Holiday Special - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 203, Holiday Special, 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 December 27th. And as evidenced by today's typical format and content, sometimes just labeling something special can go a long way. At least, that is what our participation trophy case implies.

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.

In the week just passed, the defining development was the Bank of Japan's decision to increase the band on their yield curve control, or their target for 10-year JGBs, from plus or minus 25 basis points to plus or minus 50 basis points. It follows intuitively that in the wake of the announcement, JGB yields increased and pushed toward the upper bound of 50 basis points, although ultimately failed to achieve that level, at least for now.

The BOJ also increased the size of its bond purchase program from 7.3 trillion yen to nine trillion yen. Now we're taking this as an acknowledgement of the fact that it might become expensive to defend the upper bound of the new yield curve control range. It's also notable that the BOJ went out of its way to emphasize that this move is not a rate hike, per se, even if it does result in higher Japanese rates. It certainly benefited the yen, and as a result, we continue to anticipate that 2023 will see the absence of Japanese selling and the return of Japanese buying.

Now, part of this will be a function of the interest rate differential being narrowed as the BOJ continues to remove the degree of excess accommodation that's in the system. But in addition, as the Fed reaches terminal, investors in Treasuries will have a better sense of the path forward for US monetary policy expectations.

And as a result, this stabilization will work in favor of the yen and against the dollar, resulting in an easing of the onerous hedging costs currently in place for Japanese investors to buy US Treasuries and hedge them back into yen returns.

The week just passed also saw a variety of economic data. Mixed is the theme, but we did see higher than expected GDP revisions driven primarily by stronger consumption. So the third quarter's consumption profile is certainly consistent with the Fed's messaging that the US economy is on a strong enough footing to absorb a decidedly restrictive monetary policy stance for an atypically long period of time.

We also saw a solid take down of the $12 bn 20-year auction, as well as higher than expected confidence numbers from the conference board. Now in light of the risks facing the US economy in the next several quarters, it is notable that confidence has bounced off of the lows. We will highlight however, that the inverse correlation between gasoline prices and higher consumer confidence is an important underlying driver in this dynamic.

Ben Jeffery:

The second to last trading week of the year is hardly ever a paradigm shifting event, but this week did offer some fairly significant surprises following what we saw last week, both in the downside missing CPI and the December Fed meeting. And the most tradable impulse for Treasuries over the past few days was that the Bank of Japan decided to begin the process of catching up to other central banks around the world, and take the first step in changing their ultra-accommodative monetary policy stance by amending their yield curve control bands from negative 25 to positive 25 basis points to negative 50 to positive 50 basis points. And this offered a bearish impulse into global fixed income that was really the final theme of 2022, as Treasuries prepare for a holiday nap.

Ian Lyngen:

The biggest question I think that resulted from the Bank of Japan's policy decision was, what implications are there for the US Treasury market now that we finally see the one dovish holdout coming back in line with the rest of global monetary policy makers? We are characterizing the kneejerk selloff on Tuesday as about right for what an earlier than expected departure from yield curve control was worth.

And there we saw 10-year yields selloff seven to ten basis points, and it was a move that was ultimately reversed. Now, the reason that we don't think that there is a great deal more downside in the US Treasury market from the Bank of Japan's decision has to do with the fact that global financial conditions are going to become increasingly less accommodative as the Bank of Japan and the ECB continue to push forward with tightening, while the Fed reaches terminal, and attempts to hold it for an atypical period of time.

So said differently, while optically, higher 10-year Japanese yields might imply upward pressure on other sovereign borrowing in the sector, the reality is that the biggest impulse is the removal of accommodation, and what that means for the prospects for the global economy in the coming year.

Ben Jeffery:

And while this was certainly a shock from Tokyo, and I would argue there was pretty much no one in the market looking for this change to occur, the real surprise wasn't that the Bank of Japan made this change, but rather the timing of it. After all, for the first time in a very long time, Japan is finally experiencing inflation. And while until this week Kuroda was steadfastly committed to the current policy stance, given the leadership change that will be coming at the BOJ in April of next year, clearly the discussion to make this amendment and not be quite so dovish was underway, and the current leadership at the BOJ wanted to oversee the start of the transition before the new governor takes over in April.

And while in a global context, the inflation that Japan is experiencing is still very subdued, really what was the primary driver of this decision was the weakness of the yen. And as you touched on, Ian, how the yen strengthens in response to not only this adjustment of YCC, but also future ones, is going to be important as we evaluate how overseas demand for Treasuries is going to shift over, not just January and February, but really the entire course of 2023, as the Fed and other central banks arrive at their respective terminal rates, which will presumably weaken the dollar, and reverse the erosion of the appeal of Treasuries for overseas investors that was such a meaningful part of the bearishness that we saw throughout 2022.

Ian Lyngen:

And Ben, you make a good point about the fact that outright inflation in Japan, while high by Japanese standards, is still very contained when we put it in a global context. And we had an interesting question this week regarding the potential for the Bank of Japan to effectively lose control of the yield curve if the market presses the matter. So note that the Bank of Japan did increase the size of their bond buying program to nine trillion yen from 7.3 trillion yen.

And optically, one might say, well, how can they be doing more QE while widening the band? I think that in practical terms, what they're doing is, they're readying to defend the upper bound at 50 basis points. So in effect, they're saying, "We're cognizant that defending 50 basis points will be expensive," but they're prepared to do it.

Now, as we think about the prospects for an additional widening of the band when using a modified version of the Taylor Rule to suggest where outright rate should be, both policy and nominal rates in Japan, I think it's safe to say that 10-year JGBs shouldn't be yielding for 5% in nominal terms. What will more than likely occur is, the dislocation in tens versus 30-year Japanese yields will rectify itself.

So that means that yes, on the margin we might see more volatility around the 10-year JGB. The reality is that they'll let the bands increase, but only to the point where forward growth and inflation expectations make sense in terms of pricing. The next leg of expressing hawkishness at the Bank of Japan will come in the form of abandoned negative rates. Keep in mind, Japanese policy rates are currently negative 10 basis points, so it would be very well within the set of conceivable outcomes to look for the BOJ to start hiking policy rates in 2023. Then that will contribute to the ongoing flattening and inversion impulse that we have seen across markets.

Ben Jeffery:

And zooming out a bit, this discussion gets at something that we've heard increasingly discussed following the hawkish ECB we saw in the wake of the Fed, another Bank of England hike, and that is, how does the tightening that other central banks are delivering move the needle for the Fed, and ultimately the shape of the US curve? Does the fact that global policy rates are going to continue to move higher mean that US yields are going to be dragged along for the ride, and ultimately necessitate the Fed to keep up with rate hikes in Frankfurt, London, Ottawa?

Or, and this is our take on the issue, does the fact that global financial conditions are continuing to tighten take some of the pressure off Powell to step up and do even more? Whereas there was once a time where the Fed was much more responsive to global economic and market conditions. The nature of the post pandemic economy has left the FOMC's focus squarely on the domestic situation and containing US inflation. So that means that even if European yields, for example, continue to climb in response to a hawkish ECB, it doesn't necessarily mean that Treasuries are going to be rising one for one along with that.

In fact, the heightened risk of a policy error from Lagarde might actually flow a bit counterintuitively into a stronger bid for Treasuries, just given that thus far, it seems like the US economy is on comparatively stronger footing as we head into the new year.

Ian Lyngen:

Away from global monetary policy, there's also been some interesting developments with the reopening of China, and the implications for the direction of inflation, both domestically and globally. One of our biggest takeaways from the transition to a more open China is that the implications for inflation are twofold. On the one hand, demand for energy is almost by definition going to increase, and that should put upward pressure on oil prices and gasoline prices, which will ultimately flow through to a higher realized headline inflation in the US.

On the flip side, with more international trade in place, we would expect goods deflation, or the absence of inflation on the goods side, to define the first half of next year. This begs the question, are there any monetary policy implications? Our take is probably not. And the reason that we make this observation is because what continues to drive the core inflation complex isn't goods. What it is, it's shelter and housing and OER, and this by definition won't be influenced in any material way by the reopening of China. Certainly not in the year ahead.

Ben Jeffery:

And especially given the role that China plays in commodity markets, a more fully reopened China will likely be bullish for raw materials, whether that be metals, oil, or other inputs in the manufacturing process. The fact that China plays such a prominent role in terms of the global production landscape means that there is the risk that as China becomes more fully reopened, yes, their consumer base will be less restricted in spending, but also, their manufacturers will push up prices that are far more relevant on the headline inflation front than the core one.

Now, the question becomes, if we continue to see moderation in US inflation related to some of those categories you touched on Ian, probably housing most notably, medical care, used cars, the things that we've been talking about for the better part of a year, will the Fed continue to fight to stay on hold, or even deliver additional rate hikes if it's headline inflation that is continuing to climb, not as a function of domestic demand in the US, but rather international drivers, both on the demand side from China, but also on the supply side, given what's obviously still a very tumultuous geopolitical landscape?

So a widening divergence between headline and core inflation might become more relevant to trading early in the year than would otherwise be expected. And at the very least, is going to be something to keep an eye out for, and any official Fed rhetoric, as we move through the first quarter, and we get a clearer picture on exactly what the economic implications will be from a more fully reopened China.

Ian Lyngen:

Ultimately, Ben, at the end of the day, I think that the Fed is positioning itself to shift the messaging around inflation from realized inflation to forward inflation expectations. And not just break-evens and market-based measures, but also survey-based measures more importantly, because given the magnitude of the upside surprises that we saw in inflation during 2022, the reality is that household level inflation expectations are precisely what the Fed is trying to re-anchor as they reestablish price stability within the US economy on a go forward basis.

Now, if we find ourselves in a situation where headline inflation is defining the landscape in 2023, it follows intuitively that survey-based measures of inflation expectations, which are highly correlated to gasoline prices, might prove stubbornly high or stickier than the Fed would like to see. So at the end of the day, China's contribution to realized inflation, and therefore inflation expectations, might be driven by the headline, but it could still keep the Fed on hold for longer. We struggle to see a scenario in which it adds another 25 or 50 basis points on the journey to terminal, but it certainly could contribute to a stronger case for holding terminal through 2023 and into 2024.

Ben Jeffery:

And taking a bit more short term view and tactically speaking, after some of the yield moves we've seen over the past few weeks, the first several trading weeks of the year are going to be very informative as to how true trading conviction was limited going into the end of the year. Specifically on the shape of the curve, we've seen an impressive bounce in 2s/10s, back to that negative 60 level, more or less. And the question becomes, will the start of the new year be viewed as a green light for investors to start scaling into steepener positions, or will the removal of year end constraints free up some demand that has thus far been sitting on the sidelines for longer dated Treasuries?

Especially after the backup we've seen in 10-year yields from 340, that was definitely aided at least on the margin by the Bank of Japan's decision, there's definitely a case to be made that early January we'll see a higher willingness by real money participants to start the long awaited process of reaching further out the curve and capturing some of the upside and yield that is provided by the longer end of the rates market.

And so coming back from the new year, it's going to be this dynamic that will look to help set the tone in terms of the direction of rates into not only the December NFP data, but also the first Fed meeting of the new year in early February.

Ian Lyngen:

So Ben, effectively what you're saying is, new year, new fear?

Ben Jeffery:

If that's not on brand for you and I, then I don't know what is.

Ian Lyngen:

In the week ahead, the Treasury market will only be open for three and a half days. Monday is the Christmas holiday, and Friday is the recommended early close for New Year's, which sees the official market closure on January 2nd. Within these three days, it's not surprising that there is remarkably little scheduled. We do have Tuesday's $42 bn 2-year auction, Wednesday's $43 bn 5-year, and of course, the last coupon auction of the year comes on Thursday, with $35 bn 7-years.

Now, given the amount that the 2s/10s curve in particular has steepened over the course of the last several weeks, we're anticipating that if nothing else, Tuesday's supply will function as a headwind to the un-inverting trend that appears to be developing in the Treasury market. While we're certainly cognizant that the big macro trade for 2023 will be the cyclical re-steepening of the yield curve, we are not interpreting what has occurred during the final few trading weeks of December as the departure point for this cyclical move.

Instead, what we are attributing the steepening to is position squaring into year end, as well as a market that has seen very thin volumes, limited liquidity, and a collective lack of willingness to get in the front of any price action of note.

Now that being said, the first couple weeks of January won't see a wholesale return of flows and conviction, per se, but as January unfolds, we anticipate that investors will become reengaged in the broader in the macro narrative, and that will lead the 2s/10s curve to test the 40-day moving average of negative 65 basis points as the curve returns to the prior range.

Now, this is, of course, contingent on two key data points. First is the release of the December non-farm payrolls numbers on January 6th, and then of course the mid-month release of core CPI. Assuming that the employment landscape remains sufficiently strong for the Fed to continue forward with its rate hiking campaign, which is a very safe assumption at this point, and even with a degree of continued moderation on the core CPI front, that creates the perfect backdrop for a continued inversion of the curve.

The Fed has at least another 50 basis points of tightening to execute before we reach terminal. Then any evidence of either more rapidly declining inflationary pressure than anticipated, or any sign that the impact of the cumulative tightening achieved thus far has started to flow through to consumption.

Now, it's also notable in the week ahead that we do get updated Case-Shiller figures. Now, recall that the three month annualized rate in the change of home prices as presented by Case-Shiller was down negative 18.4% in the most recent update. For context, during the housing crisis, the trough for this read was negative 34%. Now we're clearly not there, but the trajectory has been rather dramatic, and it has brought into question the amount of wealth destruction that Powell is willing to deliver in order to ensure forward inflation expectations remain well anchored. For the time being, there's little to suggest that Powell is anywhere close to a pivot, and for this reason will remain cautious on the housing sector.

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 this is the last installment of Macro Horizons for 2022, we'd also like to take this opportunity to wish everyone a happy holiday and a successful new year, however one might define it. After all, sometimes success is simply the absence of abject failure. For context, note the year to date performance of the S&P 500 versus a crypto, for example.

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:

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