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Delta Doldrums - The Week Ahead

FICC Podcasts 20 août 2021
FICC Podcasts 20 août 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 August 23rd, 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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Ian Lyngen:

This is Macro Horizons episode 134 Delta Doldrums 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 August 23rd, and as return to office plans, transition back to work from home ambitions, we're reminded that office is more a state of mind than a physical location.

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 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 price action in the Treasury market was particularly telling. What we saw were a few attempts to push back toward the upper end of the prevailing range. But at the end of the day, that 125 level in 10 year yields appears to have a reasonable degree of staying power. The primary fundamental inputs that we received were from the FOMC minutes related to the July FOMC meeting.

Ian Lyngen:

Now these minutes outlined the ongoing debate at the Fed in terms of timing, the tapering of asset purchases. The Fed has made it clear that the tapering will be simultaneous, both Treasuries and mortgages, and the official announcement will occur sometime within the next three meetings. The Delta variant and the associated increase in COVID-19 cases does make it a bit more difficult to envision that the Fed would announce tapering at September to be rolled out during the fourth quarter. And we're operating on the assumption that we either see a November announcement with December implementation, or a December announcement with a January implementation. Now, while the nuance between September, November, and December might be very meaningful for some short term positions, from a broader perspective, it is not very impactful for monetary policy. And we suspect that that will lead the Fed toward a bit more cautious approach given the refocus on the pandemic that has occurred since the July FOMC meeting.

Ian Lyngen:

Another important takeaway from the week just passed was that retail sales disappointed at a time before the Delta variant became so topical. The sentiment for the month of August has continued to disappoint. It started with the University of Michigan data we've since seen the empire state and Philly Fed come in below expectations as a clear nod to the fact that we're not out of the pandemic just yet. Incoming announcements from major employers that the returned to office dates have been delayed, really reinforced this idea that the Delta variant has reintroduced pandemic uncertainty at a point when all else being equal, investors were anticipating a collective return to the new normal. Labor Day had been considered the key inflection point for returning to the office.

Ian Lyngen:

However, it now appears that the timeline has been delayed sufficiently, that we're assuming that the broader return to work movement will be an early 2022 event. In terms of direct implications for the Treasury market, this simply reinforces the range trading thesis that we've held throughout the year with the next couple of weeks, the most likely timeframe for establishing new lows in terms of yields. As it presently stands, 112 is the lower bound for ten-year rates with an opening gap at 109 to 110, which we continue to view as the most meaningful resistance, as well as an interim target in the event that we see an extension of the bond bullish price action.

Ben Jeffery:

Well, Ian, I think what was one of the most meaningful takeaways from this past week, at least from an economic perspective was July's disappointing retail sales data, and this coming at a time before the latest drives in the Delta variant with all that implies for the impact on in-person commerce.

Ian Lyngen:

To your point, Ben retail sales did come in below expectations. However, it was not a catastrophic miss. Moreover, we're coming off of elevated levels of consumption seen in the first half of the year. Now it goes without saying that the fiscal stimulus that hit the real economy at the beginning of 2021 has slowly started to work its way through the system, and to a large extent, that's really level set expectations a bit higher for the outright level of consumption. We're now pushing beyond that initial impulse, and we're facing the balance of 2021, which has its own unique set of headwinds. As you point out, the Delta variant is very much top of mind in this regard. However, all add the nuance that we're not simply trading the Delta variant, we're recalibrating forward expectations for the recovery and the global real economy, based on the notion that we will have some type of variant risk for the foreseeable future, whether it ends up being as highly contagious as Delta is obviously an open question, but nonetheless, it is reason for concern as evidenced by the fact that 10 year yields are still solidly below 125.

Ben Jeffery:

And especially early in the week, that theme of concern was readily apparent both in the headlines concerning New Zealand's decision to reenter lockdown in order to stem the spread of the virus, and also the situation in Afghanistan. While, not specifically linked to economic activity in general this week highlights the still highly uncertain global backdrop, both pertaining to the virus and geopolitics. And as we often say, whereas there once was a time that Treasury yields were a function of simply the domestic economy following the globalization of the past several decades. It's now far more a global story, which I would argue is a big reason why we have 10 year yields at 125 exactly as you say Ian.

Ian Lyngen:

This also complicates the job of monetary policy makers as the FOMC minutes from the July meeting outline, there's a significant debate at the Fed in terms of the appropriateness of timing, QE tapering.

Ben Jeffery:

So are you on team most or team several?

Ian Lyngen:

Team, few good bonds.

Ben Jeffery:

So do we want you on the wall?

Ian Lyngen:

I'm always on the fence.

Ben Jeffery:

But in all seriousness, that was one of the biggest takeaways from the July FOMC minutes that while most participants advocate for tapering beginning this year, there were several others who advocated for a 2020 to start. And while at a first pass, this would suggest that 2021 is the more likely start date for tapering for better or worse, who that several is matters. If that contingent is Chair Powell, Vice Chair Clarita, New York Fed President Williams that carries far greater weight than say maybe some non-voting members of the FOMC so left intentionally ambiguous to be sure, but this debate, which has emerged as one of the most prominent themes on the committee was reiterated in the minutes release.

Ian Lyngen:

Ben, that certainly is one of the key limitations of the FOMC minutes that they are specifically so vague on another limitation, which is especially relevant at this particular moment is the lag nature of the information presented regarding the last FOMC meeting. Recall that in late July, the Delta variant concerns were just beginning to make their way into the market. Fast forward to the latter part of August, and presumably the discussion at the committee meeting would have had a different underlying tone. So all else being equal that bolsters the argument for the several camp, which suggests tapering beginning in 2022. The other nuance that the FOMC minutes left out was precisely what tapering in 2022 implies. Is this a conversation about starting tapering in the middle of next year, or is it a debate of announcing in November implementing in December versus announcing in December and implementing in January? I would suggest that if that's the debate, it's largely a non-issue from a monetary policy perspective. And even in this current environment, it's also a non-issue for the Treasury market.

Ben Jeffery:

And outside of the tapering specifics, we also saw that most members of the committee are of the mind that the Fed has achieved substantial further progress on the price stability side of the mandate while most of the committee as well thinks that same substantial, further progress has not been achieved as it relates to employment. Which, again, is consistent with this idea that the bar for tapering has been achieved. However, the bar for liftoff is still a bit higher, and will need to be a function of ongoing progress in returning the labor market to a more healthy place.

Ian Lyngen:

One thing was made very clear in the wake of the FOMC minutes, and that is how investors will respond to a less accommodative monetary policy. Any concerns that progress towards tapering would be bond bearish were clearly dismissed given the post minutes rally. Now, the logic here certainly resonates, and that is if the Fed is pulling back from accommodation at this point in the cycle, given the headwinds facing the global economy via the Delta variant, then that will weigh on the forward economic outlook. Another aspect of pricing in the Treasury market that I think warrants a nod is we've seen a reversal of the cheaper and steeper narrative that we brought into the beginning of the year. And I've often heard that characterized as abandoning the reflation trade. In fact, if we look at 10 year breakevens, what we see is that at 225 to 240, 10 year breakevens continue to reflect expectations for inflation to remain at an elevated level going forward. For context, prior to the pandemic, 10 year breakevens struggled to trade above 200 basis points.

Ian Lyngen:

So, with a backdrop of nominal yields at 125 breakevens at 225, the fact that real yields continue to push deeper and deeper into negative territory suggest that this truly is a growth story. This also brings up the concern about what happens if the Fed is correct in characterizing the higher than expected realize inflation data thus far in 2021 as transitory, and we see a give back as the year progresses and we move into 2022? Doesn't it follow logically that breakevens should compress in that context. And if that occurs, will that put additional downward pressure on nominal rates? That's one of the big risks as we contemplate the balance of the year

Ben Jeffery:

And narrowing our focus to the rest of this month. We do have the Jackson Hole Symposium on Thursday and Friday of this week where the discussion promises to be centered on likely exactly this topic. Just how transitory will inflation ultimately prove and what is the appropriate monetary policy response at the current point in the cycle. Now the prospect for any grand revelations I think are fairly limited, but nonetheless Powell's speech will at least garner the market's attention on what will otherwise likely be a fairly quiet August trading week.

Ian Lyngen:

There's been a lot of focus on Jackson Hole in so far as the potential to add greater clarity on the tapering question. In the wake of the FOMC minutes and given all the information that has come out from the Fed over the course of the last few weeks, I would ultimately be surprised if Jackson Hole was as much of a tradable event as previously assumed. Now, if we were going into Jackson Hole, without some of the clarity recently offered, it would stand to reason that the Treasury market would react to Powell's comments regarding the scaling back of bond buying. But as it stands now, we know that it's going to be simultaneous taper of mortgages, and Treasuries.

Ian Lyngen:

We know that it's going to occur either at the end of 2021 or the beginning of 2022, the one unknown variable is how much flexibility the Fed wants to put into the process and how quickly there'll be willing to taper. Even that question is within a relatively defined range. We know that it's not going to take a year to taper. We know that three months is too quickly. So the real debate is whether it's six months, nine months, or somewhere in between, which frankly as with the precise timing of tapering is largely a event for a market that continues to look beyond tapering and focus on the timing of the liftoff rate hike.

Ben Jeffery:

And that brings us to this week's Treasury auctions. We have 60 billion twos, 61 billion fives and 62 billion sevens. And I'm going to be especially intrigued to see the sponsorship that materializes for fives for exactly that reason, Ian. The belly of the curve is most sensitive to the implied forward path of policy rates. So, at Wednesday's auction, a meaningfully strong outcome would offer some market-based evidence that liftoff will be a bit further in the future. Conversely, if a large concession is required either via an intraday cheapening or large tail that all else equal would point to earlier liftoff rather than later, and especially given the point in the calendar in the early part of the week, I certainly wouldn't be surprised to see a little bit of a flattened in concession as the front end under performs to make room for the new bonds to be auctioned.

Ben Jeffery:

And throughout August so far, the sponsorship that we've seen for longer duration Treasuries has been very encouraging. To good auctions for tens, and thirties was followed up by this past week's 20 year auction, which was the first stop through for new issue twenties since the lesser long bond was reintroduced in May, 2020. And this even after the rally out of the 30 year refunding really reiterates the notion of ongoing strong sponsorship for Treasuries in the primary market.

Ian Lyngen:

So, Ben, how are you getting to Jackson Hole?

Ben Jeffery:

Virtually.

Ian Lyngen:

Ahh, to be in the Zoom where it happened.

Ben Jeffery:

Maybe next year.

Ian Lyngen:

Maybe. In the week ahead, the Treasury market will have a variety of fundamental inputs to provide incremental trading direction. However, there won't be any top tier data until the following week when we get the August payrolls report. The incremental data inputs include existing and new home sales. The notion that the run-up in home prices have started to undermine affordability certainly resonates. So, in that context, it's reasonable to expect a slowing of some of the recent upsides seen in the real estate market. One of the key underlying questions about the run-up in home prices is how will that ultimately translate to OER, and provide a key reflationary underpinning for the CPI, and PCE series. We know that OER lags with the increases in home prices, and as the market continues to contemplate whether inflation really is transitory at this point in the cycle, we expect that the reflationists will emphasize the continued forward upside from OER. That certainly fits with the dislocations that we have seen resulting from the pandemic in terms of the US housing market.

Ian Lyngen:

However, it becomes less clear whether that's truly the demand driven type of inflation that the Fed would like to see in this cycle or a delayed influence from factors that the Fed has already characterized as transitory. Admittedly, it will be a difficult argument for the Fed to make at the end of this year, if we're still continuing to see higher than expected CPI prints, that inflation truly is transitory. Although it would be intellectually honest to say that the Fed has identified key dislocations resulting from the pandemic and the lag of OER behind increases in housing prices speaks more to a measurement issue as opposed to a broadening of the categories of inflation that would lead the Fed to reconsider their transitory characterization. On the topic of the Fed, this week's Jackson Hole Symposium will be a key focal point for the market. There's been a great deal of information already revealed related to tapering expectations via the July FOMC minutes.

Ian Lyngen:

The bigger question in the market at this moment is whether or not the Delta variant will affectively delay the Fed's tapering ambitions comparable to the way that it has delayed many of the return to office schedules. The Fed has consistently signaled an interest and a goal of retaining flexibility, particularly in the face of heightened uncertainty. So, we struggle with the idea that the Fed would want to forward commit to any particular monetary policy shift. So, to a large extent, this probably takes September off the table for a tapering announcement. Moreover, if the FOMC plans to announce in September, we would need to see that timeline reinforced when Powell speaks this week.

Ian Lyngen:

Our baseline assumption is that it doesn't occur, and we continue to focus on the November December timeframe if for no other reason that at that point, both the market, and monetary policy makers will have more information in hand. 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 the fundamental inputs weighing in the coming weeks, and we rely more heavily on the technicals. We're reminded that there's a chart on every ship at the bottom, the ocean. 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:

This podcast has been repaired with the assistance of employees, of Bank Of Montreal, BMO Nesbitt Burns 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, notwithstanding 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 suggestion that any investment strategy referenced here in may be suitable for you. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients.

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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