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Participation Trophy - The Week Ahead

FICC Podcasts 04 juin 2021
FICC Podcasts 04 juin 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 June 7th, 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.

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*Disponible en anglais seulement

Ian Lyngen:

This is Macro Horizons episode 123, Participation Trophy. Presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the training desk for the upcoming week of June 7th. As we watch the post jobs price action, we cannot help, but marvel at the fact, a 559,000 monthly gain in non-farm payrolls has triggered a Treasury market rally. We cannot help but recall old man Lyngen's sage advice that the key to happiness is lowering expectations, particularly around the holidays. Coal, the perfect gift for any season.

Speaker 2:

The views expressed here are those of the participants, not though 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. So that being said, let's get started.

 

In the week just passed, the Treasury market had a weaker than expected nonfarm payrolls report with which to contend. And the fact that the Treasury market subsequently rallied in the wake of the release speaks to the elevated levels of expectations as the US economy continues to reopen and market participants focus on the potential for inflation to sustainably returned to the system. We'll highlight that the labor market participation rate unexpectedly declined, which speaks to ongoing labor market slack.

Ian Lyngen:

And while we don't ultimately expect this to begin to resolve until in-person learning returns in September. The fact of the matter is over the course of the next several months, we'll be watching to see if by simply reopening the real economy, the workforce is compelled to become re-engaged with those frontline service sector jobs. It's been suggested that one of the key headwinds to re-engaging sideline workers are the enhanced unemployment benefits, which continue to impact roughly 15 million people. Fast forward to the exploration of those benefits over the next month or two in at least 23 states. And then the overall program in the beginning of September. And that will provide the most meaningful litmus test to workers' willingness to reenter the labor force even if the vaccination program hasn't ultimately led to herd immunity. If the price action itself in the Treasury market has been anything, the best word is uninspired.

Ian Lyngen:

The front end of the market remains contained to an extremely tight range that's a function of monetary policy expectations. And with two year yield, somewhere between 10 and 20 basis points on an ongoing basis for the foreseeable future, that really puts the onus on benchmarks further out the curve to offer a reflection of investment sentiment. 10 year yields appear very comfortable in a range between 150 and 165. If anything, the jobs data will bias us to see the typical seasonal patterns come back into play, which suggests a grind even lower in Treasury yields from the current levels. Let us not forget how smoothly tapering talk has been introduced into the broader market discourse. We've heard from several Fed officials now suggesting that the time to begin discussing tapering has arrived. And whether that is at the June meeting or later this summer remains to be seen.

Ian Lyngen:

Nonetheless, consensus expectations have coalesced around the idea that during Jackson Hole, Powell will float the unofficial trial balloons in terms of setting up the market for tapering. The official announcement will come in the fourth quarter and the implementation will quickly follow as 2022 gets underway. What strikes me as notable is this is extremely consensus at this point and still 10 year yields are closer to 150 than they are 175. More importantly for the range trading thesis, the number of market participants calling for 2 or 2.25%, 10 year yields has quickly declined. And we can see that reflected in the foreign market as well.

Ben Jeffery:

So Ian, I have a very sophisticated and refined question. What's up with payrolls?

Ian Lyngen:

That's a question that I've been pondering quite a bit myself, although I might not have been able to articulate it quite as well. The fact of the matter is we had a very strong nonfarm payrolls print for the month of May. Headline NFP increased 559,000, which led to a Treasury market rally. That's a bit counter-intuitive to be fair, but I'll point to the fact that the consensus was roughly 675,000. And more importantly, the unofficial consensus was a bit higher in the wake of the stronger than expected ADP print for the month of May, which was 978,000.

Ian Lyngen:

The takeaway being that the market continues to hold on to the reopening reflationary narrative. And despite the fact that the data suggests that we're in for a more benign pace of jobs growth, then what was suggested by the March print, which was roughly a million including revisions. The fact of the matter is that the 2021 trade still remains reopening and reflation. My biggest concern is at what point does the realities of the economic data lead to a broad based capitulation that brings Treasury yields closer to the bottom of the range, rather than to the 177 level in 10's, which I'm comfortable calling the upper bound for the foreseeable future.

Ben Jeffery:

And additionally, the three month moving average of NFP is starting to materialize somewhere in the neighborhood of call it 550,000 jobs added a month. If hiring continues on that pace, that's going to represent a meaningfully slower recovery than what Powell hinted at a few months ago, which was that the Fed would like to see several months of a million plus jobs added. With total NFP still sitting roughly eight million smaller than before the pandemic, that points to a much longer timeline to ultimately recover all those jobs.

Ben Jeffery:

Now sure, once kids are back in in-person school, some of the enhanced unemployment benefits have started to roll off in September. There's certainly an argument to be made that we could see the pace of NFP accelerate, but for the time being, we still have 15 million people receiving some form of unemployment benefits and jobs gains that have not been able to meet expectations. So really in terms of the Treasury market, it certainly reinforces the upper bound of this trading range, which was set during the peak of optimism on jobs growth and inflation. And if anything, biases my expectation more to the downside as the summer plays out.

Ian Lyngen:

I think it's also worth noting that within the BLS release, we saw an unexpected decrease in the labor market participation rate. Now that did contribute to the fact that the unemployment rate declined, although it doesn't account for all of the move. Nonetheless, the labor market participation rate is more than a percentage point below the average that was in place before the pandemic. And that points to the ongoing dislocation in a labor market resulting from the COVID-19 related restrictions.

Ian Lyngen:

One of my primary concerns as we continue to see the data underperform expectations was that in fact, what we saw during the first quarter where we had very strong stimulus driven retail sales and personal consumption on the good side, as well as a spike in hiring, that really represents as good as we're going to get for any three month period. Now, that doesn't suggest that by the end of the second quarter, real GDP growth won't have reversed all of the declines that we saw during the pandemic. And in fact, as long as real GDP prints at three and a half percent or above, the real domestic economy will be back in the green.

Ben Jeffery:

And that's a really important point that's gotten lost in a little bit of the noise around the data as the economy has reopened. While yes, NFP did disappoint. It's still 560,000 jobs added last month. And growth generally speaking is continuing at a very solid clip. So in terms of the market's expectations and the fact that we've seen the realized data undershoot some of that optimism, which can be seen in the continued grant lower in the surprise index really speaks less to a bad recovery and more to a recovery that just has failed to meet the exuberance that really defined the first half. There's another aspect to this that we're asked about very frequently, which is on the inflation front. One can point to many examples of real inflation in everyday life, but yet the official data and the one that the Fed pays the most attention to continues to show a more muted inflationary environment.

Ian Lyngen:

This is actually a question that we've received many times over the course of the years, and that is look at the core PCE and core CPI data. Why is there such a disconnect between the official data and the sense of inflation that there is in the system? Now, obviously it's much more difficult to put a number around the same amorphous concept of a sense of inflation, but anecdotally we've all seen prices rise in a variety of different categories. And to see the lack of translation between that and the official stats does beg the question, where is the disconnect? One of the things that I've always taken a fair amount of solace in is that regardless of the perception that individual investors have about the pace of inflation, the fact of the matter is that the Fed continues to base monetary policy decisions on the PCE and directly the CPI series. More importantly, if asked, given the range at which CPI is currently tracking, where would you put real inflation if it's not that number? Often, the response is somewhere between five, seven, 8% on an annualized basis.

Ben Jeffery:

So shouldn't the Fed be hiking?

Ian Lyngen:

That's a great point. In fact, if we were running at seven and a half, 8% core inflation, the fact of the matter is we'd be in a recession still. And that's part of the reason that monetary policy makers are content to look at a much steadier measure of inflation that does adjust for some of the quality considerations. The classic is the F150. The price keeps going up, but it's often a net drag on core inflation because the features and implied quality improvements are outpacing the actual price increases. Smartphones are another example of that, frankly, given the transition between the brick cell phone that I first had and the smartphone that I currently do, the present trajectory suggests that pretty soon there'll be an app that I can press to schedule space travel.

Ben Jeffery:

Wait, you don't have that yet?

Ian Lyngen:

Ugh.

Ben Jeffery:

But before we head to the moon, this brings up another interesting topic on what the Fed quote unquote should be doing. An idea that's coming up with increasing frequency is if there is concern about inflation, financial excess, too easy monetary policy, is there a realistic probability that the market could force the Fed's hand into removing accommodation and bringing monetary policy tighter? Is there a world where the Fed would be comfortable with tighter financial conditions in this current paradigm where they've clearly shown a bias to keep financial conditions as easy as possible, volatility suppressed. And a monetary policy backdrop that's been nothing, if not accommodative for a very long time.

Ian Lyngen:

Well, Ben, I think there are two aspects to that question. The first is, can the market tightened for the Fed? And the short answer is yes. We've seen that in real yields and we've seen it occur in a way that the Fed has not responded to which suggests a degree of comfort with tighter financial conditions within the context of relatively subdued nominal and still negative real yields. The other aspect of the question, and I think that this is the one that really divides investors and that is can the market force the Fed's hand? So let's think about the dynamics. This would imply that the market pushes financial conditions so much easier that the Fed feels compelled to respond by tightening policy, which is arguably the opposite of what investors might intuitively want to do. For example, inflation is coming in, higher nominal yields make sense. That actually tightens financial conditions.

Ian Lyngen:

We see the employment market eventually starting to heat up. That solidifies tapering expectations which should increase rates again, tightening financial conditions, higher rates, leading to a pullback and equity prices because inflation expectations are so high. That also tightens financial conditions. And so in the context of forcing the Fed's hand, the market would effectively have to lower equity market vol.

Ben Jeffery:

Check.

Ian Lyngen:

Decrease credit spreads to historic lows.

Ben Jeffery:

Check.

Ian Lyngen:

Keep real yield subdued, decidedly, negative.

Ben Jeffery:

Check.

Ian Lyngen:

And establish an environment in which nominal 10 and 30 year yields are presenting a new conundrum because they're so low.

Ben Jeffery:

So we're four for four.

Ian Lyngen:

On average, yes. Returning to the point. There certainly is a level of easy financial conditions that the Fed will feel compelled to respond to. Although I would suggest that what the market is doing at this moment is they're providing the Fed with sufficient cover to deliver the tapering in line with expectations and eventually a liftoff rate hike, assuming that the employment market can make further strides toward recouping those 15 million workers who are still receiving some type of assistance.

Ian Lyngen:

So this doesn't imply that it's impossible for the market to force the Fed's hand. In fact, I would say outside of the dynamic just outlined, financial stability is the proverbial elephant in the room. But the Fed has already made it abundantly clear that they're comfortable risking asset bubbles to allow the real economy time to heal. And the labor force a sufficient runway to re-engage the frontline service sector workers. All of this clears a path for an environment of continued easy financial conditions, a contained rate environment, and inflationary pressures dismissed as transitory by monetary policy officials for the time being.

Ben Jeffery:

And the next meaningful update on this front is naturally going to be the June FOMC meeting, where we do get an updated summary of economic projections. And with the updated SEP, we'll also get a refresher 2023 median dot on where Fed funds will be at the end of 2023. In our pre NFP survey, there were two clear front runners in terms of expectations on the fate of the 2023 dot first being unchanged at 12 and a half basis points AKA the effective, lower bound. That answer was picked 44% of the time, but 43% of the responses saw the median dot in 2023, coming off the effective lower bound and reaching 25 basis points. So going into this week as more as offered around expectations for the Fed meeting and what Powell will or will not say watching the price action in the belly of the curve and liftoff expectations, particularly following NFP, will offer the greatest insight on the collective mindset of the market, at least as measured by the price action and Treasuries.

Ian Lyngen:

So is there a chance that we get a social media linked Treasury product this year?

Ben Jeffery:

Is that like the BSBY?

Ian Lyngen:

The great BSBY. Well, regardless it would be meme reverting.

Ben Jeffery:

I see what you did there.

Ian Lyngen:

Makes one of us.

In the week ahead, the Treasury market will have one primary economic data point on which to base the bulk of the trading direction. That data point will be the core CPI print. The consensus currently reflects a forecast for a four tenths of a percent gain in the month of May. So it's also consistent with the headline forecast. That said, we're coming off of April's figure, which was nine tenths of a percent and a decade's high to be sure. So this sets the stage for a marginal bias higher on the inflation front. Given the market's response to elevated expectations for non-farm payrolls and the subsequent grind lower end rates we're wary of investors bringing lofty expectations into this week that are ultimately resolved with a grind, lower end rates as core prices struggled to keep up with expectations. That isn't to suggest that there are not pockets of inflation in a real economy.

Ian Lyngen:

More importantly we're content to concede that the disconnect between the sense that investors have of inflation on the ground as it were versus what ultimately makes it through to the core measures will persist. And this will contribute to a durable divergence between inflation expectations and the realized data. We're in a period where the realized data is catching up with inflation expectations. However, this will not remain the case indefinitely. And we ultimately see mean reversion on the consumer pricing front. Let's not forget that we do have three auctions in the week ahead. We have 58 billion, three years, 38 billion, 10 years to reopening and 24 billion, 30 years also a reopening. Given how well primary Treasury issuance has been received, we've grown increasingly skeptical of the argument of bond vigilantes that there will eventually be an inflection point of supply that leads to a massive repricing higher in Treasury yields.

Ian Lyngen:

In fact, as we look over the course of the next several months, we expect that the unifying theme will be one of recalibrating expectations, lower in terms of jobs growth and toward a more benign outcome in terms of the increase in consumer prices. Not that we won't see inflation, but rather it's largely priced in at this point. All of this suggests that we will continue a drift lower in Treasury yields. And we suspect that in the period around Labor Day, 10 year yields will be a lot closer to 1% than they are 2%. In contemplating the shape of the yield curve. Twos, tens has remained a remarkably directional trade, and what's more telling is the spread between fives and 30s. As we saw in the wake of non-farm payrolls as the market rallied, it was a belly led event. This is simply a function of investors pushing out expectations for the liftoff rate, hike timing.

Ian Lyngen:

And as a result, we saw a steepening in 5s/30s. Any acceleration of liftoff timing expectations, presumably driven by a stronger growth outlook will ultimately serve to flatten 5s-30s in a very typical mid cycle response for the US rates market. 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 we ponder what it will take to finally move the Treasury market from its current trading zone, we're reminded that capitulation is like a box of chocolates once it's finished, the regret sets in.

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 [inaudible 00:21:58] 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. 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 suggestion that any investment or strategy referenced here in maybe suitable for you.

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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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