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Para-Para-Paradigm - Monthly Roundtable

FICC Podcasts 13 juillet 2021
FICC Podcasts 13 juillet 2021


Disponible en anglais seulement

Margaret Kerins along with Ian Lyngen, Greg Anderson, Stephen Gallo, Ben Reitzes, Dan Belton and Ben Jeffery from BMO Capital Market’s FICC Macro Strategy team bring debate of perceived risks as the Fed attempts the thread the growth/inflation needle, the debt ceiling suspension deadline approaches, and taper talk heats up.


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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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Margaret Kerins:

This is Macro Horizon's monthly episode 29, Para-para-paradigm, presented by BMO Capital Markets. I'm your host Margaret Kerins here with Ian Lyngen, Greg Anderson, Stephen Gallo, 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, and foreign exchange.

Margaret Kerins:

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. 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, its affiliates, or subsidiaries.

Margaret Kerins:

Since our last podcast on June 1, the market narrative has shifted from fears of a Fed that is behind the inflation curve to a Fed that is on path to taper, which should contain inflation and presumably slow growth. That said, the proverbial threading of the needle risk remains a market theme, especially after today's CPI print. So the Fed's stated objectives do indeed qualify their commitment to letting inflation run a tad hot, to achieve their inclusive employment goals.

Margaret Kerins:

That qualification is of course, that longer term inflation expectations must remain well anchored at 2%. So basically, the paradigm has shifted away from the Fed being committed to full and inclusive employment at the expense of inflation to a period in the not too distant future, where the economy will be required to prove itself absent Fed purchases.

Margaret Kerins:

Said differently, the market is looking past tapering and toward the timing of rate hikes and the implications for growth momentum. This resulted in an over 50 basis point rally and 10 year yields from the March peak to last week's trough. And while the curve is flattening on the back of the stronger than expected CPI data, tens really aren't reacting. So let's kick it off with Ian. Ian, what are rates and the curve telling us? What are the main factors holding 10 year yields down and where do we go from here?

Ian Lyngen:

Well, Margaret, I think you did a very good job of outlining the dynamics that are playing out in the Treasury market at this moment, unlike where we were in Q1, where cheaper and steeper were the primary themes as inflation to come back into the system. What the market is now doing is they're moving beyond tapering and starting to focus on the liftoff rate hike timing. And the higher the realized inflation data that we see, the more quickly the market assumes that the Fed is going to respond.

Ian Lyngen:

So as a result, we've seen twos, threes, and fives experience upward pressure in yields, while tens and thirties have experienced downward pressure. Now there's an argument to be made that this is a classic monetary policy response. However, we would tend to expect flattening of this character to occur a bit later in the cycle, once the Fed had tapered and ended QE, and we had experienced more sustainable wage growth that had presumably translated into greater demand side inflation.

Ian Lyngen:

What is so perplexing about this particular cycle is that the bulk of the inflationary gains that we have seen have really been in a few defined categories, new and used auto prices being chief among them, as well as hotel, apparel, and airfare. And it's because of that concentration, that the Fed is holding on to the transitory characterization, but that's the biggest debate right now.

Ben Jeffery:

And Ian, we've seen this play out pretty explicitly in the TIPS market. That substantial sell-off in Treasuries that we saw defined much of the first quarter saw 10 year break-evens reach as high as 2.6%. That's the highest in nearly a decade, but somewhat more topically, the retracement we've seen since those peaks, saw break-evens reach as low as 2.25%, even at a time when the CPI data was demonstrating realized inflation at multi-decade highs.

Ben Jeffery:

Now this gets at two dynamics that you touched on Ian, first of which is some implied faith on the part of investors that inflation ultimately will be transitory, but I'll argue more relevantly and more recently, the Feds pivot away from offering a maximum amount of monetary policy accommodation and starting to discuss tapering and forecasting liftoff in 2023.

Ben Jeffery:

Now this begs the question of whether or not the Fed is too soon and starting to walk back some of its accommodation and with 10 year real yields still at -1%, there's still clearly some concern on the growth outlook, which is noteworthy given the impressive gains we've seen in employment. And what's broadly expected to be a robust global rebound. Now, of course, there's also several unknowns out of Washington, not least of which is the quickly approaching expiry of the debt limit suspension and also the infrastructure bill.

Margaret Kerins:

So let's put some numbers on that, Ben. Treasury still needs to decrease cash balances by about 270 billion by the end of July, due to the debt ceiling. And of course, as Treasury decreases cash balances, they pay off bills, forcing bill investors to find alternative assets to purchase. Bill issuance is already net negative 700 billion, year to date.

Margaret Kerins:

And of course, that translates pretty closely with the growth in the Fed's RRP program, which is up about 770 billion, year to date. Clearly the Fed is paying five basis points. And so the RRP program is a viable option as seen in the record uptake. So let's turn to Dan Belton for this one. Given the program limits of 80 billion a day, is there a room for another 270 billion of cash to be put, to work in the Fed to RRP program?

Dan Belton:

Yeah, so Margaret, as the RRP facility has gained attractiveness this year, the Fed has made an effort to increase access to the facility. Like you mentioned, in March, the Fed increased the counterparty limit to $80 billion a day, from 30 billion. And then at the end of April, the Fed relaxed some of the requirements to allow smaller 2a-7 funds and make it easier for GSEs to participate in the facility.

Dan Belton:

Now, we can't say for certain, if any counterparties are hitting this $80 billion limit, but it seems possible, if not likely, that that is the case. So the Fed releases trade level data from the facility after two years. So we have data through the second quarter of 2019, and we can see that the $30 billion counterparty limit was hit a few dozen times in the 2014 to 2017 period. And even though that was a smaller counterparty limit, the facility saw significantly less use during that period of about 100 to $200 billion per day versus 700 or $800 billion today.

Dan Belton:

But even if this $80 billion counterparty limit is a binding constraint, now there's a couple of points that would mitigate how limiting this facility is. Even if some counter parties are maxing out their allocations, what's more important is that there's broadly more capacity at the facility from a macro level. So over the past two weeks, the average counterparty is only lending about 10 billion or so at the facility each day. So even if some counterparties are much higher than that, that's more the exception than the norm.

Dan Belton:

And the only real constraint to the facility at the macro level is the Treasury securities available in the SOMA portfolio. And so there's ample room for the Fed to take on this additional 400 billion or so, as Treasury runs down its cash balances. And then secondly, the Fed has also demonstrated a willingness to tweak the facilities parameters if it views some of the facilities constraints as to binding.

Ian Lyngen:

One of the things that we've heard a lot from clients recently is this notion that outsized RRP usage, represents some fundamental strain or some fundamental problem in the system. Dan, what's your interpretation of this? Is this a strain or is this simply an effective new Fed tool being implemented in the front end?

Dan Belton:

Yeah, Ian. I certainly sympathize with that notion that this is reflective of some market dislocation as we near a trillion dollar daily take up in the facility, but I'm of the mind that this is really more of an effective tool that the Fed has been using and it's working the way that it's supposed to be working. Now, I don't think the Fed would like to have take up of the magnitude that it's having right now for the foreseeable future, but as we move into the fall and the debt ceiling is resolved, I think take up will probably normalize to levels that the Fed is more comfortable with.

Dan Belton:

And I think for the reasons that I just discussed, this doesn't really pose much of a systemic risk as the Fed has significant capacity to continue to absorb this excess cash in the market. And it's really more of a function of the lack of collateral relative to the cash and the front ends of the system.

Ian Lyngen:

Yeah. That makes a lot of sense. And it's also thematic with another question that we've been receiving, which is effectively a version of what's really going on right now? And the question I've heard several times is, how long can the market be wrong in their interpretation of the macro risks facing the US economy? And by wrong, I'm just referencing 10 year yields in that 125 to 135 range.

Ian Lyngen:

I think clearly the move caught a lot of investors off sides. And one of the things as we contemplate the path forward for US rates, that's important to keep in mind is that while the US is experiencing a very strong post pandemic recovery, if we look globally, whether it's the divergence between the developed and the developing world, or even perhaps more importantly, the concerns raised by the Delta variant, I think a degree of caution seems to be far more warranted in the current rebound outlook, especially given the clear concentration in the inflation complex that we've seen thus far

Stephen Gallo:

Yeah. Ian, COVID risks, so we've had this 3% rally in the DXY since its low point for the year in May. And given that the DXY is heavily weighted towards the value of European currencies versus the dollar, it's probably worth asking if we need to be rethinking COVID risks in Europe, given new variants in the virus. And I guess I would make a few observations in that regard.

Stephen Gallo:

The first point is that in the months ahead, hospitalization and mortality stats from COVID in Europe will be more important than case numbers, because what we're really looking for is evidence that the mutations of the virus are becoming vaccine resistant. As far as I know, we've got no clear evidence of vaccine resistance yet, but the normal cold and flu season in conjunction with COVID risks, will probably be presenting policymakers with a challenge, especially if one or more COVID variants proves to be vaccine resistant or if we begin to see a high incidence of people being infected with two or more COVID strains at once, or maybe if we just discovered that immunities to viruses, other than COVID, are lower than they were pre locked down.

Stephen Gallo:

The one thing I would just stress though, about the Delta variant is that it seems to me that fears of the current COVID variants being game changers are less than the fear that Europe will be heading into something nasty in the autumn. That's the one thing I would point out because the Delta variants don't seem to be presenting notable vaccine resistance just yet.

Stephen Gallo:

The other point I would make, and this is a bit more UK focused than perhaps a mitigating factor for COVID risks, is that the UK government is throwing more resources and funding at biotech firms and other drug makers that are looking to put COVID therapeutics into human trials. So the focus in the UK is shifting away from stopping the spread of COVID, only to making the virus more manageable within the population. And these preclinical candidates range from treatments, which are being developed purely in relation to COVID, to other compounds which were originally intended to treat certain auto immune diseases.

Stephen Gallo:

I don't know what's going on exactly on the continent in that regard, but that's what's happening in the UK. But right now, I think broadly speaking, you want to be waiting for better entry levels to be buying the major European currencies versus the dollar. For example, this is just one example, what has happened in some parts of continental Europe is that in order to salvage a portion of the summer tourist season, economic and border reopenings have occurred before a full safety threshold on the spread of the virus had been reached. So the tourism industry accounts for relatively high shares of employment and GDP in countries like Spain, Italy, Portugal, and Greece. So those countries may be more vulnerable to fourth or fifth waves of the virus.

Gregory Anderson:

Steven mentioned the rally in the dollar, roughly 3% in DXY. And it's interesting that that has come in the context of declining 10 year yields, where 10 year yields sure seem to drag the dollar higher in February, March yields spike earlier this year in addition to European currencies and in fact, more so than European currencies, we've seen the commodity currency.

Gregory Anderson:

So Aussie, CAD, New Zealand dollar decline against the USD over the last month and that decline in those currencies, look, the commodity prices that underlie them have gone on pause, but the currencies have outright declined three to 5%, appears to be that what happened in the FX market is it got ahead, so to speak, of the commodity prices and FX investors got left with substantial long commodity currency positions, going into the summer. The favorite sport of the summer for FX traders is attack positions. And that has happened with Aussie, CAD, Kiwi. Although, to be fair, there are some other undercurrents too.

Gregory Anderson:

So for example, Australia and New Zealand, which fared so well last year with the COVID crisis, now beginning to have their biggest surge in cases. But look, I don't think that's the main story behind the weakness in these currencies. It's more just a positioning aspect. So the last thing that interesting is that alignment with the Fed, the central banks all needed to make a shift towards a more hawkish stance, but everybody was afraid to do it, afraid that if you took any steps towards ending QE or raising rates, that currency would take off like a rocket.

Gregory Anderson:

Well, the dollar strength over the last month has given these central banks a window. And we've seen with the RBA, expect to see tonight with the [inaudible 00:15:42] and tomorrow with the Bank of Canada, more steps towards hawkishness, but without the angst and worries that the currencies will move to new highs. And then the central banks will have to pull back as a result of currency strength.

Ben Reitzes:

Greg, you mentioned the impending hawkishness of the Bank of Canada and other central banks. And I'm just going to touch on how Canada has done through the recent period and the recent rally and rates and how Canada may be a little bit different from the US and the moves there. Firstly, what we've had really over the past few months is we've had a few more washouts in Canada positioning ahead of this latest US move.

Ben Reitzes:

And so Canadian positioning from a duration perspective, at least I think was a little bit cleaner than what we saw in the US and so, while we always get swept up with moves and US rates, it wasn't quite as bad in Canada as we got in the US and because of that, Canada underperformed in tens and longs through the past couple months or so, or at least for the last few weeks.

Ben Reitzes:

And the story though is a little bit different in the front end. And again, that is Bank of Canada driven versus the Fed. And then again, the Bank of Canada is ahead of the curve with respect to tapering and pulling back on policy. And we're going to get another move on the 14th of July when they cut their QE purchases by another billion. And the bank being ahead of the Fed has really driven front end pricing as well.

Ben Reitzes:

And we're at the point in Canada right now, where despite the broader rally and rates, the front end of Canada's traded really heavy, which has been interesting. And part of that, again, positioning not great in Canada, probably skewed a little bit longer or had been going into this period. And that's been a theme for, again, most of this year, people trying to get long the front of Canada, getting burned and it's very possible, there just aren't that many guys left out there that want to put that trade on in any meaningful size and that's keeping the front end a little bit heavy.

Ben Reitzes:

But again, right now, I mean, we're priced almost to perfection in Canada. You almost have three rate hikes in 2022, which is possible, but anything beyond that is, I would argue, almost impossible, getting the bank the height four times when the Fed barely priced anything at all, this is questionable. So at this point, I think we're looking at, if there's any front end weakness, any further front end weakness, if the Bank of Canada sounds more hawkish generally and over the next few weeks or so, I think that would be a buy for the front end.

Ben Reitzes:

Going into the Bank of Canada, they are expected to be a lot more upbeat, especially more so than what the market is telling us at this point. And they're more consistent with a risk on environment generally. And so we'll see if they end up being right, or if the flattening here and the bullishness and induration ends up being correct.

Dan Belton:

Yeah. Ben, you mentioned the risk on tone and that's certainly the operative theme in the US dollar credit market. So credit spreads are only about three or four basis points off of cyclical tights that there is just at the end of June. And we think credit spreads might face some near term challenges, but more from the technical nature from seasonals, which turn a little bit bearish in August and the potential for continued volatility here.

Dan Belton:

But then we're looking to initiate long positions in credit spreads, if we see any more than five or 10 basis points of under performance or in mid August, whichever comes first. We think that the backdrop for credit has improved significantly here. We have rating upgrades that have outpaced downgrades by more than at any point in the last 10 years. And then once we get past the seasonal weakness, that's going to become an extremely supportive environment into year end. And we expect spreads are going to retest all time lows later on this year or early next year.

Dan Belton:

And spreads sit near all-time tights, despite heavy high-grade issuance, supply remains the strongest it's been in any year except for 2020. And it should stay that way, particularly after this most recent leg lower in Treasury yields, which seems poised to pull issuance forward. Now, one issue I'll point out that's worth monitoring, is that financial supply has been responsible for a big increase in the first half of this year. So, that's something to keep an eye on as these banks report earnings this week.

Ian Lyngen:

So as we think about the balance of the week, we will hear from Chair Powell, although we're not anticipating any material shift in the slightly less dovish, but still overall accommodative monetary policy tone. What I think will be more fascinating is what the Fed chooses to deliver at Jackson Hole.

Ian Lyngen:

Now, there is a camp in the market that suspects that when tapering ultimately materializes, it might be skewed toward tapering MBS before Treasuries. I'm of the mind that when the Fed does follow through on tapering, they'll simultaneously taper Treasuries and mortgages. And this isn't because there's no argument to be made for tapering mortgages more quickly, but rather, the Fed really wants to get the process of winding QE started.

Ian Lyngen:

And from a signaling perspective, adding in the nuance of MBS before Treasuries, complicates the process, to an extent that I suspect at the end of the day, the Fed just wants to get the process started and the cleanest transition would be toured a simultaneous tapering. Nonetheless, that will be one of the key focuses at Jackson Hole, as we expect to a large extent, the macro narrative to go into a summer slumber over the course of the next several weeks.

Margaret Kerins:

Ian, I completely agree with you. I think they're going to do it at the same time and for the sake of simplicity and ease of communication. I also think that the topic this year at Jackson Hole is quite interesting. The theme of course, is macro economic policy in an uneven economy. And my basic interpretation of that is, how do you stimulate the underperforming sectors without overheating the outperforming sectors? So the conversation should be quite telling.

Margaret Kerins:

On the tapering talk. Obviously the timing is been another big question that we're getting, not really sure how much it matters. We're talking about a couple of months, but if I were to put my Fed hat on, I think that the base case is that the Fed will likely want to wait to see how employment unfolds following children returning to school and the expiration of the expanded employment benefits after US Labor Day. So that for me, puts them at November 3, as the most likely date for an announcement with a December start, of course, depending on the data and how it unfolds over the next several months.

Gregory Anderson:

Margaret, I tend to agree with your tapered timeline or at least the thought that the announcement of the details of the first taper increment, November sounds about right. But I guess I do have a question in my mind about the December start of taper issue. It's just that it's so close to calendar year end, and I'm thinking back to late 2018, when the Fed was still doing quantitative tightening as calendar year end approached.

Gregory Anderson:

It was a major disruption in the cross currency basis market in which I was very close to. It was widely blamed on the Feds tight year end liquidity policy. Also, point out that there was a 20% decline in the S&P 500 and Fed received an awful lot of criticism for that. I think Powell and others on the FOMC may still have a scar or two from that episode. So I just wonder if the timing might be that there's an announcement in November, but the actual first increment of taper doesn't start until January.

Margaret Kerins:

Greg, I think that's a great point. I think it's very interesting. Another thing that we really didn't talk about was, in the minutes, they talk about wanting to be ready to taper. And for me, that preparation really signals that they want to be prepared in the event that they need to taper a little bit earlier, but they still need to have a sufficient amount of time to communicate that to the market. So quite a few different dynamics at play, but one thing we do know is that tapering is on the table and it's coming.

Margaret Kerins:

So that's a wrap. Thank you to all of our BMO experts. And thank you for listening. This concludes Macro Horizons monthly episode 29, Para-para-paradigm. Also, if you're an institutional investor, the 2021 Institutional Investors Global Fixed Income Survey is underway. I hope that you value our written strategy work and podcasts, and will find the time to vote for BMO Capital Markets' Fixed Income Strategy Team. We do strive to be the best in our focus areas, and we hope that you agree. As always, please reach out to us with any feedback and ideas on topics you'd like us to tackle.

Margaret Kerins:

Thanks for listening to Macro H, 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 Inc, and BMO Capital Markets Corporation together, BMO, who are involved in fixed income in 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.

Speaker 2:

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Speaker 2:

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Speaker 2:

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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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