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The Drive to 125 - The Week Ahead

FICC Podcasts 09 juillet 2021
FICC Podcasts 09 juillet 2021

 

Disponible en anglais seulement

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of July 12th, 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.

Podcast Disclaimer

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Ian Lyngen:

This is Macro Horizons episode 128: The Drive to 125, 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 July 12th. With CPI squarely in focus this week, evidence of upward pressure can be seen in many sectors, even grade inflation, the only reason we made it through the six most perplexing years of our lives.

Speaker 2:

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 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.

Ian Lyngen:

In the week just past, the Treasury market staged a very impressive performance. We saw 10-year yields drop as low as 125, which got us to our first-line target, that's the level that we've been focused on for some time. From here, we're looking for a consolidation pattern over the coming week or so, but ultimately think that what has occurred has really solidified the idea that we'll be in a lower rate range, if not indefinitely, at least through the summer months. Now, this is also very consistent with the typical seasonal patterns. With that, we'll emphasize the opening gap in 10-year yields at 121 to 122, which has yet to be filled, and it occurred in mid February. We suspect that once the dust settles following the upcoming CPI and supply combination, that rates will once again, continue to drift lower from here. This isn't to suggest that it won't be a choppy process, however, we continue to emphasize the notion that we are not going to be in a truly trending market in 2021, but rather, we're simply in the process of redefining the trading parameters.

Ian Lyngen:

Another notable development in the Treasury market has been the collective disinterest in trading the economic data and the way that it is typically guided rates. The best example of this is the recent non-farm payrolls print. The Treasury market managed to rally into the event and extended the gains, even despite the very strong NFP figure. Part of the overarching issue is that given the magnitude of the swings in the economic data created by the pandemic, investors simply lack context for what it means when we have an 850,000 jobs print for the month of June. One could be excused for assuming that that would have led to a backup in yields. After all, it was a very strong number in any context.

Ian Lyngen:

One of the details within the BLS report that we remain focused on was the labor market participation rate. We're still at comparatively low levels for labor market participation, and that will leave the emphasis on the fourth quarter, once in-person learning returns, we make further progress toward herd immunity, and the real economy gets back to some version of the new normal. In the interim, any upward pressure on front end yields related to bringing forward Fed liftoff expectations will prove much more sustainable than any backup in rates in 10s and 30s. As a theme, we continue to expect that the macro narrative has taken the summer off and investors will reassess the outlook in the fourth quarter.

Ian Lyngen:

Well, it's been an exciting holiday shortened week, and sure is good to see you, Ben.

Ben Jeffery:

Like a wise man once said, "Better to be seen than viewed."

Ian Lyngen:

I don't get it. Like on the Instabook?

Ben Jeffery:

Yeah, something like that.

Ian Lyngen:

Well, what we did learn this week was that the Treasury market's reaction function to economic data continues to be atypical to put it mildly. What we have seen is 10-year yields drift as low as 125, achieving that target that we've held for quite some time, and now the market is going through a period of consolidation ahead of next week's supply and inflation data. The big question has quickly become whether or not the bid that's been seen in Treasuries is sustainable and will stay in this range of roughly, let's call it, 125 to 145 for the next few months, or if the market got a bit too far ahead of itself and is due for a correction toward higher rates.

Ben Jeffery:

I would argue we're going to have to wait at least a few sessions to really get any meaningful clarity on this issue. After all, we do have a condensed supply schedule in the week ahead, with 3s and 10s both on Monday and 30s on Tuesday. Not to mention, the inflation data that, at a minimum, could create some reluctance to set new positions after the impressive move we've seen over the past week, and in the most extreme case, could reshape expectations, not only on the path forward for consumer prices, but also what that ultimately means for the Fed.

Ian Lyngen:

Well, let's take a step back, Ben. Why are the 3- and 10-year auctions both on Monday? That's not consistent with what we typically see.

Ben Jeffery:

That has to do with where the 15th falls on the calendar. With the 15th on Thursday and the Treasury's preferred one-day buffer between the last auction of the week and settlement, that leaves 30s on Tuesday and a double auction Monday with 3s and 10s. 3s coming at 11:30 AM, with 2s at the more typical 1:00 PM time slot.

Ian Lyngen:

So that means that we'll actually see the 30-year auction in the wake of the CPI data. This will provide interesting context, given the fluctuation of breakevens over the course of the last two weeks. In the 10-year space, we saw breakevens peak at roughly 260, and they've now drifted down closer to 225. When we think about the type of inflation that will be generated over the course of the next 10 years, anywhere north of 225 was ambitious, but very consistent with the most popular trade of the year, which has been embracing the inflationary narrative and driving the curve steeper and cheaper. Clearly we're now into the second half of the year, and the upside from that trade hasn't materialized.

Ben Jeffery:

It's also worth highlighting that even at 225, 10-year breakevens are still very elevated in the context of close to the last decade. Remember during the last cycle, the Fed really struggled to get 10-year breakevens up to even that 2% level. So the fact that yes, we saw 10-year breakevens get as high as 260 and have now retraced, even after that pullback, they're still at levels that indicate the Fed is on track to achieve its average inflation target and goals.

Ian Lyngen:

This brings us to one of the other unique characteristics of the Treasury market in 2021, and that is the depressed level of real yields. Real 10-year yields are at negative 1%, inflation expectations are above 2%, and still, the nominal Treasury market continues to rally. This implies, if nothing else, it will take several quarters, if not longer, to get back to an environment in which real Treasury yields are in positive territory. Now, to some extent, that's by design and consistent with the Fed's objective of providing an incentive for investors to first, move further out the nominal Treasury curve, then move further out the credit curve. So from Treasuries to mortgages, from mortgages to credit, from credit to equities, from equities to whatever is next. Now, what will be interesting to see is what happens to risk assets when the Fed slowly starts to wind down QE and not necessarily tap the brakes, but at least take their foot off of the monetary policy accelerator, as it were.

Ben Jeffery:

This past week, the idea was floated that maybe the Fed is being a bit premature in pulling back on some of its accommodation. Now, I don't know if I would go as far as to call it a policy error at this stage, but the notion that talking about tapering, the forecasted liftoff rate hike in 2023, might be too early, is especially intriguing given the fact that overall financial conditions remain extremely easy. Now, obviously, the nature of volatility means that could change very quickly, but for the time being, the speed with which policy error chatter has picked up was relevant, if nothing else.

Ian Lyngen:

Another observation worth making is the fact that we're not trading a less dovish Fed the way we might typically expect at this point in the cycle. So instead of a steep curve as inflation comes back into the system, we're seeing the opposite, which is a late-cycle trading dynamic. I think that that reality has caught investors offside to some extent, and we see that in the positioning data that continues to show that there's a reasonable short base in the Treasury market. Whether that is through a Stone and McCarthy survey or the CFTC data, there is evidence that there has been a round of short covering, which again, follows intuitively when we get 10-year yields from 177 to 125 over the course of a quarter. However, it hasn't been sufficient to completely erase the short base, and it's roughly half of what it was at the beginning of the year. That implies that the pain trade, while lessened, is still toward lower rates in this environment.

Ben Jeffery:

That's going to represent one of the most meaningful inflections over the balance of this year. What I mean by that is there will presumably come a time when those shorts continue to moderate and positioning becomes much more neutral, after which, the market could swing to a long bias. It's at that point that we'll see a meaningful pivot in the trajectory of what has been a steady grind toward lower yields as the reopening optimism, that we saw throughout much of the first quarter, has been further retraced.

Ian Lyngen:

One of the questions I've received a few times this week has to do with the probability of 10-year yields pushing as high as 2% in calendar 2021. The short answer is, the odds just got a lot lower, and that isn't to suggest that we won't see 2% 10-year yields again. In fact, I think it's very conceivable that that's the trade that defines 2022, but it will be a slow grinding move rather than a repeat of investors' collective attempt to reprice the market to a higher rate plateau that we saw in the first quarter of this year. Now, there have been developments on the pandemic front, such as the delta variant, which have re-introduced the notion that we're not entirely out of the proverbial woods when it comes to the coronavirus, and also, put an emphasis on the global recovery, as opposed to simply what is happening in the U.S. So specifically emerging markets that continue to struggle with the coronavirus are also factoring in to investment decisions as it relates to the outright level of yields.

Ben Jeffery:

That's a really important point, particularly, given some of the monetary policy decisions we've seen executed over this past week. The ECB, as expected, formerly changed their relationship with the 2% inflation target to now be symmetric, as opposed to keeping inflation below 2%, which is a signal similar to the Fed that they will be comfortable with inflation moving higher than they previously telegraphed they would. Add to this the fact that the PBOC cut the RRR by 50 basis points, and clearly, there's still a lot of uncertainty facing central banks around the world.

Ian Lyngen:

A nuance in comparing and contrasting the inflation target between the Fed and the ECB has to do with the way that inflation is measured in the U.S. versus in Europe. It's notable that in Europe, they don't include housing in their inflation measures the same way that we do in the U.S. So implicitly, by focusing on a symmetric target around 2%, excluding housing, I'll argue that that's even more of a dovish stance from the ECB.

Ben Jeffery:

Obviously inflation's role in monetary policy is critical across geographies, which begs the question for you, Ian, do you ultimately think inflation will be transitory, at least in the U.S?

Ian Lyngen:

Well, I think to a large extent, my characterization of transitory or not is meaningless in the context of the Fed. What it really comes down to is what the Fed believes, and more importantly, how the Fed characterizes the inflation that we're seeing to the market as a whole. There's little question that a rise in auto prices has been seen, a rise in airfares have been seen, a rise in apparel prices have been seen. This is all very consistent with what one might assume would occur when we're coming out of the pandemic-inspired lockdown, and layer on top of that, some of the chips supply issues. What would make it non-transitory, at least from my perspective, wouldn't be persistently higher prices per se, but rather, if we made the transition from supply side issues to demand side inflation. That would require a steady and sustainable increase in wages that drives up the aggregate numbers.

Ian Lyngen:

Now, some of the initiatives recently announced by the Biden administration suggests that upward pressure on compensation has moved into the political realm. Now, collective bargaining power has really always been the one missing component for higher wages over the course of the last two or three decades, because we no longer have a labor force as unionized as what was the case in the seventies and eighties when unions were able to bargain for cost of living adjustments, and that further drove inflation that arguably initially started on the supply side with higher energy costs.

Ben Jeffery:

In the current paradigm, there's another unique facet of the hiring landscape that also is different than what we saw during the seventies and eighties, and that is: while yes, there is some anecdotal evidence of employers actually increasing wages to bring employees from the sidelines, I would argue just as common is one-off incentives. Think signing bonuses or something akin to that. While sure that could offer the needed impulse to bring people back to work, over the longer term, it doesn't translate to higher long-term compensation that would ultimately flow through to that demand driven pickup in prices that would accompany something such as a cost of living adjustment.

Ian Lyngen:

Translating all of that back to trading the CPI numbers, when we do get a view of inflation, anything that surprises on the upside, will simply bring forward liftoff rate hike expectations, hurt the front end of the curve, and on net, probably contribute to an extension of the flattening trade. I think that lower outright yields in such an eventuality, wouldn't be that far off base.

Ben Jeffery:

Off base? Who's on first?

Ian Lyngen:

I can't really view it from here. Oh, I get it.

Ian Lyngen:

In the week ahead, the Treasury market has several key fundamental inputs to digest, as well as some supply side considerations. Supply side first, we have a new 3-year auction, as well as reopenings for 10s and 30s. Given the recent performance of the Treasury market, this will be an important litmus test for both domestic and overseas buying interest. It is a summer Monday, and all else being equal, we suspect that that will limit the setup period that the primary dealer community has, which would typically necessitate a larger concession either ahead of the event or at the auction itself. The proximity to Tuesday's CPI release will also complicate matters, as sideline investors might have an incentive to remain on the sidelines until we get a clearer picture of the current inflationary environment.

Ian Lyngen:

The ongoing debate about whether the outward pressure on inflation will prove transitory or not, will continue. Given that the base effects remain relevant between now and the end of the third quarter, we suspect that the headline and core year-over-year inflation numbers will continue to make headlines even in the event that the 3-month annualized rate begins to trend a bit lower. The market won't really be offered a good sense of whether or not the Fed's transitory characterization is apt until the fourth quarter, if not the beginning of 2022.

Ian Lyngen:

Also providing context for the price action in the Treasury market, has been the Feds telegraphed intention to taper QE. The groundwork was set even before the June FOMC meeting. However, Powell comments that June was the meeting to start talking about talking about tapering were reasonably well absorbed by the Treasury market with little net price action. Moreover, the recent FOMC minutes outline the debate among the FOMC. As it presently stands, the consensus is that there will be some clarity at Jackson Hole, regarding whether or not taper will be MBS first or simultaneously, MBS and Treasuries. From there, the market will look for an official announcement sometime in the fourth quarter, that will either be at the November or the December meeting with implementation to start with the new year.

Ian Lyngen:

Using this as a departure point, anything that challenges this timeline or brings it forward materially, will be a tradable event. Aside from that, however, the window for a repeat of the 2013 taper tantrum has effectively closed. That isn't to say that we couldn't see a five to 10 basis point backup on the official announcement as the market tries to press the trade, but that will ultimately prove to be a dip buying opportunity for the subset of investors who are now waiting for higher yields to either cover shorts or add to net long positions.

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. In lieu of our typical creative conclusion, we'd like to ask for your support in the Institutional Investor survey this year. Polls are open now and close on July 30th. We're looking for five-star rankings in the categories of U.S. Rates, technical analysis, general fixed income, short duration, and snarky podcasts. Please support us if you can and reach out if you need any help with the process. Thanks for listening.

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 2:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Inc., and BMO Capital Markets Corp. 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.

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Speaker 2:

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Speaker 2:

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Ian Lyngen, CFA Directeur général et chef, Stratégie de taux des titres en dollars US
Ben Jeffery Spécialiste en stratégie, taux américains, titres à revenu fixe

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