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Rough Road for Rates - The Week Ahead

FICC Podcasts 06 mai 2022
FICC Podcasts 06 mai 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 9th, 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 170, rough road for rates 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 9th. And with this week's emphasis on the refunding auctions in an environment with three handle tens, we're looking forward to the market putting the fun back in refunding.

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, 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 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 past the Treasury market put in a remarkably weak performance in terms of the run up in yields. We saw 10 yields as high as 3.10 give or take, and we continue to target the 3.26 level, which represents the yield peak for 10s during the last cycle. Now, the fundamentals behind this, I think are important to breakdown. First, we do have inflation expectations running, especially high, albeit off the peaks, but real yields are actually in the driver's seat at this stage. Now this is in part a function of the Feds announced balance sheet runoff program, which is expected to disproportionately hit the tips market. There's also the practical reality that the Fed has entered a hiking cycle. And while we're only 75 basis points of hiking into the process, there's more than another 200 basis points assumed at this point. So as rates in the front end increase the flow through to the balance of the curve will be a key determinant of a broader macro outlook.

Ian Lyngen:

In addition, Powell's press conference was interpreted at least on the margin as incrementally, less hawkish than anticipated. Now, part of the reason was his comment that a 75 basis point rate hike simply wasn't on the table. And I think that's what drove the initial bull steepening in the Treasury market, in the wake of the Fed, but that was ultimately reversed on Thursday and the sell off found greater momentum following the jobs report. Now nonfarm payrolls for the month of April increased 428,000 on top of the 428,000 from the month of March. In private terms, private NFP was up 4.06 versus 4.24 during March. And both of these numbers were effectively consensus. The surprise contained within the BLS report came in the form of a lower than expected average hourly earnings number of three tenths of a percent versus the consensus of four tenths. Although March's pace was revised up to five tenths of a percent from four tenths. This brought the year over year pace in line with expectations at five and a half percent, a slight down tick from March's 5.6% number.

Ian Lyngen:

Also, contained within the report, the unemployment rate was unchanged at 3.6%. The consensus was for a decline to three and a half percent. So the fact the unemployment rate didn't improve combined with the unexpected drop in a labor force participation rate to 62.2 from 64.4 left the net takeaway from this employment report more mixed than the headline would've suggested. We're concerned with the unexpected decrease in participation after all, given where we are in the cycle and the fact that wages have been steadily increasing, one would expect that sideline workers would be increasingly eager to return to the labor force. The fact that this trend is going the other direction is somewhat troubling. It also increases the possibility that the wage inflation cycle has additional room to run after all, if a 62% labor force participation rate is the new norm, then the jobs market is truly as tight as it appears to be in the data.

Ben Jeffery:

So Ian, we came into the week challenging that 3% level in 10s, which held initially, but then ultimately gave way. And now we've seen 10 year yields move decidedly beyond 3%. The Fed gave us the first 50 basis point rate hikes since 2000 and risk assets are seeming to take notice.

Ian Lyngen:

I do think that it was an extremely important week for the Treasury market, but more importantly, I think it was a meaningful week for financial markets overall. Three handled 10s while a relevant milestone, isn't really technically significant. The 3.26 target I think is a lot more relevant as we anticipate the sell off will continue into the May refunding auctions in the week ahead. More importantly, as you point out Ben, we did get an aggressive move by Powell and company. The 50 basis point rate hike was accompanied by forward guidance suggesting that we will also see a 50 basis point increase in the policy rate at the June and July meetings before transitioning to that 25 basis point a meeting cadence. So while we didn't get the 75 basis points that some market participants had been anticipating following Bullard's comments, the reality is that the Fed delivered on the hawkish side.

Ben Jeffery:

And along with 3% in nominal 10 year yields, I would argue more relevant at least from stocks perspective was the impressive sell off we saw in the tips market. 10 year real yields came into this week at negative three basis points and increased nearly a quarter of a percentage point. And the fact that we've now seen 10 year real yields move back to levels that were last seen in late 2019 points to some success on the Feds part in bringing policy back toward neutral, but also the implications that higher rates have on risk asset valuations, on consumer behavior, and on the housing market as we've also seen mortgage rates move to five and a half percent.

Ian Lyngen:

Upward pressure on rates is also consistent with the Feds announcement of running down the balance sheet. So the Fed is going to let 60 billion a month in treasuries mature and 35 billion a month in mortgages. While this might have initially been seen as a potential steepener for the curve in practical terms, what has been delivered thus far is an increase in real yields. And I think as you point out Ben, part of that is a function of how relevant the Fed's QE program was in the tips market, given the comparative size versus nominals. As the Fed is poised to back out of the market, it follows intuitively that we would see such an increase in real yields. What I find fascinating is that the increase in real yields, the wobbles in the equity market, and the strength of the dollar have all provided a pretty material tightening to financial conditions. So while the Fed is only delivered two hikes this cycle for an aggregate of 75 basis points, the reality is that the market is doing a lot of the heavy lifting in terms of tightening for the Fed.

Ben Jeffery:

And Ian correct me if you disagree, but we also got the question a lot this week of is the Powell put no longer applicable given that the NASDAQ is down over 20% year to date, the S&P 500 is similarly down 14, 15%. Is there no longer a level of stock decline that would cause the Fed to moderate their hawkishness and maybe move from a 50 bp every meeting rate hike cadence to a 25 basis point or something even slower. I would argue that the Powell put still exists, but if the price action over this past week is any indication, clearly the strike price is much lower than it was previously. And that's simply a function of just how high inflation has been running and how high inflation expectations still remain. Admittedly breakevens are off the peaks, but definitely at more elevated levels than the Fed would ideally be comfortable with.

Ian Lyngen:

Ben, I agree that the Powell put still exist and it struck much lower than it was in prior cycles, but let's face it. If stocks were down 50% year to date, the Fed would do something. The question is we're down 13%. Is the inflection point 20%, 25%? That's what we don't know. And I think that the process of price discovery in the coming weeks will be particularly telling in this regard. Now, as we've mentioned in the past, it is less about the outright level of equities and any associated move as it pertains to financial conditions and more a function of the pace. So if the market limits down several sessions in a row, then that's going to spike equity volatility, which contributes to tighter financial conditions. If it's a slow, measured grind lower, I would say that the Fed would probably characterize that as a success because it demonstrates their ability to slowly extract some of the asset price inflation that has characterized so much of this cycle.

Ian Lyngen:

On the topic of asset price inflation, Ben you observed how high mortgage rates have become. And I think that that's going to be a key dynamic that comes into play during the second half of the year, i.e elevated borrowing costs begin to undermine the upside pressure on home prices. Now we're certainly not in the camp expecting there to be a meaningful reversal in some of the recent gains in home prices, rather a moderation of the pace and a period of stagnation as buyers struggle with the higher prices. This is in sharp contrast to what we saw in the 2008 and 2009 period, where we saw an expanded base of potential home buyers, including remarkably easy lending terms. This certainly hasn't occurred during the current cycle. And as is evident when we look at household balance sheets, the consumer is still on relatively strong footing, all things considered.

Ben Jeffery:

And outside of the housing market and as we think about what the next big event risk might be, I do also think it's worth discussing the impact that higher rates will have on the corporate sector just given the huge increase in corporate debt that we've seen over the past several years. And a lot of this leverage is going to now need to be refinanced at rates that are at levels we haven't seen since 2019. So for those firms, maybe of a lower credit quality that are very reliant on easy access to cheap debt, it's going to be somewhat of a concerning period in the event that revenue growth does not keep up to a sufficient degree to keep some of these businesses operating.

Ben Jeffery:

Especially now that the Fed has shown us that unlike in prior cycles, they're not going to be willing just yet anyway, to step in and calm any volatility. If anything, some normalization on the corporate side in terms of debt levels could be something that the Fed would actually be encouraged by. Now, of course they want that to be an orderly process, but as we think about the next part of the cycle, I do think overall leverage in the system and that leverages relationship with what is now higher yields will be something to watch.

Ian Lyngen:

And this brings us to the notion that not all higher input prices are ultimately going to be passed through to the consumer. Thus, far a lot of producers have been able to push higher costs onto consumers. I think that this is most evident in the energy sector where gasoline prices continue to drive headline inflation higher. And we're now seeing increases in food costs work their way through the system as well. But the other aspect of this dynamic is when one has higher input prices that are not transferable to the end user, the net result is profit compression. And profit compression at a point when rates are rising, really does bring valuations into question on a fundamental basis. So as we think about the coming months in terms of financial markets, an important area to watch will be what occurs in aggregate in valuation terms, both on the equity side, but also in the credit space as well.

Ben Jeffery:

And just to bring the conversation a bit more short term and what we're expecting for the upcoming trading week, yes, CPI on Wednesday morning is going to be the clear headliner in terms of economic fundamentals, but we also have the 10 and 30 year refundings that could add some additional upward pressure on long end yields. And I would actually argue that dynamic contributed on the margin to the sell off we saw late this week. There has been chatter and some concern that the cross currency considerations in Japan might translate to a moderated foreign bid, which could mean that we will need to see a bit larger auction accommodations than might otherwise be expected. Generally speaking, 10 year refundings, unlike reopenings have been met with good demand while the inverse is true for the long bond. New issue long bond auction have a strong tailing trend.

Ben Jeffery:

So we'll certainly be watching to see if that dynamic is extended on Wednesday and Thursday. We also did learn this past week that given new sweeping fiscal spending is probably going to be unlikely to make it through Congress in its current form, that the Treasury Department felt comfortable continuing with their coupon auction cuts. Twos, threes, and fives will all decline by a billion dollars a month in this upcoming quarter, sevens by $2 billion a month. 10s and 30s by one billion over the course of the quarter and 20s by two billion over the course of the quarter. We also saw that the Treasury Department is now transitioning the 17 week bill from a cash management bill that's been issued regularly for the better part of the last two years to a new benchmark for a month. And I think this exemplifies that as the Feds balance sheet rundown picks up and reaches its terminal pace that Yellen will first look to the bill market to make up for any funding shortfall before ultimately being required to increase coupon auction sizes. But that is now something that will probably be a discussion for 2023.

Ian Lyngen:

So it's in this context that I think it's so telling that investors remain relatively sidelined in the Treasury market as we continue to probe the upper bound in terms of yields. Now we've been on about the notion that the second quarter tends to be an important inflection point from a seasonal perspective. And we maintain that that will be the case. The bigger question isn't whether or not dip buying will ultimately emerge, but rather at what outright level in 10s and 30s. And then obviously what does that imply for the shape of the yield curve? Twos, 10s has quickly reversed the most recent flattening surge with a steepening move that has been largely range bound, but nonetheless has brought the curve that much further away from being inverted. We anticipate that as the next several months unfold, a new dynamic equilibrium will be discovered further out the curve while the Fed's insistence on normalizing rates will continue to put upward pressure on twos and threes, thereby reinvigorating calls for an inverted curve. And what typically follows, which are concerns about an economic slowdown and a true recession.

Ben Jeffery:

So this is the point where I should come up with a joke about a recession.

Ian Lyngen:

Ben, recessions are not a joking matter, hairlines or otherwise. In the week ahead, the Treasury market is tasked with taking down the May refunding. This starts with Tuesday's three year auction of 45 billion followed by Wednesdays 10 year at 36 billion. And then of course, 30s on Thursdays at 22 billion. The economic data in the week ahead is relatively light. But on Wednesday morning, we see the April CPI number. As it currently stands, the consensus for headline inflation during the month of April is for a 0.2% gain, which in comparison is a significant slowing versus the 1.2% print in March. So for context, this would bring the year over year pace of inflation to 8.1% from 8.5. This is very consistent with the idea that inflation during this cycle has peaked and we're entering the period where the base effects from Q2 2001 will start to moderate the year over year figures. Now it's also notable that the downshift in headline inflation represents a moderation of the monthly figures as well.

Ian Lyngen:

So at least for the time being, this appears to go beyond simply the base effects, this is something that we'll be keeping a close eye on. In addition, included in the CPI release will be the real average hourly earnings figures. So on an inflation adjusted basis, we saw a March decrease of 2.7%. Now we expect a similar pace of declined continue. And this brings us to one of our core concerns for the next part of the cycle. Specifically that real wage erosion will continue to undermine the purchasing power of the majority of consumers. The obvious risk that this represents comes in the form of a downside skew for growth in the coming quarters. Recall that the negative 1.4% GDP print for Q1 was largely a function of higher than expected inflation. So in real terms, for the same amount of nominal growth, we actually saw a slight contraction.

Ian Lyngen:

A back to back negative GDP print, which technically represents a recession is on the radar although our base case scenario doesn't imply that it is going to happen in Q2 instead, we're expecting a modest rebound in growth led by the consumer, of course, but within inflation continuing to represent a headwind. Also, within next week's CPI series, we will obviously be looking at owner's equivalent rent and the flow through of higher housing prices to the core consumer inflation measures. In addition, new and used auto prices did see a decline last month. A follow through in April would be very consistent with the overall trajectory of slowing inflation. But however, as travel continues to pick up, we'll be watching for the potential upside on private airfares contained within the CPI series.

Ian Lyngen:

Overall, we expect that the process of price discovery will continue as the upper bound for Treasury yields, particularly further out the curve is established. And as we get closer to the summer months, we anticipate yields will peak, the curve will flatten, and the Fed will continue to hike rates. 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 midyear review process comes into focus, we cannot help, but imagine the conversation between Powell and Bullard. So Jimmy, the thing is filters are very important on a number of different levels.

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 Podcast 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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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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