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Fall Hawk Watching - The Week Ahead

FICC Podcasts Nos Balados 22 septembre 2022
FICC Podcasts Nos Balados 22 septembre 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 September 26th, 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 190, Fall Hawk Watching, 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 September 26th. And with the end of the third quarter in sight, real growth tracking at just half a percent, the yield curve deeply inverted, and recessionary alarms ringing, we're left to consider what happens if an economy falls in the woods and no hawk is around to hear.

Ian Lyngen:

Each week, we offer an updated view on the U.S. 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, the Treasury market received a great deal of fundamental information to provide trading direction. The biggest event was obviously the FOMC's rate decision, and the subsequent press conference and updated summary of economic projections. The Fed moved 75 basis points, which was very consensus in line with broader expectations. And while there was the possibility that the Fed moved a hundred basis points, the committee decided not to execute that option, and instead sent clear forward guidance that the next move in November will also be 75 before downshifting to 50 basis points in December, and then 25 basis points in February of next year.

Ian Lyngen:

This means that the terminal rate for this cycle will be 4.6%, or the corridor between 425 and 475. This led intuitively to downward pressure on the yield curve with 2s/10s retesting negative 58 basis points as investors began to contemplate precisely how much damage the Fed is going to be willing to inflict on the real economy to contain forward inflation expectations. On the positive side, breakevens continued to compress, which means that real yields pushed notably higher. Now, with inflation expectations declining and the Fed being viewed as arguably the most credible inflation fighter in terms of Global Central Banking, the magnitude and pace of the move in real yield is going to become problematic for other financial markets.

Ian Lyngen:

The S&P 500 is down roughly 20% on the year, but we continue to see potential downside as not only the Fed moves forward with higher rates, but globally, other major central banks are following suit, with the exception of the Bank of Japan. The Bank of Japan announced that it was keeping rates unchanged at negative 10 basis points, and retaining the yield curve control target, which puts 10-year JGBs at zero. Now the Bank of Japan has previously let the band of acceptability around zero increase to 25 basis points in practical terms. But the fact that we didn't see another shift in that direction has extended the divergence between the Bank of Japan and other major central banks. As a result, it wasn't so surprising to see that immediately after the Bank of Japan announced no policy changes, the Japanese Ministry of Finance came out and begun intervening in the foreign exchange market in support of the yen, effectively selling dollars.

Ian Lyngen:

The question that this raises is will the MOF’s defense of the yin ultimately lead to significant selling in the Treasury market. The short answer, at least at this point, is it's unlikely to have a meaningful influence further out the curve, certainly not in tens and thirties. The bill holdings at the MOF are significant, as is the amount of money that they have parked in the RRP. So given the magnitude of their potential to intervene before needing to sell securities outright, we suspect that, at the end of the day, this is more an issue of signaling that policy rates will remain low in Japan, presumably through the end of this year and into next at the earliest, we're targeting March as a potential inflection there. But the overall influence on the global economy will be limited from this.

Ian Lyngen:

One of the other reasons that FX intervention is on our radar is that the persistent strength in the dollar has made it unattractive for Japanese investors to buy Treasuries and hedge returns back into local currency. The MOFs decision to sell dollars from their currency reserves will create a moment of stability, if nothing else, in the exchange rate, which might make it incrementally more attractive for Japanese buyers to venture back into Treasuries. Again, we're not to the point where we expect wholesale shift in investor behavior from Japan, but it's something worth pondering as the fourth quarter comes into focus.

Ben Jeffery:

So, Ian, it was the week we've all been waiting for, and we got our 75 basis point hike. But more importantly was what the Fed showed in the dot plot. We now have a terminal estimate of 4.6 expected to be reached next year, which now leaves the path forward for almost certainly another 75 basis point hike in November followed by another 50 in December. And then the question becomes, are we getting another 25 or 50 in February? Or maybe by that point, will the Fed need to have shifted to an on hold stance with rates now definitely in restrictive territory?

Ian Lyngen:

I think that is the operative question, whether or not we'll find ourselves in a situation where by the end of the year, the damage done to the real economy starts to overwhelm the Fed's ambition to deliver that extra 25 basis point rate hike. What I think is just as important as where the Fed ends up in terms of the terminal rate is the messaging around how long the Fed is going to hold policy in a restrictive stance.

Ian Lyngen:

If we look at the Fed's long run dot, they continue to suggest that 2.50 is effectively neutral, but they're telling us that in 2023, we'll end the year at 4.6. In 2024, we'll end the year at 3.9. And in 2025, we'll end the year at 2.9. That suggests that we'll be some version of restrictive for the next three years. I'm a bit skeptical that the Fed will ultimately be able to pull that off, given everything that is going on in terms of the global growth outlook, demand destruction in Europe, the looming energy crisis, to say nothing of the geopolitical landscape now that Putin has put the nuclear option on the table.

Ben Jeffery:

And the combination of hawkish central banking globally, we got a rate hike from the Bank of England, who are now preparing to start selling their gilt holdings, another rate hike from the Swiss National Bank. That, combined with what we're seeing from the Fed, is going to continue to weigh on the front end of the curve, and frankly, for the time being, make it difficult to see any meaningful pullback in two year yields now that we've firmly entered four handle territory, and twos have sold off beyond four and an eighth in an environment where clearly the market is still reluctant to catch the falling knife.

Ben Jeffery:

However, shifting attention further out the curve into the 10- and 30-year sectors, all of those risks, Ian, that you touched on, combined with concerns domestically around housing, risk asset valuations, and what will probably ultimately become the labor market, is adding to the case for investors who have either been short or underweight their benchmarks to start deploying excess cash that is built up in reaching further out the curve, and begin choosing levels at which to start adding duration exposure. In real terms, 10-year rates at 1.20, and 30-year reals even higher, offers some value in an environment when we are likely going into a global recession.

Ian Lyngen:

I'd also add that it's a pivotal time for forward monetary policy expectations more broadly. Yes, we know the Global Central Banks are almost universally in a hawkish mode, but there'll be a point in which momentum shifts and a more moderate approach becomes the norm. The challenge of the fourth quarter is going to be timing that inflection point. When we think about the event risks on the horizon for the U.S. and for the Treasury market, the first week of November is extremely important. We have the midterm elections, but more importantly, we have the Fed's next 75 basis point hike. The reason that we're focused on this in particular is because it will bring effective Fed funds above 3.80.

Ian Lyngen:

Now, there are many in the market who are operating under the assumption that effective Fed funds should create a floor for Treasury yields across the curve. We are on board with that for the two year sector, at least for the time being. But the question becomes, can 10s trade below effective Fed funds, or during the run up to the next FOMC meeting, will we see another wholesale repricing in the Treasury market that brings 10 year yields above 3.80. All else being equal, we continue to see 3.50 to 3.65 as a key battle zone for the macro narrative as we run up against effective Fed funds.

Ian Lyngen:

In the current environment, and forward monetary policy expectations laid out by the Fed, a deeper inversion beyond negative 60 to negative 75 basis points remains our baseline assumption as we continue to anticipate that once the Fed reaches terminal, that will serve as a green light for duration buyers. Another aspect of the recent Fed meeting that's worth highlighting is the fact that they downgraded the 2022 growth outlook from 1.7 to just two tenths of a percent. They also lowered next year from one seven to 1.2. This suggests that the Fed is content to see below trend growth for an extended period of time as the cost of keeping forward inflation expectations well anchored.

Ben Jeffery:

And along with all of this, we mentioned real rates earlier, and we got a great client question this week, which in effect was how have other asset classes held up comparatively well in an environment when real rates are back to levels we haven't seen since 2011 in outright terms, but just as importantly, the fact that this increase in real rates has happened so quickly and so aggressively. While yes, the S&P 500 is down 20% year to date more or less, in outright terms, that's simply giving back some, not even close to all of the massive rally we saw coming out of COVID. And relatively speaking, credit has held in even better. And, Ian, I think you'll agree with me on this. It's this dynamic that leaves us a bit more cautious as we get toward the fourth quarter and, frankly, well into 2023, which is that the ongoing influence of higher real rates has yet to truly flow through to both the real economy, but also the corporate sector, and by proxy, risk asset valuations.

Ben Jeffery:

So as time goes on and consumer behavior is refined, elevated debt levels that are now going to need to be refinanced at interest rates that are over 10 year highs points to the real risk of further revenue erosion, just based on the turning over of the economy, but also higher debt service costs, and what that is ultimately going to mean for corporate profitability, the ability of firms to continue to deliver wage increases, and ultimately, the outright size of workforces. It's from this perspective that the impact of higher rates is likely only going to become more severe as we get into the early and middle part of next year.

Ian Lyngen:

Ben, I would add that one of the reasons that I suspect risk assets have held up as comparatively well as they have is in part due to the fact that the repricing to higher real rates actually just recently occurred. It's not as though real yields have been deep into restrictive territory throughout the bulk of the year. And to your point, we haven't seen that flow through to the broader real economy.

Ian Lyngen:

In keeping with this theme, the compression of break evens, which we anticipate will continue to move lower, will only put further upward pressure on real yields, and that is by design. The Fed is doing everything it can to retain and increase credibility as an inflation fighter. And if we look at both market based measures of forward inflation expectations, as well as survey based measures, most notably the University of Michigan's medium term inflation expectations dip to 2.8% recently, what we see is that the market, and consumers more broadly, have increasing confidence in the Fed's ability and willingness to do whatever it takes to keep inflation expectations anchored.

Ian Lyngen:

It's in this context that I'll note that the Fed increased their unemployment rate forecast for next year from 3.9 to 4.4. That's more than a million jobs in payroll terms. And when we think about the potential shift in momentum and sentiment towards hiring more broadly in such an environment, what I worry about isn't Powell's ability to get the unemployment rate to 4.4%, it's to stop it before it gets to 5.4%.

Ben Jeffery:

And, Ian, that's an awesome point. And in the conversations we've had this week, it's precisely that dynamic that has investors increasingly skeptical of the potential for any sort of economic outcome that could be construed as a soft landing. Given that the labor market is a lagging indicator, while yes, the Fed is actively trying to push the unemployment rate higher to the mid 4% level, once we hit 4.5%, we're then going to 5%. And frankly, probably even closer to 6%.

Ben Jeffery:

As it currently stands, inflation is simply too high for the FOMC to really care about a higher unemployment rate. And I would argue the next big trade in the Treasury market, which will be timing the bull steepening of the curve on the other side of the cycle, will come when we hear from Powell starting to be more concerned about the outright level of unemployment than the outright level of inflation. And that, of course, will be predicated on ongoing progress in bringing core inflation lower over the next several months in quarters. And really, in terms of trading, this puts most of the onus on the incoming CPI figures firstly, but also payrolls, exactly as you touched on.

Ian Lyngen:

Let us not forget that we don't need to see non-farm payrolls print deeply into negative territory for a series of consecutive months to get the unemployment rate headed higher. We still have a large portion of the labor force that has stepped out of the market during the pandemic, and is slowly reintegrating into labor force. As workers come in from the sidelines and labor force participation increases, that in and of itself will put upward pressure on the unemployment rate.

Ian Lyngen:

The bigger question from our perspective is, what will precipitate such a shift? Why would a worker who left the labor force during the pandemic return? One aspect of it is going to have to do with the erosion of savings that has occurred during that period. We've also seen home price appreciation stall out. So if we do see the slowing in the real estate market transition into a true downturn in home prices, that would be a hit to the wealth effect, and potentially bring the incremental worker back into the labor force.

Ian Lyngen:

And let us not forget that we're now into the school season. Whereas last year, the COVID related uncertainties made in person schooling an unreliable childcare option, there's now enough stabilization that people might feel more comfortable going out and seeking employment given renewed confidence that schools will remain open. And that's to say nothing of the fact that everything cost 10% more than it did a year ago. So inflation, in and of itself, could prompt workers to reengage.

Ben Jeffery:

And while the Fed wants to fight inflation, the way they hope to head off a wage price inflation spiral is by doing precisely that, by bringing sidelined workers back into the labor force, and increasing labor supply to more closely align with the still effectively record labor demand we're seeing via the JOLTS job opening numbers. And in thinking back about August NFP print, what we saw was a two tenths of a percent increase in the unemployment rate, but that was driven entirely by a higher participation rate. It's exactly that dynamic that the Fed is hoping to continue in an orderly fashion that will presumably help take the upside off of wage growth and prevent higher inflation from becoming truly entrenched.

Ian Lyngen:

This does beg the question, Ben, if and when the employment rate turns dramatically, will it be a jolting event?

Ben Jeffery:

I'm still seeing dots.

Ian Lyngen:

In the week ahead, the Treasury market has a variety of fundamental inputs, as well as auctions to contend with. The most compelling data highlight will come on Friday with the personal income and spending numbers, as well as the core PCE print for August. Given the strength of core CPI, the current forecast for August core PCE is for an increase of half a percent. We don't expect this will ultimately be a tradable event per se, although it will give us some context for the translation of higher CPI into higher PCE, which is the Fed's favored measure. We hear from a variety of monetary policy speakers, including the chair, as well as Vice Chair Brainard, Williams, Mester, Daly, Evans, Bostic, and Collins. We don't anticipate any meaningful divergence from the hawkish messaging that we received via the FOMC decision, accompanying SEP update, as well as Powell's press conference.

Ian Lyngen:

We will highlight that during the press conference, however, Powell struck a cautionary tone in terms of the potential for a recession in 2023 and beyond. We remain very focused on the labor market outlook, as that represents one of the most important inflection points for policymakers over the balance of this year. It's difficult at this stage to anticipate anything that will prevent the Fed from delivering another 75 basis point rate hike when they meet in November. Although the trajectory of the jobs market certainly warrants attention, with the most recent initial jobless claims print at just 213. And this is for NFP survey week. So the setup for the October 7th release of non-farm payrolls will more likely than not have a positive spin as the event nears.

Ian Lyngen:

On the supply side, Tuesday offers 44 billion in five year Treasuries, 36 billion seven years on Wednesday. In terms of supply for the week ahead, Monday offers 42 billion two year notes, Tuesday sees 44 billion fives. And then on Wednesday, we see 36 billion seven years. The auction schedule is skewed a day earlier this week, so the Treasury Department has a buffer day on Thursday for Friday's settlement. Let us not forget that not only does the week ahead represents the end of the month of September, but it also represents the end of the third quarter.

Ian Lyngen:

Taking a step back, it certainly is not wasted on us that the Atlanta Fed's GDP Now tracker has the third quarter running at a pace of just 0.5% in real terms. That on the back of two negative quarters of GDP already during 2022 makes the Fed's ratcheting lower of growth expectations for the year to just plus 0.2% in aggregate, certainly consistent with the realities of the data and the trajectory of the overall global economy.

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 Global Central Banks aggressively hiking into year end, the remaining question is, who will be the first to jump out of the kettle of hawks and into the recessionary fire, as it were.

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. 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 3:

The views expressed here are those of the participants, and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure. Visit BMOCM.com/macrohorizons/legal.

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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