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Sizing Up the Downside - The Week Ahead

FICC Podcasts June 30, 2022
FICC Podcasts June 30, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of July 5th, 2022, 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 178, Sizing up the Downside. Presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey, to bring you our thoughts from the trading desk for the upcoming week of July 5th. And as the annual institutional investor fixed income poll opens on Tuesday, we ask for your support in the process this year. If you have any questions regarding how to receive a ballot, please reach out to us directly. And recall, a vote for Macro Horizons is a vote for strange, or at least slightly odd.

Speaker 2:

It is a podcast about interest rates after all.

Ian Lyngen:

Trying to keep it interesting.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, its 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, the 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:

In the week just past, the US rates market received plenty of fundamental information with which to further refine forward expectations for this cycle. First up was the mix of economic data. Durable goods came in higher than expected, increasing seven tenths of a percent month over month. Within the details, the core series also printed above expectations, as did pending home sales. On the flip side, however, consumer confidence, the conference board's measure, dropped to just 98.7. That's the weakest from this series since February 2021.

Ian Lyngen:

We'll argue, more importantly, there were some key downward revisions to first quarter's GDP print. From the final measure, we saw that overall GDP declined 1.6% during the first quarter, and consumption, which had been running up 3.1%, was ultimately revised lower to indicate a far more modest 1.8% gain. This will certainly leave the pace of consumption in focus over the coming months, with an emphasis on the next update from here being the retail sales print for the month of June. From the perspective of supply, we did see tails at all three auctions. The two year tailed six tenths of a basis point. Fives tailed three and a half basis points. And sevens tailed 1.9 basis points. Overall, we're comfortable characterizing this as a lack luster reception to supply. We also heard from Powell and several important Fed speakers, who reiterated that price stability is the most important objective of monetary policy makers at this moment.

Ian Lyngen:

While he stopped short of saying he would be content to trade a recession for longer term price stability, the takeaway from his comments did imply just that. And it's in this context that we continue to see the shape of the yield curve remain relevant, twos tens pushing back toward inversion. In the window between the holiday weekend and the run up to the July 27th FOMC meeting, our expectations are that a deeper inversion will characterize the shape of the yield curve.

Ian Lyngen:

In no small part, this is a function of the fact that the Fed has put 75 basis points on the table for the next rate hike. And while the Fed might attempt to guide market participants away from assuming that 100 basis points is possible, that certainly won't keep the market from attempting to at least put in a non-zero probability of a 100 basis point move. As a result, there will be a higher floor in two-year yields than there will in tens in the coming weeks. In the week just past, the daily volume totals were anywhere between half and three quarters of what we have seen in the prior two weeks. This is more than the classic summer doldrums. Rather, we were coming off of a period of particularly high volatility, to one in which we're seeing a consolidation in the rates market with a drift lower in overall yields.

Ben Jeffery:

Well, Ian, I don't want to be overly optimistic, but maybe, just maybe, the worst of the volatility in treasuries is behind us?

Ian Lyngen:

Having spent a career in the bond market, I can say one thing for sure, Ben. If you're going to be overly optimistic, bonds are not the place to be. That said, we have had a relatively volatile period in the treasury market, which is consistent with the inflection of the macro narrative that has transpired. The market has gone from being concerned about inflation as the public enemy number one for the economy to growing concerns that the US might be slipping into a recession. Now, while that might intuitively suggest an extended period of uncertainty, that won't necessarily translate into realized volatility.

Ian Lyngen:

And I think that's the market sentiment that you're focused on, Ben. And moreover, that's an idea worth exploring. If we find ourselves in a situation where the upper end of 10-year yields is in fact 3.50, then an extended period of consolidation certainly begins to resonate. And frankly, as it currently stands, we are squarely in the peak rates camp. Now, that doesn't imply that we've necessarily seen the upper bound of headline inflation on a year over year basis. And with that in mind, we'll be focused on the July 13th release of the CPI data for June, where we're anticipating another strong headline print while core begins to moderate.

Ben Jeffery:

And in terms of sentiment and how the market is evaluating the balance of risks over the rest of this year, and probably at this point into 2023, I would argue that even another strong CPI print, similar to what we saw in mid-June before the FOMC meeting, will at this point, be read as a green light for the Fed to deliver another 75 basis point hike on July 27th, but not drive monetary policy makers to increase their hawkishness to the next plateau. That means more 75 basis point hikes, or maybe even entertaining the idea of a full percentage point move.

Ben Jeffery:

This has to do with the fact that Powell told the market that 75 bp moves are not going to be a common occurrence, as well as the reality that unlike earlier this month, when the criticism levied against the FOMC was not doing enough, now sentiment has swung in the other direction, and that the market is growing increasingly concerned the Fed is acting too aggressively. Obviously, very closely related to the recessionary worries you touched on, Ian, but it's this swinging dovish and hawkish sentiment that I would argue leaves 75 basis points in July with probably 50 in September as the most likely outcome. After all, we know inflation is well beyond transitory and going to remain strong for at least the next several months.

Ian Lyngen:

Now, while we're in complete agreement about the near term outlook for the Fed, that isn't to suggest that the market won't attempt to price in the probability of a 100 basis point rate hike in July. Now, if the market is successful in doing that, that raises a very interesting question. Historically, the Fed has taken the opportunity to hike, for all intents and purposes, as much as the market has priced in with a few notable exceptions. The first one that jumps to mind was the initial rate hike of this current cycle, where the market was arguably comfortably priced for a 50 basis point liftoff. And the Fed, because of the situation in Ukraine and the associated uncertainties, only chose to deliver a quarter point move. Fast forward to July 27th, and we could find ourselves in a situation where the Fed funds market is pricing in 85, 90 basis points of a rate hike. And then the question becomes, would Powell risk the market disruption of a full 100 basis point hike?

Ben Jeffery:

I'm going to say no. And one of the main reasons is that unlike in June, we're going to get the CPI print before the Fed enters its pre-meeting communication moratorium. Now, in June, that moratorium was not quite as strict, given what we saw from that Wall Street Journal article, but nonetheless, the timing of June's CPI data released on July 13th gives the Fed ample opportunity to provide guidance to the market on what to expect at the July meeting. So, this should, at least on the margin, offer more official clarity on how the committee is thinking about the July meeting, after we have the most recent CPI data.

Ian Lyngen:

Let us not forget that two days after we see CPI, and before the Fed goes radio silent, we'll also have the retail sales print for June. And as we move forward and concerns about a recession become increasingly topical, our focus will be on spending and the state of the consumer. In looking at the recent consumer confidence surveys, what we see is that the University of Michigan survey is at its weakest on record. Even the conference board fell rather sharply, printing at its weakest since February of 2021. And if history is any guide, low consumer confidence tends to inhibit spending.

Ben Jeffery:

And this brings us to what will probably be the next leg of the cycle. We are already starting to see sharp declines and confidence on the consumer front driven principally by inflation. But once we start to see the outlook on the corporate side, driven by inflation, lower revenues, just general macroeconomic worries, it's at that point that we'd look for more frequent headlines surrounding hiring freezes, the potential for layoffs, more of what would traditionally be associated with the late cycle dynamics that will start to see the unemployment rate begin to creep higher. Now, we know the Fed is comfortable with the unemployment rate elevated up into a point, and that really introduces the uncertainty of how far they're going to be willing to tighten once it becomes clear that more and more people are falling out of the job market.

Ian Lyngen:

And in that context, the slow steady increase in initial jobless claims is difficult to ignore. Caveat being that claims remain at an extremely low level, historically. So, while it's a bit early in the cycle to expect a weak bias for the non-farm payroll series, we are reminded that the Fed's own projections for this year and next have the unemployment rate increasing. Now, ultimately, this all comes full circle to the underlying argument, and that is, can the FOMC and frankly, global monetary policy makers, actually orchestrate a soft landing. Or as is often the case, will they overshoot as negative sentiment gains a momentum of its own, and the Fed ultimately needs to reverse course sometime in 2023?

Ben Jeffery:

And this brings up a very interesting conversation I had with a client this week surrounding what that course reversal might look like. Is it going to be three or four fine tuning rate cuts at 25 basis points a meeting, like we saw in 2019? Or is the state of the economy combined with the aggressiveness we've seen from central banks around the world, going to necessitate a faster, more aggressive reintroduction of accommodation. There's also, of course, the unknown of whatever it is that's going to go wrong over the next 12 months. That also leaves me a bit more cautious of just how long the Fed is going to be able to leave rates at terminal. We only saw the Fed funds target band at 2.50 for seven months during the last cycle, and that was in a relatively robust economic environment without the type of inflation that we're seeing currently, or the associated hit to confidence that we've been talking about.

Ben Jeffery:

And in that instance, the first rate cut in July 2019 was long before the pandemic was even considered a risk. And even in that environment, the fact that financial markets in the economy responded negatively to rates that we're probably going to see by the end of July in this current cycle, begs the question of if the Fed is going to be able to keep policy on hold for even six months, once they reach terminal. And more importantly, from a trading perspective, let's not forget that in early 2019, when we saw the FOMC come out and say, "Hikes are over. Policy is in a good place. We're shifting to an on hold stance," the rally led by the front end of the curve as rate cuts were starting to be priced in was very fast and very dramatic. And in keeping with the hyper speed nature of this cycle, I think the argument can be made that it could be even faster and more dramatic this time around, whenever that on hold stance is ultimately communicated.

Ian Lyngen:

That goes a reasonable distance in explaining why we can have two-year yields trading near 3%, while the terminal rate assumption for this cycle is somewhere north of three and half. In practical terms, two-year yields tend to trade under the forward terminal rate expectations. In this context we're using the one year, one year forward OIS only when investors are focused on the turn of the cycle. As we contemplate our core yield curve inversion call for 2022, one of the biggest risks is that the Fed is still actively hiking while the market moves on to the next narrative, which is a recession, and starts pricing in rate cuts. That's how we can find ourselves in a situation where two year yields are at 2.75, while Fed funds are north of 3.5% At the end of the year.

Ben Jeffery:

And thinking about the front end of the curve and what exactly is fair value in the current environment, it's important to touch on what we learned from this week's treasury auctions. Twos, fives, and sevens all tailed, with fives by a pretty meaningful three and a half basis points, which runs counter to the rally that we saw last week, now that the market is seemingly content to begin to push rates in the front end higher. Of course there is the overall volatility backdrop to consider, and what was clearly a primary market participant base that demanded a bit greater auction discount, just given how much we've seen rates swing over the past several weeks. But as we think about supply's impact on the market, it was encouraging to see a bear flattening concession for supply, that ultimately gave way to a bit more of a period of stabilization.

Ben Jeffery:

As for the seven year auction, where we also saw a tail, admittedly, not as large as fives, the issue of Japanese investor behavior for that tenor specifically also suggested that we have not yet reached the point when Japan is becoming seriously interested in owning treasuries. Thus far, the moderation and foreign demand broadly that we've seen across the curve has been more than made up for by strong domestic interest, record high allocations to domestic investment funds in the case of twos and fives at May's auctions. The willingness of domestic players to step up and buy auctions at these comparatively cheaper yield levels have not prevented auction concessions, but they have kept the results relatively orderly.

Ian Lyngen:

Let's face it. The focus in Tokyo at the moment isn't US treasury auctions. It's what's going on with the Bank of Japan. The classic widow maker trade is back, i.e. plan for the BOJ to abandon yield curve control. Now, we've seen a particularly sharp decline in the value of the yen recently, which has increased the hedging cost, making it less attractive for Japanese investors to buy treasuries and hedge them back to yen. And this is in part been what has kept Japanese investors away from treasuries. In the event that we do see a period of stabilization in the yen, as well as confidence in the Bank of Japan's commitment to keeping yield curve control in place, that should incrementally reduce hedging costs, and potentially serve as a trigger to get Japanese investors, once again, engaged in US treasuries.

Ben Jeffery:

So, fair to say this summer we're in for a bit of a Tokyo drift?

Ian Lyngen:

Go greased lightning.

Ian Lyngen:

In the holiday shortened week ahead, treasury market participants will have very little economic data to provide trading direction early in the week. We do have ISM services on Wednesday, as well as the FOMC meeting minutes. The minutes will be interesting in so far as we will get a sense for how close the Fed was to actually delivering a 100 basis point rate hike, if that was at all, in fact, on the table. In addition, it will be useful to learn more about the conversation surrounding future rate increases, most notably, for obvious reasons, being the July rate hike. Now, it's clear that the Fed doesn't want the market to assume that 75 basis points is the new normal, but for all intents and purposes, in the very near term, at least, i.e., the July meeting and potentially even the September meeting, the base case scenario has to be 75 basis points.

Ian Lyngen:

In addition, and despite Powell's recent comments that the shape of the yield curve is not a top line item for the Fed, any discussion around how the market is responding to the Fed's hiking campaign will be notable. While in the past a flatter curve this early in the hiking cycle has been dismissed as a conundrum, at this point in financial market history, it has simply become the norm. And that's one of the reasons we're content to hold the flattening call. Not because we think that there's anything truly unique going on in the 10- and 30-year sector during this particular cycle, but rather the it's different this time mantra applies more aptly to the front end of the curve, and the Fed’s demonstrated an impressive aggressiveness in fighting inflation. The economic data picks up in relevance significantly as the week comes to an end with the June non-farm payrolls report. Expectations currently have the consensus at plus 275,000 jobs, with an unemployment rate at 3.6%. As we've noted, it's still early enough in the data cycle that one shouldn't expect a particularly weak jobs report on Friday.

Ian Lyngen:

Nonetheless, there's a reasonable amount of asymmetry around the risks, as we contemplate the official BLS data. Specifically, a weaker payrolls print will trigger a disproportionately large response versus another consensus or stronger than expected read on the jobs market. The notion there being that to a large extent, a strong labor market remains market participants' baseline assumption over the course of the coming months. Anything that could serve to convince investors otherwise will be a net positive for duration. And the bigger question becomes whether or not that dips the curve deeper into inversion, or if the market starts to price in a higher probability of rate cuts in the latter part of 2023 and the beginning of 2024.

Ian Lyngen:

In that second scenario, a stronger payrolls print could be positive for the front end of the curve as well, and ultimately resolve in steeper twos, tens. Not our base case scenario, but certainly something worth keeping in mind as the market prepares for Friday's release of the June non-farm payrolls figures. 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 as we head into the long holiday weekend, we are reminded of the importance of family, friends, and firework safety, not necessarily in that order.

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 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. You can listen to this show and subscribe on Apple podcasts 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.

Speaker 3:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated, and BMO Capital Markets Corporation, together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Not withstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell, or to buy, or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or a suggestion that any investment or strategy referenced herein may be suitable for you.

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

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