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Sirens of September - The Week Ahead

FICC Podcasts 03 septembre 2021
FICC Podcasts 03 septembre 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 September 7th, 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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Disponible en anglais seulement

Ian Lyngen:

This is Macro Horizons episode 136. Sirens of September. Presented by BMO capital markets. I'm your host, Ian Lyngen, and here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of September 7th. And as yet another pandemic summer comes to an end with return to normal plans on hold, we're reminded that while socially distant and virtual events have many similarities, unfortunately only one has a mute microphone option.

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 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.

Ian Lyngen:

In the week just past, the treasury market got several key fundamental inputs that have helped refined monetary policy expectations going forward. The first and most notable was the disappointing non-farm payrolls print. What we saw was a number that came in well below market expectations for August. Now it was accompanied by a decrease in the unemployment rate to 5.2%, as well as an increase in average hourly earnings. Now this conforms well with the broader perception that the Delta variant has led to a pause for the reopening, rehiring, return to office expectations that the market had held for the post labor day period earlier this year. As expectations are further refined, it will be very meaningful to see if the Delta variant was simply a risk that postponed the return to office scenario by two or three months, or if it will ultimately be the cause of much longer delays.

Ian Lyngen:

Clearly the FDA's full approval of mRNA vaccines has shifted the dynamic in terms of firms encouraging more strongly vaccinations, as opposed to taking a hands-off approach. This introduces some logistical risks in getting the workforce re-engaged with in-person work. However, it should eventually be more supportive for the frontline service sector businesses that function as support the densely populated urban centers.

Ian Lyngen:

Within the details of the August BLS data however, the fact that leisure and hospitality jobs were effectively flat on the month is a very telling indicator in terms of hiring sentiment in those sectors. It goes without saying that this is more than a one-off single month dynamic, and what we're seeing is a shift in forward expectations not only associated with the Delta variant, but a realization that the pandemic just got that much longer, because there is now this rolling variant risk. While the medical community is likely to come up with a solution for Delta, the bigger risk is how will consumption and work patterns permanently change when faced with the risk of a new variant on a perpetual basis?

Ian Lyngen:

We'll suggest that the next stage for settling in for the new norm of expectations won't be picking the precise time in which we will be back to normal, but rather the length of the period that the hybrid model that we're currently in simply becomes the new normal.

Ben Jeffery:

Well, how about those jobs numbers?

Ian Lyngen:

Or rather, how about the absence of a good portion of the jobs numbers that people were anticipating? Ben, I think it is notable that nonfarm payrolls came in so far below market expectations, and if we break down the details of what was absent, the most notable absence was the leisure and hospitality industry.

Ben Jeffery:

And really what I would argue that suggests is two things. One, that the rising risk of the Delta variant has delayed plans to bring back workers in those sectors that are most pandemic specific. And the other point I'll argue is that maybe we're starting to see the entirety of the reopening hiring trend start to run its course.

Ian Lyngen:

Yeah, I'm certainly sympathetic to the idea that if the Delta variant can derail rehiring plans so quickly, that perhaps the bulk of the hiring is behind us. And that implies not only have we seen the peaks in the monthly hiring data, but also the peaks in growth in terms of real GDP might be in for the cycle.

Ian Lyngen:

We've long been concerned about the risk that between stimulus and early reopening ambitions, the growth profile was so heavily weighted in the first and second quarter of this year, that it was always going to be a challenge for the real economy to continue at that pace during the second half. Also within the BLS series, we saw a much stronger than expected average hourly earnings gains. In fact, at six tenths of a percent month over month, nominal wages were up twice what the consensus was calling for, which was three tenths of a percent.

Ian Lyngen:

Now this has certainly contributed to some of the reflationary ambitions, and when we saw the post nonfarm payrolls reaction in the treasury market, it was a classic bear steepener. Now typically one might look at a disappointing headline in FP print, comparable to what we just saw and assume that treasuries had to rally. In fact, it follows intuitively that if the market has moved beyond tapering, which it has, to focusing on the timing for the first rate hike that anything delaying the liftoff rate hike would actually contribute to the risk for inflation going forward. Said differently, the economic data has provided the fed the opportunity to re-engage with the new framework, which implies lower for longer in terms of policy rates.

 

Ben Jeffery:

And Ian, I completely agree that while yes, August jobs numbers were meaningfully weak, it was still nearly 250,000 jobs added last month. And so from that perspective, while it's certainly lessens the probability that we see in announcement of tapering at the September FLMC, it wasn't bad enough to take tapering off the table this year, which really will leave the market's focus on the November or December meeting for the Fed to formally announce they're going to start winding down their bond buying.

Ian Lyngen:

I would also add as further evidence to this notion that tapering no longer matters in terms of the outright level of treasury yields, as you point out Ben, the takeaway from NFP is that a September tapering is effectively off the table, and still 10 and 30 year yields were higher in the wake of the data. So again, that simply brings us back to one of our core tenants for this point in the cycle. And that is, it's not about official bond buying. It's about inflation and the Fed's willingness to let it run hotter during this cycle than we've seen in past cycles.

Ben Jeffery:

And in thinking about the tapering process, it's also worth highlighting the results of our pre NFP survey this week. We saw 46% expect that tapering will be done within six to nine months with the second most common response nine to 12 months, and that took 30% of the answers. So in practical terms, what this suggests is that at this moment, the collective expectation is that tapering will take roughly nine months. Although should we see a more concerning trend in labor market gains, I think there's certainly an argument to be made that the Fed will want to be more gradual and tapering than maybe they otherwise would've been.

Ian Lyngen:

And if nothing else, this dynamic reinforces what I would say was a pretty consensus timeline for the transition out of QE, and to the point where the fed can consider normalizing policy rates. Recall that Powell at Jackson Hole really emphasized the difference between the thresholds for tapering and the threshold for increasing policy rates. And what I suspect will characterize the balance of this year will be Fed speak that continues to stress this difference to market participants. It's one thing to begin tapering, it is an entirely different issue than to start putting the brakes on the real economy.

Ben Jeffery:

And there's also another dynamic to highlight in terms of it's not yet time to tap the brakes on the real economy. And that's been the performance of the economic surprise index, which has continued to push even further into negative territory and is now back to outright levels that we haven't seen since the worst days of the pandemic in 2020. So it wouldn't surprise me to see the narrative shift from a late 2022 early 2023 rate hike, toward a mid 2023 to end 2023 liftoff.

Ian Lyngen:

And if that does occur again, somewhat counter-intuitively I'd expect that we would see a drift higher in 10 and 30 year rates, especially if we continue to see the upside surprises that have been evident in the core inflation series. One of the key assumptions between now and the end of the year is that where the transitory categories that have been putting upward pressure on inflation might moderate, namely used and new auto costs, we will see the lagged impact of the higher housing costs flow through via OER and rent. And given how significant that subcategory is in driving the core series, this is expected to put what is effectively a floor in place for the inflation series.

Ian Lyngen:

Now, when we map this against what we're seeing in terms of market pricing, it's worth highlighting that the rally and nominal treasuries did not occur with a reduction in forward inflation expectations. In fact, as we can see with ten-year breakevens above 225 and five-year five-year forwards comfortably above 200 basis points, the market continues to expect inflation to be a key component for this next stage of the cycle.

Ben Jeffery:

And that brings up the risk that at this point in the cycle, the specter of higher consumer prices may actually end up being a drag on that consumption. And given the role that consumption plays in overall growth in the US, that's a very concerning development. If in fact higher inflation is here to stay and that higher inflation deter is spending, the Fed is going to be caught in the unenviable position of being called on to tighten policy to offset higher prices at a time when the growth landscape would actually suggest that there would need to be more accommodation offered.

Ian Lyngen:

That might lead one to assume that there's risk for stagflation, although I'd caution against going down that particular path. Nonetheless, as many of the confidence surveys have illustrated, consumers are delaying or forgoing major purchases, simply because the perception is that they have been priced out of the market. So that implies one of two things. Either prices will correct lower, which we struggle to envision in any collective way, or there will be a slowing of spending as we move forward into the balance of this year.

Ian Lyngen:

Let us not forget that the September 22nd FOMC meeting also includes updated SEP forecasts. So this will afford the market a better understanding of how the Fed is interpreting the recent shift in economic data. The June SEP had 2021's growth at 7%. Given some of the headwinds that have been presented thus far, the Fed's growth assumptions going forward will surely garner attention one way or the other.

Ben Jeffery:

And in addition to growth assumptions, we also will get a look at the 2024 doc for the first time. So alongside any upward revisions to 2022 and 2023, the look at the 2024 doy will be very informative in terms of assessing how quickly the Fed anticipates they will be able to raise rates, and where they expect policy will ultimately be able to reach this cycle. The longer-term dot at two and a half percent is likely to remain on changed, but nonetheless, as the hiking cycle comes into greater focus and there's more actively debated, the nature of how the Fed will endeavor to get rates off zero will be especially important for the shape of the curve.

Ian Lyngen:

You mentioned the Fed's terminal rate assumption. That is an important anchoring for the treasury market going forward. We talk about the notion that we could see a reflationary surge leading to the introduction of greater term premium, as investors require a higher return to go further out the curve, but that can only go so far if the Fed's terminal rate is only two and a half percent. So if we think about over the course of the next 10 years on average, what will the policy rate be? Well, the upper bound is two and a half percent, and there's only so much more inflationary premium that can be priced into the market. So it ultimately does come down to the growth profile and still persistently and deeply negative real yields.

Ben Jeffery:

And taking a little bit more global view, we've also started to see a meaningful divergence between the recovery in the US and some notable markets abroad. This past week, we saw disappointing Chinese PMIs, and also a decades high print on inflation in Europe. So this idea that some markets are going to lag in the recovery while others may be experiencing higher inflation while still others may be feeling the ramifications from the prospect of higher policy rates in the US really creates an environment where cross winds across geographies and asset classes are going to make for an especially compelling fall as the implications from the September FOMC fade, the market prepares for tapering and investors begin to turn their attention to 2022 and what ultimately lays ahead.

Ian Lyngen:

So in summary, Ben, what you're saying is just buy bonds.

Ben Jeffery:

That seems to be what we've learned from this year.

Ian Lyngen:

In the holiday shortened week ahead, the treasury market will have few economic data points to respond to. However, we do have the 10 and 30 year auctions. There's 38 billion 10's on offer on Wednesday, followed by 24 billion 30's on Thursday. Given the recent reception to primary issuance in the treasury market, we can't help but assume that there will be more than enough sponsorship to take down supply. When we layer the disappointing non-farm payrolls report on top of this, all else being equal, we'll assume that any auction accommodation or backup in rates in anticipation of supply will provide a buy in opportunity, and we'll stick with a strategy of buying the auctions assuming that they'll mark the yield highs for the week as suppliers absorbed and rates drift lower.

Ian Lyngen:

Now we've been in a definable range in the treasury market for quite some time. In 10 year space yields between one 12 and 142 have been the norms. We do not expect that that will change before this September 22nd FOMC meeting. However, we're certainly cognizant that the next data event risk is the September 14th release of core CPI. Given the higher than expected average hourly earnings print, we'll reiterate the idea that the low market participation rate at this stage has created pockets of labor scarcity, which have resulted in higher earnings for a certain sectors and contributed to overall wage gains. The translation of higher wages to sustainable demand side inflation has thus far been one of the biggest uncertainties for the economy.

 

 

Ian Lyngen:

If we find ourselves in a situation where this temporary labor scarcity translates through to a broadening of the categories of core inflation, the Fed is going to find themselves in a very challenging situation because while ostensibly it will appear that reflation has become self perpetuating, the fact that the labor market participation rate is so low speaks to another transitory impact from the pandemic. On net, we expect the fed will hold fast to the transitory narrative in terms of inflation seen thus far, but we're certainly cognizant that there will be pushback on the part of market participants.

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 our patent pended spherical rates forecasting model offers reply hazy, try again, we're reminded of page one from the strategist guide to the galaxy. Rates will go up and rates will go down, but not necessarily in that order.

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 that 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 FIC 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 [inaudible 00:19:15] 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.

Speaker 2:

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Speaker 2:

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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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