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Peak of Summer - The Week Ahead

FICC Podcasts 05 août 2022
FICC Podcasts 05 août 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 August 8th, 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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Disponible en anglais seulement

Ian Lyngen:

This is Macro Horizons episode 183, peak of summer. 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 8th. As Fridays from home have become the August norm we'll note, the pandemic inspired advice, mute don't commute.

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, started with an initial rally that brought 10-year yields as low as 2.51 only to see a significant sell off occur throughout the week. Capped following the stronger than expected July non-farm payrolls data. In the interim, we also heard from a variety of Fed speakers who pushed back against the notion that the Fed will either not be able to achieve its desired terminal rate or ultimately be forced to cut rates more quickly than anticipated in 2023.

Ian Lyngen:

Now, clearly it's far too soon for the market to have any clear understanding of how the Fed is going to behave in 2023. And frankly, it's even too soon for the Fed to have a clear direction. And this is largely a function of the fact that as monetary policy has moved to neutral and is expected to be in truly restrictive territory in September, the Fed has become more data dependent. Let us not forget that with the exception of the Bank of Japan now all major central banks are also aggressively hiking. We've seen a 50-basis-point hike from the Bank of England, we've seen 100-basis-point hike from the Bank of Canada, we've seen a 50-basis-point move from the ECB. All of this collective global tightening will at least on the margin, take some of the onus off the Fed.

Ian Lyngen:

And ultimately as other central banks are doing more heavy lifting for the FOMC, the prospects for an even higher terminal rate quickly start to fade. Following Powell's press conference, the debate shifted to whether or not the Fed would hike 75 basis points or 50 basis points in September. Non-farm payrolls unquestionably, put a check in the column for 75. That doesn't mean that this is a foregone conclusion because we'll have another jobs update as well as two CPI prints between now and the next time the FOMC meets. Jackson Hole is at the end of August and at that point, the Fed will have seen the July inflation data, but given the strength of jobs, there's little to suggest that any pivot, more dovishly that might have occurred at Jackson Hole will now be in the offing. Our core trading themes remain, we're anticipating a deeper inversion of the 2s/10s curve.

Ian Lyngen:

We're anticipating that 5s/30s continues to compress with a move below zero, a very real possibility in the wake of the refunding auctions. And for the two-year sector, we would continue to lean bearishly on the assumption that the Fed has such strong incentives to continue hiking rates through the November meeting, that there's still upside potential for two year yields. We anticipate that between now and the end of the year, the Fed will deliver at least another 100 basis points of hikes, whether that is 50 in September and 25 in November and December remains to be seen. In addition, as the Fed becomes increasingly data dependent, one needs to be cognizant of the risk that we might actually see 125 or 150-basis-points of additional tightening between now and year end. While not our base case scenario, qe do anticipate that over the course of the next three or four weeks, the incoming data will offer investors a much clearer picture as to the amount of tightening that the committee has left in them.

Ben Jeffery:

I only have one thing to say, Ian. How about those jobs?

Ian Lyngen:

It was an incredibly strong employment report. In fact, almost every aspect within the non-farm payrolls release outperformed expectations. We saw a stronger than expected headline payrolls print, private payrolls gained more than expected. We saw a five tenths of a percent month over month increase in average hourly earnings, which brought the yearly pace to 5.2%. That was in contrast to the expectations for a downshift to 4.8. Also striking was the fact that the unemployment rate dropped to 3.5, which tied with February 2020 as the lowest since 1969. Said differently, it was a very, very good month for job creation in July.

Ian Lyngen:

The one aspect of the report that might be incrementally not as optimistic was the fact that the labor force participation rate decreased to 62.1 from 62.2. Now, this was in part a driver of the lower unemployment rate, but nonetheless, it's difficult to argue that the payrolls report was anything except stellar. Now, there might have been an argument at the beginning of the week that would've suggested that a 50-basis-point rate hike in September was the path of least resistance. The July employment report put 75-basis-points squarely back on the table.

Ben Jeffery:

And the sharp reaction in the market immediately after the jobs data pushed 2s/10s through that negative 40 level we've been watching and into the negative 40 to a negative 55 zone that we're expecting is going to offer something of a guide at least into the September 21st meeting and the wholesale move toward higher yields across the curve certainly reflects exactly that dynamic, Ian. While there was never really a debate if September was going to be a 25 or 50-basis-point hike, in the discussion on 50 versus 75, the employment data, and I would argue average hourly earnings specifically, definitely tilted the scales and valuations in the front end firmly more in favor of 75-basis-points.

Ben Jeffery:

Now, September 21st and the Fed meeting is still a long way away. And before that we have, yes, another jobs report in September, but also two more CPI reads that I would argue are both the real information that the committee wants to see before convening to make their decision about whether we're going to get another 75-basis-points, or if a down shift in the pace of tightening to 50-basis-points would be more appropriate, should we see inflation begin to come off a bit more significantly.

Ian Lyngen:

And speaking of the ever-shifting macro narrative, recall it was just a week ago when we learned that we had two back-to-back quarters of negative real GDP growth, which would traditionally be considered a recession. It's been fascinating to see how quickly and coordinated the Fed speak pushing back against that narrative has become. In the week just passed, we had a variety of official Fed commentary that made it abundantly clear that any interpretation of July's rate hike as a dovish 75 was misplaced.

Ian Lyngen:

To a large extent, this is also the Fed signaling to investors that the amount of rate cuts that are priced into 2023 are a reach for what will ultimately be realized. One of our calls for the balance of 2022 is that the Fed is going to prove increasingly stubborn in their hawkishness. Now, this is largely a function of the fact that the Fed is playing a much longer-term game insofar as retaining their inflation fighting credibility. While market participants are worried about the risks of a near term recession from a longer term perspective, price stability is going to be essential for the US economy.

Ben Jeffery:

And let's not forget Ian, aside from the economic fundamentals, the questions of employment and inflation, I'll stop short of calling it a flight to quality, but we did see a bit of a safe haven bid surrounding Speaker Pelosi's trip to Taiwan and Beijing's response in terms of launching military drills in and around the Taiwan Strait, that did get 10-year yields to 2.51, a single basis-point away from our year-end target and a resurgence of a new variety of geopolitical tensions this time in East Asia contributes to the argument that investors are going to be increasingly willing to buy any future dips and treasuries.

Ben Jeffery:

After Pelosi's trip to Taiwan concluded, we saw a fairly significant relief sell-off in treasuries that was fueled by the stronger than expected ISM services read, but that selling pressure in the middle part of the week, ultimately stalled out at 2.85, still a significant distance from 3%. And the fact that we're already seeing investors willing to get involved in duration well below 3%, makes it seem increasingly likely that a sell-off to 3.25 and certainly 3.50 is further and further off the table for this year.

Ian Lyngen:

The best bearish case for treasuries still remains that we are entering an environment with structurally higher inflation going forward. The offset of course, being how hawkish the Fed has been, we certainly come down on the side of suggesting that the increased hawkishness only further makes the case for a range trade in 10 and 30-year yields. However, upward pressure on the two and three year sector is going to be difficult to ignore. Recall that Greenspan's conundrum was the fact that the Fed effectively lost control of the longer end of the curve, I suspect that what we'll see during the balance of 2022 is Powell's conundrum, which is that the Fed will ostensibly have lost control of the front end of the curve.

Ian Lyngen:

What does that look like? The best description would be two-year yields trading well inside of effective Fed funds because in such an environment, what investors would be assuming is that while the Fed might have achieved terminal, they're not going to be able to hold monetary policy steady as long as they would like. Our expectation is that in fact, the Fed will push back on that assumption on the part of investors and at least during the first half of next year, really stick to the idea that they will continue to retain terminal longer this cycle than they have in prior moves.

Ben Jeffery:

And in addition to fighting inflation by keeping rates in restrictive territory for longer this cycle than in previous ones, staying on hold would also give the Fed the opportunity to continue to run down its balance sheet. Remember, we're still in the early days of the process of QT and we've yet to see the pace of the rundown of treasuries reach what will probably be its maximum velocity in September at $60 billion a month. This process is being pointed to as already driving some liquidity issues in the treasury market and while the broader macro uncertainty probably deserves the lion’s share of the credit for that, the cessation of the Fed’s bond buying and now running down of SOMA's portfolio has certainly added to the generally thinner liquidity between on the run and off the run treasury securities.

Ben Jeffery:

This brings us to something that was revealed in the refunding announcement, which was TBAC’s discussion of the potential for the treasury department to bring back their buyback program and an effort to bring down total that outstanding, but also help improve liquidity issues by purchasing more illiquid off the run securities and in doing so clear more space to issue more on the runs, which in turn will improve liquidity, presumably bring the cost of borrowing lower, which is ultimately in keeping with the treasury department's goal of issuing treasuries at the least risk-adjusted rate to the taxpayer.

Ben Jeffery:

Now, the details within the TBAC charge indicated that this issue is still very early on in terms of its serious discussion and is going to be studied further. But if the recession is going to be mild enough that Congress can avoid any sweeping new fiscal initiatives and massively growing deficit, Yellen’s endeavors to start to pay down some of the government's debt could certainly be something to consider in the later part of next year at the earliest.

Ian Lyngen:

If nothing else, it's an interesting transition insofar as the treasury department, addressing some of the liquidity concerns further out the curve in particular, historically, that has primarily been the responsibility of the Fed, but there is a strong argument to be made that as a function of dis-intermediating banks over the course of the last 15, 20 years, the combination of the Fed and the treasury department have materially shifted the trading dynamics in US rates; as a result, buybacks could arguably be seen as the next extension of that transition.

Ben Jeffery:

And along with the buyback discussion, we also saw the treasury cut twenties 2 billion for the quarter versus one billion for tens and thirties, which was on the smaller side of what some in the market were expecting. Additionally, within the language of the policy statement, there was nothing that indicated a broader rethink of the 20-year program is underway, or that there's any near term risk that the treasury department is giving up on 20-year issuance. Obviously the fact that twenties have underperformed means that treasury is paying a higher interest to issue those bonds, but for the time being rather than contemplate winding down that program only to likely eventually need to reintroduce some other variety of treasury note or bond as borrowing needs pick back up. It seems that twenties are here to stay and we won't necessarily see twenties be cut by larger than tens and thirties going forward.

Ian Lyngen:

Recall that this experience is not that dissimilar from how the Fed addressed some of the dislocations in the seven-year. And I suspect that they would characterize that experience overall as a success. And what remains to be seen is whether or not the inversion of 20s/30s is ultimately resolved by the Fed's action, or if that ends up being a semi-permanent part of the shape of the yield curve.

Ben Jeffery:

And on the issue of supply, obviously this week's main event is going to be July's CPI data, but especially what's going to be limited conviction and probably low trading volumes in the second week of August. We're somewhat cautious that the lead up to this week's 10- and 30-year auctions may result in a bit larger concession than would otherwise be expected. I would argue that dynamic added to the knee jerk sell off we saw in the wake of NFP and particularly given the size of the rally that got tens to 2.51 over this past week, a period of bearish retracement and consolidation in this once again, bullishly redefined range should leave a setup for this week's refunding auctions, at least a decent round of dip buying. Now, we've tended to see 10-year auctions tail recently, the last five have all done so, but even if we do see a tail for tens, I suspect it'll be relatively modest. Barring of course, a massive surprise in the inflation data before the auction on Wednesday morning.

Ian Lyngen:

And on the topic of surprises, it still amazes me that we are 183 episodes into Macro Horizons and no one has canceled us yet.

Ben Jeffery:

I hate to break it to you, but I don't think SIFMA listens.

Ian Lyngen:

SIFMA who? In the week ahead, the treasury market will have the refunding auction with which to contend that contains 42 billion 3-year notes on Tuesday, 35 billion 10-year notes on Wednesday, as well as 21 billion 30-year bonds on Thursday. There is a variety of Fedspeak as well. We have Evans, Kashkari, and Daly, all non-voters all speaking in the middle of August, not a compelling setup for any concerted communication effort on the part of monetary policymakers. Said differently, everything that the Fed needed to say to refine market expectations was said last week. As a result, a curve flattening bias, which might be put on hold via an auction concession for tens and thirties will ultimately reemerge and does continue to have the fundamental backing of a hawkish Fed with broad based recession angst continuing to grow. Clearly the geopolitical tensions will put in a bullish underpinning for the treasury market, but that's not to say that rates don't have some upside potential, particularly as an in range auction concession, if nothing else. We maintain that the yield peaks for the cycle in 10-year space are in, and that's 3.50.

Ian Lyngen:

The prospects to retest 3.25 are relatively low. However, a scenario in which tens breach 3% once again is very easy to conceive. Particularly as we focus on the July CPI data, the consensus is looking for a down shift in the headline to two tenths of a percent month over month, that would bring the yearly pace to 8.8% down from 9.1%. This is consistent with the decline in energy prices that we saw during the month of July. Most notably the average gasoline cost continued to slip lower; core CPI on the other hand is seen increasing half a percent, which is something of a moderation, but still running well above the long run average within the core CPI data will be focused on new and used auto prices as well as OER or owner's equivalent rent and the rental numbers.

Ian Lyngen:

We know that as people are priced out of the purchase market, there's been increasing demand on the rental side, which has extended the period in which housing continues to provide a stable pillar of core inflation. Now, at some point, the moderation in yearly gains of home prices will eventually weigh on the core series. That said, OER and the energy component within that does bias this series a bit higher for the next several months. Other areas of concern on the inflation front include airfares, which can function as a direct flow through of higher jet fuel cost to consumers. Although given some of the labor shortage issues that are impacting the major travel hubs, upward pressure on travel expenses might continue to be the new norm until there's greater resolution on the employment front. And while we'd like to assume that the upcoming August Friday will be a complete non-event, the University of Michigan survey is released mid-morning and within that, the market will be very attuned to the 5 to 10 year inflation expectations component.

Ian Lyngen:

That number peaked at 3.3%, which was revised down to 3.1% and most recently came in at 2.8. It goes without saying that this series will be closely followed, especially given the higher than expected average hourly earnings figures from the employment report. And the risk of the US is on the precipice of a wage inflation spiral.

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 we wade through the dizzy number of out of office replies, it strikes us that in the office notifications might be more appropriate for now, virtual or otherwise. 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:

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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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