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That 70s FOMO - The Week Ahead

FICC Podcasts 29 avril 2022
FICC Podcasts 29 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 May 2nd, 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 169, that 70s FOMO 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 2nd. And with endless comparisons between now and the 1970s styled stagflation, we cannot help, but ponder whether gasoline shortages and rationing will be replaced by runs on avocado toast, white sneakers, and perhaps a generation skipping trust filled with deeded access to rolls of toilet paper. You never know.

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. In the week just past the Treasury market, had an unwelcome surprise in the form of a negative GDP print. In the first quarter, the US economy contracted 1.4%. Now the consensus was for a very benign 1% increase, but the fact that the economy actually shrank in real terms has focused the market on the notion of stagflation and what it could mean if the US economy actually drifted into a full official recession.

Now, when we look at the details of what drove real GDP lower, personal consumption did disappoint, but the bigger issue was the fact that the PCE deflator or inflation was up 8%. So for the same amount of nominal growth, the more inflation we have, the lower we see real GDP, and that's precisely what happened. Now there was also a bit of a give back in terms of the massive rebuild of inventories seen in the fourth quarter of 2021, recall that Q4s GDP print was up 6.9%. So that gives better context for what the decline in real growth actually implies. So if nothing else, it served as a reminder, that inflation is omnipresent at this point. And the Fed is justified in ratcheting up the pace of rate hikes as well as announcing balance sheet runoff in the very near term. What flew below the radar to some extent was the disappointment of the year over year core PCE figures for the month of March.

Now this was embedded in the first quarter GDP data. So it wasn't so much a market event as it offered us some solace in the idea that we probably have seen a peak in core inflation on a year over year basis. Now this becomes particularly relevant on May 11th when we get the CPI print for the month of April. As it stands now, consensus is for a two tenths of a percent headline increase and four tenths of a percent core move. Again, a very important space to watch as the second quarter unfolds.

This week also saw a relatively uninspired series of auctions. While the $48 billion two year auction stopped through 1.2 basis points, the five year at 49 billion tailed one basis point and the seven year at 44 billion tailed 1.8 basis points. The takeaway there being that underwriting the belly of the curve at this particular moment in the cycle is unsurprisingly somewhat challenging. Nonetheless, we're reminded that despite the fundamentals supporting higher yields in twos, threes, fives, and perhaps sevens, the Treasury market is running up against the traditional seasonal patterns that suggest that longer dated Treasuries may peak in yield terms between now and the end of the second quarter.

Ben Jeffery:

So Ian, I thought with the curve back from inversion, the recession was canceled. What went on with Q1 GDP?

Ian Lyngen:

Well, it was a fascinating growth report for the first quarter of 2022. Now we did see the curve invert earlier we've seen since it re-steepened, but that re-steepening was largely a function of the market's shift in focus to the potential for the Fed balance sheet unwind announcement and the practical implications of what that might mean for the Treasury Department's borrowing profile. So that aspect of it was what I will argue, something of a head fake. We thought that it was going to be a supply story. It turns out that the overarching fundamentals of a central bank removing monetary policy accommodation really ended up being the story.

I'll caution here however, that the drop in real GDP was also a bit of a head fake. And by that I simply mean that what we actually saw was a larger than expected increase in the price deflator, i.e. inflation was up 8% in the first quarter. So as we've noted in the past for the same amount of nominal growth, it's important to keep in mind whenever inflation increases, you see a decrease in real GDP, and that's precisely what we saw on Thursday. This doesn't however, imply that the economy is actually poised for recession. In fact, if we see moderation on the inflation front over the course of the second quarter, which is pretty consensus at this point at a steady increase in consumption that bodes well for a rebound in growth.

Ben Jeffery:

And I completely agree with all those points, Ian, and would just add that the market's reaction following the data also reinforced the idea that right now investors focus is trained squarely on the inflation picture. In a more traditional environment, a surprise economic contraction would be viewed as bullish for bonds, but what actually ended up transpiring was that we saw 10 year yields rise throughout the bulk of Thursday's session. Admittedly, below that 2.98 level we saw reached last week. But nonetheless, at this point it seems that eight handle on headline inflation is really what is dictating the price action at the moment. And as we watched the yield moves play out over the rest of the week, it wasn't particularly surprising to see that market based inflation expectations rebounded quite sharply. We got down below 2.90 and 10 year break evens earlier this week and heading into the weekend. The fact that 10 year breaks are now back above 3% emphasizes the fact that inflation still remains very, very elevated.

Ian Lyngen:

And that's where I think makes this cycle so unique is that the inflation numbers that we're seeing remain very high, both by the headline and the core measures. Although we're starting to see an increase in the divergence between headline and core. This was evident in the Q1 GDP numbers where headline inflation printed at 8% versus a consensus of 7.2, whereas core inflation disappointed at 5.2%. Difficult to argue that 5.2 is a low number by any measure, but what's more important in this context is the trajectory.

And then on Friday we saw the employment cost index, which printed at a record high at 1.4% on a quarterly annualized basis. Now that brings up the risk of a wage inflation spiral. So more people are making more money in nominal terms and the logic holds that it should continue to put upward pressure on consumer goods that begin to increase simply because of the pandemic inspired supply chain issues. And then the war in Eastern Europe. Fast forward to the second half of this year, the biggest question quickly becomes are we truly in a stagflationary environment, which would be characterized not only as elevated consumer goods prices for a sustainable period, but also an increase in the unemployment rate as firms become reluctant to hire given the overall lack of price stability.

Ben Jeffery:

And it's precisely that dynamic that makes this current paradigm very highly inflationary, but I think you and I agree Ian, that calling it stagflationary is a bit alarmist at least at this point. We already have the unemployment rate back to effectively where we were in February 2020 before the pandemic. And there still exists 11 million job openings, at least per the JOLT survey that speaks to this idea that the labor market remains very, very tight. As we heard from Powell, the Fed is even of the mind that the labor market is too tight and it's the risk of that wage price spiral that you touched on and maybe was hinted at in the employment cost index that is giving the committee cover to proceed aggressively with their removal of monetary policy accommodation. It's also worth mentioning that unlike the last two years, the economy and household balance sheets are also not going to be benefiting from the same fiscal support we've seen, but nonetheless, clearly there are factors out there that continue to run counter to the transitory narrative.

Ian Lyngen:

I'd add that yes, Ben, you make a great point about the lack of fiscal stimulus during this point of the recovery. However, we do know that there's a reasonable amount of excess savings that had been accumulated on the household level, but there's also the potential for consumers to access some of the built up home equity that is clearly in the market, given the amount of home price appreciation that we've seen throughout the pandemic. So as another source of potential spendable dollars, that certainly has to be on the radar. And moreover to hear Powell shift his characterization of the labor market as potentially too tight, embedded in that is the idea that the Fed has come to the conclusion that the reduced labor force participation rate is the new norm. So on net, fewer people in the jobs market are demanding higher wages, and that does truly risk contributing to the ongoing upward pressure on inflation.

Ben Jeffery:

And just jumping off that idea you mentioned around home price appreciation and what that might mean for the wealth effect. I also think at after this last week, we would be remiss not to discuss what we've seen in risk assets. And what's looking like growing wobbles and equity valuations as the corporate sector is coming to grips with not only higher treasury yields, but also an earning season that is fairly middle of the road. Now the S&P 500 off 10, 12% from all time highs is hardly the level of correction that would warrant a rethink from a monetary policy perspective. But as we get next week's Fed meeting and the demand profile of the domestic economy starts to begin to feel the impact of the Fed's normalization, how much further stocks decline is going to be something that's very thematic over the balance of this year.

Ian, a great point that you make often is it's not necessarily the outright size of the decline in equities, but rather the manner in which it occurs, meaning that the market can handle the S&P 500 15, 20, maybe even 25% off the all time highs if it occurs in a slower, more grinding, orderly fashion. A material pick up in volatility and sharp selloffs day, after day, after day does not represent the type of market conditions that the Fed would be comfortable with. I certainly don't think that it’s this week's story, but particularly as we watch this earning season come to a close, it will be something to keep in mind.

Ian Lyngen:

I'd also add that the Fed is probably reasonably happy with a little bit of asset price deflation because recall one of the biggest criticisms levied against the Fed prior to the pandemic was that they were struggling to create true demand driven consumer price inflation. Instead, the best that they could hope for was asset price inflation that occurred not only in equities, but also in the housing market. And so reversing a bit of that is certainly consistent with the idea that the Fed is attempting to cool the overall economy, as well as take advantage of the opportunity that's presented to them to push forward with monetary policy normalization.

It's in this context that I think that the Treasury markets flattening continues to make sense. I suspect that ultimately we will reinvert particularly in twos, tens, and it won't be a function of the market anticipating a recession, but rather the reality that as inflation comes into the system and appears more persistent, that the Fed will at least have the flexibility, whether they deliver on it is another story, but they'll at least have the flexibility to step up with additional half point hikes beyond May and June. As well as if they choose, target an even higher terminal policy rate for this cycle. All of this is negative for the front end of the curve. And as we've seen the path toward a flatter curve is the market's default position at this point.

Ben Jeffery:

And we're reaching the point in the year when that flattener could very likely transition from what's been a bearish one clearly with 10 year yields within striking distance of 3% to a more bullish one as long end Treasury yields look increasingly attractive, both to domestic and foreign investors. Now a crucial piece of that foreign component is obviously buying from Japan. Japan's the largest foreign holder of Treasuries. But we did learn this week that given currency hedging costs and the moves we've seen in the yen that Japanese life insurers, traditionally big players in longer duration securities are rethinking their allocation to foreign bonds and may shift their demand more toward domestic or European securities, which I think the argument could be made, has probably contributed to this impressive sell off we've seen so far during 2022. As we move toward the May refunding auctions and even Treasury supply throughout the summer, it's going to be very important to keep an eye on foreign allocations at Treasury auctions, just give than what that might imply in terms of Japanese investors willingness to buy Treasuries.

Ian Lyngen:

So Ben, on the topic of underwriting the US Treasury Department's massive deficit, what are you thinking about the refunding?

Ben Jeffery:

Yeah, Wednesday's headliner might be the FOMC meeting, but let's not forget. We also get the May refunding announcement. It's generally expected that this is going to be the last quarter that we see coupon auction size cuts simply given the influence that lessened Fed reinvestment is going to have on the Treasury Department's borrowing needs. If in fact the Fed is going to be reinvesting $60 billion less per month over the course of the next few years, that will need to be made up for by larger issuance eventually.

Now as with the rest of the market, the Treasury Department doesn't yet have the official plans on what the Fed is going to do with its balance sheet. So one more quarter of coupon auction size cuts probably led by the 20 year sector is the consensus for Wednesday mornings announcement at this stage. Within the details maybe a T back charge or something similar, could certainly discuss the timing and size of the eventual increase in auction sizes that will need to come at some point down the road. But early in the process and once we get through tax season, looking for bill auction sizes to begin growing and the bulk of any funding needs to be concentrated there is the path of least resistance. I don't think anything contained within the new information at 8:30 on Wednesday morning is going to really reshape the market. For that, I think we'll have to wait for the Fed, but it will nonetheless offer some new context about how issuance is going to shape up now that we've reached this point in the cycle.

Ian Lyngen:

And we'll offer Yellen the same advice that we got from old man Lyngen and that was you always want to be on the right side of compound interest. In the week ahead, the Treasury market has an array of potential drivers to help define the next stage of flattening. On Monday, we have ISM manufacturing. Tuesday, we see the jolts data and then the main events occur on Wednesday. Obviously the FOMC decision is very top of mind. We're expecting a 50 basis point increase in the Fed funds target range, as well as the announcement of the balance sheet runoff plans. Within the March FOMC meeting minutes, the Fed did a very good job of outlining their expectations and providing the market with sufficient guidance.

Specifically, we're looking for $60 billion a month in Treasury runoff and $35 billion a month in mortgage runoff. Unlike during the last cycle, the maximum runoff numbers will it be achieved very quickly, stepping up over the course of just three months. In addition, the way in which the Fed has decided to run down its bill portfolio is notable, specifically during the months where the coupon runoff doesn't get to the 60 billion cap, the Fed will make up the difference by letting bills mature. We'll argue that the more relevant question is actually in the mortgage market.

Now, assuming that $35 billion a month is allowed to mature, the fact of the matter is it will be very difficult to reach that number given what's currently held in Soma. And the fact that mortgage rates have been increasing. So the potential for a fresh round of refies is very low. This then implies that at some point, the Fed will choose to actively sell mortgages into the market. Now, the Fed has the facility established and has conducted a few dry runs or small operations to get the market accustomed to the process. So if, and when the FMOC decides to execute on outright sales of mortgages, at least the plumbing is in place. Wednesday also offers ISM services with the consensus there for a 58.7 print, but more importantly, we'll get the refunding announcement. Note that the three year sector is expected to be 45 billion, the 10 year 36 billion, and the new 30 year 22 billion.

This array of data and Fed events all occurs in the run up to the April non-farm payrolls print. Expectations there are for roughly a 400,000 increase in NFP and the unemployment rate at 3.6%. Average hourly earnings are seen increasing for tenths of a percent during the month of April. Now in the wake of the strong employment cost index, it's very conceivable that the biggest number on Friday is actually average hourly earnings. This wouldn't be a great departure from the way in which the Treasury market has traded the employment report in recent months. And so we're content with the notion that for the time being all eyes are on wages and the Fed's response to the potential wage inflation spiral.

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 the NFL draft well underway, we'll spend the weekend trying to unblock those unrecognized numbers. Who knows by next week we could be in the starting lineup for team potential spam. Go spammers. 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. 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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