to 11% of 2019 GDP, but output declined by 15% in Q2 2020 and suffered a second dip in Q1 2021. Meanwhile, US fiscal packages amounted to 25% of 2019 GDP, while GDP declined by 10% in Q2 2020. Consequently, the Eurozone’s output gap is -4.1% of GDP, while that of the US has essentially closed. The contrasting nature of the stimuli accentuated the different outcomes created by their respective size. In Europe, governmental support focused on keeping people at work, which left aggregate supply unchanged. In the US, public programs allowed jobs to disappear, but they placed money directly in the pockets of consumers, which caused aggregate demand to rise relative to aggregate supply. In this context, a wage-price spiral is unlikely to develop in Europe as long as the energy crisis does not continue through 2022. First, the labor shortage problems are less acute in the Eurozone than in the US or the UK. Chart 6 highlights the factors limiting production in various industries. In the industrial sector, the “labor shortages” category has grown, but pale compared to the role of “material and equipment shortages” as a problem. In the services sector, the “weak demand” and “other” categories are greater obstacles to production than the “labor” factor, which remains at Q1 2020 levels (Chart 6, middle panel). Only in the construction sector are “labor shortages” the chief problem, but they still hurt production less than “insufficient demand” did in February 2021, when real estate prices were already strong (Chart 6, bottom panel). Second, labor market slack remains comparable to 2011 levels, when the ECB erroneously increased interest rates to fight energy-driven inflation (Chart 7). Additionally, the rise in persons available to work but not currently seeking employment represent 75% of the increase in labor market slack since Q4 2019. At the crisis peak in Q2 2020, this category accounted for 105% of the increase in labor market slack. This suggests that, as the vaccination campaign continues to progress across the continent; as households use up their savings; and as government supports ebb across Europe, a large share of those who are a part of the labor market slack will start looking for jobs again, which will increase the supply of workers and limit wage pressures. If traders are overly worried about realized inflation remaining high in Europe, they are also over-emphasizing some CPI swap measures that trade above 2%. CPI swaps only tell one part of the inflation expectations story, because they are one and the same as energy prices. Elevated energy prices sap spending power in the rest of the economy, if other inflation expectation measures remain well anchored; thus, rising energy inflation rarely translates into broad-based pricing pressure. For now, our Common Inflation Expectation measure for the Eurozone, based on the New York Fed’s method for the US, is still toward the low-end of its distribution, even though it includes CPI swaps (Chart 8). This confirms that the energy crisis remains a relative-price shock and that it is unlikely to lead to a generalized inflation outburst in the Euro Area. Chart 8Different Inflation Expectations Bottom Line: Markets expect a first 10bps ECB rate hike by June 2022 and the deposit rate to be 25bps higher by September 2023. However, unlike in the US, there are few signs that European inflation reflects anything more than higher energy prices, rising taxes, and base effects. Moreover, the stories in the press of labor shortages are exaggerated, while broad-based inflation expectations are not unmoored. In this context, we lean against the EONIA pricing and expect the ECB to increase rates in 2024, at the earliest. Fiscal Policy Unlike Last Decade The 2010s were a lost decade for Europe. GDP only overtook its 2008 peak in 2015. Today, GDP is recovering much faster from the recession than it did twelve years ago, and it is unlikely to relapse as it did back then. Chart 9A Lost Decade The European economic underperformance last decade was rooted in fiscal policy. As the top panel of Chart 9 highlights, the fiscal thrust during the GFC was minimal, at 1.3% of GDP, and was rapidly followed by a negative fiscal thrust. Moreover, the ECB unduly tightened policy in 2011 and left peripheral spreads fester at elevated levels between 2011 and 2014. This combination substantially hurt demand, especially in the European periphery. Capex proved particularly vulnerable. It is derived demand and therefore adds considerable variance to GDP. Faced with strong policy headwinds, its share of GDP plunged for most of the decade, which greatly contributed to the European economic malaise (Chart 9, bottom panel). According to the IMF, the Eurozone fiscal thrust will not exert the same drag as it did last decade; hence, capex is also unlikely to repeat its mediocre performance. Instead, the poorer Eastern and Central European economies as well as the weaker peripheral nations will receive a significant fillip from the NGEU program (Chart 10). When the NGEU grants and loans as well as the EU’s Multiannual Financial Framework funds are aggregated together, the EU will provide EUR1.9 trillion funding (adjusted for inflation) to member states over the next five years (Table 1). These sums will prevent any meaningful fiscal retrenchment from taking place. Table 1Bigger Spending The NGEU funds will be particularly supportive for capex. The Recovery and Resilience Facility (RRF), which will be the main instrument to deliver funds across Europe, is heavily weighted toward green transition, reskilling, and digital transformation (Chart 11, top panel). Practically, this spending focuses on electrical, power, water, and broadband infrastructures, as well as renovation and modernization projects (Chart 11, bottom panel). This reinforces the notion that capex is unlikely to follow the same trajectory it did last decade. The implication of more accommodative fiscal policy and more robust capex is that the European output gap will close much faster than it did after the GFC. Hence, even if we expect the current inflation spike to pass next year, inflation will ultimately settle higher than it did last decade. Moreover, in the second half of the 2020s, European inflation will trend higher as full employment will be achieved. Bottom Line: The Euro Area is unlikely to experience another lost decade like the previous one. European trend growth remains low, but fiscal policy will not be as tight. Consequently, capex will not be as depressed, especially because the NGEU grants will greatly incentivize investments in certain sectors of the economy. As a result, the output gap will close much faster than it did in the 2010s. Moreover, once the current pandemic-driven inflation surge passes, CPI will settle at a higher level than it did last decade and will trend higher durably in the second half of the 2020s. Investment Implications Three main conclusions can be derived from our expectation on European inflation and growth dynamics over the coming decade. First, the inflation yield curve will steepen meaningfully. Today, near-term CPI swaps are lifted by energy markets and 2-year CPI swaps are 20bps above 20-year CPI swaps (Chart 12). From 2012 to 2020, 20-year CPI swaps stood between 30 bps and 150 bps above short maturity ones. Second, a steeper inflation curve, along with greater inflation risk toward the end of the decade will cause the European term premium to normalize from its -1.21% level. This will allow German 10-year yields to rise and the European yield curve to steepen (Chart 13). Chart 12Long-Term Inflation Expectations Have Upside Chart 13A Steeper German Yield Curve Third, higher German yields and a steeper curve will greatly benefit European banks (Chart 14, top panel). This pattern will be especially evident against insurance firms, which have massively outperformed deposit-taking institutions over the past seven years as yields fell (Chart 14, bottom panel). Additionally, banks’ balance sheets have become more robust than they once were and NPLs are unlikely to rise meaningfully as a result of government guarantees and easy fiscal policy (Chart 15). Investors should go long bank/short insurance on a cyclical basis. Chart 14Long Bank / Short Insurance Chart 15Imporving Balance Sheets A Tactical Buying Opportunity In European High-Yield Corporate Bond Market Chart 16Tactical Buying Opportunity The 40 basis points widening in European high-yield spreads has created a tactical buying opportunity. Inflation fears spurred by rising energy prices and by input prices are the likely culprit behind the recent spread widening (Chart 16). Although US junk spreads have already narrowed significantly, European high-yield corporate bond spreads are still 40 bps wider than at the beginning of September.     The 12-month breakeven spread, which measures the degree of spread widening required over a 12-month period for corporate bond returns to break even with a duration-matched position in government bond securities, now ranks at its 20th percentile, from 10th (Chart 16, second panel). Spreads will narrow back to near post-crisis lows before year-end on both an absolute and breakeven basis: First, monetary and fiscal policy remain very accommodative. Importantly, Spain and Italy will receive large shares of the NGEU funds until 2026. Second, growth will remain above trend despite recent inflation worries. Third, the European default rate is still falling, leaving the worst of the default cycle behind (Chart 16, third panel). Finally, our bottom-up Corporate Health Monitor signals improving corporate health, which historically coincides with narrowing spreads (Chart 16, bottom panel). Bottom Line: The recent widening in European high-yield spreads represents a short window of opportunity to buy the dip. Beyond this timeframe, a more cautious approach toward European credit is appropriate, as the ECB will become less active in the bond market. A French Update Last month, French President Emmanuel Macron unveiled a EUR30 billion investment plan aimed at supporting and fostering industrial and tech “champions of the future.” This new plan comes on top of the EUR100 billion recovery package that was announced in September 2020 to face the pandemic. While these investments will be made across many sectors of the French economy, the focus will be the French tech and energy sectors (Chart 17, top panel). This announcement comes six months before the next presidential election and amid the emergence of Eric Zemmour as a potential far-right candidate. However, Zemmour’s candidacy is unlikely to alter our expectation that Macron will be re-elected in 2022. Recent polls that include Zemmour as a potential candidate in the first-round show that he is appealing to Marine Le Pen’s voter base (Chart 17, bottom panel). Meanwhile, former Prime Minister Edouard Philippe—who would have made a formidable opponent to Macron had he decided to run—announced the creation of his own party with the objective of supporting Macron’s re-election campaign. Chart 18Recent Developments Support These Trades These political developments come as the French health and economic picture keeps improving. Although the vaccination pace has slowed in France, 68% of the population is fully vaccinated and 76% of the population has received at least one dose. Thus, the healthcare system continues to weather well recent COVID waves. Moreover, business confidence remains robust and reached its highest reading since July 2007, despite supply issues holding back production. The French jobs market is also recovering, with the unemployment rate expected to fall to 7.6% in Q3 from 8% in Q2. The introduction of a new investment plan, the emergence of a far-right candidate and Edouard Philippe’s newfound support, and the COVID-19 and economic developments bode well for President Macron’s chances at re-election. This implies additional French reforms over the next five years that aim to suppress unit labor costs and to make French exports more competitive vis-à-vis their main competitor, Germany. As a result, investors should overweight French industrial stocks relative to German ones (Chart 18, top panel). Meantime, additional investment in the French tech is bullish for a sector that is inexpensive relative to its European peers. Overweight French tech equities relative to European ones (Chart 18, panel 2 and 3).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights The 26th Conference of the Parties (COP26) will open this weekend in Glasgow, Scotland, amid a global crisis induced in no small measure by policies and regulations that led to energy-market failures. Price-distorting regulations and ad hoc fixes – e.g., retail price caps, "windfall profits" taxes – will compound the current crisis. Mad rushes to cover energy and space-heating demand in spot coal and gas markets when renewable-energy output falters will be repeated, given utility-scale battery storage will continue to be insufficient to replace hydrocarbons in the transition to a low-carbon economy.  On the back of higher coal, gas and oil demand, CO2 emissions will return to trend growth or higher this year (Chart of the Week). Base metals capex will have to increase at the mining and refining levels to meet renewables and EV demand.  This includes the need to diversify metals' production and refining concentration risks more broadly.1 We remain strategically long the COMT ETF and the S&P GSCI index, as these fundamental imbalances are addressed.  We also are initiating a resting buy order on the XME ETF if this basic materials ETF trades down to $40/share. Feature Going into the COP26 meetings starting this weekend, delegates no doubt will be preoccupied with the global energy crisis engulfing markets as the Northern Hemisphere winter approaches. In no small measure, the crisis is a product of poor policy design and regulatory measures meant to accelerate the transition to low-carbon economies globally. This is most apparent in China, the UK and the EU. China and the UK use retail price-caps to control the cost of energy to households. In China, the price caps recently brought state-owned electricity providers to the brink of bankruptcy, because suppliers were not able to pass through higher wholesale prices for coal and natural gas to retail consumers. In the UK, retail price caps actually did result in bankruptcies of smaller electricity providers. In the EU, price caps and "windfall profits" taxes are being imposed on retail energy providers in different states in the wake of the energy crisis.2 China's Impressive Renewables Push China has been making significant progress in introducing renewable energy to their energy supply mix, particularly wind and solar (Chart 2), accounting for 81.5% of Asia-Pacific's wind generation last year, and 55.5% of the region's solar generation. China generates just 11% of its energy from renewables. This has been insufficient to meet demand over the past year, owing to a combination of reduced coal supplies; colder-than-normal temperatures last winter, and hotter-than-normal temps during the summer brought on by a La Niña event. While energy demand was expanding over the course of the year due to strong economic growth in 1H21 and weather-related demand over the course of the year (for heating and cooling), provincial officials were vigorously enforcing the state-mandated "dual-control policy," which in some instances led to overly aggressive shutdowns of coal mines that left local markets short of the fuel needed to supply ~ 63% of the country's electricity.3 Chinese authorities have said that they would “go all out” to boost coal production in a bid to tackle widespread power cuts. Some 20 provinces in China have experienced electricity rationing and blackouts over the past month due to power-production shortfalls driven by a lack of coal. The power rationing was imposed due to a shortage of coal supply, which led to the surge in coal prices. The high coal prices, in turn, forced coal-power companies to cut back their production to avoid losses that threatened to bankrupt them.4 To be able to ensure coal and electricity supplies this winter, state authorities released new rules to enforce a policy scheme that includes increasing coal production capacity and revising the electricity pricing mechanism. China's state-owned Global Times news service reported more than 150 coal mines have been approved to re-open.5 The regional governments can prioritize their energy intensity targets over energy consumption. Coal-fired power prices, which are largely state-controlled, will be allowed to fluctuate by up to 20% from baseline levels. However, raising household tariffs is seen as a difficult task politically, given that China's per-capita income remains low.6 UK, EU Market-Distortions The UK electricity production and supply market consists of three segments – producing, distributing, and selling electricity. Entities can operate in any or all of these areas. As in many things, the UK punches way above its weight in renewables, accounting for 15% of wind generation and 7.5% of solar produced in Europe, as seen in Chart 2. Wind can supply ~ 25% of UK power, depending on weather conditions. For all renewables, the UK accounts for 14% of Europe's total generation capacity. Twice a year, the national energy regulator, The Office of Gas and Electricity Markets (Ofgem) sets a cap on the price at which electricity sellers or retailers can supply power to the final consumer. While the maximum price retailers can sell electricity to consumers is capped, the price they can buy it from the electricity producer is not. This price depends on market factors, including fuel costs. When wind power dropped sharply this past summer, electric suppliers were forced to scramble for natgas as a generation fuel, and, at the margin, coal. In the UK, natural gas powers more than 35% of the electricity mix, and accounts for 15% of Europe's natgas-fired generation. Coal generation in the UK accounts for 1% of Europe's coal fueled electricity generation. China's push to secure additional coal and natgas places it in direct competition for limited supplies with European buyers. High demand, stiff competition, reduced supply, and low inventories all contribute to higher gas prices globally (Chart 3). Easing pandemic related restrictions globally has released pent-up energy demand, which is expected to move higher over the next few months, as the Northern Hemisphere possibly sees another colder-than-normal winter, and economic growth boosts manufacturing demand. Capping selling prices during periods of very high fuel costs squeezes retailers’ profit margins. In the last six weeks, seven UK retailers have gone under, affecting ~ 1.5 million consumers. Such a system favors the incumbents: retailers that can produce their own electricity and hedge their exposure to price volatility have access to lower costs of capital and higher economies of scale. When retailers are no longer able to operate due to bankruptcy, their customers are distributed to the remaining suppliers. The British government would prefer to offer financial support to persuade larger companies to take on stranded consumers than save retailers who are being forced to go out of business.7 However, as wholesale gas prices rise, industry operators – even the more established ones – may not be keen to borrow from the government to take on additional consumers. The EU also finds itself facing stiff competition from Asia for natgas imports. According to Qatar’s energy minister, suppliers prefer Asian buyers since they purchase natgas on fixed long-term contracts to ensure energy security, unlike European buyers which purchase much of their  fuel on the spot market.8 The EU's natgas imports are projected to remain uncertain as Russian exports have fallen below pre-pandemic levels and supply via the NordStream2 pipeline is delayed. With one of the lowest working inventories within the EU (Chart 4), the UK, which imports ~ 65% of its natural gas, is unable to protect itself from supply volatility. These high prices coincided with low wind speeds earlier this year, curtailing wind power, which as of 2020, is the UK’s second highest electricity source. Unfocused Policy Hinders Energy Transition It is impossible to gainsay the merit of the decarbonization of the global economy. Disrupting weather patterns, spewing particulates and chemicals into the atmosphere, dumping plastics into the oceans and waterways, and ravaging forests worldwide do not contribute to any species fitness for survival. However, policymakers appear to be completely ignoring existing constraints any serious decarbonization effort would require. Encouraging the winddown of fossil fuels decades before sufficient renewable-energy and carbon-capture technologies are developed and deployed to replace the lost energy indirectly forces a harsh calculation: Do sovereign governments want to restrict income growth and quality-of-life improvements to the energy available from renewables (including EVs) at any point in time? Who actually makes that choice and enforces the rules and regulations that go with it? We have written about the enormous increase in base metals supply that will be required over the coming decades to develop and deploy renewables, most recently in La Niña And The Energy Transition last month. Base metals – like oil and gas markets – are extremely tight, and are operating in years-long physical deficit conditions, as can be seen in the bellwether copper and Brent markets (Charts 5 and 6). Chart 5Base Metals Markets Are Tight … Chart 6As Is Oil... Any policy contemplating a global buildout of renewable-energy generation and its supporting grids, along with EVs and their supporting infrastructure, should start with the recognition laws, regulations and rules need to encourage responsible, safe and sound incentives for developing the supply side of base metals markets. An argument also could be made for fossil-fuels, which arguably should receive technology subsidies and favorable tax treatment – not unlike those granted to renewables and EVs – to invest in carbon-capture tech development. Rules and regulations favoring long-term contracts so that producers are able to address stranded-asset concerns and secure funding for these projects also should be developed. Investment Implications Absent a more thought-out and focused effort to write laws, develop rules and regulations on at least the level of trading blocs, the evolution to a low-carbon energy future will be halting and volatile. This in an of itself is detrimental to funding such an enormous undertaking. Until something like it comes along, we remain long commodity-index exposure – the S&P GSCI index and the COMT ETF – and long the PICK ETF. At tonight's close we are opening a resting order to buy the XME ETF if if trades to or below $40/share.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish Crude oil markets unexpectedly moved lower mid-week on the back of yet another drop in Cushing, OK, inventory levels reported by the US EIA. Cushing crude-oil stocks stood at 27.3mm barrels vs. 31.2mm barrels for the week ended 22 October 2021. Two years ago, Cushing inventories were at 46mm barrels. Markets had been rallying on falling Cushing storage levels over the past couple of weeks. The EIA's estimate of refined-product demand – known as "Product Supplied" – remains below comparable 2019 levels at this time of year, although not by much (19.8mm b/d vs. 21.6mm b/d). We expect global oil and liquids demand to rebound above 100mm b/d in the current quarter. Stronger demand in 2022 and 2023 prompted us to raise our Brent forecasts to $80/bbl and $81/bbl, respectively (Chart 7). Base Metals: Bullish Copper continues to trade lower as markets price in a higher likelihood of softer demand for the bellwether metal as the global power-supply crunch weighs on manufacturing activity, particularly in China. Copper inventories are still at precariously low levels, with the red metal in global inventories hitting lows not seen since 2008 (Chart 8). This will keep copper's forward curve backwardated over time, as inventories are drawn to fill the gap between supply and demand globally. Low inventory levels are expected to persist as power rationing in China, which was responsible for more than 41% of global refined copper output in 2020, persists. Precious Metals: Bullish Federal Reserve Chairman Jerome Powell's remarks stating supply disruptions are expected to keep US inflation elevated next year are supportive to base metals. Higher inflation will increase demand for the yellow metal, as investors look for a hedge against USD debasement. However, the Fed's asset-purchase taper, which we expect to be announced in November, and the interest rate hikes we expect as a result of it beginning in end-2022, will push bond yields higher and raise the opportunity cost of holding non-yielding gold. That said, we believe the Fed will remain behind the inflation curve and will work to keep real rates weak, which will tend to support gold prices. Chart 7 Chart 8       Footnotes 1     Please see our report entitled La Niña And The Energy Transition, published on September 30, 2021, for discussion. 2     Please see Spain to Cap Windfall Energy Profits as Rally Hits Inflation published by bloomberglaw.com on September 14, 2021. 3    Please see carbonbrief.org's China Briefing for 23 and 30 September and 14 October 2021 for additional discussion, and fn 1 above. 4    Please see ‘All out’ to beat power shortages; 2050 ‘net-zero’ for airlines; ‘Critical decade” for global warming, published by China Brief on 7 October, 2021. 5    Please see Chinese officials move to increase coal output amid shortage published by globaltimes.cn 13 October 2021. 6    Data from the World Bank showed China's GDP per capita reached $10,500 in 2020, below the global average of $10,926. Some experts expect any reform to be gradual. 7     Please see Kwarteng insists UK will avoid power shortages as gas crisis worsens, published by the Financial Times on September 20, 2021. 8    Please see Qatar calls for embrace of gas producers for energy transition, published by the Financial Times on October 24, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

Highlights Bank of Canada: Rising inflation, high capacity utilization, and monetary policy constraints will force the Bank of Canada to taper further and move up the timing of its first rate hike to H1/2022. Stay underweight Canadian government bonds in global government bond portfolios. Also, upgrade Canadian real return bonds to neutral within the underweight allocation to better reflect the mixed signals from our suite of Canadian inflation breakeven indicators. Bank of England: Markets have aggressively shifted UK interest rate expectations, with a rate hike now expected before year-end. We expect that outcome to occur, but the vote will be close. Stay underweight UK Gilts in global bond portfolios. Maintain a curve steepening bias that would win if a hike is delayed to 2022 or, counterintuitively, even if the Bank of England does indeed hike in November or December - longer-term UK yields are still too low relative to the likely peak in Bank Rate. Feature Chart of the WeekAn Inflation Shock For Bond Yields Steadily climbing inflation expectations, fueled by rising energy prices and persistent supply-chain disruptions, remain a thorn in the side of global bond markets. 10-year US TIPS breakevens have climbed to a 15-year high of 2.7%, while breakevens on 10-year German inflation-linked bonds are at a 9-year high of 2%. Rising inflation expectations are keeping upward pressure on nominal bond yields in the major developed economies, as markets start to slowly reprice the pace and timing of future interest rate increases (Chart of the Week). Market expectations on interest rates, however, can adjust much more quickly when policymakers change their tune. We have already seen that recently in smaller countries like Norway and New Zealand. Rate hikes delivered by the Norges Bank and Reserve Bank of New Zealand over the past month - which were telegraphed well in advance by the central banks – were a negative shock that pushed up bond yields in those countries. The next central bank “liftoff” within the developed economies is expected to occur in the UK and Canada, according to pricing in overnight index swap (OIS) curves (Table 1). In this report, we consider the outlook for monetary policy and government bond yields in both countries, which represent two of our highest conviction underweight recommendations. Table 1Markets Are Pulling Forward Rate Hikes Canada: Watch For A Bond Bearish Policy Shift In Canada, given the economic backdrop and policy constraints, we believe the Bank of Canada (BoC) will have to deliver on the hawkish market-implied path for interest rates, which calls for an initial rate hike to occur in Q2/2022 – much sooner than the central bank’s current messaging on liftoff. Chart 2ACanadian Inflation Not Looking So "Transitory" Anymore First on the BoC’s mind is inflation. Canadian CPI inflation came in at 4.4% year-over-year in September, blowing through analyst expectations and hitting an 18-year high (Charts 2A and 2B). The CPI-trim, a measure of core inflation which strips out extreme price movements, hit 3.4% year-over-year, the highest reading since 1991. All eight major components of the CPI rose on a yearly basis. On an annualized monthly basis, the energy-driven Transportation aggregate declined and less volatile components like Shelter (+1.1%) and Clothing (+0.7%) led the pack in terms of their contribution to the overall figure.   The data show that inflationary pressures are clearly broadening out in the Great White North, no longer constrained to “transitory” sectors. The effect of this inflationary pressure is also starting to make its mark on consumer and business sentiment. Chart 3Rising Inflation Expectations Are Hurting Canadian Consumer Sentiment According to the BoC Survey of Consumer Expectations, the 1-year-ahead forecast of inflation reached a series high of 3.7% in Q3/2021 (Chart 3). While longer-term inflation expectations are more subdued, that doesn’t mean that inflation is not a worry for the Canadian consumer. With inflation expected to run much higher than expected wage growth (+2%) over the next year, consumers expect a decline in their real purchasing power. Correspondingly, consumer confidence is taking a hit—the Bloomberg/Nanos consumer sentiment index has fallen 7.3 points since the July peak. Canadian businesses are much more upbeat. The overall summary indicator from the BoC’s Business Outlook Survey for Q3/2021 climbed to the highest level in the 18-year history of the series (Chart 4). Firms reported continued expectations of strong demand, but with capacity constraints starting to weigh on sales - a quarter of firms surveyed reporting that a lack of capacity and skills will have a negative impact on sales over the next twelve months. In response, more companies are planning on increasing capital expenditure and hiring over the next year (Chart 4, middle panel). More than half of firms surveyed by the BoC indicated that investment spending will be higher over the next two years compared to typical pre-pandemic levels. Chart 4Canadian Businesses Are Brushing Up Against Capacity Constraints However, hiring plans will likely face difficulty, given the large share of firms (64%), reporting more intense labor shortages (Chart 4, bottom panel). A net 50% of respondents now expect wage growth to accelerate over the coming year, driven by a need to attract and retain workers amid strong labor demand. With regards to inflation, the BoC Business Outlook Survey measures the share of respondents that expect inflation over the next two years to fall within four different ranges—below 1%, between 1% and 2%, between 2% and 3%, and above 3% (Chart 5). We can “back out” a point estimate of expected inflation for Canadian firms by assigning a specific level to each of these ranges – 0.5, 1.5%, 2.5%, and 3.5%, respectively – and using the shares of respondents to calculate a weighted average expected inflation rate for the next two years.1 Based on this estimate, Canadian business inflation expectations have bounced rapidly since the 2020 trough and are now at all-time highs. The BoC has already begun to respond to the normalization of the economy and rising inflationary pressures indicated by its business survey by tapering the pace of its bond buying program. The Bank is now targeting weekly bond purchases of C$2bn, down from C$5bn at the start of the program and with another reduction expected at this week’s policy meeting (Chart 6). The size of the balance sheet has also fallen in absolute terms, driven by the Bank drawing down its holdings of treasury bills to virtually zero while also ending pandemic emergency liquidity programs. Chart 5Putting A Number To Canadian Business Inflation Expectations Chart 6The BoC Is Moving Towards Normalizing Policy The BoC now owns a massive 36.5% of Canadian government bonds outstanding – a share acquired in a very short time for this pandemic-era stimulus program. Thus, tapering now is not only necessary from a forward guidance perspective, signaling an eventual shift to less accommodative monetary policy and rate hikes, but also to ensure liquidity in the Canadian sovereign bond market. The remaining BoC tapering will be fairly quick, setting up the more important shift to the timing of the first rate increase. The Canadian OIS curve is currently pricing in BoC liftoff in April 2022, ahead of the BoC’s current guidance of a likely rate hike in the second half of the year (Chart 7). Given the developments on the inflation front, we are inclined to side with the market’s assessment of an earlier hike. In the longer run, rates might even be able to rise further than discounted in swap curves. The real policy rate, calculated as the policy rate minus the BoC’s CPI-trim measure, is negative and a significant distance from the New York Fed’s Q2/2020 estimate of the natural real rate of interest (R-star) for Canada of 1.4%. Admittedly, those estimates have not been updated by the New York Fed for over a year, given the uncertainties over trend growth and output gap measurement created by the pandemic shock. The BoC’s own estimates for the neutral nominal policy interest rate - last updated in April 2021 and therefore inclusive of any structural impacts of the pandemic on potential growth - range from 1.75% to 2.75%.2 The OIS forward curve expects the BoC to only lift rates to 2% in the next hiking cycle, barely in the lower end of the BoC’s neutral range of estimates. After subtracting the mid-point of the BoC’s 1-3% inflation target, presumably a level of inflation consistent with a neutral policy rate, the BoC’s implied real policy rate range is -0.25% to +0.75%. The current level of the real policy rate is near the bottom of that range. Thus, real rates, and the real bond yields that track them over time, have room to rise if the BoC begins to hike rates at a faster pace, and to a higher level, than the market expects. We see this as a likely outcome given the extent of the Canadian inflation overshoot and the robust optimism evident in Canadian business sentiment, thus justifying our current negative view on Canadian government bonds. To think about this mix of rising inflation expectations and increased BoC hawkishness down the road, and its implication for the Canadian inflation-linked bond market, we turn to our Canadian comprehensive breakeven indicator (Chart 8). This indicator combines three measures, on an equal-weighted and standardized basis, to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and the midpoint of the BoC’s 1-3% target inflation, and the gap between market-based and survey-based measures of inflation expectations. Going forward, we will be using the Canadian Business Outlook Survey measure of inflation expectations, introduced in Chart 5, for this indicator. Chart 8Upgrade Canadian Inflation-Linked Bonds To Neutral Two out of three measures point towards Canadian breakevens having further upside. Firstly, they are cheap under our fair value model, where the rise in breakevens has lagged the yearly growth in oil prices. Secondly, breakevens are a long distance away from the survey-based business inflation expectations. However, both forces are more than counteracted with Canadian headline inflation nearly two standard deviations from the BoC’s target, which indicates that the central bank must step in to address high realized inflation. Given these diverging signals on the upside potential for breakevens, we see a neutral allocation to Canadian linkers as more appropriate for the time being Bottom Line: Rising inflation, high capacity utilization, and monetary policy constraints will force the Bank of Canada to taper further and move up the timing of its first rate hike to H1/2022. Stay underweight Canadian government bonds in global government bond portfolios. Also, upgrade Canadian real return bonds to neutral within the underweight allocation to better reflect the mixed signals from our suite of Canadian inflation breakeven indicators. Will The BoE Actually Hike By December? Chart 9UK Gilts Have Been Hammered By BoE Hawkishness We downgraded our recommended stance on UK government bonds to underweight on August 11 and, since then, Gilts have severely underperformed their developed market peers (Chart 9).3 We had anticipated that the Bank of England (BoE) would be forced to shift their policy guidance in a less dovish direction because of rising UK inflation expectations. Yet we have been surprised by how quickly the BoE has shifted to an open discussion about the potential for imminent interest rate hikes. The BoE’s new chief economist, Huw Pill, commented in the Financial Times last week that UK inflation will likely hit, or even exceed, 5% by early next year, and that the November 4 Monetary Policy Committee (MPC) was “live” with regards to a potential rate hike.4 This followed BoE Governor Andrew Bailey’s comment that the Bank “will have to act” to contain rising inflation expectations. Mixed signals on economic momentum are not making the BoE’s decisions any easier. The preliminary October Markit PMIs ticked higher for both manufacturing and services, but remain below the peak seen last May. At the same time, UK consumer confidence has fallen since August, thanks in part to rapidly rising inflation that has reduced the perceived real buying power of UK consumers. High Inflation Might Last Longer Chart 10Why The BoE Is More Worried About Inflation The BoE’s last set of economic forecasts, published in August, called for headline inflation to temporarily climb to 4% by year-end, before gradually returning to the central bank’s 2% target level in 2022. Yet the BoE’s newfound nervousness over inflation is well-founded, for a number of reasons (Chart 10): The domestic economic recovery has led to a robust labor market, with job vacancies relative to unemployment fully recovering to pre-COVID levels. The 3-month moving average of wage growth remains elevated at 6.9%, although the BoE believes some of that increase could be due to compositional issues related to the pandemic. The BoE is projecting that the UK output gap is narrowing rapidly and would be fully closed in the second half of 2022. This suggests growing underlying inflation pressures were already in place before the latest boost to inflation from global supply-chain disruptions. UK energy costs are soaring, particularly for natural gas which remains the main source for UK electricity production. UK natural gas inventories are the lowest within Europe, yet the supply response from major providers has been slow to develop – most notably, Russia, which is seeking regulatory approval to begin shipping gas through the Nord Stream 2 pipeline. While natural gas prices have stopped rising, for now, inadequate supplies during an expected cold UK winter could keep the upward pressure on UK inflation from energy. UK house price inflation remains well supported, even with the recent expiration of the stamp duty reductions initiated as a form of pandemic economic stimulus. According to the Royal Institution of Chartered Surveyors (RICS), the ratio of UK home sales to inventories is still quite elevated (bottom panel). Given a still-favorable demand/supply balance, and low borrowing costs, UK house price inflation will likely not cool as much as the BoE would prefer to see. Stay Defensive On UK Rates Exposure The combination of rising UK inflation and increasingly hawkish BoE comments has resulted in a rapid upward repricing of UK interest rate expectations over the past few months (Chart 11). Markets now expect the BoE to raise Bank Rate to 1%, from the current 0.1%, by late 2022. More interesting is what is discounted after that. The OIS curve is pricing in no additional rate increases in 2023 and a rate cut in 2024. In other words, the market now believes that the BoE is about to embark on a policy mistake with rate hikes that will need to be quickly reversed. Chart 11Markets Are Pricing In A BoE Policy Error We think there is a risk of a more aggressive-than-expected BoE tightening cycle. The surge in UK inflation expectations is not trivial nor “transitory”. Looking at survey-based measures of expectations like the YouGov/Citigroup survey, or market-based measures like CPI swaps, inflation is expected to reach at least 4% both in the short-term and over the longer-run (Chart 12). If Bank Rate were to peak at a mere 1%, as indicated in the OIS curve, that would still leave UK real interest rates in deeply negative territory even if there was a pullback in inflation expectations. We expect the votes on whether to hike rates at either the November or December MPC meetings to be close. There will be a new Monetary Policy Report published for the November 4 meeting, which will include a new set of economic and inflation forecasts that will give the BoE a platform to signal, or deliver, a rate hike. In the end, we think that the senior leadership on the MPC has already revealed too much of its hawkish hand, and a rate hike will occur by year-end. Looking beyond liftoff into 2022, we still see markets pricing in too shallow a path for Bank Rate over the next couple of years, leaving us comfortable to maintain our underweight stance on UK Gilts. With regards to positioning along the Gilt yield curve, however, we see the potential for more curve steepening even if after the BoE begins to lift rates. The implied path for UK real interest rates, taken as the gap between the UK OIS forwards and CPI swap forwards, shows that markets expect the BoE to keep policy rates well below expected inflation for well into the next decade (Chart 13). At the same time, the wide current gap between the actual real policy rate (Bank Rate minus headline inflation) and the New York Fed’s most recent estimate of the UK neutral real rate (r-star) suggests that the Gilt curve is far too flat (bottom panel). Chart 12The BoE Cannot Ignore This Perversely, this creates a situation where the UK curve steepeners can be an attractive near-term hedge to an underweight stance on UK Gilts. If the BoE does not deliver on the strongly hinted rate hike in November or December, the Gilt curve can steepen as shorter-maturity Gilt yields fall but longer-dated yields remain boosted by high inflation expectations.However, if the BoE does hike and more tightening is signaled, longer-term yields will likely rise more than shorter-term yields as the market prices in a higher future trajectory for policy rates. Bottom Line: Stay underweight UK Gilts in global bond portfolios, but maintain a curve steepening bias that would win if a hike is delayed to 2022 or, counterintuitively, even if the Bank of England does indeed hike in November or December - longer-term UK yields are still too low relative to the likely peak in Bank Rate. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 For this calculation, we exclude firms that did not provide a response to the BoC Business Outlook Survey. 2 The Bank of Canada’s Staff Analytical Note on neutral rate estimation can be found here: https://www.bankofcanada.ca/2021/04/staff-analytical-note-2021-6/ 3 Please see BCA Research Global Fixed Income Strategy and European Investment Strategy Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. 4https://www.ft.com/content/bce7b1c5-0272-480f-8630-85c477e7d69 Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index