August Again - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 131, August Again, presented by BMO Capital Markets.

Ian Lyngen:

I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of August 2nd. And as summer trading conditions set in, we cannot help, but ponder where the macro narrative goes on vacation.

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 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 had several important inputs with which to contend and the net result was lower rates. We came into the week expecting a bit more dovish tilt from the FOMC, given the increase in COVID-19 cases domestically and abroad, and the focus on the delta variant. What The Fed delivered was surprising only insofar as there was minimum acknowledgement to the increased uncertainty associated with the pandemic.

Ian Lyngen:

What we did hear from Powell was that the tapering timeline that we were characterizing as consensus remains on track. So, that is an announcement in November, December. And, ultimately, asset purchases are reduced in January scaling to an end by the end of 2022, whether that process is a nine month process, or a 12 month process remains to be seen. But, all else equal, the economic data over the course of the next several months will dictate the pace of a tapering more so than the actual timing.

Ian Lyngen:

We also saw real GDP for the second quarter, which came in at 6.5%. This is on top of the 6.3% revised Q1 levels. Now, this was a disappointment versus the consensus, but a lot of that was a function of the fact that the inflation component within the series came in higher than expected. So, for the exact same amount of nominal GDP growth, the more inflation we see the less real GDP growth that we see. Now, it's much too early in the cycle to start talking about stagflation even if some of the recent consumer confidence surveys have shown that higher prices are undermining consumer confidence, and serving as a meaningful inhibition to spending. When we think about the next stage of the cycle, one of the primary debates in the market is whether or not higher prices will lead to workers requiring higher wages. Now, historically that translation, if it occurs, occurs with a lag and it also incurs when there is either collective bargaining power, which doesn't really exist in the US economy in any meaningful way, or there's labor scarcity of another type.

Ian Lyngen:

Now, the lack of workers, or lack of workers willing to engage in frontline service sector jobs at current wages does, in and of itself, represent the biggest risk for the second half of the year. If nominal wage pressure emerges and persists that's the primary way in which we could see higher realized inflation take hold and continue to perpetuate further gains in the coming quarters. That said, we're increasingly of the mind that growth has peaked and inflation has peaked for this cycle. The moderation doesn't necessarily need to return growth to prior levels. However, it will take some of the urgency off of the reflationary narrative, and bring into question how long it's going to take before the employment market has fully recovered?

Ben Jeffery:

Well, Ian, we got the July Fed meeting, and while the statement confirmed that the economy has made progress toward achieving the committee's goals, we haven't yet crossed that "substantial" line in the sand, at least, not as indicated by Powell's press conference.

Ian Lyngen:

I think that what The Fed is doing is they're going with the market consensus for timing of tapering, which is a November, December announcement to be rolled out officially in January. Now, we will get a little more clarity from Jackson Hole. However, a September announcement of tapering seems very unlikely, at this point. Particularly in the context of the delta variant.

Ian Lyngen:

What The Fed is also tasked with is continuing to reinforce the idea that the economy has returned to pre-pandemic levels in aggregate, but there are still sectors that continue to struggle. And it follows intuitively what those sectors are, frontline service sector firms, as well as many parts of the travel and hospitality industry. The reason that that will remain relevant as 2021 plays out is because of the implications for the employment market. Labor market participation is still lower than The Fed would like to see. And while the unemployment rate has come down, there's still more than 12 million workers receiving some type of unemployment benefit.

Ben Jeffery:

And in addition to those more macro considerations, on the topic of the composition of tapering itself, Powell went as far as to explicitly say that there was relatively little support for tapering MBS sooner than Treasuries. And while, generally speaking, I think that notion was well held among market participants the fact that the chair went as far as to explicitly say that the timeline on starting pairing those asset purchases will be consistent across Treasuries and MBS removes at least a degree of uncertainty around the process.

Ben Jeffery:

Now, when exactly tapering will begin and at what pace it will run, that will be a discussion for future meetings and something to look out for in the minutes releases over the course of the next several meetings.

Ian Lyngen:

One thing is relatively clear, however, the market has already priced in tapering. And it's very unlikely, particularly on the bond bearish side, that we will see anything more than a few basis points of re-steepening as the market tries to press that potential trade.

Ian Lyngen:

In fact, given what has occurred over the course of the last few weeks, it would appear that the knee jerk response to tapering might actually be bond bullish. Just this notion that The Fed is stepping away from an extremely accommodative monetary policy stance at a moment with an increased level of uncertainty associated with the path out of the pandemic.

Ben Jeffery:

And this was exemplified very well on the first look at real GDP for the second quarter. The number itself came in below estimates at 6.5%, which really begs the question of whether The Fed will need to revise its formal forecast at the updated SEP, which will be released on the September 22nd meeting.

Ben Jeffery:

As it currently stands, the aspirations are for 7% overall growth in 2021. And with the first and second quarter growth reads now in hand, to me at least, it's difficult to imagine that we're going to see a material acceleration and growth from here. After all in the first half, we had two rounds of fiscal stimulus and the uptick in consumption brought on by the removal of COVID restrictions. So, even without the delta variant to consider and what that might mean for in-person commerce over the next two quarters, The Fed's formal GDP estimates in September will certainly be a space to watch.

Ian Lyngen:

I'll make the argument that the grand reopening that investors came into the year expecting would occur after Labor Day has because of accelerated vaccinations early in the year, really been brought forward. And when we layer on top of it, the risk for future variants, we might find that the real economy in the US in particular is as reopened now as it will be by the end of the year, which has implications for the employment market, as well as patterns of consumption that have been developed during the pandemic. And were thought to, at least at the time, be temporary.

Ian Lyngen:

This outlook also contributes to the broader discourse related to inflation. If we find ourselves beyond the initial surge in demand, particularly on the service sector, then perhaps peak inflation and peak growth are both on the books for this cycle. And we're going to see a moderation lower, and lower, and lower which, again, only serves to reinforce the range trading thesis for the Treasury market.

Ben Jeffery:

But even a moderation in growth and inflation will be coming from, historically, very elevated levels. So, in terms of what it means for The Fed, I don't think that reality will be enough to completely derail monetary policy normalization. But what it may do is serve to recalibrate estimates on when we will see the liftoff rate hike. And what that means is that the price action in the belly of the curve is going to be especially topical over the course of August, and as we get into September.

Ben Jeffery:

If, in fact, The Fed will need to walk back some of the more aggressive normalization assumptions, not unreasonable to see a renewed belly out performance and the five-year sector in particular move toward lower yields.

Ian Lyngen:

Further, to your point, there will be an inflection point some time during the second half of the year. What we have seen thus far has simply been short covering as the reflationary narrative comes into question. What I find fascinating is if we look at ten-year breakevens, they're still very elevated by historic standards, which reflects investor sentiment around inflation. So, it's not so much that the market is pricing out elevated inflation for the time being but, rather, the underlying growth outlook has dimmed considerably. And this is evidenced by record low 10 year real yields, which dipped as low as negative 116 basis points this week.

Ben Jeffery:

And especially ahead of the jobs numbers this week, and maybe even more consequentially the participation rate. It's the participation rate that remains stubbornly low, even in an environment when, exactly as you say, Ian, the economy is likely as reopened as it's going to get. So, in terms of framing the trajectory of the recovery overall and in the labor market it's really going to be up to maybe, as Powell was want to say, "the passage of time" in order to start to see that labor market participation rate move back up and more broad based employment gains.

Ben Jeffery:

I think we're probably going to have to wait until September when we get the expiry of some of the enhanced unemployment benefits to really get a clearer picture on this issue. And, in more practical terms, it probably won't be until November and December when data for the post September period is revealed that we'll really have a greater understanding on exactly how hiring dynamics are going to play out once in-person learning is presumably back to being the normal operating procedure, and the unemployment benefits associated with the pandemic have expired.

Ian Lyngen:

So, on that, I would say that the upcoming Non-Farm Payrolls report is just about as untradeable as the most recent ones, where the market has just been content to look past the data and refocus on the evolution of the pandemic.

Ian Lyngen:

In this context, it's important to keep in mind that payroll increases in July were presumably based on hiring processes already underway, and a different outlook for the post pandemic period. It really has only been a few weeks since the delta variant, once again, became topical, and the implications for employment needs, and the shape of in-person commerce over the next several quarters has come into question. Therefore, on its base level, not only is it already dated July information, but it's information on hiring decisions based on a decidedly different understanding of where we were in the pandemic

Ben Jeffery:

And outside of the more macro fundamentals of the jobs report, we also get the August refunding announcement. While coupon auction sizes are expected to remain unchanged for another quarter, at their current record large levels the progress through the pandemic has now brought the market to the point when the process of estimating coupon size cuts are now underway.

Ben Jeffery:

The debate, at this point, seems to be centered on whether the Treasury Department will endeavor to do this at the November or February refunding announcement. And really the most critical aspect of this is going to be how conservative they want to be and maintaining either A, a higher cash balance. Or B, more flexibility on the potential for future fiscal spending. Given the desire to keep bills as a share outstanding in that 15 to 20% range, the bulk of the cuts are going to need to come from coupons with the lion share of those trims likely coming from the 2, 3, 5, and 7 year sectors, given that they were the parts of the curve that were most quickly ramped up during the pandemic.

Ben Jeffery:

Now, I think 10s, 20s and 30s will also be coming down as well, just perhaps at a slightly more moderate pace, if only for Yellen to take advantage of a yield curve that's still quite flat by historical standards. So, a lower interest costs by moving borrowing further out the curve resonates in terms of keeping overall cost to the taxpayer as low as possible.

Ian Lyngen:

This will have some implications for QE and the composition of bond buying only in so far as it changes the average maturity of issuance, and Treasury debt outstanding. But, nonetheless, we'll be cautious of concerns, or observations that there's a stealth twist underway. When, in fact, it's just the lag between the implementation of monetary policy, and the realities of the changing composition of issuance.

Ben Jeffery:

This also brings us to a question we feel that this week on the shape of the curve and the territory that it continues to hold in both 2s, 10s and 5s, 30s. And that is, given the degree to which the reflation trade pushed in the fourth quarter, have we already seen the steepest the curve will be for this cycle? The extremes in the shape of the curve this cycle were always likely going to be lower than cycles past. And Ian, while I think we're in the camp anticipating that we will see a steeper curve environment, that will likely be a 2022 or beyond development.

Ian Lyngen:

And while we will find ourselves in a situation where growth and inflation have moderated from the current levels, that doesn't mean that they won't be running higher than they were at the end of the last cycle.

Ian Lyngen:

The most important caveat to the outlook, however, really does come down to wage inflation. And wage inflation will be a function of whether or not there are labor shortages. And, if so, how long they persist. As with some of the initial dislocations created in the inflation complex being characterized as transitory by The Fed, we view any pockets of higher wages, particularly on the frontline service sector, as similarly transitory, or temporary as the real economy continues to adjust to the post pandemic norms.

Ben Jeffery:

Normal, always very loosely defined in the context of this team.

Ian Lyngen:

Norm, as it ever was.

Ian Lyngen:

In the week ahead, the Treasury market will be faced with a new calendar. So, any month end buying pressure will presumably be offset as positions are re-established with the month of August in mind. There are no Treasury coupon auctions during the first week of August, which implies that we will have, presumably, a relatively clean read of the market's equilibrium ahead of the July BLS Employment report.

Ian Lyngen:

Consensus currently stands at roughly 750,000 jobs added in July, as well as an increase in average hourly earnings of three tenths of a percent. There's no question that the market is now shifting to more traditional summer trading conditions. That implies lower volumes, limited conviction and, potentially, choppier price action. These conditions will most likely persist until after Labor Day, which puts us in the middle of September before the market engages in any broader collective rethink of the path forward for inflation, and the real economy.

Ian Lyngen:

In terms of outright levels that we're tracking in the Treasury market, our first target for 10 year yields is an opening gap between 109 and 110. Now a move to rates that low doesn't necessarily need to be accompanied by disappointment on the jobs front. But instead, will rely more heavily on expectations associated with the delta variant, and what those mean for an economy that was generally expected to be a lot more reopened in the third quarter than it looks like it will. Nonetheless, we're continuing to hold the broader range trading thesis for Treasuries this year. What we saw in the first quarter was the establishment of the upper bound for yields when 10 year yields hit 177. We have since seen short covering and a reassessment of expectations going forward in terms of growth and inflation which, ultimately, brought 10 year yields down to 112.

Ian Lyngen:

And we suspect that there is a reasonable probability that 10 year yields dip below 1% over the course of the summer. If that were to occur, first and foremost, it would be short-lived. We don't expect a zero handled 10s to define the next stage of the cycle. In addition, if it does happen, it will occur over the course of the next 5 to 6 weeks when the seasonal patterns are the strongest for Treasuries. Limited conviction will allow for outsize moves to occur. And, ultimately, it won't be until September when cooler heads prevail.

Ian Lyngen:

The primary shift in the outlook that would need to occur for 10 year yields to remain close to or below 1% would be a collective shift in positions from what was short to neutral, from neutral to outright long. An outright long Treasury position in aggregate, given the performance of the US economy and elevated inflation expectations, would be very difficult to imagine being sustainable. Nonetheless, a brief tactical bullish trade from here remains our near-term outlook.

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 return to office plans become more uncertain, we cannot help, but sigh a little bit of relief, which only puts further stress on our ever shrinking apparel. Ah, the delta 20.

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.

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