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Summer Hike Wave - The Week Ahead

FICC Podcasts 22 juillet 2022
FICC Podcasts 22 juillet 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 July 25th, 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 18, summer hike wave 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 July 25th.

Ian Lyngen:

And with the last week of II voting upon us, it's not wasted on us that the process is akin to a good old fashioned telethon. Websites are standing by and the first 100 voters get a free podcast.

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.

Ian Lyngen:

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 past, the Treasury market put in an impressive performance with 10-year yields dropping below 2.75. This, despite the fact that we saw the ECB hike rates by 50 basis points and the FOMC is expected next week to increase policy rates by 75 basis points.

Ian Lyngen:

There's a very meaningful dynamic playing out in the US rates market at the moment. Specifically, investors have quickly begun looking beyond the inflation as everything trade and more closely examining the prospects for a slowdown of some magnitude.

Ian Lyngen:

Now, the economic data has yet to reflect a significant slowing in activity, but there are signs that we might be in for a slower pace of growth during the balance of the year.

Ian Lyngen:

Now, as we approach the GDP print for the second quarter, which is released on Thursday, July 28th, the reality is with a roughly half percent growth estimate. In real terms, that one should have a downtick into negative territory on the radar, if nothing else.

Ian Lyngen:

We also saw a notable disappointment in the US PMI series in which the service sector component dropped below 50 to mark the weakest level since May of 2022. This was consistent with the weakness seen in Germany, as well as France. This is troubling, not insofar as its hard data per se, but it does reflect a very clear corporate sentiment. And that is that the economic outlook has dimmed.

Ian Lyngen:

This has yet to flow through to the hiring landscape, although the most recent Initial Jobless Claims print was the highest of the year. That said, in outright terms, Initial Jobless Claims are still so low that one shouldn't assume a material impact on the July Nonfarm Payrolls numbers, nor frankly, on the unemployment rate.

Ian Lyngen:

At this stage in the cycle, the most meaningful upward potential for the unemployment rate comes in the form of labor force participation, i.e., more sidelined investors coming back into the workforce either because savings have been depleted or elevated cost and forward inflation expectations are high enough to warrant coming back to work as it were.

Ian Lyngen:

Within the ECB’s announcement of a 50 basis point rate hike, we also learned that they're going to be establishing a new tool, the TPI, which will be designed to keep core European spreads in line specifically the run up in Italian yields versus Bunds.

Ian Lyngen:

It's clear that the political uncertainty in Italy following the resignation of Draghi has added to the potential credit risk in Italy to say nothing of the impact that that economy has seen during the last two years as a result of the coronavirus.

Ian Lyngen:

If nothing else, the net takeaway the last week from the global rates market is a shift towards growing apprehension of building headwinds, as opposed to lingering concerns that inflation will lead investors to demand a greater inflation premium to go further out the yield curve.

Ben Jeffery:

So this week there wasn't a ton of fundamental information offered, but we did get 10-year yields back up to that 3.08 level, we saw challenged in the wake of last week's CPI print.

Ben Jeffery:

Before buying interest emerged, we got 10s well through 2.90, and now the benchmark of all benchmarks is looking at 2.75.

Ian Lyngen:

The fact that the Treasury market has managed to put in such an impressive rally without any major shift in the realized economic data, I think is very telling in so far as the fact that the outlook is at something of a pivot point.

Ian Lyngen:

Ultimately, investors are looking forward to the balance of 2022 and attempting to gauge the probability that the US economy will be in a recession. The one thing that we did see last week was a 50 basis point rate hike from the ECB.

Ian Lyngen:

The consensus was for a 25 basis point move. And the fact that they over delivered wasn't that much of a surprise, given the discussion in the media about the probability of a 50 basis point hike beforehand.

Ian Lyngen:

Recall, this is becoming a trend of global policy makers to “leak” the decision in the traditional radio silent period.

Ben Jeffery:

And within what we heard from Lagarde, there was a very relevant nuance that she hinted at, which I would argue is becoming one of the most hotly debated topics around the hiking cycles that we're seeing from the ECB, from the BOC, the BOE and the Fed.

Ben Jeffery:

And that is that even though liftoff in Europe was larger than expected, and remember, we got that surprise a 100 bp rate hike from the bank of Canada last week.

Ben Jeffery:

Lagarde went as far as to explicitly say that, even though they're moving faster, that doesn't mean that the finish line for the hiking cycle is at a higher terminal rate level.

Ben Jeffery:

And I would argue it was that comment that triggered the reversal of the early increase in yields we saw in response to the 50 bp hike that ultimately resolved in a rally across the curve that was led by the belly very much in keeping with the idea that it's the terminal rate assumption that matters most for the belly of the curve.

Ben Jeffery:

And even though policy rates are moving up quickly, that doesn't necessarily mean that they're going to get to a materially higher level. And that's something we've certainly seen reflected in the Fed Funds futures market with terminals still being priced late this year, early next year, at somewhere around 3.50.

Ian Lyngen:

I'll be the first to admit that I came into Thursday's session assuming that the ECB would be largely a non-event for the Treasury market, even with a 50 basis point rate hike.

Ian Lyngen:

And if we look at the price action that immediately followed the 50 basis point move, we can see that the Treasury market was listless, to put it mildly, slightly higher in rates.

Ian Lyngen:

And as you point out Ben, it wasn't until the terminal rate comment that we actually saw some significant flows start to materialize.

Ian Lyngen:

Recall that there was a notable block buyer in FV. That was the initial trigger for the rally and reflected a degree of growing apprehension regarding the possibility of a European recession in the coming quarters.

Ben Jeffery:

Ian, what do you think the ECB's decision means for the Fed? After that 50 basis point hike, I think you and I both received several questions on, does this mean that the Fed's going to be going by a full percentage point on Wednesday?

Ben Jeffery:

Or does the more aggressive stance in Europe take some of the pressure off Powell to be unduly hawkish, both in July and then in September as well?

Ian Lyngen:

I think that the fact that the ECB has now joined the ranks of the hawkish central bankers bodes well for the ability for the global central banking community to keep forward inflation expectations contained. And that's precisely what we saw after the ECB’s move was a push lower in breakevens in the US and that follows intuitively.

Ian Lyngen:

And so, I'm erring on the side of assuming that if more of the heavy lifting is being done by other central banks, the Fed won't need to be quite as aggressive.

Ian Lyngen:

I still think that the Fed goes 75 basis points on July 27th and then another 75 basis points in September. Now, the November and December meetings; however, become far less obvious, particularly if we do see any further evidence that the jobs market is continuing to normalize and that real consumption remains under pressure.

Ben Jeffery:

And on the jobs front, we did receive some interesting new information this week, both via Initial Jobless Claims that on a four-week moving average basis are now back to their highest level since late 2021, extending the trend of the slow increase that we've been seeing.

Ben Jeffery:

But also as corporate earnings season rolls on, we've now seen several headlines on slowing the pace of hiring, hiring freezes, or just a general rethink of the appropriate size of workforces given the headwinds that are increasingly starting to face revenue growth and what that will ultimately end up necessitating in terms of cost savings in order to preserve profitability.

Ben Jeffery:

So while no, we've not yet seen sweeping layoffs make their way through the economy, we are starting to see the pace of hiring slow, and that's going to make the weekly jobless claims figures, but also the NFP numbers that we're going to get over the next several months, especially relevant in assessing what might be an approaching inflection in the trajectory of the jobs market.

Ian Lyngen:

And recall that the employment statistics are notoriously lagging indicators as they reflect decisions made weeks, if not months earlier. And they're also a gauge of sentiment in so far as firm's willingness to add to payrolls.

Ian Lyngen:

It's in this context that we'll be watching the Labor Force Participation Rate because as prices have increased and spendable real dollars have been reduced, it wouldn't be out of character for the US labor force to see participation increase, particularly in the less than 55 year old cohort.

Ben Jeffery:

And while that may on the surface be detrimental to the overall unemployment rate, it will presumably take some of the upward pressure off nominal wages that we've been seeing, which is as we've heard from Powell, exactly what the Fed is trying to do in order to avoid that wage price spiral that would risk self-perpetuating inflation that could accelerate in a very harmful way.

Ben Jeffery:

I would argue, this is exactly why we are now discussing three back-to-back 75 basis point moves from the Fed and rate hikes of a surprise magnitude from central banks everywhere, except of course, the Bank of Japan.

Ian Lyngen:

The Bank of Japan's decision not to change the ban for yield curve control, and in fact, to come out and reiterate that they are committed to YCC and keeping rates negative has reinforced the weakness that we have seen in the yen.

Ian Lyngen:

And one of the things that has characterized 2022 thus far in the Treasury market is the conspicuous absence of Japanese investors. In fact, Japanese investors continue to be net sellers of overseas notes and bonds.

Ian Lyngen:

Now, part of this is a function of the fact that hedging costs are so onerous and the weakness in the yen certainly has not helped that case.

Ian Lyngen:

What we're anticipating is that a period of stability in the yen over the course of the summer will alleviate some of the issues with hedging costs and provide the incremental incentive at least to get Japanese investors back in buying Treasuries, which will ultimately reinforce our expectation that the 3.50 level in 10-year yields will represent this cycle's peak. And from here 2.70 is the most obvious target.

Ben Jeffery:

And this is something that you and I have been on board with Ian, but is also a theme of this year that we've heard among clients and that is: generally, market participants have been thinking about 2022 in three distinct phases.

Ben Jeffery:

The first half of the year was always going to be defined by these eye popping inflation numbers that we've been seeing combined with a global central banking community that's moving aggressively to contain inflation.

Ben Jeffery:

I think you and I both agree that pointed to higher yields and probably more apparently a flattening and deeply inverted yield curve. But now we're reaching the point where we've seen a period of stability after we got 10s to that 3.26 and then ultimately 3.50 level that advocates more for a range trading bias in being a bit more tactical in terms of outright duration with maybe keeping that flattening lean on.

Ben Jeffery:

And now that we're making our way more completely through the summer months, we're starting to see in some of the positioning data, but also just anecdotally that the range trading idea is giving way more to a dip buying mentality and investors more aggressively picking spots to either take off shorts or start adding core or long duration positions in a more material way.

Ben Jeffery:

Some of the survey based measures we look at still show that real money is underweight their benchmarks, which points to capacity to add duration in the long end. And especially as these slow down worries become more pronounced.

Ben Jeffery:

It's going to be that buying behavior that I think we see push yields even lower from here and why we're still holding that 2.50 target in 10s to end 2022.

Ian Lyngen:

I'd also note that one of the questions that we've received several times this week has to do with the prudence of shifting a bias from flattening to steepening.

Ian Lyngen:

Now, the logic holds that we've gone through the process of fully pricing in the Fed's rate hiking cycle. And if in fact, the economy is poised to materially slowdown that the next logical move would be a re-steepening of 2s/10s that occurs in a bullish fashion.

Ian Lyngen:

Now, if we've learned anything this year, it's that the unwind of the Fed's balance sheet and the introduction of QT turned out not to be the massive steepener that some had anticipated.

Ian Lyngen:

So as we think about the most reasonable path forward to a steeper curve, it does occur in the form of the market pricing in more rate cuts from the Fed in 2023.

Ian Lyngen:

Now, as we ponder 2023, it strikes us that the market has already shifted to pricing in aggressive rate cuts in 2023. As it currently stands, the market's reflecting roughly 45 basis points of rate cuts from the Fed next year.

Ian Lyngen:

And it strikes us that even in the event that the Fed causes a recession of some significance that the relevance of inflation and the fact that the year-over-year measures that are going to struggle to mean revert by the end of this year, does imply that the Fed might need to keep rates on hold longer than it has in prior cycles. Said differently, a 2s/10s re-steepener makes sense but it's far too soon.

Ben Jeffery:

And one of the issues we've discussed frequently, both as the Fed was cutting and as the Fed has been hiking, is whether or not the market can force the Fed's hand to do either of those things.

Ben Jeffery:

What leaves me somewhat more concerned about 2023 is that with the market already pricing in rate cuts by the end of next year, the Fed is going to have to actively push back against that even to keep rates on hold at terminal, wherever that may end up being.

Ben Jeffery:

And in practical terms, what this means for financial conditions is that even if the Fed is not hiking, by leaving rates on hold in contrast to what the market is pricing, that will still push financial conditions tighter.

Ben Jeffery:

And that's the risk to equities, and frankly, overall market volatility that needs to be on the radar once the Fed does shift from hiking mode to a period on hold that will presumably set in in the early part of next year.

Ian Lyngen:

Said differently, at the beginning of this year, financial conditions tightened long before the Fed delivered its first rate hike. So in effect, the market was tightening for the Fed.

Ian Lyngen:

Fast forward to the middle of next year when the market anticipates that the Fed would/should be cutting rates. And instead of the market easing for the Fed by easing financial conditions, a selloff in the equity market will have the exact opposite impact; therefore, tightening financial conditions all the more. And that will leave the Fed in a difficult spot because the only way that they can conceivably address that is by cutting rates.

Ian Lyngen:

This also brings up another question that we receive this week and that is, would the Fed cut rates while still letting the balance sheet unwind in the background?

Ben Jeffery:

We don't think so.

Ian Lyngen:

Very little chance. Nonetheless, it is interesting to ponder whether or not QT could withstand a couple small fine tuning rate cuts. We think that the first thing that the Fed will do, if concern grows that the economy is slowing too quickly and the unemployment rate is increasing too sharply is address the balance sheet unwind. And frankly, that could be a H1 2023 issue.

Ben Jeffery:

One thing's for sure, we always knew 2022 was going to be a hard year for central bankers. And now, it looks like 2023 will be as well.

Ian Lyngen:

2030 is looking pretty good though.

Ben Jeffery:

That assumes a lot.

Ian Lyngen:

On a forward basis.

Ian Lyngen:

In the week ahead, the Treasury market will have a wide variety of new information from which to derive trading direction. First and foremost will be Wednesday afternoon’s FOMC rate decision.

Ian Lyngen:

Current expectations hold that the Fed will deliver another 75 basis point rate hike. This is in line with our thinking and as we ponder how the Fed will frame the move, I think it's useful to consider the outright magnitude of the rate hike implies a particularly hawkish framing on the part of the FOMC. So certainly in the statement, we would expect the language to outline the necessity of such a dramatic move.

Ian Lyngen:

On the other hand, the press conference carries with it a bit more event risk insofar as there isn't an updated SEP or projections. So, Powell’s tone and sentiment will be more market impactful.

Ian Lyngen:

If the Fed is uncomfortable committing to another 75 basis point rate hike in September, we might see a more dovish characterization of the hike, or if as we're anticipating, Powell leaves a 75 basis point move in September on the table, then the hawkish hike narrative will persist.

Ian Lyngen:

On Thursday, it's notable that we see the first look at second quarter GDP, recall Q1 GDP printed at negative 1.6% in real terms, that was a function of the impact of the stronger dollar on net exports, as well as the fact that inflation was so high that real spending took a hit.

Ian Lyngen:

For the second quarter, the consensus is at plus 0.5%. The GDPNow tracker is at negative, roughly one and half percent. So if nothing else, it will be a traded event in so far as two negative back-to-back quarters if real GDP have historically been characterized as a recession. But that doesn't mean that rule of thumb will apply during this cycle.

Ian Lyngen:

And that observation stems from the fact that the unemployment rate is at 3.6% and the overall labor market remains on strong footing. Nonetheless, it goes without saying that even a technical recession in the first half of this year won't derail the Fed next week, and it won't derail the Fed from pushing forward with the objective of getting monetary policy rates back above 3%.

Ian Lyngen:

Let us not forget the upcoming week's Treasury supply. On Monday afternoon, we have 45 billion in two-year notes. On Tuesday, we have 46 billion in fives, and then on Thursday, 38 billion in sevens.

Ian Lyngen:

If anything, the front loaded supply should alleviate some of the downward pressure on rates that we've recently seen in the two-year sector in particular, and contribute to a deeper inversion of the 2s/10s yield curve, which is trending at roughly negative 20 basis points after dipping as low as negative 27 and a half.

Ian Lyngen:

We'll also have month end considerations. So, all else being equal, following the seven-year auction, and into Friday's close, we'd look for duration to outperform.

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 great heat wave hike wave of 2022 is now upon us, stay hydrated, stay in the shade. And most of all, stay out of the steepener.

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.

Ian Lyngen:

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.

Ian Lyngen:

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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