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Q-Fouria - The Week Ahead

FICC Podcasts 08 octobre 2021
FICC Podcasts 08 octobre 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 October 12th, 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 141 Q4 area presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of October 12th. And with an increasingly rare long weekend upon us, autumn in the air, and a pumpkin spice latte in hand, we're eagerly awaiting the next social media outage to test our hypothesis that it was in fact, the hours of obsessively refreshing that solved the problem.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its 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 past, the Treasury market had a fair amount of fundamental information with which to guide pricing. And of course the ongoing politics around the debt ceiling. We're characterizing this particular debt ceiling process as somewhat routine at this stage with the caveat that as is often the case with many of these decisions, it would not surprise us to see this continue to come down to the 11th hour on several more instances.

Ian Lyngen:

Setting aside the politics behind the back and forth on the debt ceiling, it is notable that the front end bills that had been under pressure as a result of the looming deadlines ever traced on the margin as the proverbial can is kicked. An often asked question is, what does a Treasury default actually look like? And while it's been a very long time since there has been a quote unquote technical default in the US, we look at the 1979 period as the archetype for if it goes bad, how bad would it go? During the first half of 1979 because of not dissimilar budgeting issues, the Treasury department was late on paying three maturing bills. What we saw in the rest of the Treasury market was a flight to quality that resulted in on net Treasury rates ending up lower, despite the technical default, admittedly, this is somewhat counterintuitive. However, it is important to keep in mind that Treasury bonds don't have a cross default.

Ian Lyngen:

So it's the equivalent of being late paying a phone bill, but one's mortgage is still, is not in default. All nuances aside, that we do ultimately expect that this problem will be resolved. And if anything, the risks are skewed toward lower rates as a result of the back and forth, or at a minimum, a cap to the extent to which the nominal market came back up as some of these concerns linger. It's also been suggested that the drama unfolding in Washington will prevent the Fed from following through with a November tapering announcement. We're skeptical that the FOMC will allow what is a fairly pedestrian debt ceiling debate at this point, influenced monetary policy, especially given some of the heightened scrutiny of the Fed.

 

Ian Lyngen:

One of the biggest questions as we contemplate monetary policy in the fourth quarter is, how will the Treasury market respond when the Fed ultimately delivers on the tapering announcement? History would suggest that it is a buy the rumor, sell the fact event. And by that I'm simply implying that rates will drift higher into the November FMOC. When we have the official tapering announcement in hand, the market will then subsequently drift lower in rates. The current global macro backdrop does imply that there's only so far that the market can rally once the Fed has delivered on its taper promise. In 10 year yields, that doesn't take 125 off the table, but it does make it much more difficult to assume that 112 will be breached.

Ben Jeffery:

Well Ian, Q4 is now solidly underway. We have the September jobs numbers in hand. And so I think it's probably a good opportunity to discuss how we see the balance of the year playing out and what might be ahead in 2022.

Ian Lyngen:

Yeah, Ben I think it might be a bit early for any official forecast for 2022, but it is worth covering some of our baseline assumptions as we move into next year and what that might imply for US rates. We're very much of the mind that the Treasury market will continue, particularly in 10s and 30s trading in a definable range, but the theme of the year ahead will be a gently upward sloping channel for rates. So that means higher highs and higher lows as the year plays out. This isn't to suggest that we're anticipating a true bear market for Treasuries, but rather the gradual repricing to a higher rate plateau as we work our way through the next stage of the pandemic. This is certainly consistent with the Fed pulling away from truly balance sheet expanding bond buying, as well as the notion that inflation while still arguably transitory, will be persistent at least for the next several quarters.

Ben Jeffery:

And we've got a very important piece of information over this past week that I think meshes very well with that narrative, Ian, and that was the Stone and McCarthy survey that showed that real money investors are now back to the shortest they have been versus their benchmarks that we've seen this cycle. So while yes, this does point to a collective expectation that we will see long end yields move steadily higher. The fact that the market is very short right now and will likely remain short into the end of 2021 will mean that any significant sell off is going to elicit some covering and will ultimately impede just how high yields will be able to run. This is to say nothing of the global yield landscape and the rest of the world that continues to lag behind the US in terms of progress out of the pandemic and economic recovery.

Ian Lyngen:

Within the context of the global rates environment, we had an insightful question from a client this week about what would happen to US rates if there were a taper tantrum in Europe, as the ECB pulls back from its QE program at some point. Our read is that it ultimately comes down to the performance of specific sectors within the EGB market. So if we see an increase in Portuguese, Italian, and Spanish yields, that triggers a flight to quality, to boons that has different implications for US rates than if we simply see a whole sale sell off in Europe. In the latter case, we would expect that would create upward pressure on Treasury yields. Whereas in the former where it's essentially a sector rotation out of the riskier names into what has historically been the higher quality boon market, we would assume that if anything, one should expect a net flight to quality move to support treasuries and cap the extent to which rates will increase.

Ben Jeffery:

And this touches on what's going to undoubtedly be a primary theme of 2022 as well. And that is how central banks globally, not just the Fed, address what's been a meaningful acceleration in consumer prices. In the US the labor market continues to show progress, albeit maybe slower than initially hoped in undoing COVID-19 damage at a time when core CPI is running over 4% on a year-over-year basis. So the balancing act between stoking a greater labor market recovery, and also limiting the degree to which prices spiral higher is going to be a very important space to watch both in the US and Europe, and frankly, everywhere.

Ian Lyngen:

As we think about the US monetary policy landscape, it's worth revisiting the Fed's new framework. Any particularly strong dovish narrative almost by definition will be anchored to this idea that under the Fed's new framework, a longer period of higher than expected average inflation will not ultimately lead to bringing forward rate hikes. Now, this would contrast with what we have heard more recently from the Fed and as such would at least ostensibly represent a policy pivot. I will add the caveat here that it is very reasonable for Powell and company to be pushing forward with reflationary concerns and emphasizing how much progress has already been made out of the pandemic to set the stage for a November or December tapering announcement. Once we're through that next policy moment, that's when one might anticipate a bit more caution as it relates to the economic outlook and an emphasis on just how far the Fed needs to see the labor market improve before they start the conversation regarding rate normalization.

Ben Jeffery:

And not only in terms of the realized data, PCE and CPI, but also as it relates to inflation expectations. This past week, we saw a 10 year break evens and five-year, five-year forward breakeven's reach levels that haven't been witnessed since that great reflation trade earlier this year played out. And while this week in particular, that was a derivative of some of the increases in energy prices that we were seeing. It's this expectation sub-component that also plays an important role in determining just how quickly the Fed is going to be willing to remove monetary policy accommodation. If we start to see 10 year breakeven's move back toward, call it 3%, that's going to create far more anxiety on the FOMC than if we hold roughly around current levels. It was also very relevant to see that our latest pre NFP survey showed that it was roughly a 50, 50 split as to whether investors expect the peak scene earlier this year in 10 year breakeven's are going to be traded through before the December FOMC meeting.

Ian Lyngen:

When thinking about the breakdown between breakeven's and real rates, I think it's useful to look at some of the price action that we have seen over the course of the last two weeks. There's been plenty of chatter about stagflation and what that might mean for the pace of real GDP growth. And if we look at the composition within the TIPS market, we see an increase in breakeven's to the detriment of real yields. So real yields have once again, retrace below negative 90 basis points. And historically this is a reasonable gauge of growth expectations. So we'd read this as the markets focus on longer term inflation has taken some of the optimism out of the growth profile going forward.

Ben Jeffery:

And there's also an argument to be made that as the market prepares for the Fed to start winding down QE, that the influence on the TIPS market might be a bit more out-sized than what we've seen in nominal Treasuries. The Fed owns $362 billion worth of TIPS, which represents a fairly impressive 22% of TIPS outstanding. So it's not unreasonable to assume that the central bank demand in the TIPS market has added to the downward pressure we've seen in real yields. So as tapering begins, at least a degree of the increase in real rates can probably be attributed to the walk back of QE.

Ian Lyngen:

In other potential asset classes, when we contemplate some of the fallout from the Feds reduction of bond buying, risk assets quickly come to mind with equity market performance as the obvious touchstone. In a recent client survey, we asked at what level of 10 year yields would one expect the S&P 500 to erase year to date gains. Somewhat surprising to us to give up the roughly 15% price improvement that we have seen during the course of the first nine months of the year, it would take 10 year yields close to 2%.

Ian Lyngen:

Now our initial take on that is that equities have already began to show signs of wobbling when tens entered that range of 155 to 160. So in the event that the Q1 yield peak of 177 were breached, we would expect a much more dramatic response in stocks. Nonetheless, is interesting to have that context for market participants expectations because that implies if we're wrong, equity investors would remain comfortable with the current valuation profile even if there is a 40 to 50 basis point sell off in tens.

Ben Jeffery:

There's also an aspect of risk asset performance that I would argue, relates to Treasury supply. And that is this idea that given this period of record net issuance and Treasuries we've seen, there's been something of a crowding out effect, probably most readily observable in the corporate bond market. As we've seen over the past 18 months, even record large Treasury auctions have done little to dissuade, very strong primary market appetite, even in the very long end of the curve. Last month, we saw domestic investors take their largest share of both 10s and 30s on record. So as supply and Treasuries begins to come down, that could somewhat counter-intuitively, clear up some demand to shift further out the credit curve.

Ian Lyngen:

Ben, you make a great point. And it was notable that strong auction performance in August was an overseas story. Whereas, in September it was a function of domestic players. Now that's somewhat in contrast to what was assumed at the time, which was a doubling down on the Treasury market from overseas buyers. What will be interesting to see is if and when that dip buying comes back into the market, should the bearish seasonals in October come to fruition and upward pressure on rates ultimately ends up being the path of least resistance.

Ben Jeffery:

And in pondering that question in the very near term, let's not forget that we do have China returning from the golden week holiday. What should offer a relatively cleaner read on overseas bidding interest now that we've seen 10 year yields back up to these current levels. In addition to the price action itself, it's also going to be worth paying attention to the moth data out of Japan over the coming weeks to see just how willing Japanese investors were to buy this latest cheapening in the Treasury market.

Ian Lyngen:

It turns out Treasuries are still big in Japan. In the week ahead, not only will we be enjoying the Monday holiday, but we'll be focused on the core inflation series that hits the market on Wednesday morning. As it currently stands, the consensus for core CPI is an increase of three tenth of a percent, not a dramatic move, but certainly a rebound from the August numbers. Much has been made about the recent run-up in energy prices and the implications for the shape of the Treasury curve. At its essence if we're seeing headline inflation run higher, that's not the type of inflation that one would expect that Fed would respond to. Therefore, if it doesn't eventually make its way through core inflation, it's very reasonable to expect that investors would need a greater inflation premium to move further out the curve. So that to some extent, accounts for why the curve was steeper as the natural gas shortages in Europe brought the entire energy complex higher.

Ian Lyngen:

What was most striking during that period was the fact that the five-year sector lagged in its response to an increase in breakeven's further out the curve. This has more to do with the fact that the Fed has already struck a particularly hawkish tone. We've brought forward rate hike expectations. And from here, the translation of higher energy prices to core goods will require such a long runway to actually come to fruition that the Fed will presumably already be undergoing the process of normalizing policy rates. Let us also not forget that the market will be scrutinizing the inflation data for any further evidence that the upside in the realized data seen during the first half of the year is in fact transitory. Now, in terms of specific categories, used auto prices are an obvious touchstone that the market will be watching, apparel prices, airfares as well as anything associated with the return of business travel and it's subsequent pause because of the Delta variant.

Ian Lyngen:

So if anything, we ultimately expect that the mix of details will leave open the question, whether or not the Fed's transitory characterization was appropriate or not. Housing remains one of the wildcard components within the CPI series. Specifically, OER. Now there is a correlation between higher home prices and OER, but it occurs typically with a lag of 16 to 18 months. So this implies that some of the initial run-up that was seen in home prices during the pandemic, we'll just now slowly start to translate through to the data as the year comes to an end. Whether or not that creates a sustainable floor for a core CPI to continue moving higher into 2022 will, to a large extent dictate the Fed's messaging around the next stage of inflation. 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 the time of the year for giving thanks approaches, top of our list will be the opportunity to discuss the debt ceiling for at least two more months.

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 Podcast or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMOs 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 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. 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 a suggestion that any investment or strategy referenced here in may be suitable for you.

Speaker 2:

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Speaker 2:

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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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