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A June to Remember - The Week Ahead

FICC Podcasts May 28, 2021
FICC Podcasts May 28, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of June 1st, 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.

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Ian Lyngen:

This is Macro Horizons, episode 122. A June To Remember 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 June 1st. And as summer unofficially begins, we look forward to tracking our unofficial miles run, golf handicap, trails hiked and nautical miles kayaked even if we won't officially be in good shape. Now where are all those health officials when we need them?

Speaker 2:

The views expressed here are those of the participants and not those at 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, 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 had a few important fundamental inputs to continue with. First was there was an increase in taper talk from Fed officials. Now, we haven't moved to the point in which this has been officially introduced in the statement, but we are starting to hear several Fed officials start to lay the groundwork for a conversation about scaling back asset purchases.

Ian Lyngen:

Presumably that conversation will occur over the course of the summer with more official unofficial trial balloons centered around Powell's Jackson Hole presentation and culminating with an official announcement sometime in Q4 with tapering to be rolled out in Q1. There's been a fair amount of debate around whether or not tapering will be MBS' first, Treasury's first or both simultaneously. We're erring on the side of assuming that they will wind down purchases simultaneously cutting back on both treasuries and mortgages. Now, the logic here is relatively straightforward, the Fed doesn't want to do anything that would create needless dislocations. And unlike during the last cycle, when the financial crisis was more closely linked to the housing market, what we will be seeing via this cycle of taper is the Fed pulling back from a broader initiative to support the economy as a whole, as opposed to one sector versus another.

Ian Lyngen:

Moreover, the taper tantrum in 2013 was certainly a learning experience for the Fed, So we expect that we'll ultimately see an increase in transparency as well as predictability as the Fed attempts to scale back out of the current bond buying program. In other recent events of note, we did see a disappointing personal spending number. However, that was accompanied with a higher than expected core PCE print. It's notable that the Treasury market had a very muted response to both. In fact, with 10-year yields at roughly 160, it's safe to say that the Treasury market is still very much in the mode of discounting the incoming information.

Ian Lyngen:

Now, this dynamic might change in the week ahead, as we see even May nonfarm payrolls series. However, for the time being, we're continuing to err on the side of the trading range in 10-year yields. We expect it will be very difficult for 10-year yields to reach above the 177 upper bound, and for all intents and purposes, a push of 10-year yields above 2% during the first half of the year is clearly off the table with the highest probability of such an event occurring in the second half as the economy comes back online and we see some of the reflationary impulses continue to work through the system, presumably with the added benefit of an improving labor market.

Ben Jeffery:

So we've now heard from vice-chair Clarida, he's open to taper talks, but yet 10-year yields fall to 155?

Ian Lyngen:

155 on taper talks, I think, really sets the stage for what we expect to see over the balance of the summer. And that is as Fed officials continue to introduce the idea that they will be scaling back the pace of asset purchases, the Treasury market will move on to what's next. So implicitly with rates dipping on the news of taper talk, what we're seeing are echoes of the trade that happened in the wake of the taper tantrum in 2013, specifically the market initially reacted negatively to the notion that the Fed was going to cut back their bond purchases only to later go on and trade what it means when the Fed starts to take away support from the real economy i.e, a monetary policy stance that is less aggressively accommodative implies that either the real economy is going to reach some level of escape velocity or we'll see some degree of mean reversion that brings into question the sustainability of the rebound.

Ben Jeffery:

There's also the very important conditional that we've heard the Fed offer around, not beginning tapering, but beginning the discussion about tapering. And that is that the recovery continues at the impressive pace we've seen for the first half of this year. Now that over half of the adults in the US have received the vaccine, it's safe to say we've entered at least the early version of the new normal. So while the pandemic undoubtedly persists globally, domestically we're quickly approaching the point when the trajectory of hiring, consumption and inflation are less directly influenced by the pandemic itself. This doesn't negate the influence of bolstered unemployment benefits or the fact that in-person school has yet to resume.

Ian Lyngen:

I also think it's notable that 23 states are now pushing back against the federal enhanced unemployment benefits. And this points to the collective sense that perhaps one thing constraint in employment at this stage in the cycle is that many workers continue to find it advantageous to simply receive unemployment benefits rather than return to the job market.

Ben Jeffery:

So going into NFP week, how does this influence the weighting you assigned to the job figures? Given that these influences are still very much at play, does that mean that we can ignore the May data? Is another miss on the scale of what we saw in April a reasonable outcome? And even that was pretty much ignored.

Ian Lyngen:

One of the fascinating parts about judging the data in the pandemic is that the word reasonable has really lost context. Given the magnitude of a lot of the misses and upside surprises, what we have seen over the course of the last several months, is the market's collective reluctance to actually trade the numbers as presented. Now, this isn't to suggest that there's a lack of confidence in the actual figures themselves, but rather given the error bands around the estimates, there's a sense that it's close enough, even when we're 500,000 jobs over or 800,000 jobs short. We'll argue that the most prudent strategy is to focus on the three-month moving average of non-farm payrolls growth, where we see roughly 550,000 jobs added every month. If Friday's number exceeds this pace, that will be marginally constructive for the outlook. But what will be more notable is if we see another print far outside the consensus, for example, anything well over a million jobs or under 300,000. Barring such an outcome, there won't be much to be extracted from the series for the broader macro economic outlook.

Ben Jeffery:

And even assuming we get 500,000 jobs added in May, that would still leave more than seven and a half million people without a job versus February 2020. And in this environment, with nearly as many people still unemployed, as the total job losses as we saw during the global financial crisis, any sustainable upside and real wages is going to remain elusive. And particularly as prices are rising as a function of supply constraints that hardly points to a robust consumption profile, something I would argue, we saw in the latest, real personal spending figures.

Ian Lyngen:

There was a decline of one-tenth of a percent. Now this is troubling because we didn't see the transition from goods consumption to service consumption that many had been anticipating would characterize the second quarter. Now, if we're not able to see an increase in spending on services and in-person commerce over the course of the summer, that will materially challenge the recovery timeline that many brought into this year. This is important, particularly in so far as it translates through to the probability of achieving sustainable demand side inflation.

Ian Lyngen:

There has been a lot of conversation surrounding the amount of fiscal and monetary policy stimulus that has been put into the system as a result of the pandemic, and the risks that this then translates through to upside inflationary pressures. We're certainly on board with that notion from a conceptual level. The issue becomes in application, whether or not the trajectory of reopening and re-engaging in frontline service sector businesses keeps up with expectations and therefore the early signs of inflation that we're seeing ultimately become self-fulfilling as workers demand more wages in the context of scarce resources as many workers remain sidelined, given the health risks presented by the pandemic, even at this stage.

Ben Jeffery:

And looking at the price action and Treasuries break even specifically, I would argue that the bulk of that upside has already been priced in. I think it's that impulse that contributed to 10-year break evens, move beyond two and a half percent, and now as investors are grappling with the realities of this next leg in the recovery, the retracement, albeit very modest at this stage in break evens resonates with an inflation outlook that has, as of right now, not continued to march ever higher as it seemed to be doing throughout the bulk of 2021.

Ian Lyngen:

Part of that is the question of just how high inflation expectations on average can remain anchored. 300 basis point 10-year breakevens, really difficult to justify given the market's collective understanding of the inflation profile in the US. Now, if we found ourselves in a situation where year over year gains in commodity prices and real wages, as well as other key inputs were sustainable, that would imply that not only will growth manage to reach a much higher plateau than many in the market are currently expecting, but higher input costs are ultimately and durably able to be passed through to the consumer. That's really the biggest question. Whether higher prices are going to create a headwind for consumption or simply be absorbed as the real economy comes back online and the savings reserves on the household level are deployed.

Ben Jeffery:

And unfortunately this week, June, probably the summer is not going to reveal any great clarity the answers to those uncertainties. So in terms of the price action itself, the most compelling trading opportunities are likely going to be a bit more tactical in nature, playing the range, playing supply, maybe some event risks thrown in there rather than any new, meaningful trend in rates. I suppose sideways is a trend, but...

Ian Lyngen:

The one caveat that I'd add in there is that the seasonal pressures in the Treasury market are about to become as relevant as they will be in 2021, whether that actually translates through to what we have seen historically, which is let's call it a 30 to 35 basis point decline in 10-year yields on average, between the beginning of June and the 15th of September remains to be seen. What we shouldn't take away, if nothing else is that it will be very difficult given the seasonal patterns and the uncertainties facing the macro outlook for 10-year yields to reprice above 2%. In fact, we continue to assume that the 1. 77% level and 10-year yields will remain the upper bound for trading in the Treasury market for the foreseeable future. Now, given the dynamics of financial markets, the foreseeable future might at best get us until October or November. And I'm content with the notion that a great deal could change between now and the post-labor day environment.

Ben Jeffery:

Not least of which could be more developments out of Washington related either to Biden's total proposed budget of $6 trillion that has a focus on the infrastructure deal, as well as any greater clarity on the direction of taxes, whether that be corporate taxes, capital gains, or personal income

Ian Lyngen:

Ben, taxes are going up.

Ben Jeffery:

But by how much?

Ian Lyngen:

A lot.

Ben Jeffery:

How much is a lot?

Ian Lyngen:

Joe will let you know.

Ben Jeffery:

But in any case, while it may be something of a quiet summer in terms of trading activity, it's safe to say that any surprises out of Washington could play a large role in recasting expectations for the recovery in the later part of this year and as we get into 2022.

Ian Lyngen:

One of the biggest risks was always that the recovery was front-loaded by the fiscal stimulus measures that the white house rolled out at the beginning of the year. Pandemic bail out 2.0 and 3.0 really did put some upside in retail sales and the consumption figures during Q1. The question now becomes how sustainable is that trajectory throughout the course of the year. We'll clearly get more context on that over the summer months as we start to see the economic data for may and June, but we suspect that a modest pullback will be easy enough for the market to excuse given the upside that we saw in Q1, which once again, really puts the emphasis on the second half of this year as the make or break for the reflationary post-pandemic steepening in the Treasury market. So, Ben, what do you have planned for the holiday weekend?

Ben Jeffery:

Oh, you didn't get the invite to the Powells’ barbecue?

Ian Lyngen:

Oh, I did. I just assumed that you didn't.

 

In the week ahead, the holiday shortened trading week will ultimately be focused on non-farm payrolls on Friday. As it presently stands, the consensus is about 675,000 jobs that were added in the month of May. This is ostensibly a great print in the context of what this series has historically delivered. However, given where we are in the recovery cycle and what we saw in March in terms of a very significant upside surprise in jobs growth, the market would be more likely than not to absorb a consensus print of 675k with a shrug and confirmation of the trading range. This is certainly at odds with the narrative that the economy is quickly rebounding and reflationary pressures can be seen in a variety of different areas. We'd be remiss not to acknowledge the fact that there have been upside surprises in the realized inflation data. And frankly, we expect that that will continue at least for the next several months.

Ian Lyngen:

The question then quickly becomes, how committed is the Fed to continue dismissing the upside prints and inflation as transitory even as the year over year numbers, which admittedly are influenced by these effects, continue to reach decade highs. One of the obvious downsides about higher realized inflation in an environment where wage growth is relatively benign on the nominal side, is that real wages will continue to decline. We've already started to see this come into play via the April PCE report, and this will be a difficult trend to fade in the event that the next several months are characterized by upside surprises on the inflation front, specifically within the employment report, investors will also be focused on the unemployment rate. The current consensus is for a 5.9% unemployment rate during the month of May, while it might be tempting to characterize this as a strong number, given the Fed's framework shift.

Ian Lyngen:

And their emphasis on the unemployment rate for the low and the middle wage earners, a number close to 6% suggested there is a fair amount of distance yet to be traveled before the Fed concludes that substantial progress has been made toward its goals. In fact, our back of the envelope calculation suggests that we'll need to have the unemployment rate a lot closer to 3% before the Fed really starts to get worried about the prospects for wage inflation to lead to sustainable true demand side inflation, and therefore ultimately spurred the fed into a monetary policy tightening mode.

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 on Memorial day weekend. And as a friendly reminder, one of the key benefits of a podcast is that it can be listened to anytime, for example, Tuesday, back at work, in the home office. Maybe we should have led with that.

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 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. 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 suggestion that any investment or strategy referenced herein maybe 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 a representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. 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. BMO is not undertaking to act as a swab advisor to you or in your best interest and you to the extent applicable, will rely solely on advice from your qualified, independent representative making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.

Speaker 2:

You should conduct your own independent analysis of the matters referred to herein together with your qualified independent representative if applicable. 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. BMO and it's affiliates may have positions long or short and effect transactions or make markets in security is mentioned herein, or provide advice or loans to, or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMO's trading desk 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

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