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Inflation Basket Case - The Week Ahead

FICC Podcasts Nos Balados 09 septembre 2022
FICC Podcasts Nos Balados 09 septembre 2022


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 12th, 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 188, Inflation Basket Case, 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 12th. And with CPI on deck and the process of drilling down to the core price changes begins, we are reminded that if one hasn't been paying for food, energy, housing, hotels, airfare, transportation, apparel, healthcare or entertainment, there really hasn't been any inflation. Air is still free as long as you don't care about temperature or quality.

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 I-A-N.L-Y-N-G-E-N, @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 passed, the Treasury market started out with a remarkably bond bearish performance that brought into question whether or not we actually have seen the peak for 10-year yields for the current cycle. We maintain that 3.50 will be the peak for this cycle and we're encouraged that while we did see initial selling pressure, eventually the price action resolved in a period of consolidation without 10-year yields breaching that 3.50 level.

Ian Lyngen:

In the event that we do see another significant round of selling between now and the end of the year in 10s and 30s, we do expect that any attempt to push 10-year yields above 3.50 will be met by significant resistance and ultimately any retest of three 50 will be a buying opportunity. The Treasury market also had the benefit of a wide variety of Fed speakers. The highlights included Brainard and Powell, both of whom left the market under the decided impression that 75-basis points on September 21st is the default position, all else being equal. Now obviously, Tuesday's CPI print will factor into the Fed's thinking on whether or not to go 50 or 75. But if the Fed were to go today, not only have monetary policy makers suggested it would be 75, but that's also consistent with what the market's pricing in.

Ian Lyngen:

We've long maintained that as long as the market prices in a 75% or higher probability of a 75-basis point move that the Fed will and should take the opportunity to move three quarters of a point. The shape of the yield curve was also once again topical this time because the market pushed back against the depths of the inversion. The initial price action occurred in the wake of nonfarm payrolls and was extended on Tuesday. While 2s/10s never emerged out of negative territory, we did see the benchmark spread push above negative 15. Now, the inversion momentum has once again picked up and we saw the curve stabilized below negative 20 basis points. We ultimately see the path of least resistance being a retest of the negative 50 to negative 60 zone with better than even odds of a breakout lower.

Ian Lyngen:

Now, our logic here is relatively straightforward to a large extent, we're simply taking the Fed at face value. The Fed is going to move 75 in September, probably 50 basis points in November with another capstone hike probably smaller in December. All of this will continue to put upward pressure on the front end of the curve while 10s and 30s continue to be guided not solely by the macroeconomic outlook for the US but instead, are taking a broader approach to incorporate some of the headwinds that are already abundantly obvious for the global growth profile.

Ian Lyngen:

To be fair, there has been a unified theme on the part of global monetary policymakers thus far in 2022, and that has been fighting inflation at all costs. Now, expectations are that this will ultimately lead to not only a slower growth outlook as well as contain inflation expectations but increase the probability of a more material and prolonged economic slowdown.

Ian Lyngen:

To be fair, the Fed has acknowledged the possibility of over tightening and even conceded that the path toward a truly soft landing is much narrower than it might have been earlier in the cycle. Said differently, policy makers are preparing investors for the potential for a larger increase in the unemployment rate and policy rates being held at terminal for an atypically long period, which of course is accompanied by the risk of a more material economic slowdown.

Ben Jeffery:

Well, Ian, you and I don't often agree, but I think on this topic we can find some common ground. It was a long, short week.

Ian Lyngen:

It certainly was a long, short week. The Treasury market returned from the Labor Day holiday with a decidedly bearish skew. We saw a pretty significant sell-off on Tuesday. Now ultimately, the extremes of the sell-off ended up being a fadable opportunity, particularly in the 10-year sector. But nonetheless, Tuesday's episode is worth exploring.

Ian Lyngen:

What we initially saw was during the overnight session, 10-year yields were up five to seven basis points. But once New York came online, the selling pressure accelerated. Now, this was consistent with the stronger than expected ISM services print, but ultimately the underlying driver was corporate issuance. There has been a lot of corporate deals brought to market, and as a result there was a combination of rate lock selling and investors lightening up duration positions to take down the new supply. So with that context, it comes as little surprise that we saw a period of consolidation and drift lower and to some extent flatter in the curve after the extremes were absorbed.

Ben Jeffery:

And that early bearishness that you touched on, Ian, was steepening in nature, which again was very much in keeping with this idea that most of the sell-off that was led by the long end of the curve was driven by supply. If only given the fact that along with heavy corporate issuance this week, we also got 2 75 basis point rate hikes. First from the Bank of Canada and then from the ECB, with the latter also committing to raise rates further given that the risks to inflation remain to the upside, while the risks to growth are definitively skewed towards the downside.

Ben Jeffery:

Put another way, it's exactly that distribution of risks that points to a flatter curve. And from that perspective, the flattening follow through after we got the bulk of issuance out of the way was encouraging as an indication of the market's current reaction function and what is still a trading environment that is not quite the summer doldrums, but also given the timing of the Labor Day holiday has not quite picked back up to what we would classify as normal just yet. Not something we've ever been abundantly familiar with.

Ian Lyngen:

Another possible explanation that was floated around for the early week selling was the idea that since September represents the first month in which the SOMA runoff will reach its maximum level, that's 60 billion in Treasuries and 35 billion in mortgages, that as a result, the implied reduction of duration that's held by the Fed should lead the curve to bear steepen.

Ian Lyngen:

Now, we'll be the first to point out that maturities out of SOMA are effectively duration neutral. However, what's more important is how the Treasury department ultimately chooses to shift issuance as borrowing needs start to increase. And it's within that context that we'd characterize the initial bear steepening as market participants attempting to push a narrative that doesn't necessarily conform to the realities of how Yellen and the Treasury department will ultimately shift their borrowing needs.

Ben Jeffery:

But the one aspect of market dynamics that is feeling the fallout from the ongoing rundown of the balance sheet is liquidity in the Treasury market. And one of our favorite measures of US rates liquidity is Bloomberg's government bond liquidity index that has now reached back to levels that are effectively in line with the extremes we saw since the pandemic, despite the fact that a similar shock has not yet anyway hit the market.

Ben Jeffery:

And in conversations we've been having with clients, one of the most frequently discussed topics and complaints is that liquidity in Treasuries is not particularly good at the moment. And the question along with that lament is when one might expect these conditions to improve. From the monetary policy side of things, once we get the September rate decision in hand, the September rate decision and a revised dot plot, along with a new press conference from Powell, there will presumably be at least a bit more clarity on how the Fed is thinking about their approach to terminal, how high that will be, whether that will be 2022 or 2023, which should in turn translate to a bit more conviction and secondary trading that should help improve the liquidity situation.

Ben Jeffery:

Now, from the Treasury department side of things, remember what we learned in the August refunding announcement and the TBAC Charge that discussed the issue of buybacks and the potential for the Treasury department to go into the secondary market and buy off the run bonds to on the one hand reduce the deficit, but also improve overall liquidity, which then in turn brings down the government's overall cost of financing.

Ben Jeffery:

Now, while the Fed would execute the buybacks on behalf of the Treasury department, this process would be far different from QE and that it would be money from the Treasury Department's cash balance that would be going to purchase these bonds, not money created by the Fed with the goal of stimulating the economy. But as we move further into 2023, it certainly wouldn't surprise me to continue to see this topic discussed both in the refunding announcements themselves but also among Fed speak or any rhetoric from the Treasury department.

Ian Lyngen:

Yeah, Ben, and if we take a step back and we think about how the Treasury department has shifted the landscape of trading in Treasuries over the course of the last 20 years, it follows almost intuitively that at moments of stress having disintermediated the dealership community, that liquidity would become more scarce.

Ian Lyngen:

When we think about the buildup of the direct bidding category combined with regulations which have made the underwriting process of the US government more of a loss leader than a money maker per se, it isn't surprising to see that as a theme, less and less capital has been committed across the street. Still, nonetheless, Treasuries are the most liquid fixed income instrument on both an absolute and relative basis.

Ben Jeffery:

But these issues while certainly contributing to the volatility we've seen, are not setting the outright level of yields nor the shape of the curve. And the fact that we saw 10-year yields move back from that 3.35, 3.36 level and left the 3.50 peak that we reached in June intact does bode well for the argument that coming out of CPI and probably more importantly, the September Fed meeting, there is a building case for investors to be adding duration exposure given the myriad of risks that are facing the domestic economy, yes, but probably more severely and importantly, the global economy.

Ben Jeffery:

Remember, Japan has been a significant net seller of Treasuries this year. We've seen the yen weaken through 144 and once that volatility subsides and we presumably start to see a change in Japanese investor behavior, as the cycle more convincingly begins to turn, given what is still a decided short base in the Treasury market, our conviction is still high in the call that we'll see 10-year yields get back to 2.50 by the end of the year.

Ian Lyngen:

And as we contemplate the balance of the year, it's important to put in context what we're anticipating in terms of the relationship between two-year yields and effective Fed funds. Historically, 2s versus fed funds only inverts after the Fed has reached terminal and the terminal policy rate has been in place for some time.

Ian Lyngen:

We expect that this cycle will be slightly different, and in this context, we mean that the effective Fed funds rate will continue rising into the end of the year, but given the uncertain global outlook, there's a reasonable probability that two don't use effective Fed funds as a floor, and instead we see an earlier inversion. The one caveat is that the Fed's commitment to holding terminal in place longer this cycle will implicitly push back on any meaningful inversion in 2s/funds.

Ian Lyngen:

Nonetheless, at some point, the next big trade in 2023 will be the bull steepening of the curve as the market attempts to price in rate cuts. Now, the sustainability of that trade and the Fed's willingness to push back against market expectations will be a significant point of contention by the midpoint of 2023.

Ben Jeffery:

And this is going to leave Powell in an even more precarious position than he's already in, which is that even once rate hikes are over, the Fed could actually still be tightening financial conditions simply by pushing back against market pricing. I would argue this latest leg tighter in the FCI that we've seen as a result of exactly that. We still have some probability of rate cuts priced into 2023, and we heard from Powell on Thursday that that is not something the Fed is actively considering.

Ben Jeffery:

So by pushing back against what's priced in the very front end of the market, mechanically, as we move forward in time and get closer to those dates, those rates are going to need to come up to match the administered rates set by the central bank. So even without hiking, holding at terminal in restrictive territory could still push financial conditions tighter, probably to the detriment of risk asset valuations, stocks and credit, and all that means for overall sentiment both in the market but also in the economy as a whole. Not to mention what's probably going to be a continued down shift in terms of the real estate market and arguably what's also the start of a move higher in the unemployment rate. Doesn't sound like a soft landing to me.

Ian Lyngen:

While it might not ultimately end up being a soft landing, both soft landings and hard landings tend to start out the same. You see a reduction in sentiment. You see a modest increase in the unemployment rate, and in this case, you see monetary policy makers willing to trade a small amount of growth to ensure forward inflation expectations remain anchored. When we look at breakevens, the 10-year sector in particular is now comfortably below 250 basis points. This speaks to an investor base that has an increasing amount of confidence in the Fed’s, not only ability, but willingness to fight inflation at all costs.

Ben Jeffery:

Well, Ian, as you told me in my interview, willingness but no ability. The strategists lament.

Ian Lyngen:

So true, although I'm not willing to admit that.

Ben Jeffery:

Do you have that ability?

Ian Lyngen:

Oh, the laments.

Ian Lyngen:

In the week ahead, the Treasury market has one primary data point of relevance, and that's the CPI print. Consumer prices for the month of August are seen decreasing one-tenth of a percent. This is very similar to the move that we saw in July where food and energy prices weighed on the overall pace of inflation. Within the core series however, expectations are for a three-tenths of a percent gain.

Ian Lyngen:

Now, embedded in that is the wild card of used auto prices, which all else being equal, we would expect to continue to be flat or lower. We'll also be watching the shelter component, OER and rent in particular, which have lagged the strong real estate market on the way up, and we would expect would eventually start to show some signs of softening as the year comes to an end. But it's still a bit early to anticipate a moderation in the gains in OER.

Ian Lyngen:

It goes without saying that the Fed has a general understanding of how inflation is shaping up. And still, the consistent message from monetary policy makers has been that a 75-basis point rate hike on the 21st of September is the default position unless there is a major surprise or dislocation between now and then. So with that backdrop, it's worth contemplating what type of inflation numbers would get the Fed to shift from 75 to 50 as their base case.

Ian Lyngen:

Obviously, a negative headline CPI is already a given in light of the consensus. But if we were to see core inflation drop below zero, that might be enough to get the Fed to downshift from 75 to 50 basis points. That said, that is certainly not our baseline assumption. After all, there's still enough momentum and core prices to anticipate that there was positive momentum for consumer prices in August.

Ian Lyngen:

The week ahead also contains three key auctions of note, we have the double header on Monday with 41 billion three-year notes, as well as 32 billion 10-year notes. Followed by Tuesday afternoons, 18 billion 30 years. The logic behind the earlier schedule has to do with this settlement of the auctions on the 15th and the fact that the Fed has built in a buffer day on the 14th. Let us not forget, we also see retail sales figures for the month of August as it currently stands. Expectations are for a modest but positive increase of two-tenths of a percent.

Ian Lyngen:

Now, investors have been closely tracking the pace of consumption, particularly given where we are in the cycle and the fact that earlier in the summer, consumers were making tradeoffs between the necessities, i.e., groceries and fuel and non-necessities. As prices at the pump begin to ease, one would expect consumption to be more broad-based, and that's something that we'll be looking for on Thursday when the retail sales figures hit.

Ian Lyngen:

Overall, we expect the longer end of the curve to remain in a range trading environment. We continue to view 3.50 as the upper bound for this cycle in 10-year yields, but we'll acknowledge that the bearishness that is flowing through the front end of the curve has enough fundamental and monetary policy justification to be sustainable for the time being. Eventually, we will see a shift where two-year yields trade below effective Fed funds, but it's still too soon to assume that that will come to fruition over the course of the next several months.

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. And with the US Open Finals at hand, we cannot help but marvel at a sport that can elegantly combine the words' fault and love without offending anyone, how civilized.

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.

Audio:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

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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