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Between a Taper and a Hike Pace - Monthly Roundtable

FICC Podcasts September 07, 2021
FICC Podcasts September 07, 2021

 

Margaret Kerins along with Ian Lyngen, Greg Anderson, Stephen Gallo, Ben Reitzes, Dan Belton and Ben Jeffery from BMO CM's FICC Macro Strategy team discuss whether or not employment data will derail taper timing, the separation of taper from from liftoff timing, credit spread and supply outlook, Canadian elections, GDP miss and implications for the BoC and the main themes driving currencies into year-end. They conclude with a rapid-fire, year-end outlook for US and Canadian rates, high quality spreads and currencies. 


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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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Margaret Kerins:

This is Macro Horizons, monthly episode 31, between a taper and a hike pace presented by BMO Capital Markets. I'm your host Margaret Kerins here with Ian Lyngen, Greg Anderson, Stephen Gallo, Ben Reitzes, Dan Belton and Ben Jeffrey from our FICC Macro Strategy team to bring you our debate of the main narratives that are dominating market pricing and what these themes imply for US rates, high quality spreads and foreign exchange. Each month, members from BMO's FICC Macro Strategy team join me for a round table focusing on relevant and timely topics that impact our markets. Please feel free to reach out on Bloomberg or email me at margaret.kerins@bmo.com with questions, comments, or topics you would like to hear more about on future episodes. We value your input and appreciate your ideas and suggestions. Thanks for joining us.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries.

Margaret Kerins:

Since our last podcast on August 3rd, 10-year treasury yields are about 20 basis points higher with the latest move sparked by the August nonfarm payrolls data, which of course was well below expectations in addition to the rapidly spreading Delta variant. The price [inaudible 00:01:31] is continuing this morning with yields about five basis points higher. So we have slower growth resulting in higher yields, which seems counterintuitive. But this is a market playbook that we've seen before. Bad news is good news because it impacts the Fed's reaction function. Over the past several weeks, the Fed has done a decent job setting up tapering caveated by the evolution of the economic data. They clearly laid the groundwork so that the market would be prepared if they needed to taper earlier than expected. Friday's job mistakes an earlier taper off the table, but leaves November and December in play.

Margaret Kerins:

The timing of the November 3rd meeting is two days before the release, the October payroll data, but ADP employment in ISM for October will be known. So market pricing will continue to be all about the data on the ground versus the risks presented by the extended pandemic timeframe. So let's kick it off with Ian. Ian at Jackson Hole, chair Powell stated his view that the substantial further progress test has been met for inflation, and also he stated that there had been clear progress toward maximum employment. What he didn't say is that the substantial further progress test has been met for employment. The employment data has been choppy, and it's not that long ago that a 200,000 print would have been viewed positively. So now we have the taper test for inflation met, clear progress, unemployment, and a positive prints. Will positive prints in the 200,000 to 300,000 range, really derail tapering, or do they need to get moving on this front due to inflation and with a potential fiscal package in the offing?

Ian Lyngen:

Well, Margaret, my takeaway is that the Fed has done a brilliant job of separating the parameters for tapering from the parameters for the first rate hike. And what we have seen over the course of the last several weeks from the Fed and as interpreted from the market's response is that investors understand this and they're expecting the Fed to follow through with tapering with an announcement either in November to be implemented in December or December to be implemented at the beginning of the year. And the focus at this stage is all about the timing of the liftoff rate hike. And you can see that as it plays out in the belly of the curve. The five-year sector in particular. And when we looked at the response on the part of the US rates market to the August nonfarm payrolls print, what we saw was what I'll characterize as a flash back to the beginning of the year when the assumption was that moderate to reasonable jobs growth and higher realized inflation would leave the Fed on hold longer under the paradigm of the new framework and in doing so re-steepen the curve.

Ian Lyngen:

So we've seen a mini re-steepening with, as you pointed out Margaret, with 10 year yields now, well over 20 basis points off the lows. The next question becomes, are the realized gains in average hourly earnings going to continue to drive this stagflation light narrative, which we expect will simply weigh on consumption as the market re-calibrates between now and the end of the year? So specifically to your point, I struggled to see any nonfarm payrolls prints between now and November or December that would derail tapering, but if the labor market isn't able to regain some of the momentum, then a 2022 rate hike will certainly be off the table.

Ben Jeffery:

And in terms of what to look for over the balance of this year, Ian, I completely agree that the area of the curve that's going to be most relevant to watch is probably going to be the five-year sector. Given the belly sensitivity to collective liftoff expectations, it's really going to need to be a function of the realized data. Now that we've gotten through the summer period, some of the base effects relating to the early days of the pandemic have begun to work themselves out, and we're presumably reaching a more normalized labor market environment that the Fed is going to be, especially to how the economy is performing. Now, Ian and Margaret, you both touched on the fact that at this point, tapering is going to be announced before the end of the year. In a client survey before the August jobs numbers, we saw roughly 52% expect that that announcement will take place at the November meeting, but that certainly doesn't mean that the incoming inflation and jobs numbers can't move the needle on the expectation on lift off, which at this point is a late 2022 or early 2023 question.

Greg Anderson:

Ben, I think this offers a good point to transition and talk about credit spreads. And we're anticipating that with credit, the current range in spreads is going to hold in the near term. And that's largely because we're expecting a low rate and potentially low volatility environment to persist into the fall. We saw a modest back-up in credit spreads this summer, and that widening total just about 10 basis points. While that move was due in part to growth concerns stemming from COVID, there was certainly a strong technical element to that move with heavy vacations and light investor activities, which we typically see leading to some weakness in credit spreads in August. But the story now is going to be about supply at least for the next two weeks. This morning, we see 22 high grade corporate borrowers in the US dollar market. That's the most of any single day on record.

Greg Anderson:

It's more than we ever saw during the 2020 unprecedented wave of supply, but we're expecting that this heavy issue, which is going to be well absorbed by the market, given that the investor base is likely well positioned to take down this supply as they typically are during this period of heavy issuance in September. And then after supply, it's likely that the focus in credit markets is going to be about the degree of continued fiscal support into year end. Another question that we'll be looking to answer is, when does the market start to feel the technical impact of Fed tapering? We've not been expecting anything like a taper tantrum to take hold here, but there will be pressure on credit spreads as the Fed's MBS and Treasury purchases are eventually forced to clear the market without the Fed support. And that could crowd out private funding and lead to some weakness in credit spreads, only this is likely to be a later 2022 story.

Ben Reitzes:

Moving north of the border, the end of summer, doesn't only mean that markets are going to be more active, we also have a federal election on tap on September 20th. That likely doesn't have huge macro implications given the way things are shaping out at the moment. Right now, the polls are pretty much a dead heat or maybe slightly in favor of the liberal party at the moment against the conservatives, with the NDP and Bloc Québécois well behind. At this moment, it looks as though we're going to get another minority government in Canada. So all of the headlines you get about policies that the parties want to put in place, probably not going to happen. At least not the way that they've laid them out at the moment. Everything likely to be watered down to some extent, but you never know. I mean, there is still some odds we could get a majority, maybe a liberals' slightly more likely, but the momentum is on the conservative side.

Ben Reitzes:

So, I wouldn't rule that out either, but for now it does look like a minority government of either the conservatives or the liberals, and really that's a toss up at the moment. But again, the macro impact would probably be pretty limited on that front. We also get the Bank of Canada early in September here. It's actually going to be September 8th, tomorrow. And because of the election, nothing really is expected. And so it's just kind of a wait and see event for them as they don't really want to get involved in politics at all. Given the likely minimal impact of the election at this point, it shouldn't impact policy moving forward. And even if there were a change of government, we wouldn't really get a big fiscal shift or any real big fiscal information for at least a few months. So don't expect any changes on that front to impact rates or Bank of Canada policy, at least for awhile. While there won't be likely much impact from a rate perspective from the election, there have been some pretty big macro data over the past couple of weeks in Canada.

Ben Reitzes:

We got a second quarter GDP number that was surprisingly negative, and you can contrast that with significantly better numbers through pretty much the rest of the world as Canada felt the third wave of COVID probably a little more than most there. And just kind of compounding that negative, the flash estimate for July GDP was negative as well. And so the bank of Canada was looking for +2% in Q2. That was -1.1. So a three percentage point missed there. For Q3, they were looking for seven and a quarter percent. That's going to get cut at least in half. So you're looking at materially weaker growth relative to what the Bank of Canada was forecasting. The October NPR is still a long ways away, but it is likely that they'll have to cut their growth forecast pretty notably, and that could push out the timing of the upper gap that could delay tapering as well, which pretty much everyone has penciled in for October.

Ben Reitzes:

So things have gotten a little bit more interesting in Canada at this point from a rate perspective. I think I'd like to wait to see a little bit more data just because stats can and has been prone to some sizable revisions of late, so you never know maybe that July number changes in a more positive manner. We'll have to wait and see. But for now again, I would say my bias would be for Canada maybe outperform a little bit near-term, but we'll see what the election brings out and we'll see what the Bank Canada has to say later this week. Finally, while I'm not expecting any big rate moves to come out of the election, we could see a little bit more action on the currency front, but I'll leave that to you, Greg.

Greg Anderson:

Ben, on the topic of dark Canada volatility, we certainly got it in August. And I guess maybe some of that was election related. We'll point out that on the date that the election basically rolled into the one month forward window is when we got the most extreme movement in both dark had spot as well as one month implied [inaudible 00:11:35]. Certainly seems like a big segment of the market was putting on hedges in dollar Canada, long dollar CAD at that instance. But that move also kind of mirrored what was going on in the broader US dollar index. So a big spike and what looked like a breakout to new highs for the year in various different implementations of dollar indices. And then that breakout, it fizzled and yuan various different axes, such as $0 exciting levels were breached and then all of a sudden the move died. And perhaps we can attribute a little bit of that to Powell disappointment that he wasn't as hawkish as maybe the minutes had set up in some people's minds, but I'm not sure that that's entirely. It just the move lost momentum.

Stephen Gallo:

Well, Greg, that's an interesting comment about the faults breakout on the top side and the dollar. I think we have to look at the China angle as is almost always the case. When we look at the dollar China exchange rate, what does it tell us about policymakers and their reaction function and their intentions right now? I think they would prefer to keep dollar China parked in the 640s. That accomplishes a couple of things for them. Number one, it reduces volatility in the exchange rate to virtually nothing, but two, and I think this is more of a sentiment thing, by keeping dollar China in the 640s, policymakers are removing depreciation pressure from EM currencies against the Chinese Yuan. And I think that's helpful for EM sentiment. And that is also an inhibiting factor for dollar strength right now, the fact that EM sentiment or EM currency sentiment could be worse, but it's not because of the influence that China has over the exchange rate.

Stephen Gallo:

And you know what? Maybe it's worth just giving the Euro a small mention. If you look at the Euro dollar chart, we bounced nicely off that 117 level a couple of weeks ago or so, and that pretty much coincided with Euro China, Euro CNH that is bouncing off the 760 levels. So again, I think we see plausible evidence here that Chinese policy makers have been tempering appreciation of the Yuan. I guess to finish off, the only thing I would say that makes me a little bit uneasy about this 640 650 range in dollar China is that if we're sort of not much higher than 645 by the time of the September FOMC and the Fed delivers a dovish rate decision or a dovish message later this month, I think it's going to be tough for policymakers to prevent a break of 640 in dollar China. I don't think they particularly want it now, but that 640 level is going to be very important in terms of how the Fed feeds into this situation.

Margaret Kerins:

Thank you, Greg and Stephen. We have covered quite a variety of topics in today's podcast. And as we've said, our base case for tapering continues to be an announcement later this year, but let's do a quick rapid fire on outlook for rates and spreads and currencies in the different sectors that we cover just to sum up today's recording. I will start it off with Ian.

Ian Lyngen:

I think that the biggest takeaway for the treasury market from the recent events is that we're going to continue to be in a range, and we're about to enter a period where the new upper bound is re-established as we make it through the Delta variant and we get a better sense of the Fed's reaction function to the mixed data with inflation still in the system, but jobs growth showing signs of flagging, at least at this stage. So our net takeaway is more of the same within a range, not a trending market, but that's to be expected given where we are in the cycle.

Ben Jeffery:

And that really leaves the most relevant price action over the balance of this year in the belly of the curve. We've reached the point where tapering is now nearly a foregone conclusion to be announced in the next several months. And from that perspective, it's going to be liftoff assumptions and whether or not the first rate hike of this cycle will be in late 2022 or early 2023, that will offer the most sustainable price action and treasuries at this point.

Greg Anderson:

With respect to credit, we're expecting a very supportive environment for credit spreads into year end, given the continued fiscal and monetary support, which we're expecting to bring more range-bound trading like Ian and Ben just talked about, which could bring a resumption of the yield drag trading environment. We're expecting credit spreads will retest historical tights around year end, and we're targeting 75 basis points in the Bloomberg Barclays index.

Ben Reitzes:

Up in Canada uncertainty is the name of the game pretty much for the rest of the year. We have an election in a few weeks and again, an uncertain outlook for who's going to win on that front, but likely a minority government, no matter who wins. Meantime, we're still dealing with fourth wave coming here, case loads are rising that clearly had an impact on the second quarter. And it's a pretty big uncertainty, whether that's going to dampen growth through the rest of 2021 and into 2022.

Greg Anderson:

Ian mentioned staying within a range in fixed income. And I would just say that our range in FX is narrower than your range. For the dollar index, we've basically been 5% wide thus far this year and I don't think we will break either edge of that and where we're call it a percent and a half away from the top of the range to put a year-end call smack dab in the middle would be US dollar index down a half a percent to a percent. I think that would be my best call for right now for year end with CAD, probably outperforming that a little bit so I'd call it 1% strength. And then the other outperform that I would point to New Zealand dollar should have rallied more this year thus far than it has. I still think it's got that potential by the time we get through the end of the year.

Stephen Gallo:

Greg, I don't see massive volatility coming in either dollar China or Euro dollar, no surprise there. Naturally, a lot is going to depend on the Fed's approach to its normalization cycle, the taper and so on as has already been mentioned, but looking specifically at Euro and RMB, I short Euro on a number of non-dollar crosses is going to remain a preferred carry trade during periods of rising risk appetite. So how that translates over to Euro dollar, I think 119, 120 in Euro dollar is pretty toppy for that currency pair. I don't like taking big exposures in dollar RMB, but if I had to pick one, it would probably be to fade dollar China's strength in the high 640s. Look for opportunities to get short of the dollar up there.

Margaret Kerins:

Okay. And that's a wrap. Thank you to all of our BMO experts and thank you for listening. This concludes Macro Horizons' monthly episode 31, Between A Taper And A Hike Pace. As always, please reach out to us with feedback and any ideas on topics you'd like us to tackle. Thanks for listening to Macro Horizons. Please visit us @bmocm.com\macrohorizons. We'd like to hear what you thought of today's episode. You can send us an email @margaret.kerins.bmo.com. You can listen to the show and subscribe on apple podcasts or your favorite podcast provider. And we'd appreciate it if you could take a moment to leave us a rating and a review. 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 is produced and edited by Puddle Creative.

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Margaret Kerins, CFA Head of FICC Macro Strategy
Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy
Benjamin Reitzes Director, Canadian Rates & Macro Strategist
Dan Belton Vice President, Fixed Income Strategy, PHD
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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