Bank On It - The Week Ahead

Ian Lyngen:

This is Macro Horizons' episode 215, Bank On It, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery and Vail Hartman to bring you our thoughts from the trading desk for the upcoming week of March 27th. And as we welcome the newest member of the Macro Horizons cast we'll address the most pressing questions of the moment. Yes, Vail's name is spelled the same as the resort. No, he is not a professional skier, but yes, he has been to Vail Colorado, albeit a very long time ago. Other similarities include, he is very tall.

Each week we offer an updated view on the U.S. 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.

The week just passed in the Treasury market was a defining moment for global financial markets. We came into the week with the news that UBS would be acquiring Credit Suisse in a deal that was strongly encouraged by the Swiss National Bank. That offered investors an initial moment of calm and the hope if nothing else, that the regional banking crisis started in the U.S. had run its course.

Unfortunately, as the week progressed, what we quickly learned was that in fact there is still a great deal of apprehension among market participants as evidenced by the rally in the front-end of the U.S. Rates complex that brought 2-year yields below 3.50 and was accompanied by a flight to quality that brought 10-year yields below 3.30. All of this occurred with the backdrop of monetary policymakers' content to push forward with the well-anticipated 25 basis point rate hike. Powell delivered the quarter point-hike, which was roughly 90% priced in ahead of time by the Fed Funds futures market, and in doing so, demonstrated that monetary policymakers believe that the tools that they have in place to address liquidity concerns for the banking system are distinct from those in place to deal with inflation and unemployment, i.e., the discount window and any additional facilities that regulators deem necessary will be in place to ensure financial sector stability, whereas rate hikes and perhaps the balance sheet will be used to anchor forward inflation expectations.

Now, clearly, as the week progressed, it became obvious that the uncertainties associated with the amount of excess demand destruction and the amount of credit tightening that will be linked to the shifts in the lending landscape create an essential unknown for the Fed. The banking sector crisis is tightening for the Fed. The unknown is how much additional tightening has this created and will it be sufficient to keep the Fed from hiking rates beyond 5% or will ultimately it create such a headwind that there will be a compelling case for the Fed to need to cut rates by the end of the year. Looking at the Fed Funds futures market investors are clearly leaning toward the latter camp.

It's also worth noting that within the SEP, the Fed's dot plot was updated to include a higher 2024 dot, but the 2023 dot was unchanged at 5.1. That implies that the Fed currently views all else being equal, the endpoint of this tightening cycle at 5.25. And now following Wednesday's move the upper bounds already at 5%, so our take is that there is a high probability that the Fed pauses in May and eventually if that extra quarter point does get delivered, it won't be until there is a much more convincing round of stabilization in the banking sector and the market is once again concerned about inflation running through the system that will be unaddressed by monetary policy and or the fallout from the tightening that the financial sector is currently inflicting on the real economy.

Now, needless to say, this isn't the first time that the U.S. has seen strains in the banking system. However, as a market, I think it's safe to say that we were collectively hoping that this would be a contained event. And while there has been additional evidence that the European banks have come under renewed scrutiny, there's still a path forward to some type of resolution that offsets the contagion that is currently playing out in the financial sector. Precisely how that will play out is the greatest question in the market at the moment. We've heard assurances from both Powell and Yellen that not only is the banking system in a strong position going into this series of events, but also the backstop of the Treasury Department, the FDIC, and of course, the Fed remain in place in the event that things deteriorate beyond the level that policymakers feel is acceptable for the balance of risks facing the real economy.

Vail Hartman:

Ian, Ben, it's been quite a volatile week. What should we make of all this?

Ian Lyngen:

Well, Vail, it certainly has been eventful, if nothing else. We saw a massive rally in the Treasury market that was triggered by the contagion associated with the banking uncertainty. Now, we came into this week with a degree of optimism that perhaps this all might be contained, but as we work through some of the details coming out of Europe and despite the assurances of monetary policymakers and the head of the Treasury Department, Janet Yellen, the market remained on edge as to how far the banking crisis will run beyond the regional lenders and what that ultimately means for monetary policy.

Obviously, Powell delivered on the 25 basis point rate hike that we were anticipating as a market and it had a decidedly dovish tone. Within the details, we saw that the Fed's SEP, the beloved dot plot, had no change to the 2023 dot. So that suggests that the terminal policy rate as the Fed envisions it at this moment or did on Wednesday is going to be a corridor between five, and five and a corridor. But frankly, an extra 25 basis point rate hike at the risk of financial system instability seems unlikely at the moment, which suggests that the FOMC might have arrived at terminal a bit early.

Ben Jeffery:

And beyond the actual hike, the unchanged SEP, which were undoubtedly the most tradable events that we saw at Wednesday's policy decision. Remember what Powell told us in the press conference in that there was the case made at the FOMC meeting for the Fed to not hike at all and for the pause that many in the market were advocating for simply in order to allow the volatility playing out in the banking sector to settle before evaluating just how appropriate it would be to continue raising rates. Ahead of the event, the Fed Funds futures market had roughly a 90% probability of the 25 basis point move that was ultimately delivered. And clearly, the argument on one hand inflation remains too high and the job market remains too tight, but on the other from a Fed credibility perspective, Powell ultimately deemed it appropriate to deliver what exactly as you touched on Ian might be the final hike of this cycle.

While it's probably too soon to have a really high conviction call on whether or not we get another 25 basis point hike in May, I would say there's also the argument to be made that the dot plot shows another 25 basis point tightening move by the end of this year. So very strictly speaking, this implies that the Fed could take May off and resume the conversation about tightening in June. However, from the market's perspective and as we watch 5s30s close in on positive 40 basis points, if the U.S. Rates market behavior recently has been any indication, once the Fed pauses it's at that point we're going to start to see the pricing of rate cuts that is already playing out become even more dramatic as the calls for less restrictive policy grow louder.

Ian Lyngen:

So essentially, as Nat should have said, "You must remember this, a pause is just a pause at least in May."

Ben Jeffery:

Nat, Jay, whatever.

Vail Hartman:

I don't get it.

Ian Lyngen:

We know Vail, give it time.

Vail Hartman:

Ian, Ben, with a 100 basis points of rate cuts now priced in for 2023, what do you guys make of this situation?

Ian Lyngen:

Well, one thing is abundantly clear and that is investors are very nervous and the market is at the moment casting a vote of no confidence, insofar as Powell's assertion that tools beyond monetary policy rates will be sufficient to address any potential contagion in the banking sector. Now to Powell and Yellen's defense, talking up the programs that are already in place should be a confidence-inspiring event for the market. However, investors seem to be a bit apprehensive at taking the comments from regulators at face value.

Ben Jeffery:

And to be honest, it's difficult to blame them. Obviously, a big contributing factor to the volatility we saw this past week was Secretary Yellen come out and say that, "blanket insurance for all bank deposits was not actively on the table," and then the following day walk those comments back only to convey a tone that implied the Treasury Department would be more willing to step up and back bank deposits for some set amount of time. While the three of us in this room clearly have no great insights about what is going to be coming down from the official sector in the coming days and weeks, the one aspect of this that is certain is that it remains a highly fluid situation and along with risk asset valuations and several big name bank valuations, the government's official response to everything that's going on is another variable that needs to be considered in evaluating what this all means for the overall economy, what it means for the Fed and ultimately what it means for just how much steeper we can see the curve move over the next several weeks.

Ian Lyngen:

I think it goes without saying that we have seen the beginning of the cyclical steepening of the yield curve that we and the market as a whole have been looking for in 2023. Now, it won't be a straight shot to positive territory across the curve. Obviously, there's been a few moments in which the 2s10s re-steepening has paused and consolidated. The 5s30s spread however is decidedly in positive territory. We reached our target of 35 basis points and we do see a path toward consolidation in here, however, at the end of the day, 5s30s is going to a 100 basis points this year and 2s10s will end 2023 in positive territory.

Another development worth noting over the course of the last week was the outright magnitude of the rally in the 10-year sector. We've now seen 10-year yields back below 3.30, which if nothing else puts a 2 handle on the radar over the course of the next several weeks. Now, this doesn't necessarily need to be triggered by a decidedly more dovish stance from the Fed, although shy of an emergency rate cut, we couldn't envision anything that would shock the market at this stage in terms of more dovish rhetoric. That being said, the bar for a rate cut in the near term is very high given the sticky nature of core inflation in the current environment and what that would imply for the Fed's commitment to re-anchoring price stability going forward.

Ben Jeffery:

And in talking about the price action, 10-year yields down to effectively 3.25, there's also a calendar aspect of the next several weeks to consider. And what I mean by that is the relative lack of any top-tier data that could truly reshape the macro narrative until we get March's payrolls report. That's not until April 7th. And obviously, as the last several weeks have shown, it's really all about the banking sector at this point, but presumably there will come a time when the dust begins to settle when there's a bit more clarity surrounding the volatility in the financial sector and the economic pillars of employment and inflation regain maybe not all, but at least more of investors' attention as we contemplate how much further 10-year yields can drop. After all, as it presently stands, the job market remains very tight.

We got another solid look at initial jobless claims during the March NFP survey week, and remember that core services ex-shelter component of CPI actually accelerated in February. Clearly, the Fed is not going to continue hiking blindly into a financial crisis, but at least through the lens of employment and inflation, there is not a super compelling case to be made for rate cuts in the near term.

Vail Hartman:

The most recent data from the Ministry of Finance revealed Japanese investors as net buyers of $25 billion of U.S. Treasuries.

Ian Lyngen:

In fact, it was 25.3 billion and it was for the week of March 17th, and that's relevant because that was the week in which the reopening auctions settled. And for a little bit of context, excluding the first week in March of 2020, last week's flows were tied as representing the largest weekly flows from Japanese investors into overseas notes and bonds. We tend to operate under the assumption that the vast majority of those flows are into Treasuries, and the monthly data which give us the breakdown and details suggest that that tends to be the case. It's also relevant that this is occurring in the month of March. March is the last month of the Japanese fiscal year. Typically, we don't see big reallocations from the Japanese investor base until the fiscal new year is underway and updated investment strategies have been put into place. So that suggests if nothing else, we might continue to see an increase in Japanese participation in the Treasury market come April and into May.

Ben Jeffery:

And so far this year we've talked a lot about the relevance of Japan for Treasuries as a whole, but it's also been apparent within some of the investor class data we've seen at the auctions. And while not explicitly knowable just yet, until we get the data around this week's 20-year auction, 10-year TIPS supply, what we saw was generally good demand both for 20s but also more relevantly in the wake of the Fed for inflation protection.

And why this is marginally more telling than would otherwise be the case is that given the fact Powell opted to be more measured in the aggressiveness of his message and the dot plot didn't show a higher terminal rate, what this means is that the peak of the upward pressure we're going to see on real yields from a monetary policy perspective is likely approaching. And along with the dot plot itself, we also saw upward revisions to the PCE figures. The Fed is acknowledging that it's going to take probably quite a long time for them to achieve their 2% inflation target. Both of these factors bode well for TIPS and I would argue that's a big reason why we saw such a strong auction result on Thursday.

Ian Lyngen:

It's not abundantly clear to me that it's going to take the Fed that long to achieve its 2% target if, in fact, we are on the precipice of a banking crisis because this is one of the key dynamics playing out in the Treasury market at the moment, and that is how much is a banking crisis worth in terms of rate hikes. Is it 50, 75 basis points that the Fed doesn't have to deliver? I'd argue at this stage we're in the 25 to 50 basis point range. If things get progressively worse, we are talking 150 or 175 basis points worth of additional tightening on top of the 475 basis points worth of rate hikes we've got over the course of the last year.

And to some extent Vail to your earlier point, this is why the market is so content to price in rate cuts by the end of 2023. The market is effectively saying that even if the Fed is going to continue to retain a hawkish stance with the goal of re-anchoring inflation expectations that the reality is, the upheaval in the banking sector will dramatically exaggerate the moves that Fed has already been able to deliver, therefore, they might need to recalibrate to the realities of the updated landscape.

Vail Hartman:

And with that backdrop, front-end supply sponsorship will be especially telling in the week ahead given the extent of the latest rally that's been led by the front-end.

Ian Lyngen:

Yeah, Vail, that's a good point, particularly when we think about the 2-year sector is representing nothing more than a 24-month rolling window of policy expectations. What has occurred over the course of the last two weeks is that a higher probability of rate cuts has certainly entered that window of uncertainty.

Ben Jeffery:

And while just a few weeks ago at Powell's Humphrey-Hawkins testimony where the chair opened the door to a 50 basis point hike, there was probably a very compelling bear case to be made for the 2-year sector. And the fact that we saw 2-year yields break 5% on the risk of not only a 50 bps hike, but an even higher terminal rate has clearly given way to the exact opposite playing out.

And so in less than a month, a 150 basis points or so of a rally in the 2-year sector, I would argue is going to actually make the result for 2s one of the most telling of the three auctions we get in this upcoming week. Because in a traditional environment, one does not really want to buy at the low yield marks if in fact there is a building case for the Fed to ultimately be forced to cut rates in the nearer term than was previously assumed, then the liquidity provided by the auction might serve as a welcome opportunity for those investors who have opted for the sidelines to begin deploying cash in the sector of the market that's going to outperform as the other side of the monetary policy cycle takes clearer shape.

Vail Hartman:

That's a useful observation, Ben. We started March with 2-year yields reaching above 5% and now with 2-year yields trading at roughly 3.50, is it possible that we see the pendulum of expectations move in the other direction?

Ian Lyngen:

Nothing is truly impossible, but at this stage in the cycle, I would characterize that as highly unlikely. Keep in mind that the Fed has a very long history of entering a tightening cycle and hiking until something breaks. What has been so unique about this cycle is that the Fed was willing to absorb a 30% down trade in the equity market in 2022 without blinking the undermining of the wealth creation in the real estate sector without altering course, obviously, what has gone on in crypto as well as what's been seen in the tech sector as far as the employment landscape. We have finally reached the point in which the banking sector has been impacted in what appears at the moment at least to be a broad manner, and that's problematic for the Fed. We're not looking at isolated bankruptcies or failed businesses in the manufacturing sector or in consumer goods or in the airlines, we are looking at the core of the Fed's responsibility, which is the functioning of financial markets, the creation of credit and what that means for potential growth and the employment environment as uncertainty has become the Fed's new mantra.

Ben Jeffery:

And on the topic of uncertainty, Vail, do you think you're going to be back on Macro Horizons next week?

Vail Hartman:

Wait, do you guys want me to make a joke?

Ian Lyngen:

Not another one.

In the week ahead, the Treasury market will continue to digest the ongoing uncertainty linked to the global banking system. It goes without saying it's difficult to envision a scenario in which we end the first quarter with investors completely convinced that the banks are out of the proverbial woods. In addition, we have a series of front-end weighted auctions in the week ahead, including $42 billion in 2s on Monday, $43 billion in 5s on Tuesday, and $37 billion in 7-years on Wednesday. Now given that Friday is the last day of the month and settlement for the auctions, this has led the process to be skewed a day earlier. Clearly, the 2-year auction on Monday afternoon after what is likely to be an interesting weekend of developments for the global financial sector will offer a useful litmus test for investor demand.

We've seen a significant rally in the front end of the market. 2-year yields in particular are well off the highs from early March, which were above 5%. And while expectations for a series of near-term cuts might be driving the bull re-steepening, it will be notable to see who ultimately steps up to take down the new supply. Of course, there are economic data releases on the calendar, including the core PCE numbers from February. Now obviously, the backward-looking fundamentals will be of secondary importance to any real-time developments in the financial sector, however, if the market does find itself in a moment of relative stability and calm, there's a compelling case to be made for a refocus on the inflation numbers for February. Recall that core CPI printed higher than anticipated during February and a follow through to core PCE may ultimately be in the offing.

A return of the macro narrative to inflation concerns would challenge the cyclical re-steepening of the yield curve that is currently underway. However, we do not think that it will ultimately bring us anywhere close to the extremes seen in 2s10s nor into negative territory for 5s30s. If anything, we would anticipate that renewed concerns regarding the sticky inflation environment will manifest in higher breakevens much more quickly than they will in offsetting the rate cut expectations being priced in. The logic here is relatively straightforward thanks to the banking crisis and the disinflationary impulse that may be associated with it that's driving the front end of the market. And even if the Fed is forced to pivot further and earlier than anticipated, that in and of itself will be dovish and require greater inflation compensation to move out the curve only in the event that the Fed's estimates of the fallout from the banking sector are incorrect, and we somehow end up managing in a soft landing scenario even despite all that's occurred in Q1.

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 in light of the elevated risk to the global financial sector, we're reminded that banking crises don't take weekends off, they just work from home, perhaps with increased urgency.

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 4:

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