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#ShipStillStuck - The Week Ahead

FICC Podcasts mars 26, 2021
FICC Podcasts mars 26, 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 March 29th, 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 Marco Horizons episode one 13, #shipstillstuck, 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 March 29th. In yet another nod to what awaits us on the other side of the pandemic, commodity markets remain focused on the “Ever Given” saga, as we're reminded that the Suez Water runs shallow. Apparently much narrower than the length of the average container ship.

Speaker 2:

The views expressed here are those of the participants and not those at BMO Capital Markets, it's affiliates, or subsidiaries.

Ian Lyngen:

Each week, we offer an updated view on the U.S. 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.

Ian Lyngen:

In the week, just passed, what was most notable in the Treasury Market was what didn't happen as opposed to what we did see. Specifically, we did not see a material challenge of the upper bound of the trading range in terms of yield, which in 10 year space comes in at 175. The fact that 175 is holding for the time being is constructive for the broader range trading thesis, as opposed to the camp anticipating a step function higher in yield throughout the course of 2021. While it's still far too early for anything conclusive on this front, we do take solace in the fact that there appears to be some dip buying interest emerging as the quarter comes to an end. Recall, we have been focused on the relevance and the potential for flows related to the Japanese fiscal year end, once the calendar turns and this key region for investing in Treasuries comes back online and the middle of April.

Ian Lyngen:

In contemplating the end of the first quarter, it's also important to keep in mind the traditional rotational flows, given the performance of risk assets during the first quarter of the year. It's safe to assume that there will be some selling in domestic equities and rolling over into the bond market. This should ultimately provide a stabilizing bid and keep that 175 level in 10 year yields off the radar for the time being. A quick glance at the fundamentals suggest that while the reflationary trade continues to be priced into the market, as evidenced by ten-year breakeven solidly above 225, what we have yet to see is that translate through to the actual economic data. Most notably the core PCE print for the month of February came in at one 10th of a percent. Now that was accompanied with an unexpected slowing in the year-over-year pace to just 1.4%.

Ian Lyngen:

As the market prepares itself for the March, April and May inflation numbers, it's important to keep in mind that the trajectory that has started 2021 suggests that the bar will be very high over the course of the next several months to bring the three month annualized rate... which is what the Fed has routinely told us to focus on, back into a range that would concern either monetary policy makers or the market more broadly. Even in that context however, most of the upside risks for inflation in the near term are going to either be transitory, consistent with a spike in upward pressure on service prices, as the economy reopens. Or simply a reflection of the base effects that are known and will come into play over the course of the next few months.

Ian Lyngen:

Regardless of the near term economic data, we don't anticipate that reflationary ambitions will be curtailed at least for the next several months. It won't be until we're far enough through the 2021 data cycle that one could expect a collective rethink or recalibration of the pace of inflation over the course of the recovery. For the time being vaccination, optimism, reopening ambitions, and the ultimate translation of more consumer dollars being put to work in the real economy is still expected to lead to a higher inflation profile in the year ahead.

Ben Jeffery:

Well, even if we've learned anything this week, it's that Suez Waters run shallow.

Ian Lyngen:

Well narrow, at least. On the topic of narrow, one could make the argument that what we have seen in the Treasury Market over the course of the last week is a narrowing of the range of consolidation that we have been focused on. Sure, 10 year yields made it to 175, but that appears to be the upper bound, at least for the time being. I think it's pretty safe to say at this stage that, that will be the high yield point for the first quarter. Although, there are still a couple more trading days until we make it to April Fool's Day. In that context, the incoming fundamental information over the course of the last week has really solidified this idea that growth and inflation expectations remain and will persist for at least a few more months, while the realized data continues to struggle. For example, durable goods disappointed, and more importantly, the year over year core PCE print unexpectedly ticked lower to 1.4%. that doesn't do much for the reflationary camp to say the least.

Ben Jeffery:

We're on the same page in that it's pretty likely that 175 is going to represent the upper bound for 10 year yields during the first quarter. That year-over-year core PCE read, excluding 2020 was the lowest since December 2015. While sure we are still in the midst of a global pandemic, these figures are going to continue to be distorted by not only fiscal stimulus, but also base effects over the next few months. But nonetheless, it does take some of the wind out of the reflationary narrative sales.

Ian Lyngen:

Well, you say that we're still in the middle of a global pandemic, but to read the headlines one could make the argument that the reopening process has already begun in earnest. What we're witnessing at this stage is a bringing forward of some of the economic upside that one might have otherwise expected in the second half of this year. Recall that when we came into 2021, the prevailing expectations were that we would have a vaccine rolled out and available to everyone sometime in the July, August timeframe. Now, clearly that has been accelerated. And with that transition, we are seeing expectations for economic growth ratcheted higher. My primary concern in this regard is that we find ourselves in a situation where we have a strong first and second quarter, and the market simply extrapolates that over the course of the next three or four quarters, which would lead to medium term expectations, being vulnerable to a mean reversion of the economic data.

Ian Lyngen:

In practical terms that means that the upside for rates and potentially risk assets as well, will be limited to the first half of this year. Now we'll be the first to make the observation that this is consistent with the seasonal patterns. However, there is something more afoot than simply the typical tendency for the Treasury Market to perform over the summer months as expectations recalibrate to the realities of the economic data cycle.

Ben Jeffery:

This gets at one of the core debates that's been playing out in the market. Is this pickup in economic activity, driven by the progress towards vaccination, driven by business re-openings? Is this boost going to serve as a level reset for the pace of consumption going forward? Or rather will it translate to a one-time jump... that I think would be reasonable to anticipate in March and some of the April data, that ultimately retraces back to levels that are more consistent with what we saw before the pandemic? Or even below what we saw before the pandemic, given some of the behavioral changes that you and I have talked about a lot, Ian. Which could linger for years, even once COVID-19 is definitively behind us.

Ian Lyngen:

Further to the point, let us keep in mind that the stimulus efforts out of Washington and the Fed as well weren't really designed to increase potential GDP, nor lead the real economy to some version of escape philosophy to a higher plateau of growth. Rather, what lawmakers were attempting to achieve was to create that bridge between the depths of the pandemic and the post-pandemic reality. As we contemplate what that post pandemic reality will look like, I think it is important to keep in mind this shifts in terms of telecommuting and working from home will have more staying power than one might have originally assumed at the beginning of the pandemic. Moreover, I'm still worried about the 10 million jobs that the U.S. economy is down versus before the pandemic.

Ian Lyngen:

Now, a lot of those were frontline service sector jobs. As a result, the prevailing logic is once the real economy is reopened, that those positions will swiftly become available again and be filled. I'm a bit hesitant of relying too heavily on that assumption simply because the scales of economies that frontline service sector firms used to be able to enjoy in the densely populated urban centers, won't return in the same form. And as a result that will introduce a degree of uncertainty and limit hiring, particularly in the smaller business sector.

Ben Jeffery:

That's especially relevant given the fact that it is NFP Week. Looking at private service, providing employment in March and April of 2020, we lost 18 million jobs in that subset of the labor market. Coming out of that initial plunge, there was a meaningful pickup, 11 million jobs returned, which as a share of the overall jobs lost is 62%. So that's definitely encouraging. But I think what we're more concerned about is the fact that that remaining 38% is not going to be as easily recovered as the jobs that we've already seen brought back. This obviously is going to be a function of just how quickly the service sector is able to retool to the new reality that will start unfolding over summer. But persistent slack in the labor market is going to naturally serve as a drag on growth over the longer term, I'm talking third, fourth quarter and beyond.

Ian Lyngen:

Another aspect of the current cycle that mirrors what we saw during the last financial crisis, is the fact that a lot of the changes in the labor force produce the type of slack that will provide a cap on real wages. To some extent losing people from the labor force does create a degree of scarcity in labor market, which would presumably put upward pressure on wages. However, given the nature of why people left the labor market, i.e., additional unemployment benefits combined with the risks of going to work during a pandemic, I suspect that what we'll find is as the economy starts to heat back up workers in that 25 to 34 year old cohort... which was hit particularly hard during the pandemic, will more quickly returned to the labor force then they did in the prior cycle. This will serve to limit upside pressure on wages as well as serve to keep the realized inflation profile in check.

Ben Jeffery:

Transitioning from some of the economic fundamentals. Arguably the biggest event of this past week was Thursday seven-year auction. The reason it was so closely watched was that following February's worst ever seven's auction, there was a substantial degree of concern that a similarly terrible auction would be enough to break the top of the yield range and drive some follow on selling. Like we saw at the end of February. Now the seven-year auction was weak. There's no doubt about that. A 2.4 basis point tail had roughly average bidding statistics. But what we didn't see was a wave of selling pressure that followed that somewhat uninspired auction. It also came after twos and five's that were pretty uneventful to be honest. So really in my opinion, the March seven-year auction helps lay to rest some of the more dire concerns on primary market demand for Treasuries.

Ian Lyngen:

Let us also not forget that we're still in the period before the Japanese fiscal year end. The fair amount of the lack of overseas participation at the February seven-year auction was attributed to this dynamic. So the fact that we only had a 2.4 basis point tail at the seven-year, given its relevance to the bear steepening, I think speaks to the fact that there are dip buyers in the market. This could become even more evident in the wake of the March nonfarm payrolls report. Once the Japanese investor community comes back online and investors calibrate expectations for the second quarter.

Ben Jeffery:

NFP is no doubt significant, but we are entering something of an interesting period just given the fact that we have two full weeks without any Treasury coupon supply. The next auction is going to be the April 3 year, which is coming on Monday the 12th. So that removes the potential for any price action driven by auction concessions and should refocus investors on A, the fundamentals of jobs and inflation but B, some more technical factors. Now that we've settled into something of a defined trading range with a meaningful inflection in momentum that had been quite bearish, but has now inflected in favor of a rally.

Ian Lyngen:

I do think that the technical profile in an environment such as this is important, especially in the context of the divergence between the actual data, and what the market is anticipating the data will be. Recall that the market spent the vast majority of the last 12 months trading beyond the pandemic. To the point in which the real economy is reopened, re-engaged, and the sideline workers are brought back in. We're nearing the point frankly, where this notion should be put to the test. What will growth look like in the new normal? What will be appropriate risk asset valuations as we move forward? A lot of these questions should intuitively be answered over the balance of 2021. The issue quickly becomes how rapidly will the market readjust when there is more information at hand. Rather than continue to extend the timeframe in which investors are anticipating inflation will come roaring back into the system.

Ian Lyngen:

As it currently stands, even the Fed has made it abundantly clear that 2021 will not be the year in which inflation breaks out. So that puts the focus on 2022, 2023 or even beyond. So in this context, the divergence between realized and expected inflation might attempt to persist into the end of this year. But I suspect that there will ultimately be a reckoning as those positions become increasingly difficult to carry, or at least justify, given what we're seeing in terms of the data on the ground.

Ben Jeffery:

A look at the economic surprise index reinforces exactly this concern. We've now seen this measure of realized data versus expectations dropped to its lowest level since the initial surge out of the pandemic. While the sustained period of consistent out-performance of the data during 2020 was likely more a function of two suppressed expectations, the fact that we've now seen all of that upside eroded and the surprise index back to levels witnessed in the darkest days of the pandemic, is concerning. Particularly, as the upside offered by stimulus starts to fade.

Ian Lyngen:

So Ben, what you're saying is that that ship has sailed like the Ever Given?

Ben Jeffery:

Never more.

Ian Lyngen:

In the week ahead, the Treasury Market will have two primary factors with which to contend. The first being the end of the first quarter, the month of March and the Japanese fiscal year end. Although it's being equal, we would expect this to be a net positive for Treasuries, and put downward pressure on yields particularly, in the 10 and 30 year sector. So a bid for duration as books are squared into the end of the quarter. There's a reasonable amount of duration extension as well as rotation out of equities into bonds. The other consideration is a March nonfarm payrolls data report. As it currently stands, expectations are for an increase in nonfarm payrolls of 600,000. This is effectively a repeat of the solid March print that we saw. The consensus is centered around the idea that we're going to see more of the sideline workers that were displaced at the beginning of the pandemic, brought back into the labor market as those frontline service sector firms reopen.

Ian Lyngen:

Now, this is an expectation that has been in place for some time. So the fact that it's coming to fruition probably won't provide any meaningful training direction as long as it's within plus or minus $200,000 of the consensus. What holds the potential to recast growth expectations going forward, is a significantly stronger print. Particularly on the private payroll side. Keep in mind that monetary policy will continue to be accommodated for the foreseeable future. The Fed has made it abundantly clear that QE will remain in place throughout 2021. That even beyond tapering, it will still be several quarters before a rate liftoff is actually on the table. So with the backdrop of an extremely accommodative monetary policy, a Fed that would like to see the unemployment rate dip back to 3.5% or below, it's really difficult to argue against assuming that there will be some upside in the employment data at one point.

Ian Lyngen:

This leads to one of our lingering concerns. And that is when we think about 2021 as a whole when we came into the year, the market generally was expecting that the timing of the reopening would focus on the summer months. Let's call it June, July, August with expectations for everyone to be up and running by September. Fast forward to today, given Biden's expectations for vaccinations to reach 200 million by the 30th of April, this will serve to bring forward the timeline of getting the economy reopened. Therefore, what we might find ourselves faced with is a very strong beginning of the year. We've already seen that in the first quarters data, but carry that through to the second quarter. The risk is that the market takes that trajectory, and simply interpolate it into the end of the year. That leaves the second half of 2021 as particularly vulnerable for under-performance in terms of jobs growth, reflation, and the real economy as a whole.

Ian Lyngen:

This isn't to suggest that the market has gotten too far ahead of the vaccination process, after all the path toward mass inoculation is well underway. But rather that the potential to recast growth to a higher plateau by the end of this year might be exaggerated at this particular moment in time. We will need more economic data and evidence that the stimulus seen thus far really has materially changed potential GDP rather than bringing consumption forward to today only to be repaired with higher taxes tomorrow. 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. While there are no guarantees in financial markets, the one commitment we can make is not to limit our foolishness to a single day in April, although it's always nice to be celebrated.

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 Nesbitt Burns Inc, 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 maybe suitable for you.

Speaker 2:

It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment, legal accounting, or tax advice, or representation that any investment or strategy is suitable or appropriate to your unique circumstances. Or otherwise the constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests. Including futures contracts, and commodity options, or any other activity, which would cause the most or any of its affiliates to be considered a commodity trading advisor under the U.S. Commodity Exchange Act. BMO is not undertaking to act as a swap advisor to you, or in your best interest in you. To the extent applicable, will rely solely on advice from your qualified independent representative making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.

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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