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US Rates Strategy

US Rates Outlook: Insurance or More?

Ian Lyngen, CFAHead of US Rates StrategyIan.Lyngen@bmo.com212-702-1703

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Our Call: Late-Cycle Inflection

Source: BMO CM

Q3 '19 Q4 '19 Q1 '202s 1.65 1.55 1.15

2s/10s 0.10 0.45 0.455s 1.45 1.40 1.20

10s 1.75 2.00 1.6030s 1.95 2.15 1.80

5s/30s 0.50 0.75 0.602s/10s/30s -0.10 0.30 0.252s/5s/10s -0.50 -0.75 -0.35

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Fed’s Dimming Economic Outlook FOMC 2019 2020 2021 Long-Run

GDP 2.10 2.00 1.80 1.90Mar Est. 2.10 1.90 1.80 1.90

Core-PCE 1.80 1.90 2.00 Mar Est. 2.00 2.00 2.00

UNR 3.60 3.70 3.80 4.30Mar Est. 3.70 3.80 3.90 4.30

Fed Funds 2.40 2.10 2.40 2.50Mar Est. 2.40 2.60 2.60 2.80

Source: FOMC, BMO CM

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Third Quarter 2019: Monetary policy uncertainty will be particularly high during the

third-quarter following the Fed’s preemptive easing plan. The debate is how far (no longer ‘if’) Powell will need to go –particularly if any additional correction in risk assets has occurred.

The trade war continues to drag out with no end in sight. The prospects for further escalation linger as hopes for a near-term deal with China dim.

Traditional economic theory holds that the 12- to 18-month lagged impact of monetary policy will begin to flow through to the real economy in H2 2019.

Source: BMO CM

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Fourth Quarter 2019: As the year winds down and the combination of mixed economic

optimism and an even more cautious Fed becomes a reality, questions about what will cause the next recession will dominate the market discussion.

A lower forward path of policy rates will be priced in as investors begin to more convincingly look beyond the ‘insurance cut’ narrative to whatever may be lurking on the horizon.

Solidifying concerns about a global slowdown will serve to contain rates and the shift in monetary policy will lead the belly to outperform. Any steepening of the curve will be offset by investors’ belief that the Fed will employ the balance sheet (i.e. a fresh round of QE) if the next economic downturn becomes severe enough. This is a new dynamic in the Treasury market based on the experience of the Fed’s response to the crisis.

Source: BMO CM

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Seasonals are a Key Factor in Our Near-term Bias

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Rolling Fed Expectations Will Imply Deeper Cuts

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Financial Conditions Much Easier in 2019

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Neutral: We’ve Passed It (Funds vs. Core-PCE)

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Volatility Drives Financial Conditions

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Front-end Inversion is Very Typical

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Fed’s Curve Preference

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Cleveland Fed’s Recession Odds Climbing

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Under-Confidence Risk

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Falling Confidence Lowers Spending

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5s/30s Cyclical Flattening Completed

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Above Average Growth Sustainable?

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Trade Remains a Wildcard due to Tariffs

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Is the CapEx Boom Over?

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Inventory Drag – Big Bet on Consumption

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Inventories Building Faster than New Orders

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Housing Continues Weighs on Domestic Growth

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Global Business Sentiment Declining

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Europe Still Leading Race Lower

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European External Export Growth Stalls

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Global Manufacturing PMIs Dismal

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Global Trade Declining Sharply

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Disappointing 2019 for US and World Economies

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European Economy Turning? Trade Concerns Linger

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Italy’s Recession Triggers European Banking Concerns

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Every Significant Recession Preceded by an Energy Spike

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Different This Time? US Oil Production Soars

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Different This Time? Concentration in Lower-end IG

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Non-Mortgage Interest Payments Spike Ahead of Recessions

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Savings Rate Falls as Interest Payments Increase

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Importance of Student Debt and Auto Loans

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Student Debt Delinquencies Remain Elevated

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<35 Year-old Homeownership Hit Hardest

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Education Loans Undermining Household Formation

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Real Wage Gains

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AHE Don’t Guarantee Accelerating Core-CPI

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Home Buying Conditions Lowest Since 2009

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Consumer Confidence and Housing Diverge

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Home Buying Conditions more than just Mortgage Rates

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Downward Pressure on Prices in 2018

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Real Net Worth Negative (YoY)

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Risk to Corporate Profit

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Corporate Receipts Drop on Tax Reforms

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Year-over-Year Core Peaked

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Rent and OER Remain Strong

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Downward Pressure on OER

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Shelter a Key Positive Contributor to Inflation

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Ex-Shelter CPI Under Pressure

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Tariffs, Soy (11.2%), and Commodity Pressure

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Autos: Driving Modest CPI Volatility

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Apparel: Transitory or Just Volatile?

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SMRA Shows Investors No Longer Short

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Sentiment Remains Overbought

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Overseas Interest in TIPS Plummets

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TIPS Ownership High in China and UK

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Hedge Adjusted 10-year Yields Range-Bound

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Japanese Investors Back in Treasuries?

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When does China Return to Treasuries?

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Foreign Official Flows Show Significant Selling

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