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Fall's First Fed - The Week Ahead

FICC Podcasts 17 septembre 2021
FICC Podcasts 17 septembre 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 September 20th, 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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Disponible en anglais seulement

Ian Lyngen:

This is Macro Horizons episode 138, Fall's First Fed, 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 September 20th. As we wait at the Walmart register for the manager to accept our [Dogecoins 00:00:21], we cannot help but wonder, "Is life nothing more than a bunch of cursing and shouting?"

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 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. That being said, let's get started.

Ian Lyngen:

In the week just past, the US rates market received several compelling pieces of new information that reinforced the dueling camps that currently exist in the market. On the one hand, we had a weaker-than-expected core CPI print for the month of August of just 1/10 of a percent. Now, this is a clear disappointment versus expectations for a 3/10 of a percent print, which would've matched the July level. For context, however, the second quarter saw two monthly CPI prints of 9/10 of a percent.

Ian Lyngen:

The inflation data offered the first real tangible evidence for the transitory camp, specifically within the details, one of the key drivers of inflation thus far had been new and used auto prices. Now, this was simply a function of supply chain issues, and they often discussed chip shortage. In August, we started to see the trend in used car prices go the other direction, with a month-over-month decline of 1.5%. Now, we don't expect car prices to decline anywhere comparable to the increases that we saw earlier this year. We do, however, expect a continued moderation and, more importantly, the upward pressure on inflation to no longer be a function of autos. When we think about other pockets of inflation, owners' equivalent rent, or OER, is an often-cited touchstone, given the recent increase in home prices. Now, there's roughly a 12 to 18-month lag between higher home prices and an increase in owners' equivalent rent. So this will leave the focus on this particular sub-component in the fourth quarter.

Ian Lyngen:

The other key economic data release that we received was the August retail sales print. It came in modestly higher than expected and was associated with upward revisions to Q3 real GDP. We also saw the Empire and Philly Fed surveys, which came in stronger than expected. These are relevant because it's September data and, as such, reinforce the idea that the drag created by the Delta variant will be short-lived. And as investors look to the year ahead, will begin to price in, as we typically do, a degree of mounting optimism. In this case, the optimism will be associated with reemerging on the other side of the pandemic and all that implies for reestablishing prior patterns of consumption.

Ben Jeffery:

Well, Ian, I think inflation's a reasonable place to start.

Ian Lyngen:

What inflation? To the point, Ben, core CPI came in notably below expectations for the month of August. This, following the strong but still disappointing payrolls report from the same month, has really led the market to rethink the overall impact from the Delta variant on the economic outlook. When we deconstruct the details of what moved in core inflation, we were not surprised to see a pullback in used auto prices, down 1.5% in the month of August. But the surprise components really came in the form of airfares, lodging away from home, car rentals, and dining out costs. Now, this is consistent with the increase in COVID cases and the apprehension around engaging in in-person commerce, but nonetheless, it's somewhat at odds with the market's broader reflationary narrative.

Ben Jeffery:

And this new information is coming at somewhat of a pivotal time, just given the fact that it does add some fundamental backing to the transitory argument with the Fed decision on Wednesday. If there was going to need to be any urgency on the part of Powell to move more quickly down the path of normalization, this week's CPI report would have been a critical variable for the chair to consider. But the fact that we saw lower-than-expected core prices probably just reinforces this idea that the Fed is still set to announce tapering in November, or maybe even December, with the question on the first rate hike of this cycle more a function of the labor market, with the goal of substantial further progress on inflation already achieved.

Ian Lyngen:

On the flip side, we saw a stronger-than-expected retail sales print on Thursday. Again, this was August data, and it really did reinforce the perception that, while there might be some hurdles on the path out of the pandemic, the fact of the matter is that ongoing consumption is going to provide a key base for real GDP growth in the third quarter. Estimates for Q3 growth are now in the four to 5% range. While this represents a deceleration from what we saw during the first half of the year, it's by no means a contraction.

Ben Jeffery:

And that spending data is especially important, just given what we saw concerning the pandemic developments in August, and the fact that while, yes, the rise of the Delta variant certainly lengthened return-to-office timelines and created some angst that the pandemic was not in fact in the ninth inning, that was insufficient to derail solid spending. Now, sure, those numbers were concentrated in non-store retailers, but it does leave the economy in at least a slightly better place during August, and Q3 as a whole, as we get toward Q4 and ultimately the end of the year. So that departure point that's a bit more solid, to me at least, suggests we should see a floor in how low yields can reach before the end of the year, even if the reaction to this week's fundamentals were hardly bearish in the traditional sense.

Ian Lyngen:

In considering the direction of Treasury yields from here, it is worth highlighting that there is a strong seasonal tendency to see the 5s30s curve steepen in the month of October. That's something that we have seen pretty consistently over the last 10 years, and it fits well with our expectations for the market to attempt to once again trade the reopening and reflationary momentum that we saw at the beginning of the year. I struggle to see 10-year yields getting as high as 1.75 to 1.77 between now and the end of the year. However, if we break that key 1.42 level in 10s, there's very little from a technical perspective to prevent an attempt at the 1.55 to 1.60 range. So it's in this context that the recent flattening that we have seen in the 5s30s curve that dipped as low as 102 basis points on Friday, really stands as a potential opportunity for a tactical re-steepening, if nothing else.

Ben Jeffery:

And not just versus 30s, but also versus 2s and 10s as well. The belly of the curve's under-performance over this past week was especially interesting ahead of the FOMC. All else being equal, the increase in five-year yields would suggest investors are setting up for something of a hawkish tone from Powell, and what that suggests about liftoff timing. So Ian, you and I are completely on the same page that, if one is of the mind, Powell will opt to sound more patient on normalizing policy rates, if not necessarily tapering, then maybe some give back in that cheapening in the five-year sector could be a compelling trade in the week ahead.

Ian Lyngen:

And that certainly is the way that the market was trading in the wake of the non-farm payrolls print. We missed by 500,000 jobs, but still, there was a net sell off with 10/30-year yields higher. This is clearly a reflection of the dynamic that we've been tracking in which liftoff rate hike expectations are flowing through to the five-year sector. The market has moved far beyond the taper trade, and we're left with a classic, somewhat late, cycle trading dynamic where any positive economic momentum, either on the growth or inflation front, brings forward expectations for the Fed to normalize rates. What is surprising, I think, for most investors is that this has occurred at such a comparatively low outright yield level.

Ben Jeffery:

This, then, brings up the question of how high we can ultimately see yields and how steep the curve will ultimately be able to reach during this cycle. Considering that we've already reached that late-cycle dynamic surrounding the shape of the curve, to me, it seems that a return to outright yield levels and curve steepness in cycles past is probably going to be pretty unlikely. Fair to say, Ian?

Ian Lyngen:

Well, what I would add to that is what we've seen over the course of the last three to four decades in terms of monetary policy, is this push towards transparency, and as investors get a better sense for the Fed's reaction to incoming economic data, a lot of the volatility further out the curve has been reduced. We see that in term premium, we see that in the outright flatness of the curve, as well as the relatively low yields in the US. This is also applicable in Europe and Japan.

Ian Lyngen:

So in that context, the most reasonable argument that I can make for a structurally steeper curve and a durable return of term premium would be what one could characterize as a less predictable Fed, or reintroducing a degree of policy risk in the four to five-year time horizon. Now, at the beginning of this year, with the Fed's focus on the new policy framework, there was this collective market understanding that the Fed would allow inflation to run hotter during this cycle, which implied that when the Fed ultimately needed to start tightening, they would be behind the curve on inflation, which introduced a degree of uncertainty insofar as how the FOMC would respond. Now, in an environment with moderating inflation, that takes away a lot of the need for term premium and/or a higher rate environment.

Ben Jeffery:

And in the current environment, policy uncertainty is not limited to the Fed. If incoming headlines are any indication, the negotiation process around the budget and the debt ceiling is heating up in Washington as President Biden tries to push his plan through Congress. Now, the debt ceiling remains almost entirely a front-end issue, and with Secretary Yellen increasing the urgency in her calls for lawmakers to either suspend or raise the debt ceiling, this issue is going to occupy more and more of the market's focus, especially after Wednesday's Fed meeting.

Ben Jeffery:

As it currently stands, the drop-dead date seems to be focused on that very late October period, maybe early November. So until that time, bill issuance is going to remain very low, which will in turn leave upward pressure on usage at the RRP facility, given the fact that even before this debt ceiling issue, we still had a monumental amount of cash in the system. Now, I think we're both on the same page that a default is extremely unlikely, but that's not going to prevent some distortions in the very front end until mid-November. Also, remember that while not immediately relevant to trading, the Treasury Department has laid the groundwork for coupon auction sizes to start declining. That will most likely be announced at the November refunding announcement, which should line up at least somewhat closely to a resolution on the debt ceiling front.

Ian Lyngen:

This all comes at a time when investors are continuing to debate the merits of expecting higher inflation going forward. The argument's been made that the reflation trade has been abandoned. I take issue with this because when we look at the five-year, five-year forward, breakevens, we see that at 2.20 to 2.25 there remains a fair amount of reflationation still priced into the market. Recall that pre-pandemic, that measure would trend in the 1.75 to 1.80 range. Even the simpler measure of 10-year breakevens on an outright basis reveal that, with a level north of 230 basis points, investors have not backed away from expecting inflation to continue to flow through the system. The bigger question in my mind at least is whether or not this is going to be the type of inflation that is effectively a tax on consumption and slows economic growth going forward, or if it can transition from being supply-side to being demand-side inflation, via wage increases, and this ultimately becomes self-perpetuating. For the time being, I'm more comfortable with the interpretation that it's a tax on consumption, or some version of stagflation light.

Ben Jeffery:

And that's going to make the result of Thursday's 10-year tips reopening very topical in evaluating how investors are viewing current valuations, and whether or not they're willing to pay up for inflation protection at this stage. Not to mention the fact that 10-year real yields are still well below negative 1%. And while, initially, a real return of negative 1% would hardly appear as a screaming buying opportunity, we've generally seen very solid sponsorship for tips throughout the depths of the pandemic, and even as we've made it into this current version of normal. Now, I think August CPI data alters that calculus somewhat, but nonetheless, Thursday's auction result is going to be a space to watch following the FOMC.

Ian Lyngen:

So is that what the millennials mean when they say, "Keeping it reals"? In the week ahead, the primary event is the Fed. We have the FOMC decision on Wednesday at 2:00, followed by Powell's press conference at 2:30. Our expectations are that the Fed will go out of its way to continue to reinforce that the threshold for tapering has been met and an official announcement is forthcoming, either at the November or December meeting, largely as a function of how the interim data performs. We also anticipate that Powell will reinforce that while tapering is given at this stage, there's a lot of uncertainty surrounding when the Fed ultimately will deliver the first rate hike. The Fed will also provide updated SEP. This will be the first opportunity that investors have to see the Fed's projections for 2024, both in terms of economic growth, inflation, the unemployment rate, and just as importantly, the Fed's projected rate hikes.

Ian Lyngen:

The market is presumably functioning on the assumption that rate hikes during this cycle will mirror that of the most recent cycle, and that is effectively 25 basis points a quarter at the beginning, accelerating to a quarter point a meeting, if and when the data dictates. The Fed has also communicated its terminal rate expectation for this cycle at 2.50. We have no reason to expect that the Fed will change that in the week ahead. Our primary rate call for the last eight weeks has been that the Treasury market will remain in a definable trading range into the September FOMC meeting. Now, whether or not Wednesday marks a departure point for a new trend in Treasuries, largely comes down to the tone struck by Powell. In the event that Powell chooses to focus on the strength of the overall economy and the recent gains, albeit slightly less than expected on the labor front, one would expect the overall event to have a relatively hawkish tone.

Ian Lyngen:

To a large extent, this is a given, if for no other reason than the proximity to an official tapering announcement. The biggest unknown, however, is whether the chair will choose to downplay the recent increase in COVID cases and any troubling implications for the next leg of the recovery. Given the recent Fed commentary, and Powell's prior acknowledgements of the risks associated with the Delta variant, we expect that the FOMC meeting on that will be balance, laying the groundwork for tapering at November or December, while reminding investors that more than one rate hike in 2023 is not a given at this point.

Ian Lyngen:

We've reached a 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 read the reviews of the new iPhone 13, we're at least reassured by Tim Cook's lack of superstition.

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 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. Notwithstanding 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.

Speaker 2:

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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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