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Tightening Tensions - The Week Ahead

FICC Podcasts 20 mai 2022
FICC Podcasts 20 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 23rd, 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 172, tightening tensions, 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 May 23rd.

Ian Lyngen:

And as upper management has grown a bit too fond of reminding us, second prize is a set of steak knives, coffee is for closers, and if all else fails, Elmo is hiring in Times Square.

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, 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 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.

Ian Lyngen:

So that being said, let's get started. In the week just past, the Treasury market received a lot of new information, not least of which being comments from Powell, which confirmed that the Fed is on track to deliver another 50 basis point rate hike in June. This is also consistent with what the market has been pricing in, but it is an acknowledgement that the Fed is content with the price action that's occurred in risk assets as equities continue to correct lower, and the S&P 500 appears to be on track to lose 20% of its value year to date.

Ian Lyngen:

Now, as we consider the ramifications from the deteriorating wealth effect, it strikes us that the front end of the market has gone from being way too cheap, to just kind of cheap. Now, this is consistent with the market's perception that the Feds are going to continue to hike rates regardless of how other asset classes perform. We'll argue that to some extent, this is true up and potentially through neutral monetary policy. Now there is an active debate as to precisely where neutral is in the current environment. Is it 1.75? Is it 2.50? Is it higher? We'll argue that it's difficult to separate the policy rate from overall financial conditions.

Ian Lyngen:

Now, while the Fed has only managed to hike rate 75 basis points since this campaign started, the market has done the bulk of the heavy lifting for the Fed. And in fact, we see overall financial conditions back to levels seen in 2019 when the Fed Funds target rate was at 2.50. So this is meaningful context as we contemplate how the market will behave going forward.

Ian Lyngen:

We also saw continued underperformance in the housing sector with existing home sales disappointing, housing starts and housing permits below expectations as well. In addition, there was a miss in NAHB all of which points to the continued fallout from higher mortgage rates. Our target of 10 year yields at 2.75 came very close to fruition with this benchmark rate dropping as low as 2.77. The curve continues to flatten, and we expect that between now and the middle of June, that the 2s/10s curve will continue to compress as will 5s/30s with a nod to the fact that there will be increased moments of choppiness as investors adjust to the reality that the Fed will be following through on at least two more 50 basis point rate hikes and remain somewhat indifferent, at least for a time being, in the performance of risk assets.

Ben Jeffery:

So I know this is a rate's podcast, but we got to talk about stocks.

Ian Lyngen:

Is that the strategist equivalent of talking about Bruno?

Ben Jeffery:

We don't do that.

Ian Lyngen:

On the topic of declining value, the reality is that the Treasury market has been largely beholden to the moves in equities over the course of the last couple weeks. Now, this is in part a function of the fact that investors have been wary of any signs that the Fed's tightening has had an adverse impact on the economy or financial markets.

Ben Jeffery:

And it's a very poignant debate at this point, because there is a difference between the S&P 500 and the performance of the real economy. At this point, hiring remains robust, growth is okay, but still risk assets are coming under a meaningful amount of pressure in response to both the fact that we saw 10-year real yields close in on positive 36 basis points, and mounting concerns that the only way the Fed is going to be able to contain inflation is by pushing the economy into a recession.

Ben Jeffery:

Now, here recession is probably most aptly defined as two consecutive negative quarters of growth, nothing akin to what we saw during the pandemic or the global financial crisis. But nonetheless, at this stage, the collective outlook on the economic recovery is dimming quickly, and that is becoming increasingly reflected in stock valuations.

Ian Lyngen:

One new piece of information that the market received in the week just passed, was confirmation from several key retailers that it's becoming increasingly difficult to pass through higher input prices to the end user. The great deal of the wage-inflation spiral assumption is based on the notion that not only will consumers pay higher prices, but they can. And what's becoming increasingly evident is the fact that given higher oil prices, higher gasoline prices, and higher food prices, consumers are needing to make trade offs. So while aggregate consumption might continue to grow in nominal terms, there have been, and will continue to be sectors that underperform.

Ben Jeffery:

And assuming this underperformance, which as you point out, Ian, was highlighted in consumer staples this week, flows through to revenue misses and underwhelming profit performance on the corporate side, drawing out that thought process to its logical conclusion. That points to some uncertainty on the health of corporate balance sheets and the ability of corporations to continue hiring as aggressively as they have been since the depths of the pandemic, and what's been obviously a very impressive rebound in the labor market.

Ben Jeffery:

If we reach the point when that dynamic starts to come under question and corporations slow hiring or even start to entertain the idea of layoffs, at that stage the stagflation argument becomes much more compelling. I think you and I agree we're some ways off from that, but the only thing that's separating the current high consumer price paradigm from a traditional definition of stagflation, is the fact that the unemployment rate is at 3.6%.

Ian Lyngen:

And in that context, we did see a higher than expected initial jobless claims print. Now granted, it was in the low 200 range, so still consistent with a tight labor market. But as we consider the evolution of the labor market over the coming months, it's worth highlighting that with a labor force participation rate of just 62.2%, there is implicitly more slack in the labor force than the 3.6% unemployment rate might imply.

Ian Lyngen:

The biggest question quickly becomes, why did people leave the labor force and will higher prices and dwindling savings in real terms force workers to reengage in the job market? We won't have any meaningful clarity on this issue until we are well into the summer months, but nonetheless, as we continue to watch the equity market reprice lower, we cannot help but ponder what the impact from a declining wealth effect will have on the pace of consumption and the composition of the post-pandemic spending profile.

Ben Jeffery:

In Tuesday's interview with Chair Powell revealed a very interesting detail in how he is thinking about the current state of the labor market. And what he's gone as far as to say is, "Employment that is simply too tight, and wages that are growing at a rate that is not consistent with the Fed's 2% inflation target."

Ben Jeffery:

One of the questions posed centered on where the natural rate of unemployment lies in this post-pandemic world. Somewhat intuitively, Powell said, "Well, it's higher than 3.6%, which means that even an increase in the unemployment rate, whether that be a function of slightly higher joblessness or more people reentering the labor force, would still be in keeping with the Fed's mandate." That's a very intriguing departure from what we've seen over the last two years in that the Fed was committed to continue bringing people in from the sidelines, finding more jobs and driving wage growth.

Ben Jeffery:

Now, a portion of Powell's tightening motivation is actually the opposite. Clearly first and foremost is to contain inflation, but now it's become apparent that the committee would be comfortable with a slightly higher unemployment rate given where NAIRU now might lie.

Ian Lyngen:

And this is also something of a departure from where we started the year when Powell was characterizing price stability as key for hiring. So we've transitioned from higher rates being a net positive for the employment market, to the employment market running so hot that the Fed needs to apply the brakes to the real economy.

Ian Lyngen:

Nonetheless, regardless of how it's framed, the reality is that the Fed is committed to following through with rate hikes over the course of this year, almost regardless of how risk assets perform. We continue to expect that the Fed will hike 50 basis points when the FOMC announces its decision on the 15th of June. Another 50 basis points will be delivered in July. And then the transition to a 25 basis point per meeting cadence will occur in September. And that will carry through to the end of the year.

Ian Lyngen:

Now, there's always going to be the risk that the equity market corrects to an extent that financial conditions tighten so dramatically that the Fed needs to respond. Whether that is down 35% year-to-date, or down 40% really remains to be seen. But as we consider how the Fed might choose to pivot less hawkishly, if need be, the most obvious way would be to transition to 25 basis point hikes sooner, or to signal to the market that the committee's terminal rate might be lower than investors are currently assuming.

Ben Jeffery:

And that's a great point, Ian, and something that the Fed deserves some credit for after setting out so aggressively in the early days of this normalization campaign. Now that we're going to most likely get three back-to-back meetings with 50 bp rate hikes, the committee is able to introduce some dovishness by simply slowing that pace of tightening to 25 basis points per meeting. And even that is still double the pace of the rate hikes we saw from 2016 to 2018.

Ben Jeffery:

So the Fed can still signal that they're going to remove policy accommodation, while also offering some concession to those in the market that are worried that they're moving too aggressively

Ian Lyngen:

To say that the Fed has their work cut out for him, would certainly be an understatement given the balance of risk that we see playing out over the course of the next several months, but it's also consistent with the notion that the curve is going to continue to flatten. 2s/10s has now pushed below 19 basis points. And our next target is 13.8 basis points, which represents the lower bound of the range that's been in place for the last couple months.

Ian Lyngen:

Now, a breakout to reinversion is still in the cards, and we suspect that the next meaningful push to achieve this milestone will occur between now and the FOMC meeting.

Ben Jeffery:

Also in outright yield terms, we saw 10-year rates get as low as 2.77, and very close to that target, we've been watching at 2.75. It's been encouraging to see the transition of the flattener from what had been a very bearish one, to now becoming an increasingly bullish one. And I would argue that really has to do with some of the more macro concerns that we were discussing earlier, Ian.

Ben Jeffery:

As an additional constructive bullet point for duration, we also saw a 2/10ths of a basis point stop through for the 20-year auction at admittedly the highest ever yield for a 20-year auction. But nonetheless, the fact that 20-year refundings have tended to tail, and the fact we also saw a stop through for 30's last week, does suggest that we're starting to see better buying interest at these levels and investors starting to be willing to take advantage of the sell off we've seen so far this year.

Ian Lyngen:

This is very consistent with where we tend to see the seasonal shift in buying for Treasuries occur. The May refunding auctions have historically represented an inflection point for the direction of Treasury yields, and that appears to be playing out this year as well. This reinforces the idea that 3.2% will represent the upper bound for 10-year yields. And we'll also note that the Japanese Ministry of Finance data saw the first week of net buying since mid-January this year.

Ian Lyngen:

Now, while this doesn't necessarily represent a wholesale shift in Japanese investor behavior, it does point to a lessening of the potential selling from the region, if nothing else.

Ben Jeffery:

But it wasn't a universally strong week for Treasury supply. And we did see a three basis point tail at the 10-year TIPS reopening. That's the largest tail since May, 2020, and while an auction discount of that magnitude is certainly not out of the question in the TIPS market, the fact that we've seen a reversal of a trend that had been consistently stopping through TIPS auctions to now tailing ones, is emblematic of some faith on the part of the market that the Fed will be able to contain any material upside in inflation.

Ben Jeffery:

We once again saw 10-year breakevens drop below 2.70 in this past week, and from a higher level, the past two weeks' under performance of TIPS shows that there seems to be diminishing value in inflation protection in a world when the Fed, and frankly central banks globally, are so committed to limiting any further upside in consumer prices.

Ben Jeffery:

That doesn't rule out another episode of widening breakevens, especially if we see any more negative news on the supply chain front, but at this point, Ian, I think you and I are on the same page that peak inflation for this cycle is probably behind us.

Ian Lyngen:

Yes. And we're certainly sympathetic to the Fed's plight, insofar as they've been called upon to use monetary policy tools to address supply chain inspired inflation. And from our perspective, at least, we can certainly attest to the struggles of attempting to do the job without the right tools. Ben.

Ben Jeffery:

Ian, as I've told you, and as the leaders of my endeavors in youth athletics repeatedly reminded me, you can't coach stupid. And our goal is that way.

Ian Lyngen:

Goal? I didn't realize you played basketball.

Ian Lyngen:

In the week ahead, the Treasury market will continue to consolidate with a bull flattening bias as all eyes remain on the performance of risk assets. The Treasury Department will have three coupon auctions on offer, 47 billion two years on Tuesday, 48 billion five years on Wednesday, and 42 billion seven years on Thursday. Given the performance of the 20-year and the generally bullish tone demonstrated by the Treasury market over the course of the last two weeks, we expect that the auctions will be reasonably well received, all things considered.

Ian Lyngen:

We also get the FOMC minutes from the last meeting in which we expect the Fed will outline the extent to which there was disagreement on the committee in terms of participants looking for a more aggressive rate hike of 75, or a less ambitious 25 basis points. Note that the vote was unanimous at the meeting itself. So the FOMC minutes could be the ideal forum for any dissents to be articulated.

Ian Lyngen:

At this stage, given the state of the markets when the Fed last met, we'll air on the side of assuming if anything, the Fed minutes will be interpreted as being hawkish. This will in all likelihood translate through to an extension of the flattening bias that's been in place. And again, we continue to focus on that 13.8 basis point level in 2s/10s as the next relevant technical level, as the process of curve compression continues.

Ian Lyngen:

The data offerings are limited, but do include the April durable goods report; expectations there are for a 6/10ths of a percent increase in the headline number. And we also see the personal income and spending numbers, as well as core PCE, which is seen increasing 3/10ths of a percent for the month of April. There are GDP revisions, but those will likely be a non-event if for no other reason than the dismal negative 1.4% print from the first quarter has already been traded and we have moved on as a market to concerns that ongoing inflation will heighten the risk of stagflation in the coming quarters.

Ian Lyngen:

While the impact of higher equity volatility resulting from a spike in the VIX, associated with the selloff in stocks will continue to tighten financial conditions, there is little to suggest that we'll receive information from the Fed in the coming weeks regarding any response to the deteriorating wealth effect and what that might or might not ultimately mean to the pace and composition of spending at this point in the cycle.

Ian Lyngen:

All else being equal, we would expect to see an increased rotation away from non-necessity spending toward the necessities of food and gasoline, which will continue to illustrate to the consumer the deteriorating purchasing power in real terms, as consumer prices continue to rise.

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 Memorial Day Weekend approaches and barbecues and backyards replace thoughts of bonds and basis points, we're reminded that three day weekends should be increasingly cherished because this year's stock market performance implies that late retirement will soon emerge as a trend.

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.

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:

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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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