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Muddied Waters Run Deep - Monthly Roundtable

FICC Podcasts 11 mai 2021
FICC Podcasts 11 mai 2021

Disponible en anglais seulement
Margaret Kerins along with Ian Lyngen, Greg Anderson, Stephen Gallo, Dan Krieter, Ben Reitzes, Dan Belton and Ben Jeffery from BMO's FICC Macro Strategy team bring you their debate of the main narratives that are dominating market pricing and what these themes imply for US and Canadian rates, high quality spreads and foreign exchange.


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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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Disponible en anglais seulement
 

Margaret Kerins:

This is Macro Horizons monthly episode 27, Muddied Waters Run Deep. Presented by BMO Capital Markets. I'm your host Margaret Kerins here with Ian Lyngen, Greg Anderson, Stephen Gallo, Dan Krieter, Ben Reitzes, Dan Belton and Ben Jeffery from our FICC Macro Strategy team to bring you our debate of the main narratives that are dominating market pricing and what these themes imply for US and Canadian rates, high quality spreads in foreign exchange. Each month members from BMO's FICC Macro Strategy team, join me for a round table, focusing on relevant and timely topics that impact our markets.

Margaret Kerins:

Please feel free to reach out on Bloomberg or email me at margaret.kerins@bmo.com, with questions, comments, or topics you would like to hear more about on future episodes. We value your input and appreciate your ideas and suggestions. Thanks for joining us.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Margaret Kerins:

So the market takes clues from today's economic data to price expectations about future growth and inflation. And there are several factors muddying the water in terms of the outlook, many of which are expected to be transitory. Friday's big miss on the number of jobs, the added versus expectations highlights the challenges of navigating through these uncertain times. And it seems unlikely that this uncertainty will change soon and markets will not have a true read on employment, longer term growth and inflation until some of these dislocations are behind us. And we actually see how the economy looks when it's forced to stand on its own two feet.

Margaret Kerins:

So let's kick it off with Ian. Ian, why have Treasuries been so ambivalent to the stronger than expected data?

Ian Lyngen:

Well, one of the most fascinating parts of trading in a Treasury market this year has been the general indifference on the part of the market to the incoming data. What we saw during the first quarter was a consistent bear steepening as optimism for the year ahead was priced in almost regardless of how the economic data played out. Now, there were moments in which it was consistent with stronger than expected prints, but at the same time, investors were willing to ignore the economic data that didn't fit the broader narrative. Fast forward to today, what we find is that the market has continued to demonstrate an indifference towards the data, but it's in the face of economic data that has been relatively weak versus expectations.

Ian Lyngen:

Very specifically, I'm referring to the April Nonfarm Payrolls print, which came in roughly 800,000 below expectations.

Margaret Kerins:

So in this backdrop of uncertainty, that's likely to persist at least through October and just based on employment alone, given that the extended benefits aren't set to expire until the end of September and kids going back to school may free parents up to go back to work. But this also might take several months. It seems unlikely that the Fed will want to make any changes to accommodation. But one of the narratives that is playing out in the market is tapering. And some expect an announcement in the fourth quarter or even possibly tapering to begin in the fourth quarter. So there are a few things that need to happen before the Fed tapers. First, as we know, there must be substantial, further progress in the US economy. And Powell has told us that the economy is nowhere near substantial, further progress.

Margaret Kerins:

Second, the Fed will message well in advance that it is time to begin thinking about tapering. And then third, of course, they must announce the tapering for a future start date. So there simply does not seem to be enough time for this sequence to happen this year. And that's even if job gains come in really strong over the next three months. Let's just say that there are a million per month, that would still leave over 5 million jobs lost, which seems like it wouldn't be substantial, further progress. Now that said, we know that tapering will happen eventually. So Ian, what do you anticipate the announcement of tapering to be worth in terms of tenure yields?

Ian Lyngen:

Well, that's a question that I think implies that there's some surprise value at the actual announcement of tapering. I suspect that when we ultimately get the trial balloons and official announcement of tapering, that it won't be worth more than 10 basis points in ten-year Treasury yields. And the reason that I suspect it will ultimately be a non-event is one because the Fed did learn some very important lessons from the 2013 taper tantrum. But more importantly, when we think about the Fed's well telegraphed response function to incoming data, what I suspect will ultimately happen is that both tapering expectations and the general macro outlook will be trading off of the same inputs.

Ian Lyngen:

So we will be pricing in a taper, not because we're anticipating the move from the Fed, but rather because what is driving the Fed to taper is the same thing that's driving a stronger growth and inflation outlook on the part of market participants.

Dan Krieter:

And Ian, I think we're seeing a similar dynamic play out in credit spreads as well. I mean, it's sort of hard to believe, but credit spreads have traded in a 12 basis point range for the entirety of 2021. And it's worth noting that credit spreads are now within two to three basis points of all time lows. So there is a high degree of optimism currently being priced in, Margaret to your point about the Fed timeline being potentially further into the future than the market is currently expecting. And I think another important piece of that is the way the Fed is approaching, not just inflation, which is obviously the hot topic right now, but also employment.

Dan Krieter:

We know the Fed is going to allow employment to run hot obviously, but one thing that maybe separates the current Fed from previous Fed regimes is going to be the Fed's increased focus on not just broad based employment, but also inclusive employment, particularly among low wage earners. This focus for the Fed may very well mean that not only are we looking at employment rates getting down to the very low 3% range, but we may even see unemployment rates with a two handle before the fed thinks about normalizing monetary policy in a significant manner.

Dan Belton:

Yeah, Dan, we view the path of least resistance for credit spreads as one, in which the economic recovery unfolds in a way that is strong enough to not warrant a resurgence of downgrades and defaults, but at the same time, not so strong that it brings significantly higher greats or accelerating inflation expectations or in the worst case outcome a premature removal of Fed accommodation. And I think Fridays Nonfarm Payrolls Report was a step in that direction, particularly given the strength of the economic data we've seen up until that point. The credit spreads are certainly priced to this Goldilocks scenario. And we saw that confirmed by the price action on Friday when credit spreads actually touched new post-pandemic tights, following that data release.

Dan Belton:

Typically of course, we would expect to see credit spreads widened given such a downside miss in the data, but it just goes to show that the status quo with respect to continue to accommodation and low rates at the same time that we're seeing an increase in economic fundamentals is really the sweet spot for risk assets here.

Ben Reitzes:

So it was disappointing as the US number was we got, I would say, equal disappointment in Canada, the job decline, maybe on the headline basis, wasn't quite as bad as expected. But the details were pretty poor to say the least. We had the first drop in full-time jobs in a year where the biggest drop in hours worked in a year, so since the initial pandemic declines. And it does look as though the second quarter started on pretty weak footing here. And we could very well see a decline in second quarter GDP and as bad as the US number may have been, you're still going to get growth in the second quarter. So pretty big juxtaposition between Canada and the US. Where does that leave things from a candidate perspective? The bigger picture is still the same. We're still looking for a recovery in the second half of the year.

Ben Reitzes:

This is just a sizeable hurdle and it looks like it's going to last at least into June at this point, as Canada continues to struggle with the third wave. But beyond that point, I mean, we're still more or less in line with the US, the Bank of Canada has been a little more aggressive. Admittedly, they'll probably have to pull back a bit on that. And those who were expecting another taper in July, will have to put those expectations on ice for now. October looks much more likely assuming we get the recovery that's expected. And policy normalization again, that's still a very long way off. Canada will probably lead the way on that front as they have led the way on tapering, but you're still looking at kind of 2023 or maybe late 2022 at the earliest. So similar to the US, normalization a very long way off.

Greg Anderson:

Ben, you mentioned the disappointing Canadian employment numbers from last Friday, but I tell you, dollar Canada didn't trade like it was a disappointment. The Canadian dollar reached a new cycle high against the US dollar. As the dollar Canada exchange rate broke support at 120, 150 Friday morning after the release, then it extended further and broke below 121, the figure yesterday. But look, I don't think this is about the outlook for the Canadian economy. Rather, this is a delayed FX market reaction to this year's commodity price rally. That rally has benefited commodity currencies in particular. In the G10, the Canadian dollar is the leader up, let's call it 5% on the year. With the Norwegian Krone, following it, plus 4%. And then Aussie and Kiwi also showing gains of let's call it 2% and 1% respectively.

Greg Anderson:

Admittedly, the Bank of Canada has been a bit less dovish than the RBA and the RBN Zed. And perhaps that is a minor contributor to CAD strength. But I think the main reason for the strength of the Canadian dollar is the remarkable turnaround in Alberta. With WCS Greg crude, averaging over $50 a barrel for the past several months. If that is in fact, the new equilibrium for WCS, then it should correspond with the dollar Canada exchange rate probably below 120. With that in mind, we pulled our outlook beyond six months in dollar Canada, below 120. That's a relatively minor adjustment for us because we had been more CAD bullish than most in the market, but others have had to make a much bigger adjustments in their outlooks and their positions.

Greg Anderson:

I think though, after the price action we've seen over the past several days, I'm now inclined to say that it is the other commodity currencies like Aussie and Kiwi, as well as maybe a Mex peso in the EDM space that are trailing the strength we have already seen in commodity prices. So I'm not sure we need to see commodity prices rise further in order to see what I would call catch up rallies in some of these other commodity currencies.

Ben Jeffery:

Yeah, Greg, and in addition, I think it's worth discussing the impact that commodity prices have had on the inflation outlook and inflation pricing that we've seen in the Treasury market over the last several weeks. In both five and 10 year break even space, we've seen that benchmark market based measure of inflation expectations reach their highest level since 2006 in 5 years, in 2013 and 10 years. So really this begs the question of just how transitory these upside inflationary pressures are going to be, that seemed to be causing a fair amount of angst at this moment. Now for the time being we've heard from the Fed, including Chair Powell, that they're going to be content to dismiss these near term inflation pickups as transitory and look through any meaningful upside and prices to keep policy accommodative for a much time.

Ben Jeffery:

This is something of a critical divergence in the market at this point, which is the "New Fed” versus the “Old Fed." In the prior paradigm, a sharp pickup in inflation would have warranted a monetary policy response, whether that be tapering the QE program earlier, rather than later, or lifting rates off zero. But given the shift to not only the average inflation targeting regime, but also the Fed's outcome-based forward guidance, the bar for normalization has been definitively raised. So 10-year break-evens at 250 basis points doesn't necessarily need to trigger a monetary policy response, but we are starting to reach the point when that worry about inflation is coming at the expense of growth.

Margaret Kerins:

So on the one hand Powell and the Fed are telling us that inflation is transitory and they will not have a monetary policy reaction to it. But on the other hand, the market seems to be pricing this as real inflation. So who's right?

Ian Lyngen:

I think that's the essential debate. Whether the market is going to be in a position to push back against the Fed's transitory narrative and enough to prompt the Fed into action. My baseline assumption is that will not occur. Instead, what we'll find is that whenever the market believes that inflation has become anything besides transitory, we'll see an increase in rates, real rates in particular. Because it will presumably be based on a positive growth narrative and that will serve to tighten conditions for the Fed. So a market tightening of sorts, which then has the counter-intuitive impact of leaving the Fed less likely to actually deliver tightening.

Ian Lyngen:

So said differently if the market tightens for the Fed, the Fed doesn't have to, and we'll find ourselves in this situation where monetary policy remain stable and predictable for quite some time.

Margaret Kerins:

Yeah. Ian, and that is certainly a scenario that has played out in the past. Another narrative playing out in the market is expectations for Treasury issuance in terms of size and composition. Some market participants expect Treasury coupon size auction cuts to occur in the fourth quarter of this year. Of course, our base case is that Treasuries more likely to leave auction sizes unchanged for a few reasons. First, there is uncertainty surrounding any additional fiscal stimulus that might come later in the year and whether Treasury will be called upon to fund the stimulus. And second, Treasury does have the desire to decrease bill issuance as a percentage of outstandings after the big run-up last year.

Margaret Kerins:

And they really want to do this so that they have the fire power to rapidly ramp up bill issuance in the event of a future downturn or crisis. And what that implies is that coupon auction sizes are likely to remain unchanged in the near term.

Dan Belton:

Yeah. And we think this could end up being a pretty significant storyline in the corporate credit market. We typically think of Treasury supply as having a non-linear impact on credit spreads. So for small increases in Treasury issuance, that tends to often erode the liquidity premium of Treasuries and can lead to modestly narrower credit spreads. But when we see a more sustained and significant increase in Treasury issuance that can lead to a crowding out of private sector borrowing, and this is almost exactly what we saw around the Fed's removal of Q3. So credit spreads widened fairly sharply around this much publicized taper tantrum of 2013, but this weakness in credit spreads was fairly short-lived and credit rebounded pretty quickly.

Dan Belton:

It was really only around a year and a half later at the end of 2014, early 2015, once the Fed was actually tapering its asset purchases, that credit spreads began to widen more significantly. But it was in a much more orderly fashion than during the taper tantrum. And this was really just due to the mechanical impact of heavier Treasury supply, having to clear the market without the Fed support. So given heavier Treasury borrowing needs, coupled with the eventual Fed taper later this year or early next year, we think that's going to be a very important storyline to watch in corporate credit markets.

Ian Lyngen:

So when we think about the classic supply and demand dynamics, they haven't really played out as one might have anticipated in the Treasury market, at least thus far this year. The plateauing of coupon auction sizes is important because it does at least take the edge off of expectations for auction sizes to continue to increase. Now, we have had a few episodes, namely, the seven-year auction, where there was evidence of supply indigestion, however, as we move past the first two quarters of the year, and we run up against some of the technical issues associated with the debt ceiling and the potential for extraordinary measures, if anything, we're moving into a period of increased uncertainty in terms of the issuance slate.

Stephen Gallo:

Ian, just to follow on from where you left off to bring the international picture into focus, obviously the European Central Bank has a big quantitative easing program too. And so there are a lot of questions about this. I think with the more conversations I have with market context and clients, I can get a feel that the consensus in the FX market is coalescing around a drift higher in Euro dollar as we head into the summer. And that seems reasonable given that the dollar is weak and we're probably through the worst of the slow vaccine rollout as such in the European Union. But as FX and rates markets price in economic recovery, in the context of what will probably be more than a trillion euros in gross issuance this year from years on governments, there are I think a number of profound questions building on the horizon that investors are starting to ask.

Stephen Gallo:

Number one, how does the ECB transition out of its emergency bond buying program into the standard asset purchase program seamlessly given that the COVID emergency is gradually receding? So my assumption is that as the purchases will need to continue in some form well beyond March of next year, which is when the emergency program is supposed to expire. So that's question number one. Question number two is the backup in yields going to be isolated to Italy, France, and other Mediterranean countries to reflect that this is where government debt ratios have increased more? Or is it going to be confined to Germany owing to the fiscal risks surrounding the September elections? And I think the answer to that question will ultimately determine how the ECB splits its bond buys between core and peripheral debt markets going forward.

Stephen Gallo:

So I think these are the important questions. What does this mean for the FX market? Well, I would think that the first order response to the backup and your rates would be for more Euro short positions to unwind, but I would insert the caveat that this will happen as long as investor risk appetite holds up okay. The one thing I would add is that the size of investor positioning in Euro dollar might remain more limited than otherwise because a repricing in Eurozone credit markets, particularly in the periphery and lower quality corporates can have both positive and negative implications for the Euro.

Margaret Kerins:

Okay. And that's a wrap. Thank you to all of our BMO experts. And thank you for listening. This concludes Macro Horizons monthly episode 27, Muddied Waters Run Deep. Please reach out to us with feedback and any ideas on topics you'd like us to tackle. Thanks for listening to Macro Horizons, please visit us at bmocm.com/macrohorizons. We'd like to hear what you thought of today's episode. You can send us an email at margaret.kerins@bmo.com. You can listen to the show and subscribe on Apple Podcasts or your favorite podcast provider. And we'd appreciate it, if you could take a moment to leave us a rating and a review. 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 is 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. Not withstanding 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.

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Margaret Kerins, CFA Chef - Stratégie macroéconomique Titres à revenu fixe
Ian Lyngen, CFA Directeur général et chef, Stratégie de taux des titres en dollars US
Greg Anderson Chef mondial, Stratégie de change
Stephen Gallo Chef de la stratégie de change pour l’Europe
Dan Krieter, CFA Directeur, Stratégie sur titres à revenu fixe
Benjamin Reitzes Directeur, spécialiste en stratégie – taux canadiens et macroéconomie
Dan Belton Vice-président - Stratégie sur titres à revenu fixe, Ph. D.
Ben Jeffery Spécialiste en stratégie, taux américains, titres à revenu fixe

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