Select Language

Search

Insights

No match found

Services

No match found

Industries

No match found

People

No match found

Insights

No match found

Services

No match found

People

No match found

Industries

No match found

2022 and Beyond - The Week Ahead

FICC Podcasts December 22, 2021
FICC Podcasts December 22, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of December 27th, 2021, and respond to questions submitted by listeners and clients.


Follow us on Apple Podcasts, Google Podcasts, Stitcher and Spotify or your preferred podcast provider.


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

Read more

Ian Lyngen:

This is Macro Horizons episode 152, 2022, and beyond, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of December 27th. And as forecast for 2022, once again, come into focus, we are reminded that precision often falsely implies accuracy, 95.436% of the time.

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 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 [inaudible 00:00:58] or email me at I-A-N dot 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, had a few fundamental inputs from which to derive incremental trading direction. But the fact the matter is, on net, the macro narrative for the balance of the year was already well established before we received the better-than-expected consumer confidence data, as well as a slightly disappointing read on existing home sales. Perhaps more notable, was the strength of the 20 year auction, which stopped up through 2.2 basis points.

Ian Lyngen:

Now, we're reluctant to call this particularly strong demand for the sector, if for no other reason, than there was a pretty significant concession in the run up to the auction itself. So buying at a discount, in a range trading environment with low liquidity condition consistent with the end of the year, doesn't offer us a great deal of macro insight. Nonetheless, given the inversion of the twenties, thirties curve, the auction did garner a reasonable amount of attention. Relatively strong performance in terms of risk assets, also contributed to the backup in Treasury yields. As 10 year rates got within striking distance of 150, we're reminded of the relevance of the departure point as we go into 2022.

Ian Lyngen:

In the event that the final week of trading this year, doesn't see a retest of 135 or 160, then we'd expect that as the new year gets underway and new positions are as establish, that we'll see a steady drift higher in rates across the curve. The one important distinction between Q1 2022 and Q1 2021 is that we expect that the bearishness will be more concentrated in the belly of the curve. Specifically as the Fed moves incrementally closer to a liftoff rate hike, the five year sector will underperform. And while 10 and 30 year yields will be net higher over the course of the first quarter, the price action will be accompanied by re-flattening of the fives, thirties, and twos, tens curve.

 

Ian Lyngen:

The path of least resistance for the very front end of the market will be toward higher rates, not because the first few rate hikes are not sufficiently priced into the two year sector. But rather, because the next phase of market deliberation will be in estimating what the terminal it for the upcoming tightening cycle will ultimately be. It's certainly far too soon for us to have a reasonable estimate. And frankly, this remains an unknown to the Fed as well.

Ian Lyngen:

Nonetheless, with new year's optimism, both on the reopening and the reflation front, we anticipate that the trend over the course of the first three months of the year, will be toward pricing in a higher terminal rate, especially given the upward pressure on inflation. And assuming that regardless of the headline non-farm payrolls print, the ongoing improvement in the unemployment rate and positive progress on labor market participation will ultimately reinforce the notion that the Fed is poised to enter a lengthy, tightening campaign.

Ben Jeffery:

Well, Ian, it's our last episode of the year. And as we come into the new year, we'll also be getting a new Fed.

Ian Lyngen:

Well, the point that I've been making throughout the bulk this year, was that apparently, the new Fed is an awful lot like the old Fed, at least insofar as the framework and what it implies for forward expectations related to monetary policy. That said, there are rotating regional governors coming on to the voting ranks that will skew the composition of the Fed marginally more hawkish. However, given the pivot from Powell in recent weeks, it's difficult to imagine that, that will be as relevant as the tone shift from the chair.

Ian Lyngen:

More importantly, we also have those three vacant seats on the board of governors. Now there's the vice chair for supervision seat, which the market has been focused on, as well as two other vacant board seats. In contemplating the risks associated with the supervision seat, it strikes us that given the current regulatory environment, as well as some of the concessions that the Biden administration is likely to make to the far left, if anything, we would expect to see an increase in regulations in the financial sector. Which on net, would be an incremental to risk assets. But ultimately, not to the extent that we would expect it to shift the overall tone of sentiment in the Treasury market, or financial markets more broadly.

Ian Lyngen:

As for the other two board seats, it almost goes without saying, that any sitting president would want to fill the board with more dovish members, which would allow for an easier monetary policy to push forward with the full employment objective. That said, given Biden's recent concern on the inflation front, it's less obvious that any future nominations will be decidedly dovish. Although it's being equal, we'll still air on the side of assuming dovish to slightly moderate, certainly not hawkish. Nonetheless, this will be topical, as 2022 gets underway. As will the process of continuing to ponder the implications from the recently updated dot plot where we saw the Fed bring forward to next year, three full rate hikes.

Ben Jeffery:

And in trying to think about who represents which dot on the dot plot, it was very relevant to hear Governor Waller's comments last week, that he thinks March liftoff should be on the table. And he even went as far as to balance sheet normalization as also serving as a potential tightening tool.

Ben Jeffery:

So in looking at the dove hawk spectrum on the committee, I think it's reasonable to say that Waller will be on the hawkish end, while all the way in favor of the doves, would be Brainard, who will be taking over for a Clarida in the vice chair position, once the current terms on the committee are up. Now that we heard Powell give up the transitory characterization of inflation and show a greater willingness to offer more hawkish rhetoric, that's going to make who exactly gets those other board seats exactly as you say, Ian, very relevant in terms of where their opinions sit relative to the chair.

Ben Jeffery:

Now we only saw two dots expecting four hikes in 2022. And it's impossible able to know who precisely those were, but at this stage, it's reasonable to assume that whoever the white house ends up nominating, is not going to be expecting a full percentage point increase in Fed funds in 2022. Granted there's a lot of information yet to be realized on the path of inflation, and exactly what the fallout from the Omicron variant is going to be. But early in the new year, FOMC composition is definitely going to be something that's frequently discussed in the U.S. rates market.

Ian Lyngen:

On the topic of the Fed, the issue of winding down the balance sheet, or simply letting the maturities in SOMA roll over and not be reinvested, will also be a topic discussed at the beginning of the year. We're going into the next phase of monetary policy, assuming that all else being equal, the Fed will keep the balance sheet steady for the first three or four rate hikes. But we're open to the idea that the Fed might instead, choose a combination of rate hikes and balance sheet wind down earlier in the process this cycle than it did during the last.

Ian Lyngen:

Now the logic here is relatively straightforward. It's simply, how aggressive does the Fed believe it's warranted to be an addressing elevated consumer prices, at this point in the cycle? The committee does have an environment with extremely easy financial conditions, which will provide the Fed the needed cover, in the event that they wanted to unwind the balance sheet and then quickly start hiking rates. My primary concern is one of signaling, not so much on the tightening, but rather in the event that the U.S. economy is faced with a recession sooner rather than later. And the Fed needs to pivot back toward an easier monetary policy stance. The optical impact of rate cuts is presumably more powerful than QE, especially in the beginning of a slowdown when heightened uncertainty will be driving investor angst.

Ben Jeffery:

So really the crux of the uncertainty is, whether the Fed would rather have more room to cut rates in the next easing cycle, or a smaller balance sheet. And in thinking about the process of stopping SOMA re-investments and ultimately bringing down the balance sheet, it's important to consider that, not only is the balance sheet north of $8 trillion in this cycle versus slightly larger than 4 trillion in the last cycle, we also have nearly 2 trillion in excess cash sitting at the RRP overnight. So if the biggest concern from monetary policy makers is once again, tripping the financial system into that scarce reserves paradigm that triggered the funding market volatility we saw in 2919, QE this time around, has built up a significant ample reserves buffer that should give much more flexibility in terms of running down the balance sheet.

Ben Jeffery:

Now, Ian, and I still completely agree with your logic that, when the time comes to offer more accommodation, the Fed would rather have more rate hikes behind it and ultimately more room to cut. But clearly, the fact that the conversation Allen sheet normalization has already started making the rounds before we've even ended QE means, that the timeline we saw between the first rate hike in 2015 and the start of the balance sheet normalization in 2017 is going to be much shorter in this cycle. Obviously, still too soon to say with a great deal of conviction, about when liftoff will be. But once we get that first hike, I would look for the rhetoric around the balance sheet to really heat up.

Ian Lyngen:

Shifting gears slightly, Ben, let's talk about the December employment report that's released at the end of the first week of trading in January. Now recall, that the November report was mixed insofar as the headline was disappointing versus the consensus. However, the unemployment rate declined. And I'll argue, more importantly, the labor market participation rate showed signs of progress toward the upside.

Ben Jeffery:

And even as we get into the new year, it's going to be the ability of the participation rate to continue improving, which will help inform how tight the labor market is ultimately viewed. Remember at the November press conference, we heard from Powell that the current labor market landscape doesn't really fit into the traditional Phillips curve narrative, whereby a solid labor market leads to rising real wages. Whether it be the JOLT survey, the labor differential, what we're still seeing at this point in the pandemic, is the difficulty in bringing more jobs online, coming from the supply side of things. So put a different way, a labor market participation rate that remains lower than probably what all else being equal, would have been expected at this point in the cycle.

Ben Jeffery:

Clearly, the pandemic was almost an unprecedented economic shock that changed the way workers behave. We've seen numerous articles about the quote unquote great resignation, difficulty in bringing people back to some of the riskiest jobs from a health perspective during the ongoing pandemic. And while this has all been enough to drive upside and nominal wages, from a real wage perspective, we're still in negative territory. And not yet at least, at risk of entering a self perpetuating inflationary environment where higher prices begets higher wages, begets higher prices, begets higher wages.

Ian Lyngen:

There's a meaningful caveat to that analysis, however, and that is, we're assuming, and I think appropriately so, that collective bargaining isn't poised to have a comeback to the level saw in the 70s and 80s. Now, we have seen headlines associated with unionization efforts of the service sector. And this comes at a point when labor scarcity is particularly high in that part of the real economy.

Ian Lyngen:

One of the offsetting concerns, is that the rise of automation in the service sector has been accelerated during the pandemic, and may ultimately serve as a counterpoint to upward pressure on wages. Nonetheless, we have seen indisputable pockets of wage inflation, although in real terms, year over year, hourly earnings and average weekly earnings are still negative, roughly 2%. Now that speaks to the magnitude of realized inflation, as well as the overall composition of wage gains.

Ben Jeffery:

So coming into the first week of the year, we've seen rates and likely will continue to see rates put in a meaningful period of consolidation as the curve similarly finds its footing in somewhat flatter territory than maybe would've been expected, even just a few months ago. And the latest moves in Treasuries point to a bit more balanced positional landscape that will be brought into the new year. So, that should clear the way to offer a bit cleaner read on the collective sentiment of Treasury, as we start to see core positions put back on in the first several weeks of the year. We'll get December's jobs and inflation data. And while the Fed meeting isn't until the 26th of the month, the intervening rhetoric from monetary policy makers will help calibrate expectations for just how willing the Fed is going to be to discuss the idea of rate hikes at the end of January. And whether or not the first live meeting in March is actually on the table for the cycle's first rate raise.

Ian Lyngen:

And let us not forget, the departure point for the beginning of 2022 matters in terms of our rate outlook, assuming that we come into the year with 10 year yields at, let's call it, 150, 155 then the prospects are improved for breaching that 177 peak that was established in Q1 of 2021. In fact, we'll argue that a two handle on 10 year yields remains a path of least resistance during first half of the year with an acknowledgement that it won't be a straight shot. And choppy price action will remain the norm as the Omicron variant works its way through the real economy.

Ben Jeffery:

Well, end of the year. And I think we've reached that point. Guess what I got you for the holidays.

Ian Lyngen:

Oh, gee, Ben, I can't even begin in to guess.

Ben Jeffery:

A subscription to Macro Horizons.

Ian Lyngen:

Oh, you shouldn't have, really.

Ian Lyngen:

In the two weeks ahead, the Treasury market will have the final auctions of 2021 in the form of 56 billion two year years on Monday, December 27th, followed by 57 billion, five years on Tuesday. And wrapping up with 56 billion, seven years on Wednesday. All else being equal, we're expecting a reasonably solid underwriting, as the year comes to an end and month in rebalancing remains topical.

Ian Lyngen:

Given the holiday nature of the week, as well as the calendar turn, our expectations are that any resulting price action will lack the typical conviction. So when cooler heads prevail during the first week of January, investor focus will quickly turn to gauging the labor market and any potential fallout from Omicron on the pace of hiring and general business sentiment. ISM manufacturing for December is on Tuesday, followed by services ISM on Thursday, both of which will set the tone for Friday's non-farm payrolls report.

Ian Lyngen:

One key observation that has been made, regarding the month of January is, it's typically a period that has been spent assessing the holiday spending season, and what it implies for retailers, as well as putting the finishing touches on fourth quarter GDP estimates. This upcoming January will have a decidedly different tone. Most notably, because of the most recent variant of the coronavirus and the implications, not only for the holiday travel season, but also on what forward restrictions might be necessary in light of how the case count develops.

Ian Lyngen:

While holiday travel plans have certainly been curtailed and patterns, assumption will surely be modified, the fact of the matter is, that health officials continue to stress the potential for an increase in the winter wave driven by the increased transmit ability of Omicron. We certainly have very little insight to offer on this topic, other than to suggest that the uncertainties associated with this might ultimately imply that the real bearish liftoff point won't be until the latter part of January, if not the beginning part of February. This is simply predicated on the notion that there'll be enough uncertainty regarding an acceleration of COVID case counts following the holidays, that investors could err on the side of caution in establishing major core positions for the year.

Ian Lyngen:

While the price action that has characterized the last two months of 2021, in terms of trading in the Treasury market, hasn't implied a great deal of optimism, per se. We continue to anticipate that as the new year gets underway, the unifying themes across financial markets will once again, be focused on the establishment of new normals as progress toward re-openings is once again seen. And there's further evidence of realized upside risk in the inflation complex.

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. As this will be our last podcast until 2022, we'd like to wish everyone a happy and safe holiday season. From all of us here at Macro Horizons, thanks for listening and we look forward to continuing the show next year. And remember, new year's resolutions are just disappointments waiting to happen. Trust us.

 

 

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:

This podcast has been prepared 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.

Speaker 2:

Not withstanding 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 a suggestion that any investment or strategy referenced herein may be suitable for you.

Speaker 2:

It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment, legal, accounting, or tax advice or representation that any investment or strategy is suitable or appropriate to your unique circumstances or otherwise constitutes an opinion or a recommendation to you.

Speaker 2:

BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts and commodity options or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the U.S. Commodity Exchange Act.

Speaker 2:

BMO is not undertaking to act as a swap advisor to you or in your best interest and you, to the extent applicable, will rely solely on advice from your qualified, independent representative in making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment. You should conduct your own independent analysis of the matters referred to herein together with your qualified independent representative, if applicable.

Speaker 2:

BMO assumes no responsibility for verification of the information in this podcast. No representation or warranty is made as to the accuracy or completeness of such information. And BMO accepts no liability whatsoever, for any loss arising from any use of or reliance on this podcast. BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter. And information may be available to BMO and or its affiliates that is not reflected herein.

Speaker 2:

BMO and its affiliates may have positions long or short, and affect transactions or make markets in securities mentioned herein, or provided advice or loans to, or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast. For further information, please go to bmocm.com/macrohorizons/legal.

 

Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy

You might also be interested in