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Into the Summer Dome - The Week Ahead

FICC Podcasts 16 juillet 2021
FICC Podcasts 16 juillet 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 July 19th, 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.

Podcast Disclaimer

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Disponible en anglais seulement.

Ian Lyngen:

This is Macro Horizons' Episode 129 Into the Summer Dome 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 July 19th. As a reminder, the Institutional Investor survey is still open. For those who enjoy Ben and Ian's excellent adventure, please participate. It's a meaningful way to provide feedback and help keep Macro Horizons on the air cast just a little bit longer. Thank you.

Automated:

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 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 great deal of information to digest, including stronger than expected inflation, Powell's, semi-annual congressional testimony, and a series of Treasury auctions to gauge investor demand from primary supply.

Ian Lyngen:

What we saw as a takeaway were several attempts on the part of the Treasury market to push rates higher. But ultimately the bull flattening that has been in place over the course of the last several weeks continued to be the primary theme. It is notable that the reflation trade remains relevant in US rate space. We can see that with 10 year breakevens at 2.25, if not higher throughout the bulk of the week. Now, this reality combined with declining nominal rates pushed 10 year real yields to a negative a hundred basis points, if not beyond. This is largely a reflection of the building headwinds facing the global recovery, less so US specific and more broad based.

Ian Lyngen:

When we look at other regions and the risk for an increased economic impact from the return of COVID restrictions, it's difficult to conclude that the pandemic is completely over. This observation has made all the more relevant when we put it in the context of what appears to be stalling vaccination rates in the US. This notion that we would collectively be able to reach herd immunity has gone to the wayside, as we continue to focus on moving forward in reopening the US economy. There's a strong argument to be that we are actually as reopened as we will be for quite some time, with the one caveat being that the transition from a work from home environment to a work from work. Even if hybrid environment that will occur after Labor Day will add yet another nuance into gauging the performance of the real economy.

Ian Lyngen:

In addition to generally dovish comments from Powell, the chair did make the observation that he was surprised by how strong inflation has been over the course of the last several months. Now, this is relevant for two reasons. One is, it does provide yet another reason to bring forward, lift off hike timing expectations. But at the same time, it puts the FOMCs overall dovish stance, even if it's less so than at the beginning of the year, into the context of they're still dovish. Even though we have seen inflation outperform in the way that it has. While some of those headlines might have been eyebrow raising. The fact of the matter is that the Fed does remain committed to the new framework, which explicitly allows inflation to run hotter than it has in prior cycles, and for a longer period of time before the Fed will be compelled to respond.

Ben Jeffery:

So Ian, we got Chair Powell's congressional testimony, the 10 and 30 year July reopening auctions. But maybe most notably another month with a meaningfully higher than expected CPI read.

Ian Lyngen:

One of the most notable trends in the economic data recently has been the outperformance of CPI. So we've seen that both on the headline and more importantly, on the core measure. Now, it is relevant to keep in mind, however, that while the market is continuing to debate whether or not this is truly transitory inflation, that the US economy is experiencing for the time being, at least. The Fed is content to characterize it as a temporary and pandemic related surge in prices. When we drill down into the details of the data, what we see is that there are several categories that have been responsible for the bulk of the upside. Used auto prices have been the most notable, which have effectively increased 30% over the course of the last three months.

Ian Lyngen:

Now, we know that that supply chain related and it has to do with some of the dislocations that were created during the pandemic. As the real economy normalizes, I think that most investors would look at the auto component as the biggest outlier. The other sub-categories that increased, included lodging away from home, airfares, restaurant costs, all of which are categories when we would assume would be experiencing reflation, given what happened in 2020.

Ben Jeffery:

This gets at what I would argue is the crux of the argument from those who are more dovish on the FOMC. That is that the economy has relatively recently re-emerged from a period of being nearly completely closed. So during the past 18 months, suppliers, supply chains retooled to an environment that was defined by extremely suppressed demand. Now that domestically at least, almost all of the COVID mitigating restrictions we've seen have been relaxed. Demand has picked up far more swiftly than those supply chains are able to retool themselves back to what was the pre-pandemic normal, to service an economy that was functioning "as normal." So from this perspective, the passage of time will eventually lead to some of these supply related distortions working themselves out. To say nothing of the fact that we heard from Powell this week, that the committee is going to continue talking about tapering for the coming meetings. Which all else equal points to the wind down of asset purchases starting sometime right around the beginning of 2022.

Ian Lyngen:

This is consistent with our take that the market has already priced in QE tapering, as long as the Fed sticks to the consensus timeline. Which is for an announcement either at the November or December meeting followed by implementation in the new year. Even if it were to be brought forward a month or two, I don't think that we'll ultimately see a massive repricing as a result of that. If anything, as we have seen with the market bringing forward rate hike expectations, it wouldn't necessarily be a bearish impulse for the longer end of the curve. In fact, we might simply see the curve flattening extend further and weigh on outright yield levels.

Ben Jeffery:

While there's definitely a consensus around the timing of tapering, what's emerged as a debate within the details is what approach the Fed is going to take in terms of trimming its MBS buying versus Treasury buying. Now, given the performance of the real estate sector throughout the pandemic and what continues to be a very robust housing market. We've definitely heard the observation offered that it would be prudent for the Fed to trim MBS purchases either first or at a bit more rapid clip. Now, we've heard from the Fed that really the influence of MBS buying and Treasury buying both helped the housing market. So from that perspective, it seems that there's some backing to a simultaneous taper of both asset classes. But nonetheless, it will certainly be a topic that is discussed at the July 28th meeting and something, hopefully we'll get greater clarity on both through the Fed speak in August and likely the minutes of the July meeting itself.

Ian Lyngen:

Well, that's being equal. I think there's a very good argument for the Fed to taper MBS before Treasuries, but the Fed's running up against the calendar constraint. If they were to attempt to lay the groundwork and deliver MBS tapering before Treasury tapering, that would effectively put the beginning of Treasury tapering off into at least the second quarter of next year. If the Fed's objective is to start backing out of balance sheet expand in QE, while it still has the cover of extremely easy financial conditions. It makes the most sense for the Fed to deliver tapering in both sectors at the same time. Nonetheless, Ben, as you point out, this is a question that we've received a number of times. I would say it speaks more to investors ongoing hunt for yield than it necessarily reflects a divergence in macro expectations. By that, I simply mean the Fed's participation in the mortgage market has arguably led to bigger impacts on rates than we've seen in US Treasuries.

Ian Lyngen:

As a result, participants in that market have been forced to either wait for higher yields, or get involved in a market valuations that they don't necessarily find compelling from a fundamental perspective. Let us not forget that almost by definition this is what QE is supposed to do. The Fed's objective is to first move investors further out the maturity curve, which is what started in the Treasury market and then the credit curve. So rather than investing in mortgages, investors seeking yield will move to corporate high yield bonds and eventually equities.

Ben Jeffery:

Maybe even crypto.

Ian Lyngen:

Oh, Dogecoin.

Ben Jeffery:

But in all seriousness, despite concerns about risk asset valuations and "market froth." This is in a way exactly what the Fed endeavored to do in order to offset the massive amount of tightening experienced in financial conditions during the early days of the pandemic. So the fact that they've now been able to successfully kickoff the taper in conversation and project 50 basis points of rate hikes in 2023, while still leaving financial conditions at effectively their easiest levels on record, has got to be something that Powell is encouraged by.

Ian Lyngen:

We've also seen very little financial stability risk. While as you point out, Ben, there are certainly sectors in which one could say that there is bubble risk. For the time being, at least, the Fed has made it abundantly clear that they're willing to accept some of that risk to continue to push down the unemployment rate. What I suspect will prove thematic over the course of the next couple months, will be the degree to which the US economy is able to bring in sidelined workers and increase the labor market participation rate back to normal levels. This potential overhang in labor capacity is one of the dividing points among market participants. One camp suggests that once we're past Labor Day, the unemployment benefits start to roll off and in person learning provides the right incentives to get workers reengaged in the labor force.

Ian Lyngen:

That we will see wage pressures moderate, and the unemployment rate actually increase along with labor market participation rate. The flip side of that argument is, what if the changes that occurred during the pandemic end up being a lot stickier than we're expecting? That implies a degree of stain power for the current level of labor market participation. That the worker scarcity that we're seeing isn't transitory and won't be reversed once the world gets back to work in the fourth quarter.

Ben Jeffery:

But even in the case of your latter example, Ian, I would still argue that in that environment material upward pressure on real wages is still going to be somewhat hard to come by. Which then in turn will not translate to the type of true demand side inflation that the Fed is pursuing. Fair to say?

Ian Lyngen:

I suspect that ultimately as employers continue to embrace automation and we don't see the return of collective bargaining power driven by unions, comparable to what we saw in the '70s and '80s. That it will be very difficult for the inflation complex to reach escape velocity that brings us to a sustainably higher plateau.

Ben Jeffery:

I would argue that the price action we saw this week in the Treasury market is starting to incorporate, at least on the margin exactly that reality. After we saw 10 year yields dip below 1.25, we saw a fairly substantial amount of selling pressure that pushed hands back to and through 1.40. But rather than a wholesale reversal, back up of 1.50 and toward that 1.60 level. Really what we've seen is a bit of a period of stabilization here. What's most notable about this period of stabilization is that it's taking place in the 1.25 to 1.40 zone, not the 1.50 to 1.75 zone. Which suggests more staying power, at least over the course of the next few weeks, the next month. It implies that it's going to be from that zone that the market returns from summer, and some of these distortions that we've discussed that will be ending around Labor Day will start to be incorporated into valuations.

Ian Lyngen:

It's also important to keep in mind that there'll be no collective inflection moment for the economic data that we'll see in early September. We actually won't see any of these trends start to materialize until we're well into the fourth quarter, if not the beginning of 2022. This doesn't hold true simply for investors, but also for the Fed. So monetary policy makers are going to, once again, be in a situation where they're effectively flying blind. Which brings us back to some of the trading dynamics that we've seen in the market recently, where we continue to ignore the realized data and instead are relying very heavily on these forward macro narratives.

Ian Lyngen:

Specifically the one that has taken hold over the course of the last several weeks is that, as the global economy continues to show differing performances between regions, with a special nod to emerging markets that continue to struggle with the pandemic. That rebasing expectations to a higher level might have been a bit premature, as we saw in the first quarter. This broad-based recalibration back to a rate range and trading dynamic that was comparable to what we have seen in prior cycles. Also speaks to the idea that the Fed has shown their hand in so far as they would be willing to respond to inflation, if it does end up being materially higher than the committee expected.

Ben Jeffery:

But for better or worse, I think it's fair to say that none of these issues are going to be resolved in the week ahead. After all it is the third week of July, and what many are anticipating will be one of the last "opportunities" to work from home or retain a bit more flexibility. Which all else equal should leave the process of establishing a new volume bold in Treasuries as the path of least resistance, at least heading into the July FOMC meeting.

Ian Lyngen:

Ah, the path of least resistance. A personal favorite route.

Ben Jeffery:

Is there any other way?

Ian Lyngen:

Not that I found. In the week ahead, the Treasury market will have very little in terms of fundamental inputs to help guide trading direction. It's an environment such as this, that we tend to lean more heavily on the technicals. The bullish momentum that accompanied the rally in 10 year yields back below 1.25 has dissipated somewhat, as the market has pushed forward with what we expect will ultimately be an extended period of consolidation. The bull flattening dynamic is here to stay, at least until we're through the summer. But that doesn't mean that incremental gains won't be increasingly difficult to achieve. In fact, we're targeting an opening gap in 10 year yields at 1.21 to 1.22.

Ian Lyngen:

Now, we suspect that that level will be unlikely to see in the month of July, barring either a disappointment for Q2 real GDP or something more dramatic out of the Fed. One of the biggest questions in the market at the moment is, why our Treasury is trading in a typical late cycle dynamic? When growing expectations for Fed rate hikes lead to weakness in the front of the curve, but an outright rally in 10s and 30s. Historically, this has been price action that emerges once the Fed is well into a tightening campaign. Given that the consensus currently holds that we won't see the first rate hike until the end of next year at the earliest.

Ian Lyngen:

It is curious that this price action has emerged. Will suggest that this is a carryover from the market's understanding of how the Fed will respond to inflation, if and when it reaches levels worrying to monetary policy makers. In taking a step back, if we think about the last three decades of monetary policy, what the Fed has routinely done is reinforced this idea that they will step up to combat inflation if and when it occurs. In many cases, they've chosen to get ahead of any potential reflationary scenario. Now, the Fed has made an effort with the new framework to convince the market that they have changed their relationship with inflation. Now, in this context, the June FOMC meeting and the increase to the 2023 dot plot takes us a step back.

Ian Lyngen:

It's fair to say that what the last couple of weeks of trading and Treasuries has revealed is that, the market is viewing the new Fed pretty much in line with the old Fed in so far as their reaction function to higher than expected inflation. This certainly creates a communications challenge for the Fed, especially if they still intend to keep policy rates as low as they can, until the unemployment rate reaches record lows or below. Regardless of one's interpretation of the Fed, the primary driver in rates market over the course of the next several weeks will be more about limited liquidity, and summer trading conditions than it will be any wholesale rethink of the macro narrative. 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. As an astute client recently observed, if you run into hard times, just keep on punning.

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 the 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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