Australia

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

Special Report

Highlights The last two years have taught us to live with Covid-19. This means global growth will remain strong in 2022. That is not reflected in a strong dollar. The RMB will be a key arbiter between a bullish and bearish dollar view. This is because a weak RMB will be deflationary for many commodity currencies, especially if it reflects weak Chinese demand. Inflation in the US will remain stronger than in other countries. The key question is what the Federal Reserve does next year. In our view, they will stay patient which will keep real interest rates in the US very low. Upside in the DXY is nearing exhaustion according to most of our technical indicators. We upgraded our near-term target to 98. Over a longer horizon, we believe the DXY will break below 90, towards 85 in the next 12-18 months. A key theme for 2022 will be central bank convergence. Either inflation proves sticky and dovish central banks turn a tad more hawkish, or inflation subsides and aggressive rate hikes priced in some G10 OIS curves are revised a tad lower. The path for bond yields will naturally be critical. Lower bond yields will initially favor defensive currencies such as the DXY, CHF and JPY. This is appropriate positioning in the near-term. Further out in 2022, as bond yields rise, the Scandinavian currencies will be winners. Portfolio flows into US equities have been a key driver of the dollar rally. This has been because of the outperformance of technology. Should this change, equity flows could switch from friend to foe for the dollar. A green technology revolution is underway and this will benefit the currencies of countries that will supply these raw materials. The AUD could be a star in 2022 and beyond. The rise in cryptocurrencies will continue to face a natural gravitational pull from policy makers.    Gold and silver will rise in 2022, but silver will outperform gold. Feature 2022 has spooky echoes of 2020. In December 2019, we were optimistic about the global growth outlook, positive on risk assets, and bearish the US dollar. That view was torpedoed in March 2020, when it became widely apparent that COVID-19 was a truly global epidemic. More specifically, the dollar DXY index (a proxy for safe-haven demand) rose to a high of 103. US Treasury yields fell to a low of 0.5%. Chart 1Covid-19 And The Dollar Today, the DXY index is sitting at 96, exactly the midpoint of the March 2020 highs and the January 2021 lows. Once again, the dollar is discounting that the new Omicron strain will be malignant – worse than the Delta variant, but not as catastrophic as the original outbreak (Chart 1). Going into 2022, we are cautiously optimistic. First, we have two years of data on the virus and are learning to live with it. This suggests the panic of March 2020 will not be repeated. Second, policymakers are likely to stay very accommodative in the face of another exogenous shock. This will especially be the case for the Fed. Our near-term target for the DXY index is 98, given that the macro landscape remains fraught with risks. This is a speculative level based on exhaustion from our technical indicators (the dollar is overbought) and valuation models (the dollar is expensive). Beyond this level, if our scenario analysis plays out as expected, we believe the DXY index will break below 90 in 2022. Omicron And The Global Growth Picture Chart 2Global Growth And The Dollar Our golden rule for trading the dollar is simple – sell the dollar if global growth will remain robust, and US growth will underperform its G10 counterparts. Historically, this rule has worked like clockwork. Using Bloomberg consensus growth estimates for 2022, US growth is slated to stay strong, but give way to other economies (Chart 2).  News on the Omicron variant continues to be fluid. As we go to press, Pfizer suggests a third booster dose of its vaccine results in a 25-fold increase in the antibodies that attack the virus. Additionally, a new vaccine to combat the Omicron variant will be available by March. If this proves accurate, it suggests the world population essentially has protection against this new strain. The good news is that vaccinations are ramping up around the world, especially in emerging markets. Countries like the US and the UK were the first countries to see a majority of their population vaccinated. Now many developed and emerging market countries have a higher share of their population vaccinated compared to the US (Chart 3). Chart 3ARising Vaccinations Outside The US Chart 3BRising Vaccinations Outside The US This has resulted in a subtle shift – growth estimates for 2022 are increasingly favoring other countries relative to the US (Chart 4). Let us consider the case of Japan - just in June this year, ahead of the Olympics, only 25% of the population was vaccinated. Today, Japan has vaccinated 77% of its population and new daily infections are near record lows. While Omicron is a viable risk, the starting point for Japan is very encouraging and should open a window for a recovery in pent-up demand and a pickup in animal spirits. Chart 4ARising Growth Momentum Outside The US This template could very much apply to other countries as well. This view is not embedded in the dollar, which continues to price in an outperformance of US growth (Chart 5). The Risks From A China Slowdown China sits at the epicenter of a bullish and bearish dollar view. If Chinese growth is bottoming, then the historical relationship between the credit impulse and pro-cyclical currencies will hold (Chart 6). This will benefit the EUR, the AUD, the CAD and even the SEK which that track the Chinese credit impulse in real time. As an expression of this view, we went long the AUD at 70 cents. Chart 5Economic Surprises Outside The US Chart 6Chinese Credit Demand And Currencies Just as global policy makers are calibrating the risk from the Omicron variant, the Chinese authorities are also acknowledging the risk of an avalanche from a property slowdown. They have already eased monetary policy on this basis. Specific to the dollar, a key arbiter of a bullish or bearish view will be the Chinese RMB. So far, markets have judiciously separated the risk, judging that the Chinese authorities can surgically diffuse the real estate market, without broad-based repercussions in other parts of the economy (such as the export sector). Equities and corporate credit prices have collapsed in specific segments of the Chinese market but the RMB remains strong (Chart 7). Correspondingly, inflows into China remain very robust, a testament to the fact that Chinese growth (while slowing) remains well above that of many other countries (Chart 8). Chart 7The RMB Has Diverged From The Carnage In China Chart 8Strong Portfolio Inflows Into China China contributed 20% to global GDP in 2021 and will likely contribute a bigger share in 2022, according to the IMF (Chart 9). This suggests that foreign direct investment in China will remain strong . This will occur at a time when the authorities could have diffused the risk from a property market slowdown. The commodity-side of the equation will also be important to monitor, especially as it correlates strongly with developed-market commodity currencies. It is remarkable that despite the slowdown in Chinese real estate, commodity prices remain resilient (Chart 10). This has been due to adjustment on the supply side, as our colleagues in the Commodity & Energy Strategy team have been writing. Finally, China offers one of the best real rates in major economies. It also runs a current account surplus. This suggests there is natural demand and support for the RMB (Chart 11). A strong RMB limits how low developed-market commodity currencies can fall. Chart 10Commodity Prices Remain Well Bid Chart 11Real Interest Rates Favor The RMB Inflation And The Policy Response Output gaps are closing around the world as fiscal stimulus has helped plug the gap in aggregate demand. This suggests that while inflation has been boosted by idiosyncratic factors (supply bottlenecks) that could soon be resolved, rising aggregate demand will start to pose a serious problem to the inflation mandate of many central banks. Chart 12A Key Driver Of The Dollar Rally As we wrote a few weeks ago, there have been consistencies and contradictions with the market response to higher inflation. The market is now pricing in that the Fed will raise interest rates much faster, compared to earlier this year. According to the overnight index swap (OIS) curve, the Fed is now expected to lift rates at least twice by December 2022, compared to earlier this year. Meanwhile, market pricing is even more aggressive when looking at the December 2022 Eurodollar contract, relative to either the Euribor contract (European equivalent) or Tibor (Japanese equivalent) (Chart 12). The reality is that outside the ECB and the BoJ, other central banks have actually been more proactive compared to the Federal Reserve. The Bank Of Canada has ended QE and will likely raise interest rates early next year, the Reserve Bank of New Zealand has ended QE and raised rates twice, and the Reserve Bank of Australia has already been tapering asset purchases. The Bank of England will also be ahead of the Fed in raising interest rates, according to our Global Fixed Income Strategy colleagues. This suggests that the pricing of a policy divergence between the Fed and other G10 central banks could be a miscalculation and a potential source of weakness for the dollar. Chart 13The US Is Generating Genuine Inflation Rising inflation is a global phenomenon and not specific to the US (Chart 13). So either inflation subsides and the Fed turns a tad more accommodative, or inflation proves sticky and other central banks turn a tad more hawkish to defend their policy mandates. We have two key short-term trades penned on this view – long EUR/GBP and long AUD/NZD. While the European Central Bank will lag the Bank of England (and the Fed) in raising interest rates, expectations for the path of policy are too hawkish in the UK, with 4 rate hikes priced in by the end of 2022. Similarly, hawkish expectations for the Reserve Bank of New Zealand are likely to be revised lower, relative to the Reserve Bank of Australia. As for the US, the Fed is likely to hike interest rates next year but real rates will remain very low relative to history (Chart 14A and 14B). Low real rates will curb the appeal of US Treasuries. Chart 14AReal Interest Rates In The US Are Very Negative The Dollar And The Equity Market Chart 15The US Stock Market And The Dollar One of the biggest drivers of a strong dollar this year (aside from rising interest rate expectations), has been equity inflows. The greenback tends to do well when US bourses are outperforming their overseas peers (Chart 15). It is also the case that value tends to underperform growth in an environment where the dollar is rising. We discussed this topic in depth in our special report last summer. Flows tend to gravitate to capital markets with the highest expected returns. So if investors expect the pandemic winners (technology and healthcare) to keep driving the market in an Omicron setting, the US bourses that are overweight these sectors will do well. We will err on the other side of this trade for 2022. Part of that is based on our analysis of the global growth picture in the first section of this report. If growth rotates from the US to other economies, their bourses should do well as profits in these economies recover. Earnings revisions in the US have been sharply revised lower compared to other countries (Chart 16). This has usually led to a lower dollar eventually. In the case of the euro area, there has been a strong and consistent relationship between relative earnings revisions vis-à-vis the US, and the performance of the euro (Chart 17). Chart 16Earnings Revisions Are Moving Against US Companies Chart 17Earnings Revisions Are Moving In Favor Of Euro Area Companies In a nutshell, should profits in cyclical sectors recover on the back of rising bond yields, strong commodity prices and a tentative bottoming in the Chinese economy, value sectors that are heavily concentrated in countries with more cyclical currencies such as Australia, Norway, Sweden, and Canada, will benefit. Ditto for their currencies. The Outlook For Petrocurrencies When the pandemic first hit in 2020, oil prices (specifically the Western Texas Intermediate blend) went negative. This drop pushed the Canadian dollar towards 68 cents and USD/NOK punched above 12. This time around, the drop in oil prices (20% from the peak for the Brent blend) has been more muted. We think this sanguine market reaction is more appropiate in our view for two key reasons. First, as our colleagues in the Commodity & Energy Stategy team have highlighted, investment in the resource sector, specifically oil and gas, has been anemic in recent years. In Canada, investment in the oil and gas sector has dropped 68% since 2014 at the same time as energy companies are becoming more and more compliant vis-à-vis climate change (Chart 18). Second, if we are right, and Omicron proves to be a red herring, then transportation demand (the biggest source of oil demand) will keep recovering. In terms of currencies, our preference is to be long a petrocurrency basket relative to oil consumers. As the US is the biggest oil producer in the world (Chart 19), being long petrocurriences versus the dollar has diverged from its historical positive relationship with oil prices. Chart 20 shows that a currency basket of oil producers versus consumers has had both a strong positive correlation with oil prices and has outperformed a traditional petrocurrency basket. Chart 19The US Is Now A Major Oil Producer Chart 20Hold A Basket Of Oil Consumers Versus Producers Technical And Valuation Indicators The dollar tends to be a momentum-driven currency. Past strength begets further strength. We modelled this when we published our FX Trading Model, which showed that a momentum strategy outperformed over time (Chart 21).  The problem with momentum is that it works until it does not. Net speculative long positions in the dollar are approaching levels that have historically signaled exhaustion (Chart 22). There is a dearth of dollar bears in today’s environment. That is positive from a contrarian standpoint. Meanwhile, our capitulation index (a measure of how overbought or oversold the dollar is) is approaching peak levels. Chart 21The Dollar Is A Momentum Currency Chart 22Long Dollar Is A Consensus Trade Valuation is another headwind for the dollar. According to all of our in-house models, the dollar is expensive. That is the case according to both our in-house curated PPP model (Chart 23) and a simple one based on headline consumer prices (Chart 24). Chart 24The Dollar is Expensive     In a broader sense, we have built an attractiveness ranking for currencies (Chart 25). This ranks G10 currencies on a swathe of measures, including their basic balances, our internal valuation models, sentiment measures, economic divergences, and external vulnerability. The ranking is in order of preference, with a lower score suggesting the currency is sitting in the top/most attractive quartile of the measures. The Norwegian krone and Swedish krona are especially attractive as 2022 plays. More specifically, the Scandinavian currencies have been one of the hardest hit this year. The Norwegian krone will benefit from the reopening of economies, particularly through the rising terms-of-trade. The Swedish krona will benefit from a pickup in the industrial sector, and continued strength in global trade. The least attractive G10 currencies are the New Zealand dollar and the greenback. This is mostly due to valuation. As we have highlighted in previous reports, valuation is a poor timing tool in the short term but over a longer-term horizon, currencies tend to revert towards fair value. Where Next For EUR/USD? Our bias is that the euro has bottomed. The ECB will lag the Fed in raising interest rates, but the spread between German bund yields and US Treasuries does not justify the current level of the euro. More importantly, if European growth recovers next year, this will sustain portfolio flows into the eurozone, which are cratering (Chart 26). Our 2022 target for EUR/USD is 1.25, a level that will unwind 10.6% of the undervaluation versus the dollar. Beyond valuation,s a few key factors support the euro: As a pioneer in green energy and a pro-cyclical currency, the euro will benefit from portfolio flows into renewable energy companies, as well as foreign direct investment. A close proxy for these flows are copper prices, that have positively diverged from the performance of the euro (Chart 27). Chart 26The Euro And Portfolio Flows Chart 27EUR/USD And Copper ​​​​​ Inflation in the euro area is lagging the US, but is undeniably strong. As such, while the ECB will lag the Fed in tightening monetary policy, the divergence in monetary policy will not widen. Earnings revisions are moving in favor of European companies, as we have shown earlier. Historically, this has put a floor under the euro. Safe-Haven Demand: Long JPY Safe-haven currencies will perform well in the near term. We are long the yen, which is the cheapest currency according to our models and also one of the most shorted. CHF will also do well in the near term, though as we have argued, will induce more intervention from the Swiss National Bank. We are long both the yen and CHF/NZD as short-term trades, but our preference is for the yen. First, Japan has one of the highest real rates in the developed world. So, outflows from JGBs are going to be curtailed. Second, the DXY and USD/JPY have a strong positive correlation, and this places the yen in a very enviable position as the dollar weakens in 2022 (Chart 28). A Final Word On Gold, Silver, And Precious Metals Chart 29Hold Some Gold Along with our commodity strategists, we remain bullish precious metals. In our view, inflation could prove stickier than most investors expect. This will depress real rates and support precious metals. Within the precious metals sphere, we particularly like silver and platinum.  Almost every major economy now has negative real interest rates. Gold (and silver) have a long-standing relationship with negative interest rates (Chart 29). Central banks are also becoming net purchasers of gold, which is bullish for demand. The true precious metals winner in 2022 could be silver. The Gold/Silver ratio (GSR) tends to track the US dollar quite closely, so a bearish view on the dollar can be expressed by being short the GSR (Chart 30). Second, gold is very expensive compared to silver (Chart 31). In general, when gold tends to make new highs (as it did in 2020), silver tends to follow suit. This means silver prices could double from current levels over the next few years, to reclaim their 2011 highs. Finally, the bullish case for platinum is the same as for silver. It has lagged both gold and palladium prices. Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters. Chart 30Hold Some Silver Chart 31Stay Short The GSR Concluding Thoughts Our currency positions, as we enter 2022, are biased towards a lower dollar, but we also acknowledge that there are key risks to the view. Our recommendations are as follows: The DXY will could touch 98 in the near term, but will break below 90 over the next 12-18 months. An attractiveness ranking reveals the most appealing currencies are JPY, SEK, and NOK, while the least attractive are USD and NZD. Chart 32Hold Some AUD Policy convergence will be a key theme at the onset of 2022. Stay long EUR/GBP and AUD/NZD as a play on this theme. Look to buy a basket of oil producers versus consumers once volatility subsides. We went long the AUD at 70 cents. Terms of trade are likely to remain a tailwind for the Australian dollar (Chart 32). The AUD will benefit specifically in a green revolution.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com​​​​​​​ Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Highlights Expectations for monetary policy in Australia have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. This pricing defies guidance from the Reserve Bank of Australia (RBA), which calls for no rate hikes until 2024. An update of our RBA Checklist shows that while there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth (specifically, Chinese import demand) and inflation (specifically, wage growth) for the RBA to credibly remain on the sidelines next year. Fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Also position for a steeper yield curve (that should also benefit Australian bank stocks) and wider breakevens on Australian inflation-linked bonds. The Australian dollar offers compelling medium-term value, but play that through positions on the crosses (long AUD/NZD & AUD/CHF) with the RBA/Fed policy gap keeping a lid on AUD/USD in the near term. Feature With inflation surging across the world, investors have become hyper-sensitive to any potentially hawkish turn by central banks that have used ultra-accommodative monetary policy to fight the economic shock of the COVID-19 pandemic. Rapidly shifting interest rate expectations have triggered bouts of bond and currency volatility in countries like the UK, Canada and New Zealand over the past several months – with perhaps the biggest shock seen in Australia. Australian government bonds had enjoyed an impressive period of outperformance versus developed market peers between March and September of 2021. All that changed in late October (Chart 1), when the RBA effectively abandoned its yield curve control policy that anchored shorter-maturity bond yields with asset purchases, triggering a spike in Australian yields (the yield on the April 2024 government bond that was targeted by the RBA jumped +80bps in a single week). Interest rate expectations have rapidly been repriced higher to the point where there are now nearly four rate hikes in 2022 discounted in the Australian overnight index swap (OIS) curve – even with the RBA still formally saying that it does not expect to lift rates until 2024 (Chart 2). Chart 1The RBA Will Likely Disappoint Market Expectations Chart 2A Very Aggressive Term Structure For Aussie Interest Rates   In this Special Report, we revisit our RBA Checklist, originally introduced in January of this year, to determine if the time is indeed right to expect tighter monetary policy in Australia next year, which has implications for not only the Australian bond market but also the Australian dollar. While much of the checklist is flashing a need for the RBA to begin lifting rates, there are still enough lingering uncertainties on the outlook for inflation, the labor market and export demand to keep the central bank on hold in 2022. Checking In On Our RBA Checklist Chart 3Tentative Signs Of A Rebound In Aussie Economic Activity Before the recent Australian bond market turbulence, the potent policy mix from the RBA since the start of the pandemic – cutting the Cash Rate to 0.1%, with aggressive quantitative easing (QE) and yield curve control, all reinforced with very dovish forward guidance – helped cap market pricing for interest rate hikes. A sharp outbreak of the Delta Variant earlier this year, leading to severe economic restrictions in Australia’s major cities, also helped anchor bond yields Down Under on a relative basis compared with other countries. As RBA Governor Philip Lowe noted in his speech following the November 2 RBA policy meeting, “At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As [pandemic] restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life.” At the same time, Lowe stated that “the latest data and forecasts do not warrant an increase in the Cash Rate in 2022.” Thus, any attempt to begin unwinding RBA policy accommodation would require clear evidence that the impacts of the pandemic on economic growth, and also on inflation and financial stability, were evolving such that emergency policy settings were no longer required. On the growth front, there are already signs of recovery looking at reliable cyclical indicators like the manufacturing and services PMIs, which have rebounded by 6.2 points and 8.9 points, respectively, from the August lows (Chart 3). Yet while inflation expectations have remained fairly stable – the 5-year/5-year Australia CPI swap rate has stayed in a 2.2-2.5% range throughout 2021, despite the Delta outbreak – our RBA Monitor has rolled over, led by the economic growth components. This suggests there may be some diminished pressure for tighter monetary policy in Australia. To get a clearer picture on the outlook for Australian monetary policy over the next year, it is a good time to revisit our RBA Checklist - the most important things to monitor to determine when the RBA could be expected to turn more hawkish. We compiled the Checklist back in January, and the elements are still relevant today. 1.  The COVID-19 vaccination process goes quickly and smoothly (✓) We are placing a checkmark next to this part of our RBA Checklist. After a very slow start earlier in 2021, Australia has executed a successful vaccination campaign with 71% of the population now fully vaccinated (Chart 4). More importantly, the number of daily new infections is rolling over rapidly, and hospitalization rates remain low. This is allowing economic restrictions to be lifted quickly. Chart 4The Beginning Of The End Of Australia's 2021 COVID Crisis 2.  Private sector demand accelerates as the impulse from COVID fiscal stimulus fades (✓?) We are tentatively giving a checkmark for this component of the Checklist, but with a question mark given some of the cross-currents visible on the consumer spending side. Real consumer spending rebounded sharply in the first half of 2021 (Chart 5). However,  the Delta lockdowns weighed on consumer confidence and demand in Q3, with retail sales contracting on a year-over-year basis (both in nominal and inflation-adjusted terms). Furthermore, much of the spending boom was fueled by Australian households running down the high savings accumulated during the 2020 COVID lockdowns. The household savings rate fell from a peak of 22% in Q2 2020 to 10% in Q2 2021, the last data point available, while real disposable income growth actually fell by -2.6% on a year-over-year basis in Q2. We expect the next few consumer confidence prints to improve sharply as economic restrictions are lifted, with consumer spending following suit. This would lead us to remove the question mark next to this item of the RBA Checklist. Already, business confidence is rebounding with the NAB survey bouncing 6 points in October (Chart 6), which should translate into increased capital spending and hiring activity by Australian companies that have maintained profitability during the pandemic (top panel). Chart 5Australia's Economy Holding Up Well Despite COVID Wave Chart 6Resilient Business Confidence Will Support Employment   3. Inflation, both realized and expected, returns to the RBA’s 2-3% target (✓?) We are giving another tentative checkmark with a question mark for this entry in the RBA Checklist, given that wage growth remains modest despite high realized inflation. Australian headline CPI inflation, on a year-over-year basis, was 3.8% in Q2/2021 and 3.0% in Q3/2021, above the top of the 2-3% RBA target. Much of that inflation has come from the Transport sector, which includes the prices of both car fuel and new car prices, which contributed 1.1% to inflation in Q3 (Chart 7). The former is impacted by high oil prices and the latter is influenced by the global supply chain disruption and shortage of semiconductors used in cars. Beyond those sectors, there was a modest pickup in inflation across much of the consumption basket. Underlying inflation was more subdued but did pick up over the same Q2/Q3 period. Annual growth in the trimmed mean CPI accelerated from 1.6% in Q2 to 2.1% in Q3 - returning to the bottom half of the RBA’s target range for the first time since Q4/2015 (Chart 8). The latest RBA projections call for underlying inflation to stay in the lower half of the inflation target range in 2022 (2.25%) and 2023 (2.5%), although this is conditional on a steady tightening of the Australian labor market. The RBA is forecasting the unemployment rate, which was at 5.2% in October, to fall to 4.25% by the end of 2022 and 4% by the end of 2023. The RBA expects a tighter labor market to eventually boost wage growth to a pace consistent with underlying inflation staying within the RBA target band – which would then augur for tighter monetary policy. The central bank has repeatedly stated that annual growth in the Wage Cost Index, its most preferred measure of Australian wages, has historically been in the 3-4% range when underlying inflation was consistently between 2-3%. The Wage Cost Index grew by only 2.2% on a year-over-year basis in Q3, so still well below the pace that would convince the RBA that underlying inflation would stay within the target. This argues for a wait-and-see approach. Chart 8Wage Uncertainty Preventing A Hawkish RBA Turn Chart 9A Rising Participation Rate Will Cushion Tightening In The Labor Market RBA Governor Lowe has noted that there is still ample spare capacity in labor markets that opened up because of COVID lockdowns, which will prevent a more rapid decline in the unemployment rate even with labor demand still quite strong. On that note – the Australian labor force participation rate fell from a 2021 high of 66.3% in March of this year to 64.7% in October, a 1.6 percentage point decline that provides a buffer to absorb the strong labor demand in Australia (Chart 9). Given that Australian inflation and wages are reported less frequently (quarterly) than employment data (monthly), it is a challenge for the RBA to quickly assess to true state of inflationary pressure in the Australian economy. We see the inflation data as being far more important than labor market developments in assessing the RBA’s next move. The RBA will likely want to a few more Wage Cost Index and CPI prints before signaling any move to hike rates sooner than currently projected. The RBA will not have a complete reading on wages for the first half of 2022 until August, when the Q2/2022 Wage Cost Index is released. Thus, it would not be until well into the latter half of 2022 before any shift in hawkish messaging could plausibly occur, at the earliest, even if CPI inflation were to surprise to the upside over the same period. The RBA will need to see price inflation confirmed by wage inflation before changing its stance. In a nutshell, robust inflation prints out of Australia will need to be reinforced by strong wage data, for the RBA to move the dial closer to market expectations for interest rate hikes. 4. House price inflation is accelerating (✓) We are placing a checkmark next to this piece of our Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets are overheating could prompt the RBA to consider tightening monetary policy sooner than expected. On that front, there is plenty of evidence to give the RBA anxiety. Median house prices grew at a 16.8% year-over-year rate in Q2, the fastest pace since 2003, and now appear very expensive relative to median incomes (Chart 10). Chart 10House Price Appreciation Could Moderate High prices may eventually begin to turn away buyers, as the “good time to buy a home” component of the Melbourne/Westpac consumer confidence survey has fallen sharply (bottom panel). Some of that decline may also be due to the Delta wave, as the growth rate of new building approvals has also slowed alongside rising COVID cases (top panel). The RBA will likely want to see a few post-Delta prints on Australian house prices and housing demand to determine the true underlying trends. But given the extreme readings on overall house prices, the housing market is a legitimate reason for the RBA to turn more hawkish. 5. Export demand, particularly from China, is strong (x) We are NOT placing a checkmark next to this item of our RBA Checklist. A booming external environment could lead the RBA to feel more comfortable signaling rate hikes. So far, that has been the case via a rising terms of trade, which has positive implications for the valuation of the Australian dollar, as we discuss below. But on the volume front - which is critical for the growth outlook, and RBA policy decisions, given the importance of the export sector to the Australian economy - there is reason for caution. First, the Chinese economy continues to slow down. The Chinese credit impulse, one of the key gauges of momentum in domestic activity peaked in October last year and has been rolling over since. Historically, this has been a bad omen for Aussie exports in general, as well as the performance of the AUD (Chart 11). Almost 40% of Australian exports go to China. This suggests that exports of both coal and iron ore are particularly susceptible to a further slowdown in Chinese construction activity. That said, the slowdown in China has probably passed the “maximum deceleration” phase and the odds are that, going forward, both monetary and fiscal policy will be marginally eased. This will help cushion the Australian dollar and bond yields from undershooting below current levels. Chinese bond yields have already declined, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it has become a good proxy for monetary conditions. As such, the trend in Chinese bond yields has tended to lead Chinese imports. As Chinese going concerns finance working capital requirements at lower rates, this could help stabilize import volumes (Chart 12). Chart 11A Slowdown In China Is A Risk For The AUD Chart 12Easing Financial Conditions In China Political tensions between Australia and China remain a key point of contention for higher Aussie terms of trade and an improving basic balance. However, many Australian exports are fungible and have been redirected to other countries. For example, despite China’s ban on Australian coal imports, Aussie export volumes and terms of trade remain robust, leading to a sharp improvement in Australia’s external accounts (Chart 13). This is because Australian exports to Japan, India, and South Korea have picked up as China has redirected imports of coal from Australia to other countries. Commodity prices remain resilient, but could face downside in the coming months. This is especially the case for Australian export prices, which have outperformed that of other commodity-producing nations, leading to the sharp improvement in the terms of trade (Chart 14). Part of the story has been a supply-side shock. But Australia is also relatively competitive in supplying the types of raw materials that China needs and wants such as higher-grade iron ore, which is more expensive, pollutes less, and is in high demand. Similarly, Australia is one of the largest exporters of liquefied natural gas, of which prices have been soaring in recent months amidst a global push to clean the planet. Chart 13An Improving Basic Balance Supports The AUD Chart 14Australian Terms Of Trade Are Robust Historically, the terms of trade has been one of the best explanatory variables for the AUD. That said, our model suggests that even a 15%-20% decline in forward prices will still keep the AUD undervalued relative to levels implied by terms of trade (Chart 15). While Australian export prices have overtaken their 2011 highs, the AUD remains around 35% below 2011 levels. On a longer-term basis, Australia’s terms-of-trade improvement is likely to continue. First, a boom in global infrastructure spending is likely to keep the prices of the commodities Australia exports well bid. This includes both copper and iron ore. Second, China’s clean energy policy shift away from coal and towards natural gas will buffet LNG export volumes (Chart 16). Given that reducing - if not outright eliminating - pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and LNG import volumes. Chart 15A Drop In Commodities Is Well Discounted By The AUD In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart 17). Significant investment in resource projects over the last decade are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, even in the absence of RBA rate hikes. This argues for short-term caution, but a longer-term bullish view on the Aussie. Chart 17External Funding Will Face Competition From Domestic Savings Investment Implications A check of our RBA Checklist shows that the argument in favor of tighter monetary policy is becoming more compelling. However, the uncertainties over Australian wages and Chinese growth – both critical for the RBA’s next move - will not be resolved until the second half of 2022, so RBA tightening is not likely until the first half of 2023 at the earliest. There are a number of ways that investors can position for continued RBA dovishness in 2022. Fixed Income Bond investors should overweight Australian government bonds in global portfolios, as the RBA will not match the policy tightening expected in the US, Canada or the UK. Those overweights should be concentrated versus the US, given the lower yield beta of Australian government bonds versus US Treasuries (Chart 18). For dedicated Australian bond investors, maintain a below-benchmark duration stance as longer-maturity yields have more room to rise as the economy continues to recover from the Delta wave. In addition, favor inflation-linked debt over nominal bonds, as both survey-based inflation expectations and the fair value from our 10-year breakeven spread model are rising. Wider breakevens pushing up longer-term yields, and a dovish RBA capping shorter-maturity bond yields, both point to a bearish steepening of the government bond yield curve over the next 6-12 months (Chart 19). Chart 18Remain Overweight Aussie Bonds... Chart 19...And Position For A Steeper Yield Curve Currency A lot of pessimism is already embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. One catalyst will be a continued reversal in COVID-19 infection rates. The second is valuation. The Aussie is at fair value on a PPP basis, but remains very cheap on a terms-of-trade basis. Historically, terms of trade have had much better explanatory power for the direction of the Aussie, compared to relative real interest rates or fluctuations from purchasing power parity. Even accounting for falling commodity prices, the valuation margin of safety makes the AUD a good bet over a cyclical horizon, though in the very near-term, it is fraught with risks. We have a limit-buy on AUD/USD at 70 cents, which could be a capitulation level. On the upside, if the Aussie closes its undervaluation gap vis-à-vis terms of trade as it has done historically, this will lift AUD/USD towards 85 cents and beyond. Finally, sentiment on the Aussie is very depressed. Extreme short positioning suggests a dearth of buyers and the potential for a short covering rally (Chart 20). On the crosses, we are already long AUD/NZD, but AUD/CHF and AUD/CAD should also be winners in any Aussie short squeeze. Chart 20Lots Of Shorts In The Aussie Equities 37% of the MSCI Australia index is financials, while 16% is materials. Therefore, a call on the Australian equity market is a call on banks and resources. On the resource front, Australian producers will benefit from a pickup in natural gas exports and a shift away from coal. Therefore, the strategy will be to overweight Australian LNG producers in a resource portfolio. On banks, a relatively dovish RBA will keep the Australian yield curve steep. Meanwhile, banks have still underperformed the improvement in the interest rate term structure. A bottoming economy will also benefit banks, as investors start to price in the prospect for interest rate hikes beyond 2023 (Chart 21). Chart 21A Steeper Yield Curve Will Benefit Banks   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Highlights Expectations for monetary policy in Australia have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. This pricing defies guidance from the Reserve Bank of Australia (RBA), which calls for no rate hikes until 2024. An update of our RBA Checklist shows that while there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth (specifically, Chinese import demand) and inflation (specifically, wage growth) for the RBA to credibly remain on the sidelines next year. Fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Also position for a steeper yield curve (that should also benefit Australian bank stocks) and wider breakevens on Australian inflation-linked bonds. The Australian dollar offers compelling medium-term value, but play that through positions on the crosses (long AUD/NZD & AUD/CHF) with the RBA/Fed policy gap keeping a lid on AUD/USD in the near term. Feature With inflation surging across the world, investors have become hyper-sensitive to any potentially hawkish turn by central banks that have used ultra-accommodative monetary policy to fight the economic shock of the COVID-19 pandemic. Rapidly shifting interest rate expectations have triggered bouts of bond and currency volatility in countries like the UK, Canada and New Zealand over the past several months – with perhaps the biggest shock seen in Australia. Australian government bonds had enjoyed an impressive period of outperformance versus developed market peers between March and September of 2021. All that changed in late October (Chart 1), when the RBA effectively abandoned its yield curve control policy that anchored shorter-maturity bond yields with asset purchases, triggering a spike in Australian yields (the yield on the April 2024 government bond that was targeted by the RBA jumped +80bps in a single week). Interest rate expectations have rapidly been repriced higher to the point where there are now nearly four rate hikes in 2022 discounted in the Australian overnight index swap (OIS) curve – even with the RBA still formally saying that it does not expect to lift rates until 2024 (Chart 2). Chart 1The RBA Will Likely Disappoint Market Expectations Chart 2A Very Aggressive Term Structure For Aussie Interest Rates   In this Special Report, we revisit our RBA Checklist, originally introduced in January of this year, to determine if the time is indeed right to expect tighter monetary policy in Australia next year, which has implications for not only the Australian bond market but also the Australian dollar. While much of the checklist is flashing a need for the RBA to begin lifting rates, there are still enough lingering uncertainties on the outlook for inflation, the labor market and export demand to keep the central bank on hold in 2022. Checking In On Our RBA Checklist Chart 3Tentative Signs Of A Rebound In Aussie Economic Activity Before the recent Australian bond market turbulence, the potent policy mix from the RBA since the start of the pandemic – cutting the Cash Rate to 0.1%, with aggressive quantitative easing (QE) and yield curve control, all reinforced with very dovish forward guidance – helped cap market pricing for interest rate hikes. A sharp outbreak of the Delta Variant earlier this year, leading to severe economic restrictions in Australia’s major cities, also helped anchor bond yields Down Under on a relative basis compared with other countries. As RBA Governor Philip Lowe noted in his speech following the November 2 RBA policy meeting, “At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As [pandemic] restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life.” At the same time, Lowe stated that “the latest data and forecasts do not warrant an increase in the Cash Rate in 2022.” Thus, any attempt to begin unwinding RBA policy accommodation would require clear evidence that the impacts of the pandemic on economic growth, and also on inflation and financial stability, were evolving such that emergency policy settings were no longer required. On the growth front, there are already signs of recovery looking at reliable cyclical indicators like the manufacturing and services PMIs, which have rebounded by 6.2 points and 8.9 points, respectively, from the August lows (Chart 3). Yet while inflation expectations have remained fairly stable – the 5-year/5-year Australia CPI swap rate has stayed in a 2.2-2.5% range throughout 2021, despite the Delta outbreak – our RBA Monitor has rolled over, led by the economic growth components. This suggests there may be some diminished pressure for tighter monetary policy in Australia. To get a clearer picture on the outlook for Australian monetary policy over the next year, it is a good time to revisit our RBA Checklist - the most important things to monitor to determine when the RBA could be expected to turn more hawkish. We compiled the Checklist back in January, and the elements are still relevant today. 1.  The COVID-19 vaccination process goes quickly and smoothly (✓) We are placing a checkmark next to this part of our RBA Checklist. After a very slow start earlier in 2021, Australia has executed a successful vaccination campaign with 71% of the population now fully vaccinated (Chart 4). More importantly, the number of daily new infections is rolling over rapidly, and hospitalization rates remain low. This is allowing economic restrictions to be lifted quickly. Chart 4The Beginning Of The End Of Australia's 2021 COVID Crisis 2.  Private sector demand accelerates as the impulse from COVID fiscal stimulus fades (✓?) We are tentatively giving a checkmark for this component of the Checklist, but with a question mark given some of the cross-currents visible on the consumer spending side. Real consumer spending rebounded sharply in the first half of 2021 (Chart 5). However,  the Delta lockdowns weighed on consumer confidence and demand in Q3, with retail sales contracting on a year-over-year basis (both in nominal and inflation-adjusted terms). Furthermore, much of the spending boom was fueled by Australian households running down the high savings accumulated during the 2020 COVID lockdowns. The household savings rate fell from a peak of 22% in Q2 2020 to 10% in Q2 2021, the last data point available, while real disposable income growth actually fell by -2.6% on a year-over-year basis in Q2. We expect the next few consumer confidence prints to improve sharply as economic restrictions are lifted, with consumer spending following suit. This would lead us to remove the question mark next to this item of the RBA Checklist. Already, business confidence is rebounding with the NAB survey bouncing 6 points in October (Chart 6), which should translate into increased capital spending and hiring activity by Australian companies that have maintained profitability during the pandemic (top panel). Chart 5Australia's Economy Holding Up Well Despite COVID Wave Chart 6Resilient Business Confidence Will Support Employment   3. Inflation, both realized and expected, returns to the RBA’s 2-3% target (✓?) We are giving another tentative checkmark with a question mark for this entry in the RBA Checklist, given that wage growth remains modest despite high realized inflation. Australian headline CPI inflation, on a year-over-year basis, was 3.8% in Q2/2021 and 3.0% in Q3/2021, above the top of the 2-3% RBA target. Much of that inflation has come from the Transport sector, which includes the prices of both car fuel and new car prices, which contributed 1.1% to inflation in Q3 (Chart 7). The former is impacted by high oil prices and the latter is influenced by the global supply chain disruption and shortage of semiconductors used in cars. Beyond those sectors, there was a modest pickup in inflation across much of the consumption basket. Underlying inflation was more subdued but did pick up over the same Q2/Q3 period. Annual growth in the trimmed mean CPI accelerated from 1.6% in Q2 to 2.1% in Q3 - returning to the bottom half of the RBA’s target range for the first time since Q4/2015 (Chart 8). The latest RBA projections call for underlying inflation to stay in the lower half of the inflation target range in 2022 (2.25%) and 2023 (2.5%), although this is conditional on a steady tightening of the Australian labor market. The RBA is forecasting the unemployment rate, which was at 5.2% in October, to fall to 4.25% by the end of 2022 and 4% by the end of 2023. The RBA expects a tighter labor market to eventually boost wage growth to a pace consistent with underlying inflation staying within the RBA target band – which would then augur for tighter monetary policy. The central bank has repeatedly stated that annual growth in the Wage Cost Index, its most preferred measure of Australian wages, has historically been in the 3-4% range when underlying inflation was consistently between 2-3%. The Wage Cost Index grew by only 2.2% on a year-over-year basis in Q3, so still well below the pace that would convince the RBA that underlying inflation would stay within the target. This argues for a wait-and-see approach. Chart 8Wage Uncertainty Preventing A Hawkish RBA Turn Chart 9A Rising Participation Rate Will Cushion Tightening In The Labor Market RBA Governor Lowe has noted that there is still ample spare capacity in labor markets that opened up because of COVID lockdowns, which will prevent a more rapid decline in the unemployment rate even with labor demand still quite strong. On that note – the Australian labor force participation rate fell from a 2021 high of 66.3% in March of this year to 64.7% in October, a 1.6 percentage point decline that provides a buffer to absorb the strong labor demand in Australia (Chart 9). Given that Australian inflation and wages are reported less frequently (quarterly) than employment data (monthly), it is a challenge for the RBA to quickly assess to true state of inflationary pressure in the Australian economy. We see the inflation data as being far more important than labor market developments in assessing the RBA’s next move. The RBA will likely want to a few more Wage Cost Index and CPI prints before signaling any move to hike rates sooner than currently projected. The RBA will not have a complete reading on wages for the first half of 2022 until August, when the Q2/2022 Wage Cost Index is released. Thus, it would not be until well into the latter half of 2022 before any shift in hawkish messaging could plausibly occur, at the earliest, even if CPI inflation were to surprise to the upside over the same period. The RBA will need to see price inflation confirmed by wage inflation before changing its stance. In a nutshell, robust inflation prints out of Australia will need to be reinforced by strong wage data, for the RBA to move the dial closer to market expectations for interest rate hikes. 4. House price inflation is accelerating (✓) We are placing a checkmark next to this piece of our Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets are overheating could prompt the RBA to consider tightening monetary policy sooner than expected. On that front, there is plenty of evidence to give the RBA anxiety. Median house prices grew at a 16.8% year-over-year rate in Q2, the fastest pace since 2003, and now appear very expensive relative to median incomes (Chart 10). Chart 10House Price Appreciation Could Moderate High prices may eventually begin to turn away buyers, as the “good time to buy a home” component of the Melbourne/Westpac consumer confidence survey has fallen sharply (bottom panel). Some of that decline may also be due to the Delta wave, as the growth rate of new building approvals has also slowed alongside rising COVID cases (top panel). The RBA will likely want to see a few post-Delta prints on Australian house prices and housing demand to determine the true underlying trends. But given the extreme readings on overall house prices, the housing market is a legitimate reason for the RBA to turn more hawkish. 5. Export demand, particularly from China, is strong (x) We are NOT placing a checkmark next to this item of our RBA Checklist. A booming external environment could lead the RBA to feel more comfortable signaling rate hikes. So far, that has been the case via a rising terms of trade, which has positive implications for the valuation of the Australian dollar, as we discuss below. But on the volume front - which is critical for the growth outlook, and RBA policy decisions, given the importance of the export sector to the Australian economy - there is reason for caution. First, the Chinese economy continues to slow down. The Chinese credit impulse, one of the key gauges of momentum in domestic activity peaked in October last year and has been rolling over since. Historically, this has been a bad omen for Aussie exports in general, as well as the performance of the AUD (Chart 11). Almost 40% of Australian exports go to China. This suggests that exports of both coal and iron ore are particularly susceptible to a further slowdown in Chinese construction activity. That said, the slowdown in China has probably passed the “maximum deceleration” phase and the odds are that, going forward, both monetary and fiscal policy will be marginally eased. This will help cushion the Australian dollar and bond yields from undershooting below current levels. Chinese bond yields have already declined, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it has become a good proxy for monetary conditions. As such, the trend in Chinese bond yields has tended to lead Chinese imports. As Chinese going concerns finance working capital requirements at lower rates, this could help stabilize import volumes (Chart 12). Chart 11A Slowdown In China Is A Risk For The AUD Chart 12Easing Financial Conditions In China Political tensions between Australia and China remain a key point of contention for higher Aussie terms of trade and an improving basic balance. However, many Australian exports are fungible and have been redirected to other countries. For example, despite China’s ban on Australian coal imports, Aussie export volumes and terms of trade remain robust, leading to a sharp improvement in Australia’s external accounts (Chart 13). This is because Australian exports to Japan, India, and South Korea have picked up as China has redirected imports of coal from Australia to other countries. Commodity prices remain resilient, but could face downside in the coming months. This is especially the case for Australian export prices, which have outperformed that of other commodity-producing nations, leading to the sharp improvement in the terms of trade (Chart 14). Part of the story has been a supply-side shock. But Australia is also relatively competitive in supplying the types of raw materials that China needs and wants such as higher-grade iron ore, which is more expensive, pollutes less, and is in high demand. Similarly, Australia is one of the largest exporters of liquefied natural gas, of which prices have been soaring in recent months amidst a global push to clean the planet. Chart 13An Improving Basic Balance Supports The AUD Chart 14Australian Terms Of Trade Are Robust Historically, the terms of trade has been one of the best explanatory variables for the AUD. That said, our model suggests that even a 15%-20% decline in forward prices will still keep the AUD undervalued relative to levels implied by terms of trade (Chart 15). While Australian export prices have overtaken their 2011 highs, the AUD remains around 35% below 2011 levels. On a longer-term basis, Australia’s terms-of-trade improvement is likely to continue. First, a boom in global infrastructure spending is likely to keep the prices of the commodities Australia exports well bid. This includes both copper and iron ore. Second, China’s clean energy policy shift away from coal and towards natural gas will buffet LNG export volumes (Chart 16). Given that reducing - if not outright eliminating - pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and LNG import volumes. Chart 15A Drop In Commodities Is Well Discounted By The AUD In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart 17). Significant investment in resource projects over the last decade are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, even in the absence of RBA rate hikes. This argues for short-term caution, but a longer-term bullish view on the Aussie. Chart 17External Funding Will Face Competition From Domestic Savings Investment Implications A check of our RBA Checklist shows that the argument in favor of tighter monetary policy is becoming more compelling. However, the uncertainties over Australian wages and Chinese growth – both critical for the RBA’s next move - will not be resolved until the second half of 2022, so RBA tightening is not likely until the first half of 2023 at the earliest. There are a number of ways that investors can position for continued RBA dovishness in 2022. Fixed Income Bond investors should overweight Australian government bonds in global portfolios, as the RBA will not match the policy tightening expected in the US, Canada or the UK. Those overweights should be concentrated versus the US, given the lower yield beta of Australian government bonds versus US Treasuries (Chart 18). For dedicated Australian bond investors, maintain a below-benchmark duration stance as longer-maturity yields have more room to rise as the economy continues to recover from the Delta wave. In addition, favor inflation-linked debt over nominal bonds, as both survey-based inflation expectations and the fair value from our 10-year breakeven spread model are rising. Wider breakevens pushing up longer-term yields, and a dovish RBA capping shorter-maturity bond yields, both point to a bearish steepening of the government bond yield curve over the next 6-12 months (Chart 19). Chart 18Remain Overweight Aussie Bonds... Chart 19...And Position For A Steeper Yield Curve Currency A lot of pessimism is already embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. One catalyst will be a continued reversal in COVID-19 infection rates. The second is valuation. The Aussie is at fair value on a PPP basis, but remains very cheap on a terms-of-trade basis. Historically, terms of trade have had much better explanatory power for the direction of the Aussie, compared to relative real interest rates or fluctuations from purchasing power parity. Even accounting for falling commodity prices, the valuation margin of safety makes the AUD a good bet over a cyclical horizon, though in the very near-term, it is fraught with risks. We have a limit-buy on AUD/USD at 70 cents, which could be a capitulation level. On the upside, if the Aussie closes its undervaluation gap vis-à-vis terms of trade as it has done historically, this will lift AUD/USD towards 85 cents and beyond. Finally, sentiment on the Aussie is very depressed. Extreme short positioning suggests a dearth of buyers and the potential for a short covering rally (Chart 20). On the crosses, we are already long AUD/NZD, but AUD/CHF and AUD/CAD should also be winners in any Aussie short squeeze. Chart 20Lots Of Shorts In The Aussie Equities 37% of the MSCI Australia index is financials, while 16% is materials. Therefore, a call on the Australian equity market is a call on banks and resources. On the resource front, Australian producers will benefit from a pickup in natural gas exports and a shift away from coal. Therefore, the strategy will be to overweight Australian LNG producers in a resource portfolio. On banks, a relatively dovish RBA will keep the Australian yield curve steep. Meanwhile, banks have still underperformed the improvement in the interest rate term structure. A bottoming economy will also benefit banks, as investors start to price in the prospect for interest rate hikes beyond 2023 (Chart 21). Chart 21A Steeper Yield Curve Will Benefit Banks   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@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 Duration & Country Allocation: Global bond yields have been driven by growth and inflation expectations over the past year, but shifting policy expectations are now the more important driver. Tighter monetary policies will pressure global bond yields higher over the next 6-12 months, but not equally. Stay underweight countries where tapering and rate hikes are more likely (the US, the UK, Canada, New Zealand) relative to countries where policymakers will move much more slowly (euro area, Australia, Japan). Inflation-Linked Bonds: An update of our Comprehensive Breakeven Indicators shows limited scope for a further widening of breakeven inflation rates between nominal and index-linked government bonds in most developed economies, most notably in Europe. Downgrade strategic (6-18 months) exposure to inflation-linked bonds (vs nominals) to underweight in Germany, France and Italy. Feature Chart of the WeekGlobal Bond Yield Drivers: Inflation Now, Labor Later “Actually, we talked about inflation, inflation, inflation. That has been a topic that has occupied a lot of our time and a lot of our debates.” – ECB President Christine Lagarde Are you tired of talking about inflation? Central bankers likely are. The only problem is that is the job of monetary policymakers to worry about inflation – and the appropriate policy response – when it is rising as fast as been the case in 2021. The current global inflation surge, on the back of supply squeezes for both durable goods and commodity prices, will ease to some degree in 2022. This does not mean, however, that global bond yields have seen their cyclical peak. The driver of higher yields is already starting to transition from high inflation to tightening labor markets and rising wage costs – more enduring sources of potential inflation that will require monetary tightening in many, but not all, countries (Chart of the Week). This week, we discuss the implications of this shift to more policy-driven yields for the country allocation decisions in a government bond portfolio, for both nominal and inflation-linked debt. Shorter-Term Bond Yields Awaken, Longer-Term Yields Take Notice October represented a shift in the relative performance of developed economy government bond markets compared to the previous three months, most notably at the extremes (Chart 2). UK Gilts were the largest underperformer in Q3, down 1.8% versus the Bloomberg Global Treasury index (in USD-hedged terms, duration-matched to the benchmark), while Spain (+0.7%), Australia (+0.4%) and Italy (+0.3%) were the outperformers. In October, that script was flipped with Gilts being the best performer (+2.3%), Australia being the worst performer (-4.2%) and Spain (-0.6%) and Italy (-1.5%) reversing the Q3 gains. Those particular swings in relative performance were a result of shifting market views on policy changes in those countries. The UK Gilt rally was largely contained to a single day, and focused at the long-end of the Gilt curve after the Conservative government announced a smaller-than-expected budget deficit on October 26 - with much less issuance of longer-maturity bonds – which triggered a huge -22bps decline in 30-year Gilt yields. The Australian bond selloff was a triggered by a rapid market reassessment of the next move in monetary policy for the Reserve Bank of Australia (RBA) after an upside surprise on Q3 inflation data. Italian and Spanish debt also sold off on the back of growing fears that even the European Central Bank (ECB) would be forced to tighten policy in response to higher inflation. The backup in Australian and European yields ran counter to the latest policy guidance of from the RBA and ECB, indicating speculation of a bond-bearish hawkish policy shift. In countries where policymakers have been more explicit about the need for monetary tightening, like Canada and New Zealand, government bonds performed poorly in both Q3 and October. While US Treasury returns were “flattish” in both Q3 (0.1%) and October (0.1%), the 2-year Treasury yield doubled from 0.27% to 0.52% during October as the market pulled forward the timing and pace of Fed rate hikes starting next year (Chart 3). Shifting views on monetary policy have not only impacted the relative performance of bond markets, but also the shapes of yield curves. The bigger increases seen in shorter-maturity bond yields have resulted in a fairly synchronized global move towards curve flattening (Chart 4). This would not be unusual during an actual monetary policy tightening cycle involving rate hikes. However, within the developed economies, only Norway and New Zealand have seen an actual rate hike. In other words, yield curves have been flattening on the anticipation of a rate hiking cycle – but one that is expected to be relative mild. Chart 3A Bond-Bearish Repricing Of Global Rate Expectations​​​​​​ Chart 4Some Violent Repricing Of Policy Expectations​​​​​​ Forward interest rates in Overnight Index Swap (OIS) curves are discounting higher rates in 2022 and 2023 across most countries, but with stable rates in 2024 (Chart 5). Yet the cumulative amounts of tightening are very modest, especially when compared to inflation (both realized and expected). Only in New Zealand are policy rates expected to go above 2% by 2023, with the US OIS curve discounting the Fed lifting policy rates to just 1.4%. In the UK, markets are discounting 123bps of hikes by the end of 2022 and a rate cut in 2024 – market pricing that strongly suggests that the Bank of England will make a “policy error” by tightening too much, too quickly, over the next year. Chart 5Markets Still Think Central Banks Will Not Have To Hike Much After the October repricing of rate expectations, and reshaping of yield curves, we see a few conclusions – and investment opportunities – that stand out: US Treasuries With the Fed set to begin tapering asset purchases, the market discussion has moved on to the timing and pace of the post-taper rate hike cycle. The US OIS curve is discounting two Fed hikes in the second half of 2022, starting shortly after the likely end of the Fed taper in June. That timing and pace for 2022 is a bit more aggressive than we are expecting, but a rapidly tightening US labor market and rising wage growth could force the Fed to at least match the market pricing for hikes next year. On that note – the US Employment Cost Index in Q3 rose +1.3%, the fastest quarterly pace since 2001, and +3.7% on a year-over-year basis, the highest since 2004. The greater medium-term risk for the Treasury market is that the Fed starts to signal a need to go higher and faster than the market expects in 2023 and even into 2024. US Treasury yields remain well below levels implied by growth indicators like the ISM index. Thus, there is upside potential as the Fed tightens because of persistent above-trend growth and falling unemployment over the next couple of years (Chart 6). Chart 6Stay Below-Benchmark On US Duration Exposure We continue to recommend a below-benchmark duration strategic stance for dedicated US bond investors, based on our expectation that US bond yields will climb higher over the next 12-18 months. However, our more preferred way to play this for global investors is as a spread trade versus euro area bond yields – specifically, selling 10-year US Treasury versus 10-year German bunds (Chart 7). Chart 7Position For UST Underperformance Vs. Europe​​​​​​ While headline inflation in the euro area has rapidly converged to the pace of US inflation over the past few months, this is overwhelmingly due to surging European energy costs. The pace of underlying inflation, as proxied by measures like the Cleveland Fed trimmed mean CPI and the euro area trimmed mean CPI constructed by our colleagues at BCA Research European Investment Strategy, has diverged sharply with the latter barely above 0%. The ECB will not follow the Fed into a rate hiking cycle next year, which will push US government yields higher versus European equivalents. Australia Government Bonds Chart 8Fade The RBA 'Rate Shock' In Australia The RBA fought back against the sharp repricing of Australian interest rate expectations earlier this week by signaling that no rate hikes are expected until 2023. This is a modest change from the previous forward guidance of 2024 liftoff, but a surprisingly dovish message for markets that had rapidly moved to price in rate hikes next year after the big upside surprise on Q3/2021 Australian inflation With underlying trimmed mean inflation now having crept back into the RBA’s 2-3% target range, although just barely at 2.1%, the RBA would be justified in removing some degree of monetary accommodation. The central bank has already been doing so, on the margin, with some earlier tapering of the pace of asset purchases and last week’s decision to formally abandon its yield control target on shorter-dated government bond yields. Per the RBA’s current forward guidance, however, a move to actual rate hikes would require more evidence of tighter labor markets and faster wage growth – and thus, a more sustainable move to the 2-3% inflation target - that is not yet evident in measures like the Wage Cost Index (Chart 8). We plan on doing a deeper dive into Australia for next week’s report, where we’ll more formally evaluate our strategic view on Australian bond markets. For now, we remain comfortable with our overweight stance on Australian government bonds, as the RBA is still projected to be one of the less hawkish central banks in 2022. UK Gilts The sharp rally in longer-dated UK Gilts seen at the end of October was due to a downside surprise in the expected size of the UK budget deficit next year, and the amount of Gilt issuance that will be needed to finance it. The UK Debt Management Office (DMO) said it planned to issue 194.8 billion pounds ($267.5 billion) of bonds in the current 2021/22 financial year, 57.8 billion pounds less than its previous remit back in March. The pre-budget market expectation was for a far smaller reduction of 33.8 billion pounds. The cut in issuance was most pronounced for longer-dated Gilts, -35% lower than the March budget issuance projection (Chart 9). With longer-maturity Gilts always in high demand from longer-term UK institutional investors, a major “supply shock” of reduced issuance can temporarily boost bond prices and lower yields. This is especially true in the UK where more aggressive rate hike expectations, and more defensive bond market positioning after the August/September selloff, left Gilts vulnerable to a short squeeze. The most important medium-term drivers of Gilt yields are still expectations of growth, inflation and future policy rates. There was very little change in shorter-dated Gilt yields or UK OIS forward rates after last week’s budget announcement – all the price action was the long end of the Gilt yield curve, resulting in an overall bull flattening. As we discussed in last week’s report, we expect the next move in the shape of the Gilt curve will be towards a steeper curve, likely bond-bearishly as long-term yields are still priced too low relative to how high UK policy rates will eventually have to climb in the upcoming BoE hiking cycle. The post-budget flattening has made the valuation of longer-maturity Gilt curve steepeners far more attractive, according to our UK butterfly spread valuation model (Table 1). Table 1UK Butterfly Spread Valuations From Our Curve Models Chart 10A New UK Tactical Trade: Long 10yr Bullet Vs. 7/30 Barbell The trade that stands out as most attractive is to go long the 10-year Gilt bullet versus selling a 7-year/30-year Gilt curve barbell – a butterfly spread that was last priced this attractively in 2013 (Chart 10). We are adding this as a new recommended trade in our Tactical Overlay portfolio, the details of which (specific bonds and weightings for each leg of the trade) can be found on page 17. Bottom Line: Tighter monetary policies will pressure global bond yields higher over the next 6-12 months, but not equally. Stay underweight countries where tapering and rate hikes are more likely (the US, the UK, Canada, New Zealand) relative to countries where policymakers will move much more slowly (euro area, Australia, Japan). Global Breakevens: How Much More Upside? The surge in global inflation this year has helped boost the performance of inflation-linked government bonds versus nominal equivalents. Yet current breakeven inflation rates have reached levels not seen in some time. Last week, the 10-year US TIPS breakeven hit a 15-year high of 2.7%, the 10-year German breakeven reached a 9-year high of 2.1%, while the 10-year UK breakeven climbed to 4.2% - the highest level since 1996 (!). With market-based inflation expectations reaching such historically high levels, how much more can breakevens widen – especially with central banks incrementally moving towards tighter monetary policies? To answer that question, we turn to our Comprehensive Breakeven Indicators (CBIs). The CBIs measure the upside/downside potential for breakevens for the US, Germany, France, Italy, Japan, the UK, Canada and Australia. The CBIs incorporate the following three measures: The residuals from our 10-year breakeven inflation spread fair value models, as a measure of valuation. The spread between 10-year breakevens and survey-based measures of inflation expectations, as a measure of the inflation risk premium embedded in breakevens The gap between headline inflation and the central bank inflation target, as an indication of the existing inflation backdrop and of future monetary policy moves in response to an inflation trend that can help to reverse that trend. Each of the three measures is standardized and added together to produce a single CBI. A higher reading on CBI suggests less potential for additional increases in breakevens, and vice versa. The latest readings from our CBIs are shown in Chart 11. The red diamonds for each country are the actual CBI, while the stacked bars show the individual CBI components. The highest CBI readings are in Germany and the US, while the lowest are in Canada and France. Importantly, no country has a CBI significantly below zero, indicative of the more limited upside potential for breakevens after the big run-up since mid-2020. As a way to assess the usefulness of the CBIs as an indicator of the future breakeven moves, we constructed a simple backtest. We looked at how 10-year breakevens performed in the twelve months after the CBI hit certain thresholds (Chart 12). The backtest results show that the CBIs work as intended, signaling reversals of existing trends once the CBIs climb above +0.5 or below -0.5. The average (mean) size of the breakeven reversal gets larger as the CBI moves further to extremes. Based on the latest reading from the CBIs, we are making significant changes to the recommended allocations (Chart 13) to inflation-linked bonds (ILBs) in our model bond portfolio on pages 14-15: Chart 13No Overweights In Our Revised Allocations To Global Linkers Downgrading ILBs to underweight (versus nominal government bonds) in Germany, France, Italy & Spain from the current overweight allocation. The backtested CBI history for those countries suggests breakevens are more likely to fall over the next twelve months. Furthermore, realized euro area inflation is more likely to fall in 2022, given the lack of underlying euro area inflation described earlier in this report. Downgrade Japan ILBs to neutral from overweight. While the CBI is not at a stretched level, realized Japanese core inflation has struggled to stay in positive territory – even in the current environment of soaring commodity and durable goods prices. Upgrade ILBs in Canada and Australia to neutral from underweight. The former has a CBI that is still below zero, while the latter benefits from the lack of RBA hawkishness compared to other central banks. We are maintaining our other ILB allocations in the UK (underweight vs. nominals) and the US (neutral vs. nominals). In the UK, stretched breakevens are at risk from the hawkish turn by the BoE, which is a clear response to the higher UK inflation expectations. While the US CBI is at a high level, we see better value in playing for narrowing TIPS breakevens at shorter maturity points that are even more exposed to a likely slowing of commodity fueled inflation in 2022 than longer maturity TIPS breakevens. In other words, we see a steeper US breakeven curve, but a flatter real yield curve as the Fed tightens. Bottom Line: An update of our Comprehensive Breakeven Indicators shows limited scope for a further widening of breakeven inflation rates between nominal and index-linked government bonds in most developed economies, most notably in Europe.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.co Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index