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Summer Jobs - The Week Ahead

FICC Podcasts 26 mai 2022
FICC Podcasts 26 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 31st, 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 173: Summer Jobs. 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 May 31st. With the May payrolls report quickly approaching, we cannot help but be a bit nostalgic for our first forays into the labor force. One of us started out as a newspaper delivery professional while the other was a lacrosse coach. Hint: it takes three first names to play lacrosse. Doesn't it Benjamin Herbert Jeffrey? At least he's not the third.

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 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. That being said, let's get started.

Ian Lyngen:

It was an exciting week in the Treasury market. We saw a pretty significant rally that had 10 year yields as low as 2.70. The yield curve initially started the process flatter, but ultimately ended up re-steepening somewhat, particularly in the 2s/10s space. Now this contrasts with the fact that we did have $47 billion in the two year auction on Tuesday, but this was an auction that was very well received, particularly given the overall state of the market with a 0.8 basis point stop through.

Ian Lyngen:

It's been a while since there's been such demonstrated demand for the front end of the curve, and that would follow intuitively given the notion that the Fed has signaled, yet again, that they're going to continue moving forward with two 50 basis point rate hikes at the upcoming meetings followed by a transition to a cadence of 25 basis points in September. Now the biggest question in the market at this moment is whether or not the selloff in risk assets is ultimately going to prove sufficient to derail the Fed's plans.

Ian Lyngen:

Our read is that by forward committing to the two 50 basis point rate hikes, Powell has effectively locked the Fed into this course of action. Now, this isn't necessarily a negative thing. After all, there is a strong incentive to, at a minimum, normalize policy rates, which implies getting Fed funds back to neutral. Admittedly, neutral is more of a state of mind than anything else at this point, given the wide range of estimates, somewhere between 2 and 3% for Fed funds. Nonetheless, we're comfortable with the characterization of neutral as a level that you'll know not when you get there, but once you've passed it. And to a large extent, that's what the market is grappling with at the moment.

Ian Lyngen:

Has the market's willingness to price in a full rate hike cycle so early in the process led to tightening of financial conditions that we would typically see much later once the Fed had already gone through neutral. That's the biggest uncertainty, and to a large extent, why we're seeing equities continue to struggle here. Now it goes without saying that an extended period of stabilization in risk assets would be a net positive for the outlook, particularly in equities, but at the same time, it's worth noting that if we see stabilization in stocks, that will serve to reinforce the Fed's hiking ambitions. Said differently, a rebound in equities will give the Fed the all clear signal to continue normalizing rates with rate hikes at every meeting this year, continuing on to 2023.

Ian Lyngen:

Moreover at this stage, a rebound in stocks would increase the terminal rate assumption for this cycle. Whether that gets us materially above 3% or not remains to be seen, and more importantly, we've yet to see the extent of the fallout from the 20% correction in the S&P 500 and what that might mean to current or forward consumption plans. Recall that the wealth effect is very meaningful insofar as it does drive disposable spending, and in an environment where the pandemic has brought forward retirement for a significant amount of the 55 and older cohort, the notion that equities are now underperforming and prices are higher, might easily translate into shifting patterns of consumption and the reintroduction of austerity on the household level.

Ben Jeffrey:

So the price action this week in the Treasury market to me suggested that there is some growing skepticism the Fed will actually be able to follow through on what the Fed has told us they are planning to deliver, but we haven't heard anything from either the minutes on Wednesday or any of the Fed rhetoric to suggest that it's time to truly question Powell's commitment to give us two more 50 bp hikes with more to follow, to bring policy to neutral and beyond.

Ian Lyngen:

I think in practical terms, two 50 basis point rate hikes, one in June and one in July, not only represents the path of least resistance, but Powell has, for better or worse, forward committed to this process. For the Fed to start to back away from those two half-point hikes, I think, would become a real credibility issue. Also keep in mind, inflation has been set forth as public enemy number one for the real economy, as well as financial markets. For the Fed to shift course at this point, I think, would increase the level of investor angst and presumably further weigh on risk assets, at least in the medium term. Now, would there be a knee-jerk bounce in stocks if the Fed were to moderate the pace of rate hikes? Of course, but whether that ultimately translated through to a rebound of any meaningful magnitude is far less obvious.

Ian Lyngen:

The other aspect of this that is worth exploring is the relationship between financial conditions and the Fed funds rate. Unlike in any prior cycle, the market has been very willing, and frankly eager, to price in the full extent of the expected rate hikes. As a result, Fed funds futures reflected a terminal rate above 3% as recently as mid-May. Fast forward to Memorial day weekend, and those assumptions have been significantly curtailed. However, given the volatility in equities, the increase in real yields, the strength of the dollar and the widening of credit spreads, financial conditions are now back to the level seen in 2019, when Fed funds were at 2.50. So said differently, the market is doing a lot of heavy lifting during this hiking cycle, leaving the Fed with the only obligation of following through on what's being priced in, or if they deem it prudent, to moderate the selloff in equities, they can use the well-established communication channels to augment investors' understanding of their current reaction function, i.e. They could dial back the hawkishness.

Ben Jeffrey:

And a very important aspect of the Fed committing to three consecutive 50bp rate hikes is that they're able to, as you point out Ian, walk back the hawkishness and offer the relatively dovish impulse of slowing rate hikes without actually increasing the amount of accommodation they're providing. Even dropping the size and pace of rate hikes to 25 basis points every meeting is double the rate that Fed funds was climbing from 2016 to 2018. Through that lens, the Fed has given themselves the flexibility to continue pressing on the economic brakes, but perhaps not quite so aggressively as 50 bp rate hikes once every six weeks. It's also worth acknowledging that, unlike last week, we've seen stocks not surge back to the latest peaks, but nor has there been another round of consistent down 2, 3% days in domestic equity indices, which in terms of the overall state of market functioning and volatility, does provide both investors and monetary policy makers some breathing room as the financial system re-calibrates to both the new economic and global monetary policy realities that have come to define 2022 so far.

Ian Lyngen:

Let's talk a little bit about the economic data. We saw a very weak new home sales print for the month of April. Expectations were for the pace to decrease by roughly a percent and a half. We saw a 16.6% decline. Now this is clear evidence that monetary policy is having its logical impact with higher mortgage rates leading to lessening demand for what is arguably a very hot housing market. But the implications from this shift might have larger ramifications. If we look at the surprise index of economic data, for example, what we see is, at present, the surprise index is negative 39, which is the lowest it has been since mid-September 2021. For context, during that period, 10 year yields were roughly 145 basis points lower than current levels. Now granted, this measures the economic performance versus expectations, as opposed to looking at the growth profile in the US in outright terms.

Ben Jeffrey:

It's the expectations component of that that's really useful in thinking about the latest price action we've seen in Treasuries. We were looking for 2.75 in 10 year yields to be achieved, and we got through that level as low as 2.70, right around the five year auction. This suggests that Ian, you and I, as well as the market as a whole, have reached this point where maybe the conversation needs to turn to the other side of this economic cycle. We've gotten a very solid rebound from the depths of the pandemic. It's taken place very quickly, sure. Now there's already growing evidence that the corporate sector is starting to feel profit squeezes and consider the appropriate size of their workforces and other dynamics that were far more typical of conversations that we were having around the eighth and ninth innings of the last economic cycle. But in the current paradigm, it's taking place slightly more than two years after we saw the recession associated with the pandemic.

Ian Lyngen:

Setting aside your golf references for a moment, Ben, I think it's a very important point to emphasize the speed with which everything has occurred during this cycle. If for no other reason, then it implies that as we start to trade the potential for a recession, it's not a one off move, but rather we are bringing forward a typical narrative at a time when the market, as mentioned earlier, has already made significant progress in tightening financial conditions. Now to say that this complicates the outlook for the Fed would be an understatement, particularly when we layer on top of this the fact that the ECB is readying to begin hiking rates, and generally speaking, most Western central banks are into their tightening cycles.

Ben Jeffrey:

We also did have the final of May's Treasury auctions this week. Twos, fives, and sevens. It was very interesting to see, one, the strength of the bid that met twos despite no discernible concession, and two, the tail that was required at the five year auction and what this suggests about the willingness of auction participants to buy at current levels. For the first time since earlier in 2022, we actually saw last month's auctions clear at higher yields than this month's.

Ben Jeffrey:

This speaks to this idea that you've been talking about, Ian, which is now that we've seen the grand repricing of 2022 so far, it may be time for a bit of a period of stabilization now that we have greater clarity on what the Fed is going to deliver and positioning has become a bit more balanced. Remember it wasn't that long ago that two year yields were at 2.85. Now that we've rallied back through 2.50, I think it's safe to say that the hawkish monetary policy assumption extremes and bearish valuation extremes are probably in the rear view mirror, at least for the next several months, as we continue to watch how the economy performs, how inflation may or may not moderate and what that will ultimately mean for the likelihood of a more material slow down in 2023.

Ian Lyngen:

This is certainly consistent with the notion that 3.2% will represent the upper bound of trading for 10 year yields, and this conforms with the broader seasonal patterns that tend to favor lower yields between now and the middle of September. We have started to see some early evidence that Japanese investors are once again reengaging in the markets. The last two weeks of data from Japan's Ministry of Finance has shown a net buying of nearly eight billion in overseas notes and bonds. Now, this did follow a very long stretch of effectively 15 weeks of straight selling, which totaled nearly $75 billion. So a drop in the bucket, perhaps, but from a directional perspective, it is encouraging to see Japanese investors once again buying bonds. Now, we'll offer the caveat that this data doesn't just represent US Treasuries. It includes all sovereign debt, but historically the vast majority of the flows have been into Treasuries.

Ben Jeffrey:

Then thinking about large pockets of foreign demand for Treasuries, we're also learning a bit more about the situation in China and what is gradually seeming to be the removal of some COVID restrictions in Shanghai, a presumably improving logistical situation there. But from the perspective of global growth, we also learned that Beijing is going to deliver more stimulus to impact some of the effect of these lockdowns, the PBOC cut rates, and while growth in China is surely not going to be great in 2022, the stimulative efforts from the official side should presumably help take some of the edge off the downside there. Nonetheless, given the increasing role that China is playing in global output, not to mention their critical place in terms of international trade, these sorts of issues add to what is a growing list of reasons to like owning Treasuries, whether you're a foreign investor or a domestic one.

Ian Lyngen:

Let's not forget that Treasuries have historically traded with an embedded insurance policy implied. By that, I simply mean that one wants to be long Treasuries in a variety of different scenarios that could lead to safe haven flows. Geopolitical uncertainty, a slowing global outlook, concerns about a potential for a US recession, all reinforce the baseline value proposition of US Treasuries as a global asset.

Ben Jeffrey:

That's quite the sales pitch for Treasuries, Ian.

Ian Lyngen:

I wouldn't be selling them here. I'd be buying them.

Ben Jeffrey:

You're welcome, Janet.

Ian Lyngen:

In the holiday shortened week ahead, the Treasury market will see the Marquee Data of the May non-farm payrolls print. Expectations are for an increase of 350,000 jobs, and the unemployment rate at 3.5%. This is a down tick in the unemployment rate from April's level of 3.6%. The recent labor market data has demonstrated, if nothing else, that the jobs profile remains very strong in the US. The one caveat that we'll offer has to do with labor force participation. At 62.2%, labor force participation overall is lower than one might have otherwise anticipated it would be at this point in the cycle. In examining the progress of labor force participation throughout the pandemic, what we see is that the 16 to 19 year olds were initially stopped out very early in the pandemic, but as 2022 unfolds, we see participation in that age group is back to its pre pandemic levels.

Ian Lyngen:

The 55 and older cohort did see retirements brought forward and labor force participation decline in that context. We don't expect that will be reversing any time soon. It's primarily the 45 to 55 year old group that continues to see lower labor force participation. That certainly begs the question of what's keeping the subset of the labor force sideline. If we see the combination of higher prices and growing economic uncertainty start to undermine forward expectations, will we see people reenter the jobs market and put a cap on the amount of upward pressure that we have seen in wages? This is one of our baseline expectations for the balance of the year and is consistent with the notion that the real economy might be slowing more quickly than the market anticipated at the beginning of the year. We are reminded that employment is a lagging indicator, and as such, we wouldn't expect to see the overall jobs figures undermined this early in the cycle.

Ian Lyngen:

This notion has been reinforced by the fact that jobless claims continue to remain close to 200,000, so very good figures in that regard, and there hasn't been any material evidence via the surveys or the other proxies of employment to suggest that we'll see weakening any time soon. Nonetheless, the market is unquestionably on guard for any evidence that the broader sentiment reflected in risk assets is translating through to the real economy.

Ian Lyngen:

If nothing else, Treasuries will be trading off of consumer confidence on Tuesday, ISM manufacturing on Wednesday, and ADP on Thursday in the setup to the official BLS data on Friday. We anticipate that the curve will remain range bound, and if anything, downward pressure on 10 and 30 year yields will develop over the course of the first half of June as the June 15th FOMC meeting comes into sight.

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. As we enter the long holiday weekend with the ever elusive early close, we'll take a page from the Buffet manual, Jimmy, not Warren and observe it's two o'clock somewhere.

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. Please email me directly with any feedback 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 [inaudible 00:20:51] Incorporated, 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 or 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 suggestion that any investment or strategy referenced herein may be suitable for you.

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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