Out of the (Home) Office - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 121, Out of the (Home) Office. Presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of May 24th. And with summertime nearly upon us and the big screen debut of In The Heights at hand, we're already looking forward to the sequel to learn if Usnavy ultimately joined the Navy.

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The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates, or subsidiaries.

Ian Lyngen:

Each week, we offer an updated view on the US rates market and a bad joke or two. But more importantly, this show is centered on responding directly to questions submitted by listeners and clients. We also end each show with our musings on the week ahead. Please feel free to reach out on Bloomberg or email me at ian.lyngen@bmo.com with questions for future episodes. We value your input and hope to keep the show as interactive as possible. So that being said, let's get started.

Ian Lyngen:

The week just passed in the Treasury market was notable for two primary reasons. The first reason was the fact that the Treasury market managed to maintain a relatively contained range, all things considered. We had the 20 year auction, the 10 year TIPS auction, both really came and went with little lasting market impact. More importantly, we saw the 10 year yield unable to push beyond 170 and ultimately resolve into a lower rate range with the 160 to 165 area representing the greatest amount of volume traded for Treasuries.

Ian Lyngen:

Further in the curve, we have seen some upward pressure on the usage of the RRP program, which is very consistent with the amount of cash that's floating around in the system as the TGA gets wound down and the Treasury department deploys cash to the state and local government levels. The second development that made this week notable was what came out of the FOMC minutes. Specifically, several participants believe that it will be appropriate to begin discussing the timeline for tapering over the next several meetings.

Ian Lyngen:

Now, we will argue that this is consistent with the broader consensus, which suggests that the unofficial trial balloons will occur at Jackson Hole in August, with the official announcement coming sometime in the fourth quarter and implementation of tapering a Q1 event. We have seen sufficient mixed messages from the economic data to suggest that the Fed won't have any particular urgency to bring forward tapering, nor to ultimately bring forward the first lift off rate hike.

Ian Lyngen:

Now, we ultimately expect that any pushback on the part of Fedspeak will not be directed at the lift off rate hike expectations, but rather centered around tapering. Now, that's simply because even as it currently stands, with the market pointing to either late 2022 or early 2023 for lift off, it's still too far out on the horizon for the Fed to see any need in refining those expectations. More immediately, however, are the prospects for tapering and the Fed's efforts to make any upcoming adjustment to the pace of asset purchases much more seamless than we saw during the taper tantrum in 2013.

Ian Lyngen:

With this backdrop, it follows intuitively that we expect the market to maintain a relatively tight trading range over the course of the next several weeks, with the caveat being that given the level of transparency that the Fed has provided in terms of what it will take to get tapering on the table, what we expect will transpire is you will have the market trading real time expectations of the Fed taper based on the same fundamental influences of the economic data.

Ian Lyngen:

Inflation, growth domestically as a departure point, but ultimately on the same measures on a global scale, which will, at the end of the day, truly dictate at the transition from an extremely accommodative monetary policy stance to one that is still providing accommodation, but represents a scaling back as the real economy reopens and begins to heat up, as sidelined workers are once again brought into the ranks of the employed.

Ben Jeffery:

So while it was not particularly inspired in terms of the net price action this week in the Treasury market, remember what we were coming out of, an 800,000 miss in NFP and the highest Core CPI read since 1981. But yet, here 10 year yields are, right in the middle of the range.

Ian Lyngen:

Right in the middle of the range were between 160 and 165, and that's after taking down the 20 year auction, as well as 10 year TIPS. I do think it's worth highlighting the performance of the 10 year TIPS auction. We saw what had been previously an average tail. But given the relevance of inflation expectations at this point in the cycle, I was somewhat surprised that there wasn't more aggressive bidding for inflation protection. What's your take on that, Ben?

Ben Jeffery:

Looking at the price action and real yields over the past several months when we did see four consecutive stop throughs at 10 year TIPS auctions, pretty notable there. What we saw was one of the most relevant themes of the first quarter, which was after what had been an increase in nominal Treasury yields driven pretty much entirely by a move higher in break evens, real yields began to rise pretty substantially from roughly negative 110 basis points to as "high" as negative 58 basis points.

Ben Jeffery:

But now that we've seen some of the ambitions on the recovery moderated on the margin and real rates brought back mid range, this week's auction stopped at negative 80.5 basis points. Really, to me, it suggests a bit of stabilization in this current paradigm while the market awaits greater clarity on whatever comes next in terms of the recovery.

Ian Lyngen:

This is also very consistent with the idea that some aspects of the recovery might have peaked. We see that in terms of manufacturing sentiment with the regional manufacturing surveys, as well as the ISM numbers starting to retrace off the highs. But this is also consistent with the notion that the initial leg of the reflationary trade might have run its course.

Ian Lyngen:

That doesn't mean that we won't see inflation come back into the system later in the cycle, but this reflects a broader dynamic of bringing forward all of the upside in terms of growth, rehiring, and reflation, which really does set up the next several months to be an important inflection point for the outlook.

Ben Jeffery:

And on TIPS specifically, there's also a bit more of a flows driven factor. Given last week's adjustment to the QE program, which shifted the Fed's buying in favor of longer dated coupons while purchasing marginally less TIPS and shorter dated coupons. Also, the day before the 10 year TIPS auction, we did get the FOMC minutes where we saw what could be argued as the first formal hint that may be the FOMC could be starting to potentially begin maybe thinking about tapering.

Ian Lyngen:

What you're saying is that one day in the future, if everything goes according to plan, there might be the possibility that the amount of purchases and the Treasury and mortgage market could be potentially scaled back.

Ben Jeffery:

Definitely maybe.

Ian Lyngen:

Yeah, that sounds about right. In all seriousness, this is the point in the cycle where monetary policy officials should be discussing the correct time to bring tapering into the broader market discourse. Now, I'll make the argument that this particular episode of tapering will be much different than what we saw in 2013 and 2014. And the primary reason is not sequencing or the magnitude of tapering per se, but rather the fact that investors generally know what to expect.

Ian Lyngen:

Now, whether 2021-22 ultimately mirrors the process of tapering during the previous cycle remains to be seen, but it's not new to investors. So unlike during the taper tantrum, there's no real concern that the Fed is going to ultimately end up selling mortgages, or ultimately end up selling Treasuries directly into the market to scale back their portfolio. Rather, we understand that all else being equal, the Fed will stop buying rollover maturities, and at some point attempt to normalize the balance sheet by maturities run off.

Ian Lyngen:

But that latter leg of that won't be at least until 2025, 2026 at the earliest. This largely insulates the Treasury market in terms of price response when we ultimately do get the announcement.

Ben Jeffery:

And over the past several weeks, the specter of tapering was something that many pointed to as what would ultimately be the catalyst to get us back to handle 10 year yields. But now that we've seen the first hint at the discussion that got 10 year yields just below 170, presumably there'll be more communication on the topic throughout the summer in the lead up to Jackson Hole. Maybe that gets us another sell-off of a comparable scale.

Ben Jeffery:

But if 10 year yields are back between 160 and 170, that still leaves us well shy of the top of the trading range at 177, which begs the question, is that level going to serve as the ceiling for 10 year yields for the next two quarters?

Ian Lyngen:

So I would say yes. And the reason that I'm assuming that is because we're entering the period of the year where the seasonals tend to be particularly constructive for the Treasury market. On average, we tend to see 10 year yields drop roughly 35 basis points from the beginning of June to the middle of September. Layer on top of that, all of the uncertainties associated with reopening the US economy, as well as the continued battle against COVID-19 overseas. The latter aspect of that will come into greater relief over the next several months.

Ian Lyngen:

Because while the US appears to be rapidly approaching a post-pandemic reality, what's going on overseas, particularly in emerging markets, will continue to provide a stabilizing bid for the Treasury market and really make that 2% 10 year yield more elusive than I think many anticipated at the beginning of this year.

Ben Jeffery:

And not solely from a seasonal perspective, but also given where some of the macro stars are aligning, around that end of August, early September period. We have the Jackson Hole symposium in late August. We have the unemployment benefits rolling off, maybe, maybe not, on Labor Day. And of course, another three months of jobs and inflation data to assess just how well the recovery is going. Now in terms of price action in the Treasury market, this points less to trending yields and more to a drift roughly around the levels where the market will enter summer.

Ben Jeffery:

Call that Memorial Day. So in keeping with the adage, never sell a quiet market, Ian, I think your take that 177 will be the ceiling on 10 year rates makes a lot of sense.

Ian Lyngen:

That does beg the question, what would it take to get 10 year yields to 2% over the course of the next two months? I think that the short answer to that is another nine-tenths of a percent month over month print on Core CPI combined with an NSP print above two million. Aside from that, I think it will be very difficult for the market to embrace the reflation reopening trade in the way that it had previously.

Ben Jeffery:

And on the inflation front, as investors have come to grips with what we saw last week, the influence of supply chain bottlenecks has become readily apparent. So again, in sticking with this idea of the passage of time is going to give us greater clarity on exactly where inflation and hiring stand at this stage in the recovery.

Ben Jeffery:

As some of these supply disruptions begin to fade, maybe most notably the chip shortage, which inspired that 10% month over month increased in used auto prices and accounted for more than a third of the overall Core-CPI increase, it's once those nuances have been worked through that I think we'll have a clearer picture of the inflation landscape and suggest another print on the scale we saw in April is unlikely in the near term.

Ian Lyngen:

Let us not forget that there is a distinct difference between supply side inflation and demand side inflation. All we're really seeing at this stage is classic supply side inflationary pressures. And at its essence, that functions more as a tax on consumption rather than a reflection of an economy that is heating up. It's the clarity on this debate we'll receive over the course of the next several months that will ultimately drive inflation expectations and the market's response to them.

Ben Jeffery:

And focusing more specifically on this week in the Treasury market, in terms of economic data, we do get confidence figures, as well as durable goods orders. But really similar to this past week, what will be the most market moving is the May auction of twos, fives, and sevens, and any associated demand for duration around month end, which on the margin would be a flattener, even if it's unlikely that these factors will break the trading range.

Ian Lyngen:

One of the questions that we've received quite frequently over the last week or so has been related to the RRP take-up. Now, there's a ton of cash in the very front end of the market. However, it is notable that we're starting to see record high usage of the reverse repo program outside of calendar dates, of course.

Ben Jeffery:

On Thursday, specifically, we saw over $350 billion put at the Fed overnight at a rate of 0.0.

Ian Lyngen:

Seven years of college down the drain.

Ben Jeffery:

And this raises the question of the urgency on the part of the Fed to deliver on any tweaks of their administered rates, whether that be IOER or the rate offered at the RRP facility itself. Now, there is a bit of a calendar consideration this week specifically, given the fact that GSEs have more cash to deploy, but more generally, the theme of liquidity leaving the TGA and beginning to make its way into the market via the state level relief funds promises to keep the pressure we've been seeing on the money market intact.

Ben Jeffery:

Now, for the time being, effective Fed funds has been able to hold at six basis points. But if we start to see consistent prints at five basis points or below, which has been the threshold that has triggered technical adjustments in the past, the committee certainly has the ability to make these changes at an FOMC meeting or not.

Ian Lyngen:

One of the things that the Fed has done a very good job of is distancing adjustments to the administered rates from monetary policy meetings. And in doing that, they have really, from an investor's perspective at least, delineated the two. You have adjustments in the administered rates, and you have monetary policy as a separate issue. So that ultimately decreases the potential market impact of any such change by the Fed, especially further out the curve. Now, clearly it will have implications for repo rates and for effective Fed funds by design.

Ian Lyngen:

However, there'll be very little carry through even out to the two year sector, frankly.

Ben Jeffery:

And for all the work we've done on this, it's still really not clear how this impacts mule coin.

Ian Lyngen:

Wrong pack animal.

Ian Lyngen:

In the week ahead, the Treasury market will have front end supply with which to contend. We'll have twos, fives, and sevens. The seven year auction, given its weak performance earlier this year, will remain a focal point and perhaps even a touchstone for the bond vigilantes, particularly if there is a greater concession required to take down this week's supply.

Ian Lyngen:

All else being equal, however, given the stability in the Treasury market and the fact that rates have pulled off of the highs, we anticipate this round of the underwriting of the federal deficit will be uneventful as market participants look forward to month end duration needs and a transition into June, and what will presumably be summer trading conditions. There are a couple of data points of note on the calendar, however, first being durable goods on Thursday, which will provide some additional context for business spending in the second quarter.

Ian Lyngen:

More importantly, however, will be the personal income and spending report on Friday. This will be April's data and provide additional information on the pace of consumption as the second quarter got underway. Recall that the flat headline retail sales print for April suggested that goods consumption at least had waned after a very strong first quarter. The question in quickly becomes whether or not that was shifted into service consumption.

Ian Lyngen:

And as that information is contained in personal spending, a more detailed breakdown will be useful as we gauge precisely where the economy is in the reopening process and the implications for hiring.

Ian Lyngen:

One of our primary concerns about the pace of growth in the balance of 2021 remains that the combination of an accelerated timeline to vaccinations and reopenings, as well as the massive amount of fiscal stimulus injected into the real economy during the first quarter has effectively front loaded the economic upside to the beginning of the year, perhaps even simply the first quarter.

Ian Lyngen:

In that case, the risk then becomes that investors will take the trajectory with which we started this year and assumes that a version of it is able to continue unabated into the end of the year. There's a fair amount of optimism implied with such an outlook. But versus the Fed's own forecast for real GDP for 2021 to be 6.5%, the economy will need to continue a pace to avoid more material disappointment. We've reached the point in this week's episode where we'd like to offer our sincere thanks and condolences to anyone who has managed to make it this far.

Ian Lyngen:

As we approach the increasingly rare and elusive SIFMA recommended Friday early close, we're reminded that if the pandemic has taught us anything, it's that it's two o'clock somewhere and there's true value in putting the leisure back in F leisure. Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy effort as interactive as possible, we'd love to hear what you thought of today's episode. So please email me directly with any feedback at ian.lyngen@bmo.com.

Ian Lyngen:

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