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Second Quarter Conundrum - The Week Ahead

FICC Podcasts 01 avril 2022
FICC Podcasts 01 avril 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 April 4th, 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 165, second quarter conundrum presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of April 4th. And with the first quarter officially closed with an inverted yield curve and investors pondering the outperformance of the long end, we're reminded of the sage wisdom; don't call it a conundrum, it's been here for years, rocking its peers and putting expansions in fear. Thanks, LL.

Speaker 2:

The views expressed here are those of the participants and not those 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, 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 Room or email me at I-A-N.L-Y-N-G-E-N@B-M-O.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:

In the week just past, there were several key developments in the treasury market. The first notable of which was the inversion of both the twos-tens curve and a deeper inversion of fives-thirties in the run up to month end. Now, we did officially close the month with twos-tens very slightly inverted, and part of that had to do with obviously month end buying. It's also represented the end of the first quarter. So it goes without saying that there were rotational flows as well given the comparative performance of equities versus ponds, this would constitute selling stocks and buying treasuries.

Ian Lyngen:

But we also saw a continued rise in treasury yields, very thematic and consistent with where we are in the cycle. Odds of a 50 basis point rate hike in May continue to increase as has the probability that we'll see another half point delivered at the June meeting. This intuitively weighed on the front end of the curve with two year yields pushing beyond 245 with an eye on a target of 250. Now, this clearly implies a greater inversion of the twos-tens curve, as well as fives-thirties. And in fact, at this point, most benchmark spreads are now inverted.

Ian Lyngen:

The one notable exception, and this becomes relevant as the conversation shifts towards the probability of a recession is the three month bill versus 10 year yields curve. This is the curve that the fed sites as having the most predictive power in terms of forecasting a recession. And given that there's still another 180 to 190 basis points to go before this curve inverts, we're cautious against overinterpreting the implications from a flatter curve. The only thing that we can take away from an inverted curve is that investors are more willing to pay up for duration and accept a lower yield than they are to invest money for just two years.

Ian Lyngen:

In two words, reinvestment risk. The notion here being that investors believe the fed and the market is content to price in a more aggressive path to rate normalization, but expect over the medium to long-term that policy rates will need to be lowered to adjust to the performance of the real economy. This has always been a primary tenant in the treasury market, specifically the more aggressive the fed normalizes policy rates, and the more quickly they hike, the sooner they will not only take the edge off of inflation expectations, but also the sooner they'll ultimately need to cut rates as the next cycle begins.

Ian Lyngen:

Non farm payrolls also had a solid showing while headline NFP did slightly disappoint. The overall number was still very strong and the unemployment figure declined to 3.6%, and a further demonstration of the underlying strength in the employment market. We're reminded that employment is in fact a lagging indicator, and so it follows intuitively that we would continue to see strength in the sector intel and unless financial conditions are ultimately tightened to the point that companies reconsider their hiring plans.

Ian Lyngen:

It's much too soon in the cycle to have this on the radar per se, but given how condensed the overall business and rate cycle has been, we're content to keep an eye on the employment market over the course of the next two quarters for any indication that the underlying trends might be waiting.

Ben Jeffery:

While it was a solid payrolls figure, fairly close to consensus almost all the way around, but yet twos-tens back below zero.

Ian Lyngen:

And I'd suggest that the inverted yield curve is very consistent with the way that the market has performed throughout the bulk of this cycle, i.e everything has been accelerated. Now, a great deal has been said about the flatness of the yield curve being premature, given everything that's going on in terms of the real economy. But the reality is both twos-tens as well as fives-thirties have dip below zero for the first time in the cycle. And we struggle to imagine that being materially challenged anytime soon. The caveat being that we will see moments of tactical re-steepening associated with auctions and or positioning, but the fundamentals behind the flat curve are difficult to argue.

Ben Jeffery:

And the knee jerk response to March's payrolls figures are very indicative of what's likely going to define the market's reaction function to the realized economic data, at least over the balance of the second quarter, if not beyond. And that is that the bar for the data to really derail the feds tightening ambitions is very high and by very high, I mean probably consecutive negative NFP reads that really call into question the economy's ability to continue to bring in workers from the sidelines.

Ben Jeffery:

We saw the labor force participation rate move higher to its highest level since March 2020, but there's still more improvement to be realized there. So even after the Fed's first rate hike and even after Powell delivers another 50 basis points on May 4th, monetary policy is not going to be the binding constraint in continuing to bring people into the labor force.

Ben Jeffery:

If anything, and this is a great point you've made recently, Ian. Even weaker reads on the hiring front can very easily be attributed to the detrimental impact of inflation running at a 40 year high. So softer jobs numbers, somewhat counterintuitively could be read as a green light for the fed to continue forward with 50 bp in May, maybe 50 bp in June and clearly further tightening beyond there.

Ian Lyngen:

I think that that's a fair assumption in terms of the cadence of rate hikes this year, 50 basis points at both the May and June meeting followed by 25 basis points at each subsequent meeting. What remains to be seen is how the fed chooses to deal with the balance sheet runoff. Powell has offered the market the guidance that the announcement could come as soon as the May meeting, we're certainly on board with that at least conceptually and we'll be watching Wednesday's release of the March FOMC meeting minutes for greater clarity on that front.

Ian Lyngen:

It goes without saying that the minutes will contain details of the discussions surrounding the decision to lift off 25 basis points versus 50 basis points in March. But this is also the perfect forum for the fed to offer further guidance in terms of the balance sheet runoff. The questions are at what level will runoff be capped and will there be a step up function to get there or will we simply see the cap numbers announced and the market react accordingly?

Ben Jeffery:

And there's also the issue of selling treasuries from SOMA that continues to be discussed as a potential policy lever to pull sometime further down the line. We remain skeptical that the FOMC will ultimately decide to use that tool if only given the maturity profile of the treasuries that are currently in SOMA. Just north of 2 trillion in notes, bonds, tips and FRNs are going to be maturing over the balance of this year through the end of 2024.

Ben Jeffery:

And with our expectation that the fed would like to bring the balance sheet down to between 6 and 6 1/2 trillion dollars simply by delivering on outsized runoff caps and treasuries and mortgages, they'll be able to bring the balance sheet down very quickly without necessarily needing to take on the challenge of communicating, selling treasuries on an outright basis from Selma's holdings.

Ian Lyngen:

This dynamic gets a little more complicated when we think about the mortgage portfolio. However, there is a reasonable chance that at some point in the cycle, the fed chooses to sell mortgages directly out of its portfolio. However, as a departure point, we expect that the process will be set up in such a way that the fed isn't compelled to make up shortfalls below the cap by selling outright into the market.

Ian Lyngen:

This brings us to the secondary question, and I think the one that is probably more relevant in terms of how the treasury market responds, and that is how does the treasury department decide to make up the funding shortfalls? So for context, recall that the way the fed reinvests maturities into the treasury market is via add-ons at auction. So the fed doesn't actually go into the market and by securities directly from private participants, what this implies is that over the course of the next several quarters, the treasury department's quarterly refunding announcements will become more tradable events.

Ben Jeffery:

And in the early days of balance sheet normalization, the scale of the rundown and thus funding need on the other side from the treasury department's perspective can be readily absorbed in the bill market, moving beyond the first few months, maybe first few quarters of the rundown with a nod to the uncertainty around any new spending out of Washington, we will need to see coupon auction sizes once again start to increase to meet the treasury department's needs to fund the deficit. And while that may provide a bearish impulse, maybe some of that tactical steepening that you hinted at earlier, Ian.

Ben Jeffery:

Given what we're continuing to see in terms of treasury auction performance, these increases are not going to be on the scale that will really call into question the ability of the market to take down the government's issuance. After all, if we learned nothing from the pandemic and the year of record net issuance that accompanied the massive amount of stimulus that made its way into the system, it's that treasury auctions will continue to bring out buyers. On Monday and Tuesday of this last week, we saw a small tail for fives sure, but generally speaking twos-fives and sevens, the most susceptible sectors along with threes to rate hikes find a bid that was nothing if not solid to conclude marches coupon on supply series.

Ian Lyngen:

A question that we've received a number of times over the course of the last week or so has been a version of how does the price action thus far change the year end forecast that we brought in to 2022 for the rates market? The short answer is that the market at lease thus far is behaving generally in line with our expectations, and we haven't been compelled, at least not yet to make any meaningful changes to our forecast for 10 and 30 year yields. We expect tens to end 2022 at 2.25%.

Ian Lyngen:

Obviously, there'll be a bit of an upward bias given the price action we've seen thus far. However, the market is conforming to the traditional seasonal patterns that we tend to see in treasuries, where we bring in a renewed amount of optimism at the beginning of every year, we price to perfection. And in this case, that is a series of fed rate hikes that doesn't end up derailing the equity market or otherwise tightening financial conditions. And then as the second and third quarter of the year unfold, the market is faced with the hard data on the performance of the real economy. And the market gets a better sense of the risks around the more optimistic scenarios.

Ian Lyngen:

The one sector of the curve that we have nudged higher forecast in terms of rates has been the very front end, particularly two year yields, and to some extent fives. But a quick glance of the fed funds futures market reveals that in 2023 investors are assuming that we reach a terminal rate somewhere close to 3%. So our takeaway is two year yields up against 250 at the end of the year will fully reflect not only the rate hikes that have been achieved, but also what investors anticipate for next year.

Ian Lyngen:

Let us not forget that the fed tends not to be able to maintain the terminal rate in any cycle. In fact, history shows that terminal tends to hold between six and nine months. So said differently, once the fed finishes this hiking campaign, the next move is going to be a series of eases.

Ben Jeffery:

And especially given how quickly this cycle has played out, both in terms of the labor market recovery, the pickup in inflation and how quickly the fed is going to raise rates. It's not unreasonable to assume the period the fed will be able to stay on hold will also be condensed. So exactly to your point, Ian. In the near term, we can surely see a deeper curve inversion, but before too long, the market's focus is going to start shifting toward how exactly the fed will adjust rates off terminal, and whether that will be in a fine tuning fashion, similar to 2019 or if a more substantial deterioration in the recovery will require more dramatic action.

Ian Lyngen:

And I think that's going to be the debate that plays out over the course of this year. Not whether or not the fed is going to continue to normalize rates because they've made that much abundantly clear, but rather what will occur once the fed has finally removed enough accommodation that they're no longer worried about losing the anchor of inflation expectations.

Ben Jeffery:

And even over this past week, we've seen some of the edge taken off break evens, both in outright tenure yields and five year, five year forward space. A great deal of that initial increase that saw 10 breakevens reach their record high just beyond 3% can clearly be attributed to the price action in the oil market resulting from war in Ukraine. But nonetheless, this latest period of stabilization is partially in response to a pullback in oil sure, but also the increasing conviction with which the market is in a swift return of policy rates to neutral territory and even beyond.

Ian Lyngen:

We also saw the Biden administration announce that it will be releasing a million barrels per day from the Strategic Petroleum Reserves for 180 days or effectively the next six months. The fact this represents the run-up to the midterm elections is not lost on us, but we digress. Nonetheless, the implications for the energy market are relatively straightforward, additional supply at a moment when sanctions against Russia are taking out of the market a core source of crude supply. Now, when we look at the details of the numbers, it won't be sufficient to completely offset the Russian factor, but nonetheless, it should, as you point out, Ben, take some of the edge off of the upward pressure we've seen on breakevens.

Ben Jeffery:

And as we think about the price action going into and coming out of Wednesday's minutes release, let's not forget that it is a new month, it is a new quarter and in Japan, it's a new fiscal year. So we'll be very attentive to any outsized flows from the region that may provide greater context for just how willing Tokyo is going to be to buy this latest dip we've seen in the long end of the curve.

Ian Lyngen:

Another question that has come up several times recently is when do we expect Japan to come in and start buying? As a point of clarification, the fiscal new year is simply the removal of a potential inhibition, as opposed to an actual inclination to start buying. Now, this might sound like a bit of needless nuance, but the fact of the matter is portfolio managers in Japan have plenty of time to begin scaling back into treasuries if and when that's their decision. So Ben you're right, that this will be a topic that we monitor closely, but one would be remiss to assume that there's a wall of cash in Japan just waiting to be deployed into treasuries in the first week of April.

Ben Jeffery:

Oh, yeah. Happy April Fools Day.

Ian Lyngen:

You pushed record, right?

Ben Jeffery:

Oh, no.

Ian Lyngen:

Ooh. In the week ahead, the Treasury Department has a unique reprieve from both supply and in a meaningful economic data. The most meaningful event will be the release of the FOMC meeting minutes from the March meeting. Now, as we've discussed, we'll be focused on any indication of the breakdown between those in the media advocating for a 50 basis point liftoff, as opposed to the 25 basis point liftoff that was achieved and any guidance that we might extract from that as it applies to the May meeting.

Ian Lyngen:

All it's being equal, our take is that a half point hike is a foregone conclusion at this point, simply given Powell's recent reiteration of the fact that 50 basis points is on the table even having seen the price action that followed the March FOMC press conference. This certainly isn't to suggest that 50 basis points at every meeting will become the norm, but rather that the urgency to normalize policy rates has been reinforced by the geopolitical uncertainties which have put upward pressure on the energy complex.

Ian Lyngen:

Now, this brings us to one of our underlying concerns for the second and third quarter, and that is that we'll start to see a divergence between headline inflation prints and core inflation prints, particularly on a year over year basis. Given the relevance of oil prices and gasoline to headline CPI to say nothing of higher food costs that are associated with the disruptions because of the war in Ukraine, it goes without saying that the headline prints will increase for the next few months. But when we think about the trajectory of core, specifically the pace of auto prices, as well as apparel of prices and some of the other sub-components, it's not unreasonable to expect that we'll see some moderation in April, May and June.

Ian Lyngen:

This will put the fed in the same position that the ECB currently is. The ECB has seen remarkably high year over year headline inflation at 7.5% with core lagging materially at just 3%. Now, this brings up the question is higher inflation a function of a stronger economy or are the supply side dynamics undermining consumption in real terms? Said differently, is inflation simply functioning as a tax on consumption? That case is much more strongly made in Europe than it is in the US at this moment.

Ian Lyngen:

But fast forward to this summer, when we do have the base effects kick in for the second quarter inflation data, and the fed might be faced with an entirely different inflation profile. We were encouraged to see the pullback in breakevens off the recent peaks, if nothing else, this is a vote of confidence in the fed's ability and willingness to combat inflation. And it's also consistent with the idea that treasury yields, particularly in the long end of the curve are reaching levels that could entice some otherwise sidelined investors.

Ian Lyngen:

Also within the FOMC minutes, we'll be looking for any clarity on the pace of balance sheet rundown, as well as any potential for the fed to sell mortgages directly out of SOMA. All else being equal, we expect that the first full week of trading in the second quarter in the treasury market to be volatile, choppy and highly contingent on headlines coming out of Eastern Europe.

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. And as the internet continues to reverberate with the slap herd around the world, we take solace in the fact that any joke made about interest rates is unlikely to elicit a similar reaction, at least not off the trading desk.

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 BMO's marketing team. This show has been produced and edited by Puddle Creative.

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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