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Pivot Postponed - The Week Ahead

FICC Podcasts Nos Balados 07 octobre 2022
FICC Podcasts Nos Balados 07 octobre 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 October 11th, 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 192, Pivot Postponed, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery to bring your thoughts from the trading desk for the upcoming week of October 11th, and as reality stars get fined by regulators for crypto advocacy, we're reminded that there are three calls you don't want in life. One from the SEC, one from 60 minutes, and one from your contractor. Early and under budget, no such thing. Each week we offer an updated view on the U.S. 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. That being said, let's get started.

Ian Lyngen:

In the week just passed, the Treasury market put in a choppy performance, but one that's consistent with an ongoing consolidation in the longer end of the curve. 10 year yields got as low as 3.55 before backing up to end solidly in the 3.50 to 4% range. Now, the oversold momentum that had been in place throughout much of August and September has reversed. We have seen stochastics come off of the peaks and this is a dynamic that has been consistent with the positioning landscape where we have seen some of the extreme shorts taken out of the market and some incremental dip buying momentum emerge. That said, the test of 4% 10 year yields has redefined the upper bound for the yield peaks for 2022 and does leave the market open to considering a retest of that pivotal level. In the event that 4-handle 10-year yields become a reality again, we anticipate that the next foray above 4% will last a bit longer, but ultimately prove a buy-in opportunity.

Ian Lyngen:

In terms of economic data and the week just passed, we saw disappointing construction spending and manufacturing ISM, although services ISM, ADP and of course, the headline non-farm payrolls and private payrolls outpaced expectations. More importantly, within the payroll series, we did see the unemployment rate drop, although that was at least partially a function of the decrease in the labor force participation rate. While headline payrolls continue to grow at a pace that far exceeds population growth, the outright numbers have moderated from some of the upside extremes. Nonetheless, the economic data has been very consistent with our expectations for the Fed to deliver a 75 basis point rate hike in November, followed by a downshift to 50 basis points in December, and ultimately capped by 25 basis points in February, which would ring the effective Fed funds to 4.6%.

Ian Lyngen:

Our opinion is only partially informed by the feds updated dot plot and the SEP. It's also a function of what we're seeing priced into the Fed funds futures market with the nod to the fact that perhaps that logic is a bit circular. What we are comfortable with is the idea that the market has a better understanding of the Fed's reaction function to higher than expected realized inflation data, and as long as the unemployment rate continues to remain comfortably below that 4.4% that the Fed's predicting for next year, the Fed will have more than sufficient cover to hike rates deeper into restrictive territory. Moreover, once headline and core inflation begin to conform to the peak inflation narrative, we would expect that break evens would compress even further as the fourth quarter unwinds, which would push real yields higher and in effect bring monetary policy into even more restrictive territory than would've been the case had breakevens been steady.

Ben Jeffery:

Well, Ian. We've now got the final payrolls report we are going to get until the November FOMC meeting, and I would say the most notable aspect of what we saw with that NFP was just how remarkably consensus it was. Sure, headline payrolls beat slightly at 263,000 versus 255,000 expected. Average hourly earnings matched forecasts at .3 of percent month over month and 5.0% year over year. The one "surprise" was the downtick in the unemployment rate to 3.5 from 3.7, but that was mostly driven by the give back we saw in the participation rate from 62.4 to 62.3, so nothing contained within September's employment situation report takes a 75 basis point hike in November off the table or frankly another 50 basis point hike in December with terminal being achieved in February with what we're still expecting is going to be the final 25 basis point rate hike of this tightening cycle.

Ian Lyngen:

That actually brings us to a very interesting question and one that we've received several times over the course of the last week, and that is, what would it actually take to get the Fed to blink on 75 versus 50? That I think has just been made a lot more difficult in the wake of this non-farm payrolls print. As it currently stands, the consensus for next week's CPI print is for a headline up .2 of a percent and a core at .4 of a percent down from .6 of a percent during the prior month. That's a moderation of inflation, but not to the degree that the Fed would need to downshift from 75 to 50. In fact, it's difficult to envision a print on core CPI that's positive at least, which would get the Fed to blink at this point. The Fed has been successful in bringing inflation expectations back in line with the longer term trends, which from the perspective of monetary policy makers is a success.

Ian Lyngen:

The question then becomes what's the most effective route for the Fed to take to keep those inflation expectations anchored even as the realized data continues to trend above the Fed's target? We think that the short answer is to remain fully committed to the hawkish narrative and in doing so, achieve that 4.75 upper bound for effective Fed funds, which when we add in the impact of 75 basis points worth of QT gets us to effectively a policy rate of 5.5%, and as we've discussed in the past, the big challenge isn't determining whether or not the Fed wants to hold policy deep into tightening territory. It's if they can pull that off. We think that all else being equal, once the Fed does reach terminal, the messaging campaign will shift to the importance and relevance of maintaining terminal for longer than it has in prior cycles.

Ian Lyngen:

Now ultimately, something is going to break and as we've seen with the recent price action, the market is waiting for something to break. Our take is that unlike during the last several cycles, because the Fed has been so focused on the U.S. economy and inflation within the U.S. economy in particular, that there's a higher tolerance than previously for corrections in emerging markets, a more material downshift in Europe, a bigger struggle in the UK in terms of keeping momentum going forward on the GDP front, so one of the negative externalities from a hawkish Fed is that the global economy is a lot more vulnerable than it might have been during, for example, the European credit crisis.

Ben Jeffery:

This battle to stay on hold that, Ian, I think you and I agree is probably going to be the defining theme of 2023 is going to have some implications for financial conditions along with what's going to be the dollars impact on the global financial system and just the overall restrictive stance of monetary policy with what that means for the potential for any extraneous shocks to really cause a larger market impact than would otherwise be the case in an environment when funding was cheap and access to capital was easy. What I mean about the battle to stay on hold in financial conditions is that, in the wake of the NFP report, we saw the market repriced to more or less what's laid out in the dot plot in terms of the terminal rate. That 4.50 to 4.75 band that you touched on earlier, Ian, but then, and this is where it matters for financial conditions, we're still seeing a meaningful probability of some version of rate cuts taking place before the end of 2023.

Ben Jeffery:

Now, we've heard from a variety of Fed speakers over this past week, Mary Daly, Neel Kashkari, Christopher Waller, Lisa Cook, and all of them went as far as to say that they do not see rate cuts in 2023 and more tightening from the Fed is needed in order to contain inflation. Even once terminal is achieved and policy is deemed restrictive enough by the Fed, that's going to be the point, and I would argue we're already starting to see some of that, where the Fed is going to be continuing to tighten financial conditions by pushing back against the market's expectation that they're going to deliver some sort of accommodative action, and it's that tightening by staying on hold that's going to be the tight rope that Powell's going to need to walk, which will likely continue to weigh on equity valuations and probably offer a bit of a widening impulse on credit spreads as well. The question is how severe does that become and how committed will the Fed be even in the face of rapidly deteriorating risk assets?

Ian Lyngen:

I think that the essence of the question really comes down to how long does the Fed think that they need to keep policy terminal to achieve price stability over the medium to long term? As we've observed, the biggest disconnect between monetary policymakers and the market at this moment isn't the direction or the necessity in containing inflation pressures, but rather the differing timelines. The Fed is thinking of things in terms of decades of price stability, whereas market participants are considering monetary policy actions in the terms of weeks, months, maybe quarters of economic ramifications. This is why we ultimately think we'll see a continued divergence in the performance of the front-end of the Treasury market versus tens and thirties. We've already seen the 10-year sector drop to 3.55 in the week just passed, and while we have seen a bit of a sell off and a consolidation in the middle of the 3.50 to 4% range since then, there seems to be limited momentum and appetite to materially challenge that 4% level once again.

Ian Lyngen:

What I think will be interesting to see is what happens in the wake of next week's CPI. If we end up with a stronger CPI print, the market believes it understands monetary policymaker's reaction function to higher realized inflation, so it follows intuitively that terminal might be edged a bit higher. The flip side, and this is where I think it becomes more nuanced, is if we see an as expected downshift in inflation or even a underperformance of the headline or core figures, is the market going to be willing to assume that, that means that we won't get that final quarter point hike in February? If that's the outcome, I think it's misplaced and I think that monetary policy makers will push back against that assumption and let us not forget, if they are going three quarters of a point in November, they are going to need to step up the hawkish rhetoric before we get into the pre-meeting radio silence period for monetary policy makers.

Ben Jeffery:

Ian, that's a really good point and one that I think is going to be important to consider as we go into and come out of the CPI report, that even a disappointing read similar to what we saw in July's data, certainly doesn't mean that the Fed is going to be willing to declare victory in their fight against inflation. In fact, as we've heard from several committee members, what they're after is several months of evidence that inflation is decelerating and the peak in terms of year over year core prices is behind us. Now, given what we saw in last month's inflation data, that clock has been reset.

Ben Jeffery:

Now, if one assumes that the Fed is looking for two, or probably more likely three, months of encouraging inflation data, that means that at the earliest it's going to be November's inflation data released just ahead of the December FOMC. That's going to need to validate a moderation in hawkishness simply due to the lagged nature of the release of economic data, it's at least going to be another several months before the Fed would even potentially have sufficient evidence that the time was coming to moderate their hawkishness, and while given the extent of the selloff we've seen in the two-year sector, I'm not sure that necessarily ensures two-year yields at 4.75, but it also will make a sustainable, durable bid in the very front end, a difficult thing to justify if the Fed is going to be willing to maybe increase its hawkishness again, should we see the actual inflation data not behave as they would like.

Ian Lyngen:

I think that creates a very meaningful stress in the very front end of the market, and one of the questions that we've received recently is, why hasn't the Fed chosen to put a cap on the utilization of RRP? The presumed result would be that deposits would go back into the banking system and that those funds would then be used to buy assets, Treasuries, mortgages, et cetera. What strikes me is that, embedded in that question is the assumption that banks are not going to increase the amount of interest that they pay on deposits.

Ian Lyngen:

As a baseline assumption, that might have made a lot of sense over the course of the last 10 years, but the reality is, funding is getting more expensive and while no large money center bank wants to be the first to start increasing the amount they pay for deposits because of what that would do to NIM, the reality is that the Fed would probably like to see bank funding get a bit more expensive because that will compress profitability that will continue to take some of the upward momentum out of the overall economy and frankly, it is a logical outcome of tightened or monetary policy. The one caveat that I would add is that, while we do not expect that this cycle's slowdown will ultimately be a financial sector driven recession, akin to what we saw during 2008 and 2009, the fact of the matter is that the financial system is the bellwether for economic health in the U.S. and that's why it warrants closely watching.

Ben Jeffery:

Especially going into CPI, there's another bellwether of economic health. That's also been the topic of a lot of client questions we've received over the past few weeks, and that is the role that housing is playing in the inflation data and more concerningly, whether or not the fed's actions and mortgage rates back to their highest levels since 2007 is going to risk a correction in the housing market that triggers the more systemic worries that were obviously the defining characteristic of the 2008, 2009 financial crisis.

Ben Jeffery:

Ian, you and I are in agreement on this that as we've discussed this, we don't really think that's as much of a systemic risk, a growth negative risk, sure, but not one that's really concerning for the overall functioning of the financial system, just given that unlike during the prior financial crisis, lending standards on the household level are far more stringent and the overall banking sector is much better capitalized to withstand what will be probably higher default rates on mortgages, but the mechanics of that market won't pose solvency risks to some of the world's biggest banks and it's for this reason that the Fed is likely comfortable with and frankly, maybe even encouraged by the start of the inflection that we've started to see in housing and what they're hoping is going to be the lagged flow through to owner's equivalent rent within the inflation basket and more moderate gains there that will help in the goal of bringing down overall core consumer prices.

Ian Lyngen:

We've been focused on the lag between housing prices and OER, but there's also an important correlation between the unemployment rate and rents. As we see the employment picture begin to deteriorate, we would anticipate that the rotation away from home purchasing into the rental market, which has resulted in some peak gains for rent inflation will begin to moderate as the fourth quarter unfolds and 2023 quickly comes into focus. Ben, on the topic of focus and as year-end reviews become topical, I can think of a few areas for improvement.

Ben Jeffery:

What were we talking about?

Ian Lyngen:

Nothing. In the week ahead, the holiday shortened trading week will not lack for tradeable events. The highlight will be Thursday's CPI release where both the headline and core numbers are expected to moderate on a month over month basis. Within the details, we'll be looking for a downtick in the used car prices as well as a moderation in shelter costs, including OER and rent. Now, that moderation isn't going to be the mean reversal, but rather evidence that some of the softening in the housing market is beginning to slowly work its way through to the inflation series. Nonetheless, both headline and core will be running at elevated levels versus history, certainly be running at elevated levels versus the Fed's 2% inflation target. We also do see the FOMC minutes from the most recent meeting, and given that the Fed went 75 basis points last time, it follows intuitively that the tone of the overall FOMC minutes will be a hawkish one and recall that September saw an increase in the beloved dot plot as well as expectations for a higher employment rate in 2023.

Ian Lyngen:

All of this will be topical and we expect to be outlined within the minutes release. That being said, the market's primary emphasis will be on attempting to glean any insight as to the magnitude of the November rate hike i.e. 75 or 50. We'll caution against expecting too much out of the minutes simply because retaining flexibility has clearly been a key objective of the Fed and they've been successful in accomplishing this goal thus far. The week ahead also contains Treasury supply of note. We have 40 billion 3 years on Tuesday followed by 32 billion 10 years on Wednesday and capped with 18 billion 30 years on Thursday. This supply in and of itself will function as a near term floor for longer dated yields. We continue to expect the 10 year to outperform on the curve versus twos in particular, but also versus the 10 year sector. So this implies a re-steepening of the tens thirties curve, one that from a timing perspective could take hold in earnest after the 10 year auction and CPI, but before the long bond is absorbed on Thursday afternoon.

Ian Lyngen:

Once the supply and demand dynamics are satisfied, on Friday, we see retail sales and the University of Michigan sentiment print. Retail sales are expected to be up just .2 of a percent, and with a rough adjustment for CPI at the same level that brings consumption to 0.0 in real terms. This is relevant as Friday's data is for September and caps Q3. The trajectory of spending as the third quarter came to an end will be pivotal in setting up expectations for not only Q3 GDP but also, forecast for the final quarter of the year. Within the University of Michigan survey, we'll be watching for the medium term inflation component, which continues to drift lower well off of the 3.3% peak that we've seen, and as one of the Feds favored measures of survey based inflation expectations, it goes without saying that U Mich will be a tradable event.

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. Even though it's only the beginning of the fourth quarter, we're already growing anxious about year-end funding pressures, begging the question, are you down with RRP? Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy effort as interactive as possible, we'd love to hear what you thought of today's episode, so please email me directly with any feedback at ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

Speaker 3:

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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