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Ranging Bull - The Week Ahead

FICC Podcasts October 15, 2021
FICC Podcasts October 15, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of October 18th, 2021, and respond to questions submitted by listeners and clients.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Ian Lyngen:

This is Macro Horizons episode 142 Ranging Bull, 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 October 18th. And with Captain Kirk now having completed his first actual trip to outer space, we're eagerly awaiting the Amazon delivery of our hoverboard, an idea that never really took off. Get it?

Disclaimer:

The views expressed here are those of the participants and not those of BMA Capital Markets, its affiliates or subsidiaries.

Ian Lyngen:

Each week, we offer an updated view you 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 I-A-N.L-Y-N-G-E-N@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:

In the week just past, the Treasury market, received a lot of meaningful fundamental information to guide trading direction. Interestingly, the inflation series was skewed toward the stronger side. And nonetheless, we saw supportive trading in Treasuries as a theme. Early in the week, actually the overnight session on Tuesday morning, we saw 10 year yields peak at 163, slightly through that range that we had been targeting of 155 to 160, but that dip was quickly bought even ahead of the 10 year auction, which stopped through eight-tenths of a basis point.

Ian Lyngen:

And then subsequently the 30 year also received notably strong sponsorship stopping through 1.3 basis points. This was followed by a pandemic low for jobless claims, all of which suggests that there remains upward pressure on the inflation complex in the US and the jobs market is continuing to improve after the Delta variant led to a spike in COVID cases and undermined reopening confidence. We've been focused on the October seasonals in the Treasury market, which imply a steeper curve and a backup in yields.

Ian Lyngen:

What we're left to ponder after the recent price action is whether or not that dynamic has completely run its course. We're certainly still on board with the notion that it will be extremely difficult for 10 year yields to test that 177 level scene earlier this year, at least not until tapering is well underway and we're into Q1, Q2 of 2022. This leaves the Treasury market in something of a holding pattern between now and the FOMC meeting. One aspect of the price action that I will highlight is that five year yields remain decidedly above 1%.

Ian Lyngen:

Now, this is clearly a pandemic high for rates in the five year sector and also function the fact that tapering is an obvious hurdle on the way to the liftoff rate hike. So assuming that the Fed does deliver on tapering in roughly two and a half weeks, the next major policy move will be the beginning of the rate normalization campaign. This leaves us very sympathetic to the sell off that we've seen in fives and, if anything, implies that there's a floor for five year yields.

Ian Lyngen:

There's no comparable argument for a floor for yields further out the curve. However, it's also notable that 10 years yields at 150 are far from the pandemic peaks. Similarly, for 30 year yields, in short, the dynamics favoring a flattening of the 5s30s and the 5s10s curve remain in place, and we don't see a meaningful divergence from that anytime soon. The only way that one would expect to see a re-steepening take place would be if the Fed chose to air on the side of being less hawkish even in the face of accelerating inflation.

Ian Lyngen:

Inflation that comes into the system that the Fed is unwilling or unable to respond to would lead investors to demand greater inflation compensation to go further out the curve. That was the story of Q1 2021 before the Fed pivoted hawkishly and left the market with a decided impression that even despite the change in the framework, the new Fed is an awful lot like the old Fed.

Ben Jeffery:

It was a very interesting week. Not only given the price action itself, but also the backdrop in which it occurred. We saw 10 year yields reach beyond 160. But even with the 10 and 30 year reopenings, strong sponsorship materialized and now we've seen rates move decidedly lower.

Ian Lyngen:

I think part of what is going on was simply the passing of the event risks associated with the 10 and 30 year auction, as well as the core CPI number, which came in as expected at two-tenths of a percent for the month of September. Now, granted that was a particularly high two-tenths of a percent and it effectively rounded down, but nonetheless, what it wasn't is it wasn't the series that we saw between April and June when core CPI was printing in the 0.7, 0.9 range.

Ian Lyngen:

We're starting to see some of the moderation on the inflation front that the Fed had been anticipating given their transitory narrative. Now, for context, our baseline assumption isn't that we're going back to sub 2% core inflation, rather that we will see inflation continue to mean revert back to levels that imply less urgency on the part of the Fed to follow through with earlier rate hikes.

Ben Jeffery:

And while the core measure match estimates with that rounding caveat that you mentioned, Ian, the headline figure was higher than expected. This inspired a very interesting question we fielded this week, which is well, yes, the Fed focuses on core prices and determining monetary policy. If, in fact, surges in food and energy costs continue to accelerate and start to serve as a tax on consumption, will the Fed respond to the at and what would they be able to do to offset higher food prices or higher prices at the pump?

 

Ian Lyngen:

On its base level, I'd be very surprised if the Fed responded to higher energy prices, because let us not forget the reason that the Fed focuses on core CPI and core PCE is because it takes out the volatility associated with energy prices, as well as food prices. There's also an argument to be made that if more money is being spent on food and energy, there will be less disposable income to drive up core prices. To some extent, higher energy prices could serve to moderate some of the gains on the core front.

Ian Lyngen:

That said, what we saw in September was that the primary driver of core CPI at this point is OER and rent, and that is a function of the dislocations that occurred during the pandemic as people moved out of the densely populated urban centers into the first and second ring suburbs, only to find a shortage of ready housing stock. The recent run-up in energy prices also brings to mind the notion that the federal government might consider deploying the strategic oil reserves.

Ian Lyngen:

Now, our take is it's far too soon to assume that that will come into play. But when we ponder how the US' energy profile on the global stage has shifted over the course of the last few decades, it is worth highlighting that as a net exporter of oil, the ramifications from higher energy costs are somewhat different than they have been in the past, particularly when we consider the employment profile of the energy sector.

Ben Jeffery:

And in addition to these energy considerations, there's also simply the supply chain bottlenecks that now have garnered Washington's attention given the concerns on both the corporate and individual side about long lead times and higher prices. We've now seen that the Port of Los Angeles is going to operate 24/7 and several large corporations have also committed to take steps to try and alleviate some of these supply side concern that are also contributing to the upside we've seen in inflation.

Ben Jeffery:

From a longer term perspective, these factors almost by definition cannot persist indefinitely. And even if the transitory of indication that the Fed has been seeking may be taking longer to play out than initially anticipated, I think it's fair to say that there is still certainly backing to that narrative.

Ian Lyngen:

In the context of inflation and inflation expectations, one of the questions that we received this week had to do with the markets on again, off again inflationary trade. And the reason that I wanted to high this notion is it seems to be relatively common. The perception is that the curve steepens and the market's worried about inflation or flattens as inflationary concerns abate.

Ian Lyngen:

What I find fascinating is if we look within the breakeven complex, what we see is that at the beginning of 2021, the market repriced to significantly higher forward inflation expectations. 10 year break evens backed up to the 260 range. And while break evens have since stabilized at roughly 250, it's notable that they've spent the majority of 2021 near that range. So that suggests that the broader moves in nominal rates were actually a function of growth expectations, both domestically and abroad.

Ian Lyngen:

When we look at 10 year real yields, what we now see is that the sell-off in the wake of the September FOMC meeting has moderated somewhat and 10 year real yields drifted back below negative 95. Essentially, the takeaway is it's much less about an on again, off again reflation trade and more about gauging the timing and the ramifications of the pace of growth out of the pandemic.

Ben Jeffery:

There's also an aspect of the Feds tapering ambitions to consider in the TIPS market as well. We were focused on the "TIPS tantrum" given the Fed's comparatively outsized participation in the TIPS market versus the nominals market. And this week we also received greater clarity on that process via the September FOMC minutes. Participants on the committee were advocating for tapering to begin either in mid-November or mid-December presumably on the same schedule that we've seen QE announced throughout this cycle.

Ben Jeffery:

With the proof for pace telegraphed as what I would argue was consensus at $10 billion a month in Treasuries and $5 billion a month in mortgages. Now, an uncertainty that was left unanswered by the minutes is whether or not the FOMC will deliver a forward commitment to stick to that $15 billion a month pace, or if the language around the decision will offer some flexibility, say $15 billion a month, should the recovery proceed in line with forecasts or something of that nature.

Ian Lyngen:

Yeah, Ben, I think it goes without saying that they will build in a degree of flexibility. So effectively saying data dependent, the Fed will reduce QE purchases by an aggregate of $15 billion a month, unless there's a material slowdown in the real economy, or on the flip side, if there's a much higher than expected series of realized inflation data, then the Fed might choose to accelerate the process. Clearly a risk that should at least be acknowledged, even if we don't expect that it will ultimately come to fruition.

Ian Lyngen:

The Fed has done a very good job of laying the groundwork for a November announcement. They have even outlined the fact that they expect that it will end in mid-2022, which then brings us to the next debate and that is will the Fed high rates 2022, which the future's market now has fully priced in?

Ben Jeffery:

But it is important to consider that there's a lot of recovery yet to be realized between now and the end of 2022. So while this expectation that we'll see lift off before the outset of 2023 certainly resonates with the data we've seen recently, let's not forget the tendency by the market to be a bit over zealous in pricing the Fed's next move, not even necessarily in hiking cycles, but easing as well.

Ben Jeffery:

We generally have tended to see the market overestimate the speed with which the Fed will change rates. In a cutting cycle, that's taken the form of more rapid rate cuts. And in this current environment, it might arguably be translating to an earlier than expected lift off in the third quarter of next year.

 

Ian Lyngen:

Another trading tendency in the US market that could also account for what we're seeing in Fed fund futures and Euro dollars is this tendency for the market to price in the current state of monetary policy for the foreseeable future. And the foreseeable future in this context is basically defined as two or three quarters. And then at the edge of the foreseeable future, pricing in what's expected to be the next move. In this case, rate hikes.

Ian Lyngen:

So while there might be an argument to be made that the market is being overly optimistic in pricing in an early liftoff, the reality is that once taper been announced, the pricing really won't be that much of a divergence from what we tend to see in the future's market.

Ben Jeffery:

This also brings us to a question that we very often receive as investors are focusing on when the Fed is going to move, and that is, is the market able to move prices in such a way to force the Fed's hand and make them hike rates?

Ian Lyngen:

I'd argue that the market can't force the Fed to hike, although the market can force the Fed to cut. If we think about the dynamics that would need to transpire for the market to attempt to force the Fed's hand, what would we be looking for? We'd be looking for an increase in rates, particularly in the very front end of the market, which would in effect tighten for the Fed rather than prompt the Fed to tighten.

Ian Lyngen:

A significant sell-off in the front end of the market would tighten financial conditions as well, and thereby make it less likely that the Fed would be compelled to follow through with an aggressive series of rate hikes. One aspect of what I suspect will ultimately come to fruition is that when the data dictates, the Fed will make sure that the market expectations are consistent with their understanding of the appropriate time for the first rate hike.

Ian Lyngen:

The most that we could expect from the market is a repricing to mirror the Fed's anticipated tightening timeline, in effect granting them a window to tighten without disrupting expectations. That's decidedly different than the market tightening for the Fed.

Ben Jeffery:

And on the topic of great debates, we've also reached point in the year when we're going to start to need to see some clarity on who exactly is going to be, A, nominated for chair of the Fed and, B, fill some of the important vacancies that are existing and forthcoming.

Ian Lyngen:

One of the aspects of this process that jumps out at me is that all else being equal, we would've expected to hear from the buy Biden administration by this point on their preferred candidate. Now, there have been some reports out of the White House that Powell still has the support of Biden and is likely to get the nod, although it is by no means official at this point. There's still a reasonable amount of uncertainty.

Ian Lyngen:

One of the key implications from a new chair or a new round of board members would be an expression of the notion that any sitting president would like the easiest monetary policy possible, so we're assuming that any new names that make it onto the roster will be on net more dovish.

Ben Jeffery:

So while originally the rotation of voting FOMC members in the new year was going to tilt a bit hawkishly, it's now fairly reasonable to assume that with Kaplan and Rosengren's resignation, coupled with new appointments, we may ultimately see a more dovish tilt from the central bank.

Ian Lyngen:

And that would be very consistent with our broader grain trading thesis and the idea that once we do enter the new year and see further progress toward the new normal, that the realized data will allow the Fed enough flexibility not to rush into rate hikes more quickly than they would otherwise want to.

Ben Jeffery:

Bernanke, Yellen, Powell, Lyngen.

Ian Lyngen:

Well, I noticed that you left out Volcker and Greenspan.

Ben Jeffery:

That was before my time.

Ian Lyngen:

Ben, conference calls on a phone in a conference room were before your time. In the week ahead, the Treasury market will have a dearth of economic data to provide trading direction. While typically this would set the stage for the technicals to be particularly influential in US rates trading, the reality is that the Treasury market will be in a holding pattern between now and the November 3rd FOMC meeting.

Ian Lyngen:

All else being equal, the Fed has done a masterful job of setting the stage for a November taper announcement to be implemented either in mid-November or mid-December. What remains to be seen are the exact details, although the minutes from the September FOMC meeting have floated the idea of $15 billion of tapering a month that concludes QE sometime in mid-2022. At this stage, that's relatively consensus and we see very little upside in skewing the odds in either direction.

Ian Lyngen:

We're making our way to the point of the year where investors start to contemplate the year ahead and forecast anticipated market reactions to the upcoming events. Our baseline range trading thesis will continue to hold throughout 2022. That isn't to suggest that we won't see cycle high rates in 10s and 30s. In fact, that's part of our baseline call the year ahead. At its essence, the degree to which the market was overly optimistic at the beginning of this year will play out next year.

Ian Lyngen:

The primary difference being that the global economy is that much further along the path out of the pandemic and we have more information in terms of how the economy will perform, how the work from home revolution is going to impact patterns of consumption, commuting, business, travel, et cetera, and we will have a year's worth of higher than expected realized inflation.

Ian Lyngen:

This implies that the two handle on the 10 year note during the first half of the year is very doable, as is a long bond yield above 275. This would presumably be accompanied by a fresh round of optimism, continued performance in the equity market, and risk assets overall. And a notion that while 2022's real GDP numbers won't be as dramatic as 2021, we are transitioning to a more sustainable pace of growth, even if it's a bit mean reverting, and monetary policy is progressing in a pace with the liftoff rate hike looming on the Macro Horizon.

Ian Lyngen:

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. And with offices once again scheduled to reopen, we'd like to remind everyone that the shared copier is a public forum, microwaves are not for fish, and sweatpants do not qualify as business casual, and neither does Ben's cat costume.

Ben Jeffery:

I'm here live. I'm not a cat.

Ian Lyngen:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy effort as interactive possible, we'd love to hear what you thought of today's episode. Please email me directly with any feedback at ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple Podcast or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

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BMO assumes no responsibility for verification of the information in this podcast, no representation or warranty is made as to the accuracy or completeness of such information and BMO accepts no liability whatsoever for any loss arising from any use of, or reliance on, this podcast. BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter and information may be available to BMO and/or its affiliates that is not reflected herein.

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BMO and its affiliates may have positions (long or short), and effect transactions or make markets, in securities mentioned herein, or provide advice or loans to, or participate in the underwriting or restructuring of the obligations of, issuers and companies mentioned herein. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast.

Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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