New Zealand

Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022​​​​​ Chart 2Strong Fundamental Support For US Growth​​​​​ Chart 3China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022​​​​​​ Chart 5Lower Inflation Will Help Boost Consumer Confidence​​​​​​ The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way​​​​​​ Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns​​​​​​ Chart 11Stay Underweight US Interest Rate Exposure​​​​​​ Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure​​​​​​ Chart 14Expect More US-Europe Spread Widening In 2022​​​​​​ Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure​​​​​​ Chart 18Our Recommended DM Government Bond Country Allocations​​​​​​ In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability​​​​​​ In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom​​​​​​ Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom​​​​​​ On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling​​​​​​ Chart 27Euro Area Corporate Spread Valuations Are Also Stretched​​​​​​ Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022​​​​​​ When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 31Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   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 Omicron vs. The Fed: The new COVID variant has thrown a growth scare into markets, but the bigger concern is the Fed belated playing catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year with the Fed threatening to taper faster, and potentially hike sooner, than markets expect. New Zealand: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade. A Year-End Bout Of Uncertainty Chart of the WeekMarkets Have Been Worried About The Fed Since September Over the past two weeks, we have published Special Reports and thus have not had an opportunity to comment on market moves and news. Needless to say, it has been an eventful period! The emergence of the new Omicron variant, and the hawkish shift in the Fed’s guidance on future policy moves, have injected fresh uncertainty and volatility into global financial markets. Since the existence of Omicron was revealed to the world on Nov 26, 30-year US Treasury yields have fallen by as much as -23bps and the S&P 500 index has been down by as much as -4.4%. Yet the evolving Fed stance, with Fed Chair Jerome Powell hinting last week that the end of tapering and start of rate hikes could begin sooner than expected next year, is having a more lasting influence on risk asset performance. Dating back to the September 23 FOMC meeting, when the Fed first signaled an imminent tapering of bond purchases and pulled forward the timing of liftoff into 2022, the 2-year US Treasury yield has gone up from 0.22% to 0.63%. Importantly, there has been little pullback on the pricing at the front-end of the US Treasury curve due to the Omicron shock. That pre-September-FOMC low in the 2-year Treasury yield also marked the peak in riskier fixed income market performance for 2021, with the Bloomberg Global High-Yield and Emerging Market USD-Denominated Sovereign total return indices down -2.0% and -1.8%, respectively, since Sept 23 (Chart of the Week). Other risk assets also appear to be responding more to news about the Fed than Omicron. Equity markets stopped climbing since the Fed announced the first taper of bond purchases at the November 3 FOMC meeting – three weeks before the world knew of Omicron - which also coincided with troughs in the VIX index and corporate credit spreads, not only in the US but in Europe and emerging markets as well (Chart 2). Of course, it is difficult to disentangle which is having a greater impact, the variant or the Fed, when details on both are evolving at the same time. Omicron Investors are understandably right to be nervous about a new COVID variant that can reportedly evade existing vaccines and even infect those who have had COVID previously. The whole idea of “putting COVID in the rearview mirror’ that has helped fuel booming equity and credit markets was predicated on vaccines being both effective and widely available. However, when investors see COVID case numbers start to pick up in the US and Europe, with vaccination rates twice that of South Africa where Omicron was first detected (Chart 3), this raises concern about a return to pre-vaccine economic restrictions and uncertainty. Chart 2A Typical Risk-Off Response To The Emergence Of Omicron Chart 3Omicron Putting A Dent In Vaccine Optimism The “Omicron effect” on fixed income markets has been most evident in the repricing of interest rate expectations. Since the presence of Omicron was revealed on November 26, there has been a reduction in the cumulative amount of tightening discounted to the end of 2024 in the overnight index swap (OIS) curves of the major developed economies (Table 1). The moves were most evident in the US (32bps of hikes priced out), Canada (37bps) and Australia (37bps). Table 1Pricing Out Some Rate Hikes Because Of Omicron Much is still unknown about the dangers of the Omicron variant. The admittedly very early data out of South Africa, however, indicates that there has not been a major surge in hospitalizations related to Omicron cases. A new COVID strain that proves to be more virulent, but that does not strain health care systems, should help allay investor concerns over a major economic hit from Omicron. This presents an opportunity to put on positions that will profit from a rebound in global bond yields led by higher US Treasury yields. The Fed The Omicron threat to date has not been enough to move the Fed off its plans to rein in the monetary accommodation put in place in 2020 to fight the pandemic. If Omicron is to have any impact on the US economy, it will do so at a time when the economy continues to grow well above trend. The November reading on the ISM Manufacturing survey showed strength in the overall index, with a stabilization of the New Orders/Inventory ratio that leads overall growth, and only a very modest reduction in the still-elevated Prices Paid and Supplier Deliveries indices (Chart 4). The Atlanta Fed’s GDPNow model is suggesting that US real GDP growth could come in at a whopping 9.7% in Q4. As further evidence that the US economy is growing at a pace well above trend, just look to labor market data. New US jobless claims are at the lowest level since 1969. The November US Payrolls report showed that the headline unemployment rate fell 0.4 percentage points on the month to 4.2% - within the range of full employment estimates of the FOMC - even with actual job growth falling short of consensus forecasts (Chart 5, top panel). Chart 4Nothing Bond-Bullish In US Manufacturing The improving health of the labor market is being felt more broadly, with big declines seen in unemployment rates for minorities and less-educated Americans (second panel). That point is of critical importance to the Powell Fed that has emphasized reducing racial and educational gaps in US unemployment as part of reaching its goal of “maximum employment”. Chart 5Nothing Bond-Bullish In US Labor Markets Tightening labor markets are also evident in accelerating wage momentum. Excluding the 2020 spike driven by labor force compositional effects related to COVID lockdowns, the year-over-year growth in average hourly earnings reached a 39-year high of 5.9% in November (third panel). The Fed now seems willing to finally confront high US inflation and strong economic growth with some tightening of monetary policy. Chart 6A Near-Term Break From Supply-Fueled Inflation? Powell caused some investor agita last week when he indicated that the taper could end before mid-2022, the previous FOMC guidance, which would open the door for rate hikes. We see Powell’s comments as less about signaling an intensifying hawkishness and more about giving the Fed optionality on when to start lifting rates next year in the event the US economy continues to overheat. The Fed strongly believes that tapering must end before rate hikes can begin, so a more accelerated taper allows for an earlier liftoff date, if necessary. To that end, the supply fueled surge in inflation this year, which has lingered for far longer than the Fed anticipated, may be showing some signs of easing. Several indices of global shipping container prices are off the highs, while there is a reduced backlog of container ships off key US ports like Los Angeles. Overall commodity price momentum has peaked, in line with slower, but still strong, global industrial activity (Chart 6). An easing of supply-driven price pressures would be welcome by the FOMC. It would allow time to evaluate both the Omicron threat and evolving US labor market dynamics, instead of being forced to fight a rearguard action against accelerating inflation. However, a shift away from goods/commodity inflation to more domestically driven inflation would not lessen the need for the Fed to begin lifting rates next year – in fact, it could even strengthen the case for the Fed to hike rates faster, and by more, than currently discounted in markets. Importantly, forward looking indicators are still pointing to solid US growth next year (Chart 7): The Conference Board’s leading economic indicator continues to grow at a pace signaling above-trend growth US financial conditions remain highly accommodative even with the recent market turbulence The New York Fed’s yield curve based recession probability model is indicating that the spread between the 10-year US Treasury yield and the 3-month US Treasury bill rate, currently 138bps, is consistent with only a 9% chance of a US recession over the next year (bottom panel) We continue to recommend a below-benchmark duration stance within US fixed income portfolios, with a yield target on the 10-year benchmark US Treasury yield of 2-2.25% to be reached by the end of 2022. We also continue to recommend positioning in Treasury curve steepening trades. This is admittedly a counter-intuitive suggestion given that the Fed is moving towards a rate hiking cycle, but we see too much flattening priced into the Treasury forward curve over the next year (Chart 8). Chart 7A Positive Message From US Leading Growth Indicators   Chart 8Our Favorite Bearish US Rates Trades For global bond investors, our favorite trade that will benefit from higher US bond yields next year is to position for a wider 10-year US Treasury-German Bund spread (bottom panel). We expect the ECB to avoid any rate increases until at least mid-2023, well after the Fed has begun to tighten. Forward curves in the US and Germany currently discount a relatively stable Treasury-Bund spread in 2022, thus there is no negative carry incurred by positioning for a wider spread. Bottom Line: Omicron has thrown a growth scare into markets, but the bigger concern is that the Fed is belated starting to play catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year. New Zealand: How Much Further Can The Bond Selloff Go? Chart 9NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness Over the past year, New Zealand bonds have sold off much faster than developed market peers (Chart 9). Markets correctly recognized the Reserve Bank Of New Zealand (RBNZ) as a central bank that would move more aggressively to tamp down on inflation and manage the financial stability and political risks arising from soaring house prices. The RBNZ has already delivered back-to-back hikes at its October and November meetings, after its plans to hike at the August meeting were thrown off by the Delta variant. Markets are now pricing in a further 172bps of tightening over the coming year, having largely faded any downside growth risk from the Omicron variant. Expectations of continued tightening have been buoyed by the response of New Zealand policymakers, who are largely looking past the Omicron variant. Restrictions have already begun to ease, with the country having entered its “Traffic Light” COVID-19 Protection Framework. The new variant is also unlikely to affect the RBNZ’s tightening path, with Chief Economist Yuong Ha stating that, given the lifting of restrictions, the RBNZ would have raised rates even if Omicron had become known before its November 24 meeting. Given the bond-bearish backdrop, New Zealand government bonds have underperformed substantially this year. On a relative hedged and duration-matched basis, New Zealand sovereigns have underperformed by -6.6% year-to-date with -4.0 percentage points of that underperformance coming after July 21 when we formally moved to an underweight stance on New Zealand debt within global government bond portfolios (Chart 9, bottom panel). However, with monetary policy entering a new phase, led by an increasingly hawkish Fed, we believe it is appropriate to re-assess our New Zealand call and judge whether this underperformance can continue into 2022. The growth picture is broadly supportive of the RBNZ’s stated policy path. Real GDP as of Q2 was above its pre-Covid trend and 2.6% over the RBNZ’s own estimate of potential GDP, supported by an easing of travel restrictions and strong consumer spending (Chart 10). On a forward-looking basis, however, the risk is now that the economy is running too hot, jeopardizing future growth. Consumer and business sentiment has been worsening as inflation expectations soar, with consumers fearing a hit to purchasing power and businesses concerned about the impact of rising input costs on profit margins. Household and business inflation fears also have a strong basis in the realized inflation data, which has soared to a 10-year high of 4.9% (Chart 11). More troublingly, underlying inflation measures such as the trimmed mean and core (excluding food and energy) are now at series highs of 4.8% and 4%, respectively, indicating that higher inflation could prove to be sticky. The RBNZ now sees headline inflation peaking at 5.7% in Q1/2022 before settling to 2% by the end of its forecast horizon in 2024. Chart 10The NZ Economy Is Overheating Chart 11The RBNZ Will Welcome A Slight Growth Slowdown​​​​​​ The RBNZ clearly attributes higher inflation to an economy running above longer-term capacity rather than short-term supply factors. The Bank’s measure of the output gap is now at the most positive level since 2007, and survey measures of capacity utilization remain elevated. In contrast to the Fed, which is still nominally focused on maximum employment, the RBNZ actually believes that employment is above its maximum sustainable level, and sees a rising unemployment rate as necessary to ease capacity constraints. Given that the RBNZ is clearly comfortable with, and will likely welcome, a gradual rise in unemployment, it will take much more than a slight growth shock to deter the RBNZ from its tightening path. Chart 12Higher Rates Necessary To Stabilize The NZ Housing Market The newest, and most politically potent, part of the RBNZ’s remit—house prices – has further supported a bias to tighten monetary policy. However, while still dramatically elevated, house price growth looks to have peaked (Chart 12). The central bank’s hawkish shift earlier in the year has made a clear impact, with house price growth peaking shortly after mortgage rates started picking up in April of this year. Overall household mortgage credit has also begun to decelerate, indicating that the passthrough from monetary policy to credit demand and housing via the mortgage rate is working as intended. However, there is likely further to go. The last time house price growth was somewhat stable around 6.6% in the 2012-2019 period, benchmark 5-year mortgage rates averaged 6.1%. Assuming the spread between the 5-year mortgage and policy rates remains around 4%, history indicates that we would need to see the policy rate rise to at least 2% to cool down the housing market. That 2% level is also the RBNZ’s mean estimate of a “neutral” cash rate—a level at which policy would be neither accommodative nor restrictive (Chart 13). Current market pricing is quite consistent with the RBNZ’s own projected path of rates as of the November meeting—both of which are set to exceed the neutral rate by the end of 2022. Historical experience from the pre-crisis period indicates that this is not uncommon, and that a bout of restrictive policy might be needed to cool down an overheating economy. Indeed, if the RBNZ’s historical reaction to inflation is any guide, it seems likely that policymakers will want to push rates above inflation. The top two panels of Chart 14 show how anomalous deeply negative real policy rates are in New Zealand. Even if we make the case that developed market real rates are in a structural downtrend, as realized real rates have peaked out at successively lower levels with each tightening cycle, the current gap between the cash rate and core inflation seems obviously unsustainable and requires a tightening of policy. Chart 14NZ Real Rates Are Too Low​​​​​​ Chart 15Go Long The 10-Year NZ Government Bond/US Treasury Spread​​​​​​ Another way to think about where policy rates are in relation to a “neutral” level is to look at the yield curve (Chart 14, bottom panel). Typically, the yield curve inverts when markets judge that monetary policy is too restrictive and that short rates are too high relative to a long-run average. However, the New Zealand government bond curve has historically remained inverted for extended periods of time, troughing at around -100bps. This again indicates that the RBNZ is comfortable raising rates above neutral and keeping policy restrictive when needed. Putting together the four factors we have looked at—growth, inflation, asset prices, and the RBNZ’s reaction function—it looks likely that the RBNZ will continue along the tightening path it has set out and chances of any dovish surprise seem slim. At the same time, markets are priced to perfection in terms of the pace and amount of tightening discounted. For New Zealand sovereigns to continue underperforming, however, we will need to see markets price in, on the margin, even more tightening from the RBNZ relative to its peers. With the Fed and other central banks having become more focused on responding to US inflation dynamics, bond-bearish upside shocks to market rate expectations will increasingly come from outside New Zealand. At the same time, in the event of a negative global growth shock, perhaps relating to COVID-19, there is relatively more room for hikes to be priced out in New Zealand. Given our view that bond and rates markets have appropriately priced in the extent of the RBNZ’s likely tightening cycle, we are upgrading New Zealand sovereign debt to neutral, taking profits on our current underweight stance. While we do not include New Zealand debt in our model bond portfolio, we are expressing our view via a new tactical cross-country spread trade: long New Zealand 10-Year government bonds vs. US 10-Year Treasuries (Chart 15). Forwards are currently pricing in a flat spread between the two countries, meaning that any future spread tightening will put our trade in the black. Given that there is more space for markets to price in increased hawkishness from the Fed, we believe that spread compression is likely. We are implementing this trade by going long New Zealand cash bonds and shorting 10-year US Treasury futures. Details can be found on Page 18. Bottom Line: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com 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 Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

Highlights Cross-Atlantic Policy Divergence: A steadily tightening US labor market means that the Fed remains on track to formally announce tapering next month. Meanwhile, the ECB is signaling that they are in no hurry to do the same given scant evidence that surging energy prices are seeping into broader European inflation. This leads us to make the following changes to our tactical trade portfolio – taking profits on the 10-year French inflation breakeven spread widener; while switching out of the long December 2023 Euribor futures trade into a 10-year US Treasury-German Bund spread widening trade. Surging Antipodean Inflation: Australia and New Zealand are both seeing higher realized inflation, but market-based inflation expectations are falling in the former and rising in the latter. This leads us to make the following changes to our tactical trades: taking profits on the Australia-US 10-year spread widener; entering a new 10-year Australia inflation breakeven spread widener; and closing the underwater 2-year/5-year New Zealand curve flattening trade. Feature This week, we present a review of the shorter-term recommendations currently in our list of Tactical Overlay trades. These are positions that are intended to complement our strategic Model Bond Portfolio, with shorter holding periods – our goal is no longer than six months - and sometimes in smaller markets that are outside our usual core bond market coverage. As can be seen in the table on page 17, we typically organize these ideas by the type of trade (i.e. yield curve flatteners or cross-country spread wideners). Yet for the purposes of this review, we see two interesting themes that better organize the current trades and help guide our decision to keep them or enter new ones. Playing A Hawkish Fed Versus A Dovish ECB Federal Reserve officials have spent the past few months signaling that a tapering of bond purchases was increasingly likely to begin before year-end given the steadily improving US labor market. The September payrolls report released last Friday, even with the headline employment growth number below expectations for the second consecutive month, does not change that trajectory. Chart of the WeekCyclical UST Curve Flattening Pressures The US unemployment rate fell to 4.8% in September, continuing the uninterrupted decline from the April 2020 peak of 14.8% (Chart of the Week). The pace of that decline has accelerated in recent months, although the Delta variant surge in the US has created distortions in both the numerator and denominator of the unemployment rate. Now that the US Delta wave has crested and case numbers are falling, growth in both employment and the labor force should start to accelerate in the next few payrolls reports. This will result in a faster pace of US job growth, albeit with a slower decline in the unemployment rate, likely starting as soon as the October jobs report. The US Treasury curve has already been reshaping in preparation for a less accommodative Fed, with flattening seen beyond the 5-year point (middle panel). We have positioned for a more hawkish Fed, and a flatter Treasury curve, in our Tactical Overlay via a butterfly trade. Specifically, we are short a 5-year Treasury bullet versus a long position in a 2-year/10-year barbell, all using on-the-run cash Treasuries. That trade was initiated on June 22, 2021 and has so far generated a small profit of +0.27%. Our butterfly spread valuation model for that 2/5/10 Treasury butterfly shows that the 5-year bullet has not yet reached an undervalued extreme versus the 2/10 barbell (Chart 2). We are keeping this trade in our Tactical Overlay, as the current 2/5/10 butterfly spread of 23bps is still 6bps below the +1 standard deviation level implied by our model. Chart 2Stay In Our 2/5/10 UST Butterfly Trade Moving across the Atlantic, our trades have been the mirror image of our Fed recommendations, positioning for a continued dovish, reflationary ECB policy bias. We have expressed that via two trades: long 10-year French inflation breakevens and long December 2021 Euribor futures. We continue to see no reason for the ECB to follow the Fed’s path towards imminent tapering and signaling future rate hikes. Growth momentum has cooled in the euro area, with both the Markit composite PMI and the ZEW growth expectations index having peaked in June (Chart 3). At the same time, inflation expectations have picked up. The 5-year/5-year forward CPI swap rate has risen to 1.8%, still below the ECB’s 2% inflation target but well above the 2020 low of 0.7% (middle panel). Markets are focusing on the higher inflation and not the slowing growth, with the EUR overnight index swap (OIS) curve now pricing in 12bps of rate hikes in 2022 (bottom panel). We see that as a highly improbable outcome. There is little evidence that the latest pickup in euro area realized inflation is broadening out beyond surging energy price inflation and supply-constrained goods inflation (Chart 4). Euro area headline CPI inflation hit a 13-year high of 3.0% in August, with the “flash” estimate for September showing a further acceleration to 3.4%. Yet core inflation only reached 1.6% in August - a month when the trimmed mean euro area CPI inflation rate calculated by our colleagues at BCA Research European Investment Strategy was a scant 0.2%. Chart 3ECB Will Not React To This Cyclical Bout Of Inflation Chart 4Euro Area Inflation Upturn Is Not Broad-Based While the September flash estimate of core inflation did perk up to 1.9%, the trimmed mean measure shows that the rise in euro area inflation to date has not been broad based. Like the Fed, ECB officials have indicated that they view this pick-up in inflation as “transitory”, fueled by soaring energy costs and base effect comparisons to low inflation in 2020. Signs that higher inflation was feeding into “second round” effects like rising wage growth might change the ECB’s thinking. From that perspective, the recent increase in labor strike activity in Germany is a potentially worrisome sign, but the starting point is one of low wage growth – the latest available data on euro area wage costs showed a -0.1% decline during Q2/2021. Chart 5Close Our Long Dec/23 Euribor Futures Trade We have been trying to fade ECB rate hike expectations via our long December 2023 Euribor futures trade. That position, initiated on May 18, 2021 has generated a small loss of -0.11% (Chart 5). We still expect the ECB to keep rates on hold in 2022, and most likely 2023, so there is the potential for that trade to recover that underperformance. However, that position has now reached the six-month holding period “re-evaluation” limit that we have imposed on our Tactical Overlay trades. Thus, we are closing that trade this week. In its place, we are initiating a new tactical trade to position for not only persistent ECB dovishness but a more hawkish Fed – a US Treasury-German Bund spread widening trade using 10-year bond futures. The specific details of the trade (futures contracts, duration-neutral weightings on each leg of the trade) can be found in the table on page 17. This new UST-Bund trade is attractive for three reasons: Our valuation model for the Treasury-Bund spread - which uses relative policy interest rates, relative unemployment, relative inflation and the relative size of the Fed and ECB balance sheets as inputs – shows that the spread is currently undervalued by more than one full standard deviation, and fair value is rising (Chart 6). The technical backdrop for the Treasury-Bund spread has turned more favorable for wideners, with the spread having fallen back to its 200-day moving average and the 26-week change in the spread now down to levels that preceded past turning points in the spread (Chart 7). Chart 6Enter A New 10yr UST-Bund Spread Widening Trade Relative data surprises are pointing to relatively higher US yields and a wider Treasury-Bund spread, with the Citigroup Data Surprise Index for the US now rising and the euro area equivalent measure falling (Chart 8). Chart 7UST-Bund Technical Backdrop Positioned For Widening Chart 8Relative Data Surprises Favor Wider UST-Bund Spread While we are entering a new trade to play for a relatively dovish ECB, we are also choosing to take the substantial profit in our tactical trade in French inflation breakevens. Specifically, we are closing our 10-year French inflation breakeven spread widening position – long a 10-year cash OATi bond, short 10-year French bond futures – with a solid gain of +6.3%. Chart 9Take Profits On Our Long 10yr French Breakevens Trade We have held this trade for nine months, a bit longer than our typical tactical trade holding period. We did so because French 10-year breakevens continued to look cheap on our valuation model. Now, the breakeven spread has risen to fair value (Chart 9), prompting us to take our gains and move on. Diverging Inflation Expectations In Australia & New Zealand Playing Fed/ECB policy divergence was the first main theme of this Tactical Overlay trade review. The second broad theme is also a divergence, between inflation expectations in New Zealand (which are rising) and Australia (which are falling). This trend leads us to close two existing trades and enter a new position. Chart 10An Inflation-Induced Bear Steepening Of Yield Curves In New Zealand, we are closing out our 2-year/5-year government bond yield curve flattener trade, initiated on July 21, for a loss of -0.32%. While we were correct in our expectation of ramped-up hawkishness from the Reserve Bank of New Zealand (RBNZ), we were caught offside by persistently sticky inflation which has become a headache for global central bankers. With supply squeezes and high commodity prices not going away anytime soon, sovereign curves have bear-steepened across developed markets, driven by rising long-dated inflation expectations (Chart 10). This global steepening pressure also hit the New Zealand curve, to the detriment of our domestic RBNZ-focused flattener trade. There was also a technical component to the steepening in the New Zealand 2-year/5-year curve (Chart 11). With the 2-year/5-year curve having dipped far below its 200-day moving average and the 26-week rate of change at stretched levels, the flattener was already “overbought” when we entered the trade. Despite a steady stream of hawkish messaging from the RBNZ, leading to an actual rate hike last week, technicals did win out in the short term as the 2-year/5-year spread steepened back up towards the 200-day moving average. Chart 11The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors On the positive side, our decision to implement this trade as a duration-neutral “butterfly”, selling a 2-year bond, and using the proceeds to buy a weighted combination of a 5-year bond and a 3-month treasury bill with an equivalent duration to the 2-year bond, worked as intended with the butterfly underperforming as the underlying 2-year/5-year curve steepened. Looking forward, technicals are still some distance from turning favorable and will remain a headwind for the flattener trade. Implied forward rates are also not in our favor, with markets already pricing in some flattening, making this a negative carry trade. Over a cyclical horizon – i.e. beyond our normal six-month holding period for tactical trades - we still expect the shorter-end of the New Zealand to flatten. The experience of past hiking cycles shows that the 2-year/5-year curve tends to continue flattening during policy tightening, usually leveling out at 0bps before re-steepening (Chart 12). Considering that we have already been in this trade for three months, however, we do not believe our initial curve flattening bias will play out successfully over the remainder of our six-month tactical horizon. While we are closing out our flattener trade, we will investigate ways to better express our bearish cyclical view on New Zealand sovereign debt in a future report. Turning to Australia, we are closing out our long Australia/short US spread trade, implemented using 10-year bond futures, taking a healthy profit of +2.1%. We have held this trade for longer than our typical six-month holding period (the trade was initiated on January 26, 2021) because our Australia-US 10-year spread valuation model has continued to flash that the spread was too wide to its fair value (Chart 13). The model has been signaling that the spread should be negative, yet Australian yields have been unable to trade below US yields for any sustained length of time in 2021. Furthermore, the model-implied fair value is now starting to bottom out, suggesting a diminishing tailwind from the relative fundamental drivers of the spread embedded in our model. Chart 12The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon Chart 13Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Chart 14Inputs Into Our Australia-US Spread Model The inputs into our 10-year spread model are relative policy interest rates, core inflation, unemployment and the size of central bank balance sheets (to incorporate QE effects) for Australia and the US. Of these variables, the biggest drivers of the decline in the fair value since the start of the COVID pandemic in 2020 have been relative inflation and the relative size of the Fed and Reserve Bank of Australia (RBA) balance sheets as a percentage of GDP (Chart 14). Both of those trends are related. Persistently underwhelming Australian inflation – despite accelerating inflation in the US and other developed economies over the past year – has forced the RBA into a pace of asset purchases relative to GDP that exceeded even what the Fed has done since the pandemic started (bottom panel). However, Australian inflation finally began catching up to the rising trends seen elsewhere in the spring of this year, with headline CPI inflation jumping from 1.1% to 3.8% on a year-over-year basis during Q2. Australian bond yields have traded more in line with US yields since that mid-year pop in inflation, preventing the Australia-US spread from narrowing below zero and converging to our model-implied fair value. This is despite a severe COVID wave that forced much of Australia into the kind of severe lockdowns that the nation avoided during the worst of the global pandemic in 2020. With Australian inflation now moving higher and converging towards US levels, economic restrictions starting to be lifted thanks to a rapid vaccination campaign, and the RBA having already done some tapering of its asset purchases before the Fed, the fundamental rationale for holding our Australia-US trade is no longer valid, leading us to take profits. The convergence to fair value in our spread model is now more likely to come from fair value rising rather than the actual spread falling. The pickup in Australian inflation also leads us to enter a new trade Down Under. This week, we are initiating a new trade, going long 10-year Australia inflation breakevens, implemented by going long a 10-year cash inflation-linked bond and selling 10-year bond futures. The details of the new trade are shown in the table on page 17. Despite the uptick in realized Australian inflation, breakevens have actually been declining over the past several months, falling from a peak of 247bps on May 13 to the current 208bps. That move has accelerated more recently due to a rise in Australian real yields that has coincided with markets pricing in more future RBA rate hikes. Our 24-month Australia discounter, which measures the total amount of tightening over the next two years discounted in the AUD OIS curve, now shows that 104bps of rate hikes are expected by the fourth quarter of 2023 (Chart 15, bottom panel). This has occurred despite Australian wage growth remaining well below the 3-4% range that the RBA believes is consistent with underlying Australian inflation returning sustainably to the RBA’s 2-3% target band (top two panels). Chart 15Market Expectations For The RBA Are Too Hawkish Chart 16Go Long 10-Yr Australian Inflation Breakevens Australian real bond yields have begun to move higher in response to this more hawkish market policy expectation that seems overdone, helping push breakeven inflation even lower more recently. This has helped unwind some of the overvaluation of 10-year inflation breakevens from earlier in 2021. Our fundamental model for the 10-year Australian breakeven showed that the spread was over two standard deviations above fair value to start 2020 (Chart 16). The decline in the spread since that has largely eliminated that overvaluation, providing a better entry point for a new breakeven spread widening trade. With survey-based measures of inflation expectations rising even as breakevens fall back to fair value (bottom panel), we see a strong case for adding a new Australian inflation trade to our Tactical Overlay.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@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 US Treasuries: Peaking global growth expectations and the growing spread of the Delta variant are challenging the “reflation and reopening” narrative that drove bond yields higher in Q1 of this year. Underlying growth, however, is likely to stay above-trend in most developed economies over the next 1-2 years, leading to tighter labor markets, increased domestic inflation pressures, and less dovish central banks - especially in the US. We continue to recommend an overall below-benchmark duration position in global bond portfolios, with an underweight stance on US Treasuries, on a strategic (6-24 month) basis. New Zealand: House prices, inflation, and the overall economic backdrop justify the RBNZ’s recent hawkish shift. However, government bond and interest rate swap markets have not fully priced in how quickly, and how far, the RBNZ can hike during the upcoming tightening cycle. As a play on further RBNZ hawkishness, we are entering a new recommended tactical trade: a 2-year/5-year yield curve flattener in New Zealand government bonds. Feature Dear Client, We will be taking a summer break over the next two weeks to recharge our batteries for what is shaping up to be an eventful time for global financial markets over the remaining months of 2021. Next week, you will be receiving a report written by our Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. We will return to our normal publishing schedule on Tuesday, August 10. Best Regards, -Rob Robis The World’s Most Important Asset Price We spent much of last week talking with clients (still virtually, sadly) in the US and Europe. In all the meetings, the first - and in some cases, only - topic of discussion was how to interpret the fall in longer-maturity US Treasury yields over the past few months. With the benchmark 10-year US yield hitting the lowest level since February earlier this week, breaching the 1.20% level, the message from the Treasury market will remain very much top of mind for investors - and for us, too - especially with bond yields in other countries also following US yields lower. Chart 1 The falling trend in US yields can be attributed to a number of factors, some of which are more legitimately bond bullish than others. Investors are increasingly convinced that global growth momentum has peaked, including in the US. While the global manufacturing PMI is still at the highest levels seen over the past decade, our global leading economic indicator (LEI) is rolling over from a very high level (Chart 1). The plunge in the global LEI diffusion index suggests that the dip in the global LEI is broad based across all the countries in the LEI (Chart 1, middle panel). This is not a sign that growth is slowing now, though, given the long lags between the swings in the diffusion index and the LEI, and between the LEI and actual economic growth. Importantly, US leading indicators like the Conference Board LEI are not rolling over and continue to signal that US growth will remain solid over the next 6-12 months. US consumer and business confidence are still upbeat, labor demand remains robust and corporate profits are growing smartly in the Q2 earnings data available so far. US growth will inevitably decelerate from the overheated pace of Q2 that was boosted by the rapid reopening from pandemic restrictions. Yet the US economy will continue to expand at an above-trend pace into 2022 – especially with an extra boost from fiscal stimulus - that is likely to tighten US labor markets and keep the Fed on the path towards bond-bearish tapering and, eventually, rate hikes by the end of next year. The renewed pickup in COVID-19 cases in the US could damage that positive narrative on US economic confidence. The uptick in the Delta variant raises the risk of a new wave of economic restrictions, even with nearly half the US population now fully vaccinated (Chart 2). To date, the latest surge in cases has not resulted in significant surges in hospitalizations and deaths in the US and, more importantly, the UK where the Delta variant has spread far more rapidly. If the hospitalization figures were to accelerate, investors would likely interpret that as a sign that a) vaccine efficacy against the variants is not as robust as for the original strain of the virus; and/or b) the next wave of COVID has arrived before the US could achieve herd immunity. At the moment, there is little political will to impose a new wave of growth-crushing - and bond bullish – economic restrictions in the US, especially with case numbers still low compared to previous waves of the virus amid ample vaccine supplies. Even in New York City, the epicenter of the first wave of the pandemic in the US in 2020 and one of the last major cities to reopen, the mayor said this week that a return to a mask-wearing mandate was not on the table (the city’s preference is to push for more of the unvaccinated to get their jabs to fight the variant). Lower US bond yields also reflect a growing belief that the rise in US inflation will prove to be transitory, as the Fed expects. Headline CPI inflation in the US reached 5.4% in June on a year-over-year basis, but was an even faster 8.8% on a 6-month annualized basis (Chart 3). Soaring US inflation rates have been dismissed by many as simply a function of temporary supply squeezes and favorable base effect comparisons versus the pandemic-fueled price collapses in Q2/2020. Yet the longer the inflation acceleration continues, the more the narrative will shift from “transitory” to “persistent” inflation, especially if inflation also keeps moving higher outside the US as well. Chart 2Delta Variant: Highly Contagious, But Not Lethal Investors, and the Fed, will not be able to assess if the US inflation surge is truly a short-lived phenomenon until at least 2-3 more inflation data prints are available. Chart 3Is This 'Transitory' Inflation? This means the “transitory or not” question will linger until the September inflation data is available in mid-October. What will be critical is the mix of US inflation. If more domestically generated inflation rates – rents, wages, etc. – accelerate, that would result in overall US inflation being driven more by stickier core inflation rather than surging non-core inflation fueled by rising commodity prices. That implies a higher floor for headline inflation, and a more bond-bearish challenge to the “transitory” narrative as the Fed would be even more emboldened to begin dialing back monetary accommodation sooner, or faster, than the current forward guidance. Beyond the fundamentals, the Treasury market continues to work off the technically oversold condition that developed in the first quarter of 2021, leading to short-covering that is pushing yields lower. The 10-year Treasury yield became extremely stretched versus the underlying trend in yields, defined by the 200-day moving average, with survey and positioning data showing large short positioning and below-benchmark duration exposures among bond investors (Chart 4). As the factors underpinning the US “reflation trade” in Q1 have come into question in Q2, speculators have covered much of the huge short positioning that built up in the 30-year Treasury, according to the CFTC (bottom panel). However, the JP Morgan survey of client duration positioning still shows a large number of clients are running duration exposures below that of their benchmark, suggesting that real money investors have not yet capitulated even as Treasury yields have moved lower. In a report published back in June, we looked at previous episodes where the 10-year US yield became stretched versus its underlying trend over the past two decades.1 We concluded that it could take until at least August before the 10-year Treasury worked off its oversold condition, defined as the yield returning to its 200-day moving average using daily closing prices, based on the average length of those past episodes. The US 10-year yield is now below its 200-day moving average of 1.28%, but it is still too soon to declare this oversold episode over given the still large underweight duration position visible in the JP Morgan survey. Some reduction in that tilt will be necessary before longer-term Treasury yields can begin to climb again. Summing it all up, the uncertainty over global growth momentum, the Delta variant, and the underlying pace of US inflation will likely keep Treasury yields under some downward pressure, especially with short positioning not yet completely cleaned out. We suspect that it will take a reacceleration of US employment growth before US Treasury yields can begin to move higher once again. That would not begin to be visible until at least the September payrolls data – a month when extended US federal unemployment benefits expire and children return to in-person learning at school, freeing up some of the supply bottlenecks in US labor markets. Our base case scenario is that the current pickup in COVID-19 cases will not derail the US economic recovery from the pandemic. A tightening US labor market and stickier-than-expected US realized inflation will lead the Fed to announce in December a tapering of its asset purchases starting in January 2022. A shift to a less dovish Fed, and eventual rate hikes beginning at the end of 2022 after tapering is complete, will be the driver of the next upleg in US Treasury yields. Looking outside the US, our Central Bank Monitors continue to highlight that developed economy central banks are all under cyclical pressure to begin dialing back the massive monetary accommodation put in place to fight the temporary economic shock of COVID-19 (Chart 5). Yet pricing in Overnight Index Swap (OIS) markets highlight the diverging messages from policymakers. Chart 4USTs Still Working Off Oversold Condition Chart 5A Clear Message From Our Central Bank Monitors A rate hike is now expected before year-end in New Zealand and by July 2022 in Canada (Table 1) “Liftoff” is now expected in January 2023 in the US, Australia and the UK; while rates are expected to remain unchanged until November 2023 in the euro area and February 2024 in Sweden. The bigger future issue for markets, however, is the pace of rate hikes given how little tightening is expected after liftoff. Table 1Bond Markets Are Vulnerable To Hawkish Monetary Policy Shifts OIS curves are only discounting a handful of rate hikes to occur by the end of 2024 in most countries. Beyond that, 5-year/5-year forward OIS rates – a good proxy for the so-called “terminal rate”, or how high rates will end up in the next tightening cycle – show that markets have downgraded their assessment of how high global interest rates can possibly go. With global growth likely to remain above trend over the next 1-2 years, the current surge in global inflation will likely not be as transitory as the Fed and other central banks expect, leading to a faster pace of monetary tightening than markets are discounting (outside of Europe and Japan) and a renewed move higher, on average, for global bond yields led by US Treasuries. Bottom Line: Peaking global growth expectations and the growing spread of the Delta variant are challenging the “reflation and reopening” narrative that drove bond yields higher in Q1 of this year. Underlying growth, however, is likely to stay above-trend in most developed economies over the next 1-2 years, leading to tighter labor markets, increased domestic inflation pressures, and less dovish central banks - especially in the US. We continue to recommend an overall below-benchmark duration position in global bond portfolios, with an underweight stance on US Treasuries, on a strategic (6-24 month) basis. New Zealand: Primed For Liftoff Recent news from New Zealand has confirmed the market pricing of the Reserve Bank of New Zealand (RBNZ) as one of the most hawkish central banks within the developed economies. We have been of the view that the RBNZ would be among the first to withdraw the monetary accommodation put in place because of the pandemic, and recommended that investors avoid New Zealand sovereign debt in our Special Report on global house prices earlier this year.2 Increasingly, that view is being borne out, with the RBNZ delivering a hawkish surprise last week by announcing an end to the Large-Scale Asset Purchase (LSAP) program by July 23. On the surface, New Zealand’s situation does not appear that different from other higher-yielding bond markets in the developed world such as the US, UK, Australia, and Canada. However, there are a number of factors that make higher interest rates more appropriate for this economy: An unsustainable housing market If nothing else, the RBNZ’s hawkish turn can be attributed to the country’s wildly unsustainable housing market (Chart 6). Nominal house prices have been in an unimpeded accelerating trend since mid-2019, and are now growing at a whopping 28% year-over-year as of June. The anecdotal stories of housing market frothiness in New Zealand are at times unbelievable, like the recent sale of a run-down house in an Auckland suburb, with no bathroom or toilet, for a whopping two million dollars.3 The housing boom has undoubtedly been caused by accommodative monetary policy, with mortgage rates reaching all-time lows during the pandemic. While the RBNZ has implemented macroprudential measures such as increased loan-to-value restrictions on mortgages, it will take a significant pickup in mortgage rates to truly curb the acceleration in house prices. Housing affordability – or, more accurately, unaffordability - has reached a point where a 20% down payment on the median national house price is equal to 223% of the median disposable income, according to the RBNZ (Chart 6, middle panel). A similar measure, the OECD’s house price-to-income ratio, is most elevated in New Zealand among the developed economies. The overheating housing market also poses a major financial stability risk. New Zealand also leads the pack when it comes to the housing exposure of commercial bank balance sheets (Chart 6, bottom panel). With nearly half of commercial bank balance sheets composed of housing loans, New Zealand’s financial system is especially susceptible to a housing downturn. The takeaway is clear - even in the absence of other factors, the housing situation alone would be enough to force the RBNZ to act. Inflation accelerating above target The RBNZ tapering decision came a mere two days before the release of a very strong CPI print for Q2/2021, with consumer prices rising 1.3% during the quarter and 3.3% on a year-over-year basis – the fastest pace since 2011 (Chart 7). The central bank had been expecting some near-term spikes in headline inflation owing to temporary supply shortfalls and high oil prices. However, the RBNZ does not see all inflation as “transitory” and acknowledges that rising capacity pressures and labor shortages could continue to push up inflation going forward Chart 6The RBNZ's Housing Headache Chart 7A Broad-Based Spike In NZ Inflation Inflation has also been broad-based, with both tradables and non-tradables inflation running above the upper band of the RBNZ’s 1-3% inflation target. Although the bank does, on net, favor a lower New Zealand dollar (NZD) for the export-driven New Zealand economy, the depreciation in the NZD could push up tradeables inflation further, making urgent action from the RBNZ all the more necessary. Also important are the sources of inflation. The housing basket was responsible for more than a third of the rise in prices in Q2 (Chart 8). With housing affordability now a politically fraught issue creating major headaches for the RBNZ, expect the bank to be extra-sensitive to this sort of inflation. Accelerating food prices also create the risk that the “sticker shock” of rapidly rising costs for everyday spending items pushes up consumer inflation expectations past the RBNZ target range. Chart 8Prices Are Rising For 11 Out Of The 12 Groups In The NZ CPI Basket Chart 9The RBNZ Is Running Out Of Bonds To Buy An asymmetric monetary policy backdrop The monetary policy backdrop in New Zealand also favors a withdrawal of stimulus, on the margin. After only sixteen months of quantitative easing, the RBNZ now owns nearly half of all the sovereign debt outstanding in the country. That is a level of ownership on par with the ECB, which has had a long-running asset purchase program, and far exceeds the shares held by peers such as the Fed and Bank of Canada (Chart 9). Had they not terminated purchases, the RBNZ would have been limited by the simple fact that there is not enough government bond issuance for it to buy up without starting to impair the liquidity of the bond market Looking beyond the end of the LSAP, the central bank may have to push policy rates considerably higher to contain inflation. At only 0.25%, the official cash rate is 165bps below the mean estimate of the neutral rate —the rate at which monetary policy would be neither restrictive or stimulative – derived from the RBNZ’s suite of quantitative models (Chart 10). There is also some uncertainty around this number, with the upper end of the range of estimates as high as 4.5%. This signals that the RBNZ could hike rates quite a bit without choking off the economy. Chart 10The Market Is Pricing In An Extremely Slow RBNZ Hiking Cycle In this context, market pricing in the New Zealand OIS curve, which discounts a very slow hiking cycle with the policy rate not expected to reach the median RBNZ neutral rate estimate until 2028, appears overly dovish. A buoyant economic backdrop Lastly, the RBNZ has arguably already satisfied its mandate to support the economic recovery coming out of the pandemic (Chart 11). Real GDP and aggregate employment are both above pre-COVID levels, while business and consumer confidence are continuing the recovery started last year. Yields have picked up across the New Zealand government bond curve, reflecting this improvement in growth and sentiment. Even though some pandemic restrictions remain in place, the vaccination program has shown steady progress and is likely to ramp up further as the government has just acquired a large shipment of the Pfizer vaccine. Looking at the broader picture, there appears to be little remaining justification for the RBNZ to remain as accommodative as it is right now. The economic recovery from the pandemic is largely complete and the upside inflation and financial stability risks are too important to ignore. After such an abrupt end to the RBNZ’s LSAP program, rate hikes are likely just around the corner. Yet with the OIS curve now discounting a full rate hike by October of this year, markets have adjusted to a sooner than expected RBNZ liftoff date. However, we believe that the New Zealand sovereign yield curve has not fully priced in how much the RBNZ - historically one of more active central banks that is not afraid to raise or lower interest rates aggressively - will need to tighten, and how flat the curve will get, once the rate hikes begin. Although the entire New Zealand government bond curve has already flattened somewhat, experience from previous hiking cycles shows that the curve usually continues to flatten well after rate hikes begin, usually reaching zero or inverting slightly by the time the RBNZ is done hiking rates. This is especially true for the yield curve between two and five years, which is the maturity range that is most sensitive to rate hike expectations (Chart 12). Chart 11The NZ Economy Has Recovered For The Most Part Chart 12Monetary Policy And The NZ Yield Curve Currently, the 2-year/5-year New Zealand yield curve is 22bps, leaving ample room for the curve the flatten further once the RBNZ begins to hike rates. Meanwhile, implied forward rates are currently priced for a re-steepening of the curve in the short term, making a 2-year/5-year flattener an especially attractive trade in New Zealand with the RBNZ set to tighten. This is also a “cleaner” play on monetary policy expectations over a cyclical horizon than, for example, a 2s/10s flattener where the longer-maturity yield could be boosted by higher inflation expectations (and where some flattening is already discounted in the forwards). Today, we are initiating a new recommended 2-year/5-year curve flattener trade in New Zealand using cash government bonds. This trade involves selling a 2-year bond, and using the proceeds to buy a combination of a 5-year bond and a 3-month treasury bill that has the same duration as the 2-year bond. This makes the trade both duration-neutral and “proceeds-neutral” by fully investing the cash from the sale of the 2-year bond. Details of the trade, including the duration weightings and specific bonds used, can be found in our Tactical Trade Overlay table on page 17. Bottom Line: House prices, inflation, and the overall economic backdrop justify the RBNZ’s hawkish shift. However, government bond and interest rate swap markets have not fully priced in how quickly, and how far, the RBNZ can hike during the upcoming tightening cycle. As a play on further RBNZ hawkishness, we are entering a new recommended tactical trade – a 2-year/5-year yield curve flattener in New Zealand government bonds.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Global House Prices: A New Threat For Policymakers", dated May 28, 2021, available at gfis.bcaresearch.com. 3https://www.theguardian.com/world/2021/jul/15/house-with-no-toilet-sells-for-2m-as-new-zealand-property-market-soars Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the first quarter of 2021 point towards easing standards in developed markets (Chart 1). Credit standards for business loans eased outright in most regions except for the euro area and New Zealand where the pace of tightening slowed significantly. On the whole, banks expected the easing trend to continue into Q2. Chart 1Credit Standards Moving Towards Or Deeper Into Easy Territory With credit spreads at historical tights, banks across the board cited increased competition from other lenders as a reason behind easing standards, confirming that easy financial conditions are not limited solely to booming financial markets. This will help maintain a market-friendly economic growth backdrop as developed economies put pandemic restrictions behind them. At the same time, an absence of tightening lending standards by commercial banks puts incremental pressure on central banks to move towards bond-bearish tightenings of monetary policy. An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and, thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As loan officers have access to detailed, non-public information on a large number of borrowers, they are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q1/2021 (Chart 3). Nearly 20% of respondents cited an improving or less uncertain economic outlook as a very important factor behind the decision to ease standards, while roughly one-third cited increased competition from other lenders. Chart 3US Credit Conditions Chart 4High-yield Borrowers Are Exposed To A Widening In Spreads Although it did not strengthen on net, C&I loan demand did weaken at a much slower pace in Q1. The factors driving loan demand suggest a buoyant economic backdrop—about a quarter of banks reporting increased demand cited merger and acquisition needs and increased investment as very important reasons. Meanwhile, weaker loan demand was attributed to less precautionary demand for cash and an increase in internally generated funds among customers. On the consumer side, loan demand improved slightly on the whole, driven largely by a significant improvement in auto loan demand. While consumer loan demand has historically correlated well with the year-over-year growth in personal consumption expenditures, those two series diverged remarkably in Q1, with spending growth far outpacing loan growth. This divergence reflects the tremendous impact of pandemic-related transfer payments and benefits. We expect a continued recovery in consumer lending demand as unemployment benefits are withdrawn and consumers once again have to borrow to finance spending. As part of the special ad-hoc questions in this edition of the survey, respondents were asked about how lending standards had changed compared to the pre-pandemic period by borrower risk rating. Interestingly, large banks actually eased their standards for investment grade borrowers, reflecting the impact of Fed’s massive liquidity injections (Chart 4). However, despite spreads on high-yield having tightened to post-GFC lows, credit standards for below-investment grade borrowers remain much tighter than before the pandemic. So far, lower-quality borrowers have been able to go to public debt markets for financing, but this highlights a downside risk—if there is an event which causes corporate bond spreads to widen, high-yield borrowers may be starved of cheap financing options with banks still holding purse strings taut. Euro Area In the euro area, banks continued to tighten standards to enterprises, albeit at a much-reduced pace, in Q1/2021 (Chart 5). The tightening, however, was lower than expected in the previous quarter, possibly reflecting prolonged policy support and improving risk sentiment. Deteriorating risk perceptions related to the general economic and firm-specific situation were the primary contributing factor to tightening. But this was partly offset by increased competition from other lenders. The reduced pace of tightening does confirm the signal from the high-yield default rate, which is rolling over. Going forward, banks expect the pace of tightening to slow very slightly going into Q2. Chart 5Euro Area Credit Conditions Chart 6Credit Standards For Major Euro Area Economies Business credit demand continued to weaken at a faster pace in Q1, marking three consecutive quarters of deterioration. Weak fixed investment continued to be the biggest drag on demand, while the previous positive contribution from inventory and working capital needs has disappeared entirely. As we highlighted in the last edition of this chartbook, the continued drag on demand for investment reflects a lingering uncertainty regarding the pandemic which could possibly lower potential long-term growth in the euro area.2 As in the US, however, the reduction in demand also reflected already built-up liquidity buffers and the availability of internal and market-based financing. In Q2, banks expect a strong rebound in enterprise loan demand, especially from small and medium-sized enterprises (SMEs). Consumer credit demand continued to decline at a stronger pace in Q1, reflecting the continued pandemic-related restrictions in Europe over the quarter. The key drivers were lower durable goods spending and weakening consumer confidence. Banks also reported increased use of internally-generated funds, which is consistent with accumulated savings and pent-up demand during the lockdown. Assuming that the emerging Delta variant does not sidetrack the European return to normalcy, we will likely see the expected consumer credit demand rebound come to fruition. This would be consistent with recent strong consumer confidence prints out of the region. Looking individually at the four major euro area economies, credit standards for enterprises tightened in Germany, Italy, and Spain but were unchanged in France (Chart 6). In countries where standards tightened, worsening risk perceptions were the primary factor. In France, increased competition from other lenders contributed to easing on the margin. Going into Q2, standards are expected to tighten very modestly in the two core European economies while diverging in peripheral Europe—Spanish banks expect an increased pace of tightening while Italian ones expect standards to remain unchanged. UK In the UK, overall corporate credit standards, measured as an average of standards for medium and large non-financial firms, eased slightly in Q1/2021 (Chart 7A). This increase in credit availability was driven primarily by an improving economic outlook and sector-specific risk picture. As in the US and euro area, competition from capital markets also played a role and is expected to contribute to the further easing expected in Q2. Chart 7AUK Credit Conditions Chart 7BInvestment And Inventory Financing Expected To Pick Up In The UK Meanwhile, corporate loan demand is picking up at a pace not seen since Brexit, excluding the 2020 spike driven by emergency funding needs, signaling a buoyant picture. In particular, the surge in demand was driven by large non-financial firms which are also expected to drive the demand pick-up in Q2. Household loan demand fell slightly in the first quarter but is expected to rebound. Consumer confidence, which had initially lagged behind loan demand, appears to have caught up as the UK’s “Freedom Day” from pandemic restrictions approaches in July. Lenders are also expected to ease availability for unsecured household loans, primarily on the back of market share objectives. This should create the ideal backdrop for a consumption boom if the Delta variant does not further limit the UK government’s ability to deliver on its promise of a full reopening. Delving into the factors behind booming corporate loan demand, there are promising signs for the broader UK economy (Chart 7B). In a Special Report published earlier this year, we argued that UK real interest rates were depressed because the country suffered from a series of rolling economic and political shocks, the effects of which were now expected to fade.3 There are already some signs of this in the credit data, with capital investment and inventory financing demand expected to rebound in Q2. Despite work-from-home effects dampening the need for office space, on the margin, UK commercial real estate demand is strong and expected to further strengthen. Japan Chart 8Japan Credit Conditions In Japan, credit standards to firms and households eased at a slower pace in Q1/2021 (Chart 8). The vast majority of respondents indicated that standards were basically unchanged, with none of the firms reporting any tightening, and a small number reporting some degree of easing. The most important factors driving easing were aggressive competition from other bank and non-bank lenders, as well as strengthened efforts to grow the business. Going into Q2, the pace of easing is expected to continue to slow. Business loan demand, which behaves somewhat counter-cyclically in Japan, increased over Q1. The entirety of this pickup can be attributed to small firms; large and medium-sized firms on the whole decreased their loan demand. Counter to trends in other regions, firms in Japan actually saw a decrease in internally-generated funds, which was the most important factor contributing to increased loan demand. Consumer loan demand fell slightly on balance but was mostly unchanged from the previous quarter. Respondents reporting weaker demand saw a decrease in household consumption as the most important factor. Sentiment remains subdued and has lagged the recovery in loan demand seen last year. Our colleagues at BCA Research Foreign Exchange Strategy are eyeing a recovery for the Japanese economy as the government turns around its vaccination campaign and the Olympics jumpstart consumption.4 On that basis, the very modest recovery in loan demand expected by Japanese banks appears too pessimistic. Canada And New Zealand In Canada, business lending standards continued to ease at a faster pace in Q1/2021, coinciding with rebounding business confidence which is now back to pre-pandemic levels (Chart 9). This is in line with a remarkable vaccine rollout—68% of the population has already received its first dose and the pace of daily vaccinations is showing no signs of rolling over. Chart 9Canada Credit Conditions Chart 10New Zealand Credit Conditions However, housing is a major concern for Canadian policymakers. In a recent Special Report, co-authored with our colleagues at The Bank Credit Analyst, we highlighted both Canada and New Zealand as “higher risk” countries more exposed to ballooning house prices.5 In addition to low rates, mortgage lending standards, which have been easing since Q3/2020, have undoubtedly contributed to this issue. However, the Bank of Canada (BoC), with its hawkish messaging, has signaled that it will not idly stand by; there is also popular support behind raising rates to tamp down house prices. Expect mortgage standards to tighten and a pick-up in mortgage rates as the BoC nears liftoff, most likely in 2022. Credit standards in New Zealand were mostly unchanged in Q1/2021, reversing the tightening trend of previous quarters (Chart 10). Over the next six months, standards are expected to ease considerably. Business loan demand was unchanged on net, with corporates decreasing and SMEs increasing demand. SMEs are also expected to increase demand slightly over the next six months. Tepid loan demand is consistent with business confidence hovering around the neutral zero line. As in Canada, soaring house prices are a major issue for the New Zealand economy. Data on household lending is alarming on that front. Although consumer loan demand continued to weaken, demand for residential mortgages spiked to an all-time high in Q1. While demand is expected to normalize going forward, the Q1 datapoint indicates froth in the market. The Reserve Bank of New Zealand is considering a variety of macroprudential measures but will have to raise rates sooner rather than later to effectively cool down the housing market. Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q1 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. 2 Please see BCA Research Global Fixed Income Strategy Report, "GFIS Global Credit Conditions Chartbook Q1/2021: A Tentative Recovery", dated February 16, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Special Report, "Why Are UK Interest Rates Still So Low?", dated March 10, 2021, available at gfis.bcaresearch.com. 4 Please see BCA Research Foreign Exchange Strategy Report, "The Case For Japan", dated June 11, 2021, available at fes.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Global House Prices: A New Threat For Policymakers", dated May 28, 2021, available at gfis.bcaresearch.com.

Special Report

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