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The Core Issue - The Week Ahead

FICC Podcasts 13 avril 2022
FICC Podcasts 13 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 18th, 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 167: The Core Issue 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 April 18th. And if we learned anything from the March inflation data, it was an answer to the question when is a six and a half percent increase in core consumer prices a reason to buy bonds? When the market was expecting 6.6. Really?

Speaker 2:

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, 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 I-A-N.L-Y-N-G-E-N@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 in the US Treasury market, we saw what we will characterize as a remarkably impressive correction in the price action that had defined the bulk of the last several weeks in trading. Specifically, what had been a decided bare flattening trend that brought Treasury yields to the cycle highs has corrected into a bull steepener. Now the steepening aspect of it will suggest is more episodic and a function of the supply that came online, both on the corporate side as well as from the US Treasury.

Ian Lyngen:

What's more notable is that this has occurred with yields lower on an outright basis. Now, ostensibly, the market used the disappointing core CPI print as an excuse to trigger the buying, but the technicals have been oversold for quite some time and the curve skewed toward its flattening extremes both of which create the perfect dynamic for an in range correction. Such a move in this context is more tactical in nature, and will provide investors the opportunity to reset flattening trades.

Ian Lyngen:

This holds true for both 2s10s as well as 5s30s. We're not yet at the point in the cycle where one might assume that this degree of steepening will translate through into a continuation. Said differently, this is not the beginning of a broad-based reversal, but rather a tactical move that will ultimately resolve in the resumption of the prior flattening trend. The bigger question in our mind is whether or not it ultimately ends with a reestablishment of the trend toward higher rates.

Ian Lyngen:

We've been of the mind that the second quarter of 2022 was always poised to represent the upper bound for yields and that at the end of the day for 10 and 30s at least, the year would be defined as a higher range than we saw in 2021 in terms of US rates, but nonetheless a range for yields. In the very front end of the curve; however, twos, threes and fives will continue to have upside as the year plays out. The caveat there being if one looks at the terminal rate assumption that's being priced in Fed funds futures, for example, you can see that 3% was reached in the week just passed.

Ian Lyngen:

That suggests to us, at least, that the market is comfortable pushing back against what is perceived to be a Fed in maximum hawkish mode as we move forward into an environment where core inflation might actually have been transitory and a function of pandemic-related distortions. As we consider inflation data during the second quarter of this year, the base effects do imply that the peaks for year over year inflation have already been established, especially on the core side.

Ian Lyngen:

But one has to assume that to a large extent, people have incorporated that into their trading outlook. And so what we'll be anticipating is that we'll see a continued drift lower in used auto prices, home price appreciation start to moderate in terms of the gains that are translated through to the core CPI series. And at the end of the day, a more durable divergence between headline inflation being driven by gasoline and food prices, and the balance of the core inflation complex mean reverting albeit still at elevated levels versus what we saw prior to the pandemic.

Ben Jeffery:

So we got March's inflation data and it was 6.5% year over year on a core basis, but yet that was disappointing?

Ian Lyngen:

I would argue that what we're doing as a market is we entering the stage where the Treasury market, which had been content to push forward with the process of repricing to a higher rate environment is now searching for incremental reasons to buy the dip. So in the details of the core inflation print, what we saw was that the 3/10ths of a percent increase during the month of March was notably lower than the half a point consensus and marked the lowest monthly gain since 2021.

Ian Lyngen:

More importantly, when we look at the details within the core CPI series, what we see is that the used car series declined 3.8%, which was effectively one of the two core pillars that had been keeping core inflation on an upward trajectory throughout much of the last 18 months.

Ben Jeffery:

So call the factors that inspired that core CPI miss, the variables formally known as transitory. And I do think that that the divergence between core and headline prices highlights something that's probably going to be very topical as we start to make our way through the second quarter and into the summer months. Which is that given the war in Ukraine, given the ongoing supply chain issues that continue to linger in the pandemic's 17th inning, there will still be upward pressure on prices. And that will probably be most pronounced on the headline series.

Ben Jeffery:

So the question then becomes is the Fed's laid out focus on core inflation going to mean that moderating gains will lead to a less aggressive path of normalization at say the July FOMC meeting, or will the fact that headline inflation is going to remain high, keep the committee resolute in their mission to continue pushing policy rates higher?

Ian Lyngen:

Well, not to be too cynical and on the topic of resolute, I think a lot of it has to do with the political side. Let us not forget the midterm elections are in November. And given that the Biden administration has made inflation one of their number one economic agenda items, it goes without saying that between an aggressive Fed and the release of oil from this strategic petroleum reserve that the White House is doubling down on the war against inflation. Let's see how that plays out.

Ben Jeffery:

And that makes the response in the market to CPI all the more noteworthy. We saw two-year yields that traded as high as 259 on Monday reach 229 on Wednesday in the wake of the PPI release. And this hints at the dynamic that the market was content to price a meaningful amount of hawkishness exactly as we've been discussing, Ian. And now with some evidence that inflation may be moderating even without the benefit of tighter monetary policy, investors are walking back some of the more aggressive hawkish assumptions.

Ben Jeffery:

Now I think you and I are on the same page that doesn't meaningfully re lose the probability of a 50 rate hike in May, probably not even in June. But it does suggest that maybe at the July meeting we will see a down shift back to what was originally the consensus and 25 basis point hikes at every meeting.

Ian Lyngen:

Well, one thing that I am reasonably confident about is that there will not be a 50 basis point rate hike at the August meeting.

Ben Jeffery:

Forecaster of the month.

Ian Lyngen:

But in all seriousness, we are reaching a point in the cycle where the shape of the curve has gone from being an anomaly to being an essential question to the outright level of rates during the balance of 2022. And by this I'm simply making the observation that 2s10s inverted, 5s30s inverted, almost every curve except for the important one from the Fed's perspective, which is the three-month bill versus 10-year curve inverted. That was quickly followed by a relatively solid action of that move. And we have seen the curve re steeping out and I think this is the important part of the move, that occurred in a bearish fashion.

Ian Lyngen:

So if we were in fact entering an environment where we were going to see sustainably higher 10 and 30-year yields, for example, 10-year yields poised to breach the last cycles peak of 326, then we would all else being equal have assumed that the most recent rejection of the flattening would have occurred in bearish terms and pushed 10-year yields closer to 3%.

Ian Lyngen:

The fact that it didn't occur that way. And the fact that it was largely a two-year-led and implicitly Fed expectations-led move does speak to the fact that investors are starting to get increasingly apprehensive about the FOMC's ability to orchestrate a soft landing for the real economy. And let's face it, if we look back throughout the history of monetary policy, the one thing that I can say with a straight face remains remarkably elusive is a soft landing.

Ben Jeffery:

And despite the fact that inflation underwhelmed, prices on a year over year basis are still rising at their fastest rate since 1982. And this gets at one of our most frequently fielded client questions, which is why are 10-year yields not higher?

Ben Jeffery:

Isn't the market on edge that these higher prices are going to in turn translate to individuals demanding higher wages, which then increases spending capacity, which then drives higher inflation? Looking at average hourly earnings decidedly in negative territory would suggest that's not really a risk, at least not yet.

Ian Lyngen:

Well, and I think that's an important dynamic to keep in mind. So we're decidedly in the camp that the Fed in their effort to normalize rates and take the upside risk off of the inflation profile is consciously making the decision to forego a degree of growth to retain credibility as an inflation fighter. That does imply that they're bringing a recession forward, but we are not suggesting that they're bringing a recession forward to this year. Entirely different issues clearly.

Ian Lyngen:

But more importantly, within the narrative of wage gains leading to an inflationary spiral over time, there is an implicit assumption that Powell has it right when he says that the economy is currently strong enough to handle higher rates. Is the economy strong enough to handle higher rates this quarter and next? Unquestionably.

Ian Lyngen:

But is the economy strong enough to handle higher rates for a sufficient period to get that bargaining dynamic between wage earners, unionized or otherwise to push nominal and subsequent real wages higher? It would be nice to assume that was in the cards. But the reality is for us to assume that was in the cards, we would probably need to be much more optimistic, period.

Ben Jeffery:

And let's not forget before the pandemic, the Fed really struggled to get inflation to 2% from the downside. Achieving enough inflation in the system to meet their target was a challenge for the FOMC. And this is another delineation of the two schools of thought in the market, which is has the pandemic derailed the structural deflationary forces that we have seen persist over the past 20 years or so, or are those background factors still in place just being overwhelmed at the moment, given the massive economic shock that was brought on by COVID-19?

Ben Jeffery:

We are in the latter camp. And a big part of that has to do with technological advances, what that means for productivity, what that means for bargaining power for human workers, and the trend of automation that was already adding to the deflationary backdrop before the pandemic that was only accelerated during COVID.

Ben Jeffery:

We've already seen several components of the service sector opt to hire fewer people in favor of installing more machines. Whether that be kiosks or a greater reliance on apps, both of those nuances do not advocate for significantly higher real wages.

Ian Lyngen:

Now, the counter argument to this is that because of the global supply chain issues, as well as geopolitical uncertainty, the US economy is at a watershed moment in terms of getting resources from overseas. The flip side being the reverse of globalization or onshoring in one way, shape or form. While that certainly is topical and we suspect actively under way, the other issue in this context is it's inflationary, yes, but it also significantly compresses profitability.

Ian Lyngen:

I think that will be one of the major inhibitions to a wholesale shift back to onshore production. In practical terms, if we start to see a more meaningful hit to earnings with the backdrop of higher borrowing costs that's going to create a more significant repricing and risk assets, which translates through to tighter financial conditions and complicates the Fed's normalization ambitions all the more.

Ben Jeffery:

But to me, the complication of normalization ambitions should point toward a flatter curve. Why, Ian, do you think we've steepened out so significantly? 2s10s closing in on 40 BPS is a decided reversal from what had been that massive flattening move that got us inverted as recently as last week.

Ian Lyngen:

I can summarize it in a word and that's issuance. When we look at the nature of the price action that has occurred over the last several trading sessions, we've had two decided inflows in terms of new issuance. One is on the corporate side, there were several large, heavily duration-weighted yields that hit the market. And then, of course, the US Treasury Department was a big seller of 10s and 30s via the reopening auctions. I would argue that the price action was best characterized as a rally in the Treasury market in which the long end lagged.

Ian Lyngen:

Now that does sound a bit nuanced or as if it is an attempt to avoid acknowledging the steepness of the curve, but in the context of the shape of the curve, had it been only a supply issue and the overall level of rates relatively stable, one could have safely assumed that it would've been a bear steepener.

Ian Lyngen:

The fact that the front-end was bid, which was admitted consistent with taking out some of the medium-term upside risks for the Fed funds rate, nonetheless, the overall Treasury market rallied. And this reflects what we'll argue is a market that has been looking for a reason to start to scale into duration at what represents, certainly for this cycle, particularly attractive outright levels in yields.

Ben Jeffery:

So call that a parallel rally that was steepened by supply. And what we did see this week were two tailed long end auctions. 10s tailed by 3.1 basis points and the long bond by a full basis point. Very much in keeping with this idea that the outright level of rates and Treasury's position in the global financial system will bring in buyers to these massive auctions.

Ben Jeffery:

But depending on the yield moves around the events themselves, sometimes a bit of a primary market discount will be required. I would argue this week reflected exactly that dynamic.

Ian Lyngen:

And this is very consistent with the time-tested adage that there's no such thing as a bad bond, just a bad price. Ben, that's something to keep in mind when one considers attempting to pass through inflation cost to higher wages.

Ben Jeffery:

Wait, what is higher wages?

Ian Lyngen:

Oh, Ben, don't worry. They're not for you.

Ian Lyngen:

In the week ahead, the Treasury market will have a much lighter slate of economic data between a few updates on housing and the Philadelphia Fed manufacturing data, we don't anticipate that there will be a great deal to alter the broader macroeconomic outlook. Just as importantly on the supply side, we're coming off of a week that was particularly duration heavy with 10s and 30s and are presented with a week that has a $16 billion 20-year auction, as well as $20 billion of new five-year TIPS.

Ian Lyngen:

Interpreting the performance of TIPS auctions as it relates to the nominal market has always been a dubious process if nothing else. And the reality is that stronger demand for inflation over the next five years says remarkably little about forward demand phenomenal duration, especially an environment with a flattening curve and a Fed that has a signal that's willingness to do whatever it takes to keep inflation contained.

Ian Lyngen:

As we ponder real yields and the prospects for 10-year yields to get back into positive territory, we can't help but think about the correlation between higher real yields and underperformance in equities. The ramifications from higher real yields are difficult to ignore. And we would suspect that positive 10-year real yields would take the edge off of any potential upside in the US equity market.

Ian Lyngen:

While the Fed has yet to officially announce the balance sheet runoff program, the March FOMC minutes did a very good job of outlining what investors should expect. Specifically, $60 billion a month in Treasuries ramping up in three months, $35 billion a month in mortgages also ramping up over the course of three months.

Ian Lyngen:

Now such a pace even if reached earlier won't necessitate outright selling in Treasuries, but certainly not for the next several years, but could potentially lead the Fed to sell in the mortgage space. This is something that will remain a background factor and will be tracking if for no other reason than 30-year fixed mortgage rates are drifting closer to 5% than they've been in quite some time.

Ian Lyngen:

Bringing this back to the TIPS market, quantitative easing and outright bond buying was seen as having a much bigger impact in the TIPS market. The logic there being that the Fed's operations represented a disproportionate large amount of the float, if not the outright market in TIPS. Fast forward to the second half of this year when the Fed is expected to be actively unwinding the balance sheet via runoffs, it follows intuitively that there will be a bias for higher yields if nothing else.

Ian Lyngen:

We'll add that this trend will have the benefit of more Treasury issuance in this sector on an outright basis. As the Treasury Department has already signaled. In short, at this point we're unwilling to fade the modestly bullish price action that is developing in the Treasury market. Although we anticipate that the steepening nature of the move is short-lived and largely a function of supply.

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 with April showers, May allergies and the pandemic entering its 17th inning, what's not to like about spring 2022?

Ian Lyngen:

Thanks for listen 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.

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.

Speaker 2:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Inc., and BMO Capital Markets Corp. 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.

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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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