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By Any Other Name - The Week Ahead

FICC Podcasts June 11, 2021
FICC Podcasts June 11, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of June 14th, 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 124, By Any Other Name, 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 14th. As the pain trade persists, we're reminded that capitulation by any other name, which still spell retracement.

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. That being said, let's get started.

Ian Lyngen:

In the week just past, the Treasury market was presented with a series of events and economic data that would have suggested Treasury yields should have ended the week decidedly higher. The fact of the matter, however, was that 10-year yields managed to grind lower, breaking through the 150 level to reach as low as 142.5. This is telling, if for no other reason than it came despite the stronger than expected core CPI and stronger than expected headline CPI numbers, to say nothing of the 10 and 30-year auctions.

Ian Lyngen:

Now, to a large extent, the bulk of the price action has been attributed to position squaring and at its essence, a short squeeze. We will argue that this risks over simplifying matters. The market came into 2021 with a strong reflationary bias. 10-year breakevens reached as high as roughly 260 only to reverse to 230, despite the fact that the realized inflation data continues to outperform. What has underperformed has been the growth in jobs. Now, it goes without saying that coming out of the pandemic, there's a lot of complicated factors behind interpreting the real economic data. However, as recently as March, there was a sense that several monthly NonFarm payrolls prints over a million were well within the range of conceivable outcomes.

Ian Lyngen:

As it presently stands, the three month moving average has ranged between 500 and 600,000, which while very strong by historic standards, as we're coming out of the pandemic, it has less obvious ramifications for the longer term upward pressure on wages. What we have seen is short-term pockets of inflation on the consumer price side that has been driven by shortages and pipeline issues. From the perspective of wages, the upside gains appear to be a reluctance on the part of frontline workers to re-engage in in-person employment at this stage in the cycle. We're certainly sympathetic to the notion that enhanced unemployment benefits have played a role, but so have the realities of the pandemic and the nature of COVID-19 itself.

Ian Lyngen:

It's safe to say that for the time being, market participants have deferred evaluating the relative success of the reopening and the recovery process until after the summer, once the Labor Day holiday is behind us and we'll get a better sense of how the economic data has performed over the coming months. More importantly, September will be an important litmus test for workers returning to the office and for students returning to in-person learning.

Ben Jeffery:

Inflation is back.

Ian Lyngen:

It's certainly not wasted on us, that the 10-year yield is roughly half of what core inflation printed for the month of May. What will be more compelling to see is exactly how long this bullish trend can persist in the Treasury market. Now, a lot of the price action has been attributed to a short squeeze in one way, shape or form. Now, whether one believes that's a true capitulation or a short-term move as positions are squared with the summer months approaching, is open for interpretation, particularly this close to the Fed.

Ben Jeffery:

While the move after CPI was counterintuitive, multi-decade high inflation rates would not traditionally translate to a rally in Treasuries. The fact that we're likely to hear, again, from Powell on Wednesday, that this pickup in consumer prices that we're experiencing is transitory, it seems at this stage that the market is giving a fair amount of credence to the idea that the Fed continues to project. They're going to keep policy and accommodative territory, given the fact that this surge in prices is simply a function of a reopening economy meeting constrained supply chains, and this dynamic will eventually work itself out in the coming months and quarters.

Ian Lyngen:

The bigger risk remains that the upside seen in prices somehow translates through to real wage gains. While there does appear to be pockets of scarcity on the labor front resulting from a reluctance on the part of workers to re-engage in frontline employment, it's difficult to imagine that this will ultimately be a sustainable trend, unless for some reason, we find ourselves at the end of the summer and the labor market participation rate is still as low as it presently is with little incentive coming from the end of the expiration of enhanced unemployment benefits. That's really one of the primary inflection points over the course of the next several months.

Ben Jeffery:

It'll be very telling to see the degree to which Powell is willing to acknowledge this dynamic in his press conference. There will almost certainly be a question relating the impact that enhanced unemployment benefits are having on the labor market and given what we've heard from both secretary Yellen and Powell thus far, that seems to be a risk that they're willing to dismiss. There's also a childcare component to this, as well as health concerns simply relating to the pandemic, even with the vaccination process in the US having made some meaningful progress.

Ian Lyngen:

There's also an open question about whether the Fed chooses to adjust the administered rates, i.e., the very front end RRP and IOER. While ultimately it's not going to be a significant influence further out the curve in five, tens, or thirties per se, it could potentially trigger a repricing in the very front end of the curve. All else being equal, if the Fed can roll out the transition in a way that doesn't disrupt the market, I suspect that the committee would consider that a win. The bigger unknown is the degree of urgency that the Fed has at the moment to execute on a slight week higher in rates.

Ben Jeffery:

This past week, we did reach an RRP milestone with over $500 billion being parked overnight at the Fed, receiving a rate of 0.0.

Ian Lyngen:

Flat, stable and zero, it's no way to go through life.

Ben Jeffery:

But on something of a more serious note, on the topic of an adjustment to the administered rates, we have heard from New York Fed President Williams that the RRP facility is functioning as designed, and given the situation and funding markets, the Fed anticipated a great degree of usage. While $500 billion in excess cash may not be desirable for some market participants, really the fact that effective Fed funds has stayed well off the lower bound, holding steady at six basis points demonstrates the RRP facility's effectiveness. It's serving its purpose by soaking up the excess cash in the front end, which in turn, is not being used in the Fed funds market and dragging the effective rate lower.

Ben Jeffery:

The nature of the Fed funds market and the different variety of market participants that use Fed funds has led to this discrepancy between repo rates that are negative and Fed funds that's at six basis points. Nonetheless, with Fed funds effective at six basis points, the first percentile of trading at four basis points not challenging zero, and the actual increase in the 75th percentile of Fed funds trading, there is a reasonable argument to be made that the Fed can afford to be patient.

Ben Jeffery:

Now, whether that ultimately leads to them deciding to hold off on an adjustment remains to be seen, but for all the focus on some of these eye-popping numbers, the situation has proceeded in a way that really meshes with what it seems like the Fed was expecting, and as a reason why they increased counterparty limits and increased counterparty eligibility at the reverse repo facility.

Ian Lyngen:

What you're really saying is that home loan banks are big in the Fed funds market?

Ben Jeffery:

Well, when you put it like that.

Ian Lyngen:

Simple is as simple does. On top of the Fed, we also have the updated projections so the will be looking for the Fed's interpretation of the recent performance of the real economy as it applies to the projections for real GDP over the course of the next year, and 2022 and '23 as well, but also on the inflation side and how that all ultimately translates through to policy rates. As of the March updates, the median 2023 dot was at zero, although some participants were anticipating an increase in the policy rate. What will characterize as having the highest potential to be impactful for the Treasury market on Wednesday will be how the 2023 median dot plays out.

Ben Jeffery:

Based on our latest pre-NFP survey, there's a sizeable contingent of the market expecting that the 2023 dot is going to come off the zero lower bound. Two more FOMC members raising their rate projection at the end of 2023 would bring the median to 25 basis points, and three or more doing so would translate to a full hike being projected by the end of 2023. Now, in regard to our survey, 44% expected no change to the 2023 dot, which leaves slightly over half of the respondents anticipating that there will be some upward adjustment. Based on the assumption that this idea is in the market, that makes 10-year yields move through 143 all the more notable.

Ian Lyngen:

The price action also occurred in the wake of what should have, at least ostensibly, been a net negative week for the Treasury market. We had the 10-year reopening auction, although it did go reasonably well with a 1.2 basis point stop through. We also had the long bond auction that was 24 billion 30s that tailed one basis point, which is a rare event for a reopening 30s. The bear sentiment was augmented by a higher than expected core CPI print of seven tenths of a percent month over month. This, on top of what we saw in April, really leaves no question that inflation is back in the system and it is comparatively broad based. While new and used auto prices certainly were significant contributors, we also saw gains in OER, apparel as well as more reopening specific pressures such as those in the travel and hospitality industries.

Ben Jeffery:

On the 10-year auctions specifically, I'll admit a degree of surprise at just how strong the reopening was. There was no intraday concession to speak of. Yields were at effectively the lows of the day and breaking through the bottom of the trading range, but yet a 1.2 basis points stop through and non-dealer sponsorship that was well above average really pointed to one, a reluctance to fade the rally and/or two, a willingness to join it. Good demand in the primary market for the long end of the curve sets a constructive stage for 20s, which we get on Tuesday, and while less directly for the five-year TIPS reopening on Thursday, given the inflationary backdrop, it's reasonable to expect we will see at least a baseline of demand for inflation protection.

Ian Lyngen:

Let us not forget that next week also contains the May retail sales numbers. We saw a bit of a disappointment in the April series and with a consensus looking for a four tenths of a percent decline in May headline retail sales, keeping in mind this is not an inflationary adjusted number. That suggests that the second quarter will continue to struggle to keep up the strong pace of real GDP growth that was seen in Q1. Recall the print in Q1 was 6.4%. Even this was slightly below the Fed's expectations for the year, which are 6.5%. More importantly, given the degree to which consumption appears to have been front-loaded to the first quarter because of fiscal bailout 2.0 and 3.0, we really struggle to see how that momentum is going to carry forward throughout the course of 2021 in the event that NonFarm payrolls growth is unable to break away from the anchor of 500 to 600,000 jobs created every month.

Ben Jeffery:

In terms of the price action and levels to watch into and coming out of the Fed meeting, I think it's fair to say that the market has settled into something of a pattern of holding the trading range between these fundamental updates. Once the new information is in hand, even if the market isn't repricing to the fundamentals, it's the passage of the event risk that ultimately clears the way for the moves themselves. Now that 10s have stabilized for the time being between, call it 140 and 155, it's reasonable to expect that if the zone persists coming out of the Fed and Powell's press conference, the next point of focus will be the July 2nd release of the June payrolls figures. In keeping with our broader bias, it's a broad trading range that will be redefined at points, but as the summer rolls on, it's redefinition followed by consolidation, followed by redefinition.

Ian Lyngen:

Just to quickly touch on one of the more relevant aspects of the June NonFarm payrolls release on the 2nd of July, the 2nd of July is a SIFMA recommended early close of 2:00 PM, just saying.

Ben Jeffery:

Telling that we're focused on that when it's three weeks away.

Ian Lyngen:

I'm already making plans.

Ian Lyngen:

In the week ahead, the primary event in the Treasury market will be the affluency decision. While there are no expectations for the Fed funds rate itself to be changed, there's a strong argument that the administered rates, IOER and RRP, will be edged slightly higher to provide a fine tuning adjustment for some of the dynamics currently underway in the repo market. It's important to keep in mind that this is not considered a monetary policy change on the part of the Fed, so there will be minimum ramifications for the overall Treasury market. The updated economic projections will undoubtedly garner some attention. We're focused on not only the 2023 Fed funds dot, but also how the Fed shifts its expectations for 2021 in terms of real GDP, as well as the increase in core inflation.

Ian Lyngen:

We're reminded that the higher the price deflator, the lower the real growth figures, we've been constructive on the Treasury market over the course of the last several weeks and now with that 150 level in 10-year yields realized the next obvious question is does this move have room to extend, or was it simply short covering that has run its course? The fact that the price action continued despite the stronger inflation numbers suggests that investors are more focused on the pace of jobs growth than evidence of transitory inflationary pressures. In the event that CPI and PCE continue to trend higher, there will be a reckoning of the Fed's characterization of these pricing pressures as temporary, but for the time being, it's difficult to fade the Fed's interpretation of the real data.

Ian Lyngen:

Let us not forget that on Tuesday, we see the May retail sales print as a non-inflation adjusted number. The consensus, four tenths of a percent decline doesn't bode well for consumption during the second quarter. This, when combined with the overall moderating of growth and inflation ambitions as the recovery continues, if anything, reinforces the idea that 10-year yields will be range-bound and achieving the 2% level is going to be much more difficult than it might have been assumed earlier in the spring.

Ian Lyngen:

The front end of the market remains extremely well contained by monetary policy expectations, so with two-year yield stock at 15 basis points, the shape of the 2s, 10s, and 2s-30s curve has largely devolved into a directional trade. In terms of curve shape, 5s-30s is far more compelling, if for no other reason than the path toward tapering QE purchases has been largely assumed at this point, and the bigger monetary policy debate is centered on a liftoff rate hike. Whether that is in late 2022 or sometime in 2023 will be the focus of the Fed debate in the coming quarters. This translates through to pressure on the belly of the curve, the five-year sector in particular, as the market pushes back and brings forward liftoff expectations. Translating that through to the flattener, the more hawkish that the Fed is expected to be, the flatter we'll see 5s-30s and vice versa.

Ian Lyngen:

We've reached a 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 today is the 35th anniversary of the release of Ferris Bueller's Day Off and the premiere of In the Heights, we'd like to round out roll call with the Usnavy? Usnavy? Here. Usnavy? Usnavy? Usnavy?

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 a suggestion that any investment or strategy referenced herein may be suitable for you. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients.

Speaker 2:

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Speaker 2:

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Speaker 2:

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

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