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Risk of Risk-Off - The Week Ahead

FICC Podcasts 13 mai 2022
FICC Podcasts 13 mai 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 May 16th, 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 171: Risk of Risk Off 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 May 16th. And as we watch our 401(k)s turn into 301(k)s and then 201(k)s, we cannot help, but be thankful for family, good friends, smart colleagues and free podcasts.

Announcer:

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, 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. So that being said, let's get started.

Ian Lyngen:

The week just passed was a particularly volatile week in the Treasury market. We started the week with 10-year yields at 3.2%. We then subsequently saw a rally through the CPI data, as well as the 10-year refunding auction of 36 billion, which tailed nine-tenths of a basis point. Nonetheless, the Treasury market continued to rally. Now the short answer to the reason behind the rally can be easily summed up as the equity market continued to sell-off, but it's worth exploring the underlying motivations for the sell-off in equities.

Ian Lyngen:

What we see is that while there might be some sectors, particularly those that benefited the most during the pandemic that are under the most pressure, broadly speaking, equities were off across all major indices. So we are characterizing this as early evidence of the ramifications from the Fed's new, more hawkish policy stance. To be fair, the Fed has only now hiked twice for a total of 75 basis points. And while the balance sheet runoff has been announced, it won't actually be implemented until June.

Ian Lyngen:

So to a large extent, this is investors readjusting valuations to the new realities of monetary policy, both in the US as well as abroad. The stronger than expected inflation print warrants exploring. We did see headline month over month print up three-tenths of a percent slightly above the consensus. But more importantly, the core number came in at six-tenths of a percent month over month for April. Now, that's versus a four-tenths of a percent consensus.

Ian Lyngen:

To be fair, the number was a low 0.6 and on an unrounded basis was 0.569. Nonetheless, the corporate did bring the year over year pace down, although that's simply a function of the base effects and the market seemed pretty content to look past that. Within the details of the Consumer Price Index, what we saw were increases in owner's equivalent rent in rent, in airfares, in new auto prices, as well as a few less impactful categories.

Ian Lyngen:

So on that, the broad-based character of inflation represented via CPI is troubling insofar as that we're not seeing a mean reversion to a two or three-tenths of a percent month over month gain. As we ponder what that might mean for monetary policy expectations, if nothing else, the inflation print cemented the 50 basis point move in June and presumably another one in July, assuming that there isn't a material downshift as the summer unfolds.

Ian Lyngen:

We'll also argue that this makes a pretty compelling case for 50 basis points in September, rather than the 25 that Powell previously communicated. So on that it's very difficult to want to aggressively buy the front-end of the Treasury curve, even as yields in twos and threes have drifted lower on the broader flight to quality sentiment driven by the weakness in equities. Further out the curve; however, the outperformance of 10s and 30s continues to resonate. And we anticipate an attempt to re-invert the yield curve as a May or June event this year, presumably in the run up to the next Fed meeting.

Ben Jeffery:

So last week was a big week in the Treasury market. This week was always going to be another big week in the Treasury market, which really begs the question where do we start 3.20% 10s, CPI, the 10-year funding?

Ian Lyngen:

The flatter yield curve, the sell-off in the equity market, what's going on in crypto space. Frankly, there are a lot of things playing out in the Treasury market and global financial markets at this moment that really do suggest that there is a broader tone shift underway. Now we've very much been of the mind that 2022 would be defined by the FOMC's efforts to normalize monetary policy and the rate hiking cycle would be characterized as hike until something breaks.

Ian Lyngen:

Now the biggest question that we've been receiving recently is whether or not we would characterize the sell-off in the equity market and what's going on in peripheral markets as "broken." The short answer is it might be broken, but it's not broken enough at least not for Powell.

Ben Jeffery:

And I completely agree, Ian. And would just also like to add the fact that the reason it's not broken enough at least not yet is given the inflationary backdrop. While yes, April's CPI data came off March's levels. It was still stronger than expected. On a core basis, we got a six-tenths of a percent increase month over month and headline year over year was 8.2%. That is hardly transitory. And while mathematically the year over year figures will have peaked considering where we were at this time last year, the pace of moderation and inflation is not sufficient for the Fed to take its foot off the tightening brakes.

Ben Jeffery:

Despite the impressive sell-off in equities we've been seeing, a 50 basis point move in June and July are still very much the path of least resistance. And while there's plenty of time between now and the June meeting for things to change dramatically enough to bring that into question, the bar for that to happen is very, very high given what we're seeing in consumer prices.

Ian Lyngen:

What I would add to that is we are at the point in this cycle where the Fed has already reframed monetary policy in such a way that higher rates are consistent with the Fed's dual mandate, price stability, as well as to encourage hiring. Because recall, Powell's been on about this notion that price stability is key for employment growth. However, the Fed has introduced the notion that the labor market might in fact be a bit too hot. Now we saw the decline in the labor force participation rate within the employment report and that continues to trigger questions about whether or not we're actually seeing a true wage inflation spiral.

Ian Lyngen:

Now I’ll argue that the nature of inflation recently perhaps with the exception of the April print has been largely a function of supply chain issues, as well as obviously what's going on in the energy sector and with the war in Ukraine. What was most striking about Wednesday's CPI print; however, was on the core side it was relatively broad-based. Not only did we see new auto prices increase, we saw airfares up almost 19% and of course, rent and owner's equivalent rent continue to edge higher as the hot housing market flows through to the inflation data.

Ian Lyngen:

So this brings us to our next level of concern. What if we actually see the inflation numbers in the second quarter as dramatic as they were in the first quarter of this year? Now that has clear stagflationary ramifications. Specifically, we're reminded that for the same amount of nominal growth if you increase inflation, you decrease real GDP. That's exactly what we saw in the first quarter combined with the hit to net exports that drove real GDP to negative 1.4%.

Ian Lyngen:

Fast forward to the second quarter. The labor market is still tight. We're seeing a reluctance of sideline workers to reengage in the labor force. Consumption remains on track. And by and large, there's nothing in the currency market to suggest that we're going to see a near-term reversal of the strength in the dollar. Imagine, if you will, a slightly negative GDP print for the second quarter and the ramifications from that for the macro narrative.

Ben Jeffery:

So the fact that we're even discussing the however slight probability of a technical recession in the first half of 2022, absolutely not our base case. But even the idea that the issue has entered our conversation and frankly is probably more pronounced in the broader market discourse helps explain some of the bid that we've been seeing in Treasuries that brought 10-year yields from 3.20 back down to roughly 2.90 into the 10-year refunding auction, and then well through that level in the aftermath.

Ben Jeffery:

Ian, I would also add in addition to those domestic concerns that are very much top of mind, let's not forget what all of this means for the rest of the world. Higher Treasury yields, one, look increasingly attractive to foreign investors. But two have more significant implications on less developed economies, as well as the fallout that a stronger dollar has for markets that are not nearly as robust as some of the more developed Western economies.

Ben Jeffery:

Taking all of that together, adding to that what's not going to be a particularly strong outlook on China and all of a sudden a real global slowdown in an environment with very high inflation becomes a much more reasonable argument to make.

Ian Lyngen:

And just to reiterate the point, we are not assuming that the US nor the global economy is going to slip into a recession anytime soon. Nonetheless, a downshift in the pace of growth that highlights some weaker sectors or weaker regions certainly should be on the table. And let's face it, that is a version of stagflation lite that I think most investors have on the radar.

Ben Jeffery:

And another aspect of this that has been starkly highlighted over this past week is the pullback in risk. And I'm using the word risk as an intentionally broad term, whether it be crypto, equities, credit products, the gradual recalibration of the financial system as a whole to a less accommodative monetary policy backdrop and central banks globally. Not just the Fed, but the ECB, the BOC, the BOE all committed to both slowing money velocity and taking money out of the system is starting to materialize in some of the assets that were always going to be the first ones to show cracks.

Ben Jeffery:

Now, thus far, the process has been relatively orderly and that will as of now keep the tightening on track, but that certainly won't prevent the market from complaining about it at least of all you and I, Ian.

Ian Lyngen:

That's very true. One of the other concerns that we hear in the market is whether or not the Powell put exists. And if so, where is it struck? Our takeaway from the recent price action and the response of the Fed or rather lack of response from the Fed has been that while the Powell put might exist, it struck a lot lower than it has been in prior cycles. In practical terms if the S&P 500 was down 50% on the year, the Fed would do something.

Ian Lyngen:

We're now down roughly 20% and the Fed has been conspicuously absent in terms of attempting to talk the market off a ledge. So I'll argue that the Powell put is somewhere beyond 30%, but before 50%. The bigger question then becomes what can the Fed do? If in fact inflation is public enemy number one for the real economy, then pausing or slowing the hikes won't create the desired outcome for monetary policy. I'd argue that the most the Fed would be willing to shift their stance would be the rhetoric around where terminal is and/or the balance of risks.

Ben Jeffery:

And on the issue of balance of risks, there was one encouraging detail within the price action over these past few sessions that is worth highlighting. And that's in the TIPS market. We've seen 10-year break-evens move from as high as 309 basis points back toward 270 basis points. And from the Fed's perspective, the fact that their hawkishness and the fact that their communicated commitment to continue hiking is pulling down inflation expectations back toward levels that they're not yet comfortable with, but are far more comfortable with than north of 3%.

Ben Jeffery:

This should eventually, not for the next two meetings, but eventually give them comfort to transition to a more measured tightening pace once we have policy back towards some version of neutral. And I would argue that a big reason why the FOMC has started out on this 50 BPS a meeting cadence is to give them the flexibility to offer a "dovish impulse" by simply downshifting to a quarter point hike at every meeting. That's still twice as fast as they were hiking during the last cycle.

Ian Lyngen:

That's a fair point. It also does raise the issue of why isn't a 75 basis point hike on the table? Now there's a very compelling case to be made that in the wake of the six-tenths of a percent month over month core CPI print, that the Fed should step up their tightening efforts and at least consider a 75 basis point move.

Ian Lyngen:

The issue I suspect is that at the end of the day if the Fed did deliver a 75 or even 100 basis point rate hike next month, that the market would simply take that as the new norm and price in at least two or three beyond June. And that would crush the front-end of the Treasury market. We would see the curve invert rather dramatically and that would trigger another material as you so eloquently put it, Ben, recalibration of prices in risk assets.

Ben Jeffery:

And to this point, the market has done some of the Fed's work for it. We have an interest rate complex that's priced to a terminal rate of somewhere between three and three and a quarter percent in the middle part of next year. The curve is uninverted for now. Real rates are back above zero and maybe modestly in restrictive territory.

Ben Jeffery:

So what the Fed is endeavoring to do now is follow through on what it is they've said they're going to do. As we've said before, Ian, the Fed is not in the shock and awe business. And at this point, they're just trying to be able to follow through with a lot of the tightening that the market has already done.

Ian Lyngen:

If we look at financial conditions in this context, what we see to your point is that the market has in fact done a lot of heavy lifting for the Fed. With the exception of the initial response to the pandemic in 2020, conditions are now as tight as they were in 2019 when the policy rate was two and a half percent. Now, if we think about what the longer-term ramifications for that might be, we're reminded that one of the defining characteristics of this cycle has been how condensed the timeline has been. We inverted much more quickly during the cycle than we have previously. We're now seeing more sustainable downside pressure on risk assets than we would have otherwise.

Ian Lyngen:

And the real economy hasn't had time to truly respond to the tightening of financial conditions. The one market-based aspect of sentiment that has responded can be seen in the break-even space. We do see break-even broadly lower and given that well-anchored inflation expectations are a key component of the Fed's monetary policy objective, I think it's safe to say that if nothing else the Fed can consider that a success.

Ben Jeffery:

And this week, all we're looking for is a bit of success.

Ian Lyngen:

Just a modest amount.

Ben Jeffery:

Modest to moderate.

Ian Lyngen:

In the week ahead, the Treasury market will continue to respond to fluctuations in other asset classes. Most notably the moves in domestic equities have set the tone for rates, not only in the US, but globally and we'll continue to watch as the situation unfolds. On the data front, Tuesday we'll see retail sales for the month of April. The consensus call is for a 1% increase on a monthly basis. The degree to which the market is willing to consider the pace of consumption in real terms is relevant given the recent ramp in inflation.

Ian Lyngen:

We will highlight that the most recent CPI data revealed continued low real wage growth. In fact, it's well into negative territory on a year over year basis. And the implications for that are relatively straightforward. The persistent increase in consumer prices has undermined the real purchasing power of the consumer. And as we consider how this plays out over the balance of the year, it is notable that we have a backdrop of a lower than expected labor force participation rate.

Ian Lyngen:

When we look at the breakdown between age cohorts, it is unsurprising to see that during the beginning of the pandemic, the 55 and older cohort were the first to leave the labor force. And that's the group that we're not expecting to return anytime soon. That simply reflects people bringing forward their retirements and opting out of the labor force given all of the risks in shifting priorities.

Ian Lyngen:

The other group that was hit early in the pandemic was the 16 to 19-year-old cohort, but they have largely reentered the labor force. And so labor force participation in that cohort is back to pre-pandemic levels. It's the 45 to 54-year-old group that is most striking. There have been some gains, but recently those have begun to erode. Now this begs the question whether this is a permanent shift in labor force participation. And if it is, what does that imply for the risk of a continued wage inflation spiral?

Ian Lyngen:

All else being equal if higher wages are unable to bring in sideline workers, one should expect that wage increases will become the norm, not the exception over the course of the balance of this cycle. Such a dynamic would undermine productivity if for no other reason than higher input costs will squeeze profitability. At the end of the day, the last two weeks of trading have really reinforced our year end call for 10-year yields to end in a range between 225 and 250.

Ian Lyngen:

What is unfolding in the market at this point is that the buyer strike in Treasuries appears to be resolving. That 3.20% level in 10-year yields could represent the upper bound at least for a while in terms of the range for longer dated Treasury yields. We still remain comparatively bearish on the front-end of the market simply as a function of refining Fed expectations.

Ian Lyngen:

And again, see the path of least resistance in the coming weeks as an inverted yield curve with an eye on 2s/10s in particular. 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 given the price action so far this week, we can truly say that Friday the 13th has never been so frightening.

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.

Ian Lyngen:

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.

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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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