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'Tis the Seasonals - The Week Ahead

FICC Podcasts 14 mai 2021
FICC Podcasts 14 mai 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 May 17th, 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 Horizon's episode 120 ‘Tis the Seasonals 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 17th. As the seasonal patterns in the US rates market become topical in the wake of the May refunding, we're reminded that the absence of a concrete fundamental narrative doesn't negate their relevance. After all, if we shunned all the processes we don't fully understand, not only would there be no podcast, but the microwave would lose all usefulness to say nothing of the files that apparently live inside the computer. One of life's persistent mysteries.

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, 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 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.

Without question, the week just passed in the Treasury market was an exciting one. We had a very strong core CPI print. The highest since the early 80s. Headlines CPI also came in above expectations and intuitively, the Treasury market sold off. But what I find the most surprising is that the Treasury market selloff was remarkably contained. In fact, tens had trouble breaching the 170 level. And rates have since retraced leaving investors with the impression that the higher indent expected CPI won't be enough to materially reprice the overall rate level of the Treasury market. At least not for the time being.

Ian Lyngen:

Admittedly, the Fed did a very good job of excusing the data long before it happened. First, there was the emphasis on the base effects, which explain why the year over year prints were so shocking, but the Fed also preemptively characterize the spike in inflation as transitory. Fed speak that came after the release, reinforced the interpretation that the upside in CPI was transitory and really left the market without any clear takeaway in so far as the implications for monetary policy going forward. We continue to assume that if all goes well, tapering won't be a reality in Treasuries until the first quarter of 2022, that implies an official announcement in the fourth quarter and sets up Jackson Hole as the obvious venue for the proverbial trial balloons related to tapering.

Ian Lyngen:

There's a very active debate about how much in 10 year yields a taper would be worth. Our take is that the Fed learned so much from the taper tantrum of 2013, that the event itself will ultimately not be worth more than five to 10 basis points in 10 year yields. What will occur however, is we will see the communications related to tapering take on increasing significance the stronger the economic data becomes. At its essence, Treasury yields and the timing of tapering are going to be driven by the exact same inputs. So said differently, the market will respond and price in tapering long before the Fed needs to communicate it. Even in that context however, I'll suggest that our relatively consensus outlook for the timing of tapering has largely been priced into the market. So when the Fed ultimately confirms this timeline, we might see some modest price action in response to the clarity from monetary policy makers, but nothing that will recast the outright level of yields.

Ben Jeffery:

So… inflation like it's 1981.

Ian Lyngen:

Ben, what were you doing in 1981?

Ben Jeffery:

Absolutely nothing.

Ian Lyngen:

Oh, so just like now. Anyway, when we looked at the CPI print that initially came out on the core side at nine tenths of a percent month over month, it was frankly, quite shocking. If we look at the details, what we saw were an increase in used auto prices of 10% month over month, which largely reflects the chip shortage as well as the progression out of the pandemic as people get back to some version of normal life. If one subtracted out the impact of the chip shortage core prices would have still been up a little bit more than half a percent. So regardless of how one slices the data, there's little question that there was inflation in the system in the month of April. The big question now becomes, will it ultimately take on a momentum of its own? Or will price gains begin to moderate as the year unfolds?

Ben Jeffery:

And after the CPI release, the disappointing retail sales figures, I think add an important nuance around the inflation figures on just how transitory they were ultimately be. In some ways, the fact that the spending figures in April hardly lined up with a surge in inflation driven by robust consumption, reinforces the idea that the Fed has been on about, that the pickup in prices we're seeing now are driven principally by the supply side of things. And the simple fact that the economy is now getting going from what was effectively a dead stop. So naturally, as some of the kinks in the supply chain get worked out and as the new economy gets more materially underway, some of the factors that boosted prices in April are going to begin to fade, or at least that's the assumption.

Ian Lyngen:

Let us also not forget that the retail sales print, which was 0.0, is a nominal prices. So when we adjust for inflation as real GDP does, the pull back in the wake of March's strong spending figures doesn't bode especially well for growth during the second quarter. That said, it's still early enough in the cycle that we could see another strong Q2 GDP print. Although given how much of the fiscal stimulus was really concentrated in Q1, there is the underlying concern of whether the upside was simply front-loaded to the beginning of the year. And we'll struggle from here to keep up with expectations.

Ben Jeffery:

Ian, what do you make of the argument that it was that dynamic that resulted in a little bit of a counter-intuitive price response and that the knee jerk sell off in the wake of CPI didn't even get 10 yields through 170. And coming out of the pretty strong refunding auction, we quickly saw yields retrace back into that prior range to 162, which is effectively where they were before we even got the CPI read.

Ian Lyngen:

I think that there's no question that part of what is going on is the concern that supply side inflation in an environment where unemployment is still elevated, does hint of stagflation that will keep real growth contained. However, I think the broader underlying issue is one of the market's comfort in treading the economic data at this point. We saw this trend of indifference toward the data begin with the March nonfarm payrolls report, then reiterated with the April nonfarm payrolls report and now CPI. And we're still in a range that has started to become all too familiar. What I suspect will be fascinating is to see what actually breaks us out of this range. While equity performance continues to be strong on a year to date basis, we have seen stocks pull off at least modestly from the highs as inflation has come back into the system.

Ian Lyngen:

That's an important indication of investors reaction function in equities to higher implied prices. One of the big struggles for the next leg of the recovery is whether or not higher input costs will ultimately be passed through to the consumer. Yes, we saw inflation higher in April, but we also saw retail sales stumble. So we're reminded that higher prices that can't be passed through to the end-user lead to profit compression, profit compression ultimately takes the edge off of the upside risk for equities. And we find ourselves in a pattern of relatively benign gains, both in terms of the real economy, Treasury yields, and stocks.

Ben Jeffery:

There's an additional facet of that as well, which is given the nature of the shock to the economy and the labor market and the accompanying enhanced unemployment benefits, we're starting to see some news that some large multinational companies are raising wages in order to entice frontline service sector workers back into the economy. So while obviously this translates to a higher labor costs for those firms, it also does put some upward pressure on wages, which at least on the margin, adds to the argument of a consumption driven pickup in prices.

Ian Lyngen:

I'd suggest that we should be careful with that argument. Because while we will see increase in wages for some of the big multinationals on the frontline service sector level, that doesn't necessarily translate through to an increase in aggregate wages. Recall that during the beginning of the pandemic, average hourly earnings actually increased as the lower wage workers were taken out of the equation. Now, as we reintroduced the lower wage workers, it follows intuitively that we'll see downward pressure on average hourly earnings, perhaps with incentives in place for workers to come off the sidelines. Wages won't drop as much as they would otherwise. However, the larger number of lower wage workers we add into the equation, the more natural downward pressure they will be to say nothing of what happens when we adjust this all for inflation. As we saw with the April CPI series, real average hourly earnings year over year, we're down almost 4%.

Ben Jeffery:

Contributing to this idea of the data being extremely difficult to interpret and probably even more difficult to trade. What happens when we get through summer and either the bolstered unemployment benefits roll off, or there's another deal of some sort that gets through Washington? I think at this stage, it's probably unlikely that we'll get another round of direct payments, but to say that the next leg of the policy response from Congress and the White House is uncertain would be an understatement.

Ian Lyngen:

I'd also add that to imply the market knows how to trade whatever comes out of Washington at this point might be a bit misleading. Because while an infrastructure program is net positive for growth in the medium term, as well as for the employment market, the increase in taxes will create an offset that I suspect ultimately ends up outweighing any of the positive economic spin, if for no other reason, then the lag to timelines.

Ben Jeffery:

And on that front, I think there's also an argument to be made that the nature and the pickup of prices we've seen, could be operating as something of a tax on consumption. Gas prices are a textbook example in this regard. And while the Colonial Pipeline is now back up and running, these sorts of again, supply chain related shocks are presumably going to come at the expense of spending elsewhere, especially in lower and middle income households.

Ian Lyngen:

And all of this with a backdrop in Treasury rates that is remarkably similar to that, which we saw during the second half of 2019. The big difference being there is a lot more Treasury issuance to take down.

Ben Jeffery:

And this week, especially on another record matching refunding auction trio that by all accounts was met with very solid demand. We saw the fifth consecutive stop through at a new issue ten-year auction. And while 30s tailed 1.6 basis points, that is nothing, if not in line with the averages we tend to see it, their refundings. The bulk of the concessionary impulse around supply played out around tens as well. And really the fact that bonds rallied into the third year auction points again, to this idea that there continues to be a robust bench of demand for Treasuries in the primary market. Now we haven't yet received the investor class data. So exactly which type of accounts foreign versus domestic bought these bonds, won't be known for a few more weeks. If the auction stats were any indication, it's safe to say that this was an effective refunding week, which sets an encouraging stage for twenties on Wednesday, which will also be another $27 billion of duration to take down.

Ian Lyngen:

And this all at a period, when we have historically seen an inflection in the direction of Treasury yields to be lower rather than the upside that tends to be priced in at the very beginning of the year. Now we've made the arguments for the seasonals in the past, whether it is Japanese buying, it's the economic data not keeping up with expectations, or it's simply a recalibration of the outlook as more detailed becomes available. We recently received a particularly astute question, which was what, in our assumption for the path of rates going forward will be the catalyst to get 10 yields closer to 125, rather than 2%? And in response, we'll reference a comment made by Powell early in the pandemic. And that is that the passage of time will ultimately be what clarifies expectations for the pace of the recovery. I think it's fair to apply the same logic to the Treasury market as we get more information and we see the reaction function of other markets to reopening, to rehiring, and to reflation, we'll get a better sense for a true range for the dynamic equilibrium in Treasuries.

Ian Lyngen:

Our assumption is that everything that has transpired during the pandemic, while it will introduce upside risk for inflation in the near to medium term, it has done nothing to change the fundamentals of the US economy. Potential GDP is roughly where it was prior to the recession, the demographic issues that continue to impact the labor market and wages persist. We also have the longer-term downward pressure on prices from advances in technology, as well as the globalization of goods markets. All of which suggests that once we work through the volatile period of the incoming economic data and end up on the other side of the pandemic, the real economy will be faced with remarkably similar challenges to those which existed before the pandemic.

Ben Jeffery:

So what you're saying is even after all of this, we're right back where we started.

Ian Lyngen:

I never left.

 

Ian Lyngen:

In the week ahead, the Treasury market will continue to consolidate in the wake of what was an exciting week from a fundamental perspective. With the stronger than expected CPI, the upside surprise on PPI, and the flat retail sales print, the market still has a fair amount to digest as 10 year yields continue to drift slightly lower. There's very little on the economic data calendar. We do have housing starts, building permits, as well as a couple of manufacturing surveys, and existing homes. That said there's really nothing that will serve to reshape the overall outlook for rates. Instead, we'll be viewing the week ahead as an important period to focus on the technicals. Specifically after having that initial bearish price action, we've seen stochastics extend toward the bearer side only to crawl and cross now suggesting that the reversal will gain further momentum. In terms of levels to watch the 152, 155 level in 10 year yields resonates. It will be difficult to break 150, particularly on a closing basis. Without a material recalibration, a recovery expectations lower.

Ian Lyngen:

We're still early enough in the data cycle however that it will take more than a disappointing retail sales print in the context of stronger inflation to really undermine investors’ expectations for a reflationary period to dominate 2021. One of the key dynamics that we expect to play out over the course of the year is this summertime decline in Treasury yields that is so familiar and typical in this market with the caveat that this will not be a function of breakevens. Instead, it will largely play out in real yields. That means a real 10 year yields that are now roughly -90 basis points could move below -100, even to -110 basis points. This is very consistent with some of the challenges that we're expecting once the economy is fully reopened. And the idea that while the Fed is committed to bringing back all of the low wage earners initially displaced at the beginning of the pandemic, roughly eight million, still at this point.

Ian Lyngen:

The reality is that that will take much longer than the market was assuming when we came into this year. And as a result, the Fed will have an accommodative monetary policy stance, not bring forward tapering expectations and not be eager to lift the policy rate off the effective, lower bound. At least not for the foreseeable future.

Ian Lyngen:

We've reached a 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. After Musk's opinions on coins of all shapes and sizes real or otherwise, we're reminded of the time tested crypto adage doge, if you do doge, if you don't. The Elon that keeps on giving and taking back, maybe.

 

Thanks for listening to Macro Horizons. Please visit us @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 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 00:19:06] 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 the 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 a suggestion that any investment or strategy referenced here in 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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