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Bonds in the Time of War - The Week Ahead

FICC Podcasts March 04, 2022
FICC Podcasts March 04, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of March 7th, 2022, 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 161: Bonds in the Time of War 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 March 7th. And if we've learned nothing from this week, it's been an answer to question, what happens if NFP surges 678,000 and no one cares to trade it? All eyes are on Ukraine.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its 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 Bloomberg or email me at I-A-N.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. In the week just past, the Treasury market had a great deal of fundamental contributions to help drive trading direction. The biggest, obviously, being non-farm payrolls, which came in remarkably strong, all things considered, at plus 678,000 jobs. The unemployment rate declined to 3.8% and average hourly earnings disappointed, being flat month over month and up 5.1% year over year. The most remarkable aspect of that is the fact that the Treasury market completely ignored the strong payrolls print.

Ian Lyngen:

Now, this is consistent with the balance of risks facing the real economy at the moment, specifically Russia's invasion of Ukraine continues to dominate the macro narrative. Now, this has prevented 10-year yields from backing up and, in fact, we saw 10-year yields dip as low as 1.68 during the week and the twos-tens curve flattened to just 25 basis points. Now, this with a backdrop of Powell who came out and emphasized that the Fed will be hiking rates on March 16th and that he will propose increasing the policy rate by 25 basis points. This does effectively eliminate the possibility that the Fed does a 50 basis point lift off, but he did reiterate that if inflation accelerates further, that the Committee could choose to go 50 basis points at some point.

Ian Lyngen:

We'll suggest that this optionality is very par for the course for monetary policy makers and conforms with our baseline expectations, which are that the blueprint for the upcoming hiking cycle will be 25 basis points a quarter with additional quarter point hikes added during the off cycle meetings as the data dictates and allows for an accelerated pace of normalization. This is also consistent with 25 basis points at March, May, and June followed by a balance sheet runoff announcement in July. At this point, that outlook is relatively consensus and we're comfortable with the idea that it is effectively priced in. The outlook gets a lot less certain as we get into the second half of the year. Although the incentives for the Fed to continue ratcheting up policy rates higher are very high at this point in the cycle. The bigger issue is, how does the Fed balance communicating the upcoming cadence in terms of their expectations while keeping enough flexibility to allow them to increase rates either 125 basis points this year or 150 or even 175?

Ian Lyngen:

Needless to say, there's no scenario in which it makes sense for Powell to pre-commit to any course of action so we expect that on March 16th, when liftoff is realized, that there will be a cautious amount of forward guidance offered. And, of course, the market will look to the dot plot and the number of rate hikes expected by the Fed in 2022 as well as the long run number, the estimate for terminal during this cycle. All else being equal, given the mounting risks that we've seen come to fruition thus far in 2022, it's difficult to imagine that the Fed chooses the March meeting to up the ante on what terminal should be.

Ben Jeffery:

Well, Ian, on a trading desk, I've learned that when NFP hits, one should probably be in their seat.

Ian Lyngen:

Well, that certainly was not the case this week, was it? Although it was nice to see the world coming back to life and more and more people swapping out the home office for the office-office, even if that does require going back to more traditional business attire in some cases.

Ben Jeffery:

It was also a good week for a more fully staffed desk just given what we saw in the market. We saw 10-year yields get as low as 1.68 after breaking that 1.84 level and twos-tens got to 25 basis points. And when I say 25 basis points, that's the shape of the curve, not the amount that the Fed is going to hike in a little less than two weeks.

Ian Lyngen:

And we also did hear from Powell, who made it abundantly clear that he's going to propose hiking rates by 25 basis points, not 50 on March 16th.

Ben Jeffery:

But it was notable that the Chair didn't completely shut down the idea that the Committee could move by 50 basis points at some point during the tightening cycle if inflation does not begin to moderate. Now, unlike the dramatic front end re-pricing we saw in response to Bullard's comments about a 50 basis plant liftoff, the reaction to the Chair's remarks was not particularly out-sized. And, to me, that suggests that Powell was successful in predicating an even more aggressive tightening on the trajectory of the inflation data. So really what this means is that, the first rate hike, probably the second rate hike, and maybe even the third rate hike are all going to be 25 basis points if only to give the Fed the opportunity to evaluate the incoming data and just how much inflation will begin to moderate on its own before the influence of higher policy rates weigh on the increases in consumer prices.

Ian Lyngen:

This is very consistent with our stance that we'll see a quarter point hike at each of the next three meetings, March, May, and June, and then the balance sheet runoff announcement in July, which really brings us to the September meeting where there could potentially be some degree of variability. Now, the variability at play, or at least currently in terms of the market's expectations, is the difference between 25 and 50. And we're certainly comfortable with that narrative, but there's a lot that could happen, as we have seen in the developments in Eastern Europe, between now and September. So it certainly wouldn't be outside of the realm to at least see the market attempt to price in the debate being between zero and 25. So as we think about the evolution of U.S. rates over the balance of the year, if nothing else, what we have seen during the first quarter has really emphasized the amount of uncertainty that there is presently on the macro horizon.

Ben Jeffery:

I see what you did there.

Ian Lyngen:

That's one of us.

Ben Jeffery:

And really, Ian, I think that's what's going to present some of the most compelling trading opportunities as we hopefully begin to receive some greater clarity on what the world is going to look like over the next several quarters, and that is fading the extremes that inevitably will make their way into valuations. This week was a great example where, coming in from the weekend, we actually saw the chance of a 25 basis point move in March not be fully priced in. And unlike just a few weeks ago, when a 50 basis point move was almost completely priced in, ultimately, using that dislocation, whether it be in the Fed Funds Futures Market or the shape of the curve, fading that extreme ultimately proved to be a prudent strategy as the next leg of fundamental information, in this case, via Powell's Congressional testimony, made its way into the market.

Ian Lyngen:

We've been thinking about broad based geopolitical risks as being one off and perhaps providing a bullish underpinning in the Treasury market. But what we've seen over the course of the last two weeks is a very meaningful shift of the world order. Now, I certainly wouldn't say that to be sensational in any way, shape, or form, but rather from everything that we have gathered, it appears that Putin's endeavors in Ukraine have really galvanized the West and in doing so raised the stakes for how the situation ultimately plays out. And we're certainly not experts on Eastern Europe, but by the way that financial markets are trading the risks associated with Putin's aggression, it suggests to us that it's going to be extremely difficult to bring back the narrative that we saw at the beginning of the first quarter where rates were going higher, the curve was debating whether or not to steepen or flatten, and there seem to be a lot more optimism on the global outlook front than we have at this moment.

Ian Lyngen:

I struggle to see us as a market getting back there so that implies that the Fed will follow through with balance sheet normalization, but without the previously perceived urgency. Recall that some in the market were calling for an emergency rate hike just two weeks ago and now others are calling for an emergency extension of swap lines. So that pivot I think is remarkable and, if anything, simply reinforces this notion that we're going to keep trading a range in 10s and 20s and the front end of the market is going to remain beholden to monetary policy expectations. So, in short, that is a curve flattener.

Ben Jeffery:

And you touch on the chatter around dollar swap lines, and obviously the flight to quality impulse that we saw surrounding concerns on a nuclear reactor in Southern Ukraine and just the situation more broadly. This brings up another dynamic that's going to be very important as we think about how much the longer end of the curve will be able to cheapen in the short and medium term. And that is that the variety of sanctions on Russia that we've seen implemented so far have demonstrated that the dollar by far, in a way, still remains the world's reserve currency and the impact it will be able to have on not only the Russian economy, but on a global scale as well means that demand for dollars, something I think that could be argued is already showing itself in the very front end of the market, will continue to leave a deep bench of U.S. dollar safe haven duration waiting to buy any material dip.

Ben Jeffery:

We saw it when we got to 206 10-year yields, and now I would argue the deteriorating situation in Ukraine has lowered the bar for what investors will consider a viable dip, so to speak. And that will potentially be put on display via the March reopening supply of 10s and 30s that we get on Wednesday and Thursday of this upcoming week. It was extremely telling to see that within the breakdown of the investor class data from the February refunding auctions last month that we saw foreign buyers take their largest share of a 10-year auction since February 2011. Now, sure, overseas allocation is always higher at refundings versus reopenings, but nonetheless, the strong auction and then allocation statistics showed that overseas investors are still more than willing to buy Treasuries and I would argue the geopolitical developments of this past week will only add to that dynamic.

Ian Lyngen:

Shifting gears somewhat, within the BLS data, non-farm payrolls did increase 678,000, and we also saw the unemployment rate drop to 3.8%, a very impressive showing on both fronts without question. However, the wage data was a lot softer than the market was anticipating. It was effectively flat at 0.0%, an average, we know all too well, and the move brought the year over year change in wages to just 5.1%. In an environment where CPI is running north of 7%, in real terms, the consumer's spending power continues to decline, and that's one of our major worries for the first quarter, is that we could easily see a flat to slightly negative real GDP print given the significant amount of inflation that continues to make its way through the system. Now, this is arguably a classic stagflation environment, but it is also one that the Fed has signaled that it is in the process of addressing.

Ian Lyngen:

So, in this context, we will be focused on the market's reaction to Thursday's CPI print. As it presently stands, the consensus for headline CPI is an 8/10th of a percent increase. Energy, obviously, being a big component there as well as food costs. But even core CPI is seeing an increase in six-tenths of a percent. And the question that this begs is, how does the curve respond in an environment where inflation shows no real signs of moderating yet? All else being equal, one would intuitively think that, that should be a steepener. However, given how the curve has responded to previous upside surprises and inflation over the course of this year at least, I suspect that this will only double down on the flattening pressure that's already in place, because if nothing else, it solidifies market expectations for the Fed to deliver a more lengthy hiking campaign.

Ben Jeffery:

And it also emphasizes that the growth outlook is not looking so good before we've even gotten the first rate hike of the cycle. So stagflationary concerns combined with a tightening monetary policy backdrop and a curve that's already within striking distance of inversion will most likely lead to increasing chatter on the prospects for the Fed to hike the economy into a recession. Is that a reasonable risk, Ian?

Ian Lyngen:

I think it's always going to be a reasonable risk. Keep in mind that the way that the Fed tends to operate is that once they start the process of raising rates, they will continue to hike until something breaks. And my biggest concern is that something could break earlier in the normalization process than the Fed would like to see and that leaves them once again with a limited amount of policy rates to cut and a heavier reliance on the balance sheet. All of this, again, just re-emphasizes the fact that it will be very difficult to see the curve steepen out in the way that it has in prior cycles until we find ourselves in a much longer expansion. Recall that prior to the pandemic, the U.S. economy was experiencing its longest expansion in history.

Ben Jeffery:

And the role that higher oil prices are going to play on the global economy is difficult to overstate. We've seen a tendency historically for sharp increases in energy prices to proceed economic slowdown, and after WTI reached its highest level since 2008, this comparison is made all the more striking. Obviously, Russia plays a very important role for the energy market, not just in Europe, but the world as a whole, and as sanctions continue to be revealed targeting not just financial assets, but also Russian gas and oil exports, I think it's safe to say that we're not going to be reverting to a cheap oil paradigm anytime soon. And that's going to keep production that relies heavily on petroleum expensive and prices at the pump high, both of which do not bode well for a very robust consumption profile at a time when the Fed would like to be seeing the expansion accelerate, not start to slow down.

Ian Lyngen:

And that does speak to the underlying issue about the acceleration of inflation that was already in place before the geopolitical tensions really heated up. And not to suggest that the Fed is now faced with inflation that is beyond their control, but even Powell has made the observation that this is not the typical financially driven inflation. There were already supply chain issues at play before Russia invaded Ukraine and that is only going to be worsened by the realities of greater sanctions. And let us not forget, the sanctions won't be immediately repealed given how they have galvanized the West, and for that reason, we are worried about the cumulative effect on the region over time.

Ian Lyngen:

Not only does this risk a more dire economic fallout for Europe, but it also speaks to the risk for a greater destabilizing effect. One thing that we can conclude is that it will be a very pivotal period for the global economy over the next several months and there's now little question that U.S. Treasuries remain the world's flight to quality instrument. On that note, Ben, what's your spirit instrument?

Ben Jeffery:

Tuba, obviously.

Ian Lyngen:

Hm. Mine's a Treasury.

Ben Jeffery:

How do you play a Treasury?

Ian Lyngen:

So you haven't been listening at all. In the week ahead, the Treasury market, for all intents and purposes, has one data point to watch and that's Thursday's release of the Consumer Price Index for the month of February. There's a lot of inflation running through the system. That much is known. The Fed is poised to increase policy rates on the 16th of March. It's with this backdrop that the price action the Treasury market will be so informative in so far as investors are actively trying to weigh the relevance of the situation in Ukraine versus the implied upward pressure on rates from elevated inflation. Our near term outlook for the market continues to favor the flattening of twos-tens in particular. It's very reasonable to expect that the window between the March and the May FOMC Meetings will be a prime opportunity to see the twos-tens curve invert. Now, dropping below zero on this benchmark spread doesn't necessarily imply that the real economy is on the precipice of recession.

Ian Lyngen:

However, it almost goes without saying that the financial media will focus on the traditional relationship between the shape of the curve and any potential signaling power. From our perspective, we continue to side with the Fed who has long maintained that the key curve is the three month bill versus 10-year spread, and that has plenty of room to go before it is even close to the point of inversion. Let us not forget that the week ahead also has three Treasury auctions of note, Tuesday's 48 billion three-year, Wednesdays, 34 billion 10-year, and, of course, the long bond reopening of 20 billion on Thursday. Participation at the refunding auctions in February was very strong and this is consistent with investors looking for the liquidity provided by the size of the auctions as well as to take advantage of what was a pretty significant backup in rates before the auctions themselves.

Ian Lyngen:

Given the flight to quality that has occurred since the last 10 and 30-year auctions, it's difficult to imagine that some type of concession isn't warranted either immediately ahead of the auction or at the auction itself. That being said, we expect that there will continue to be sufficient demand for the primary issuance of Treasuries, and if there is any meaningful steepening of the curve, either into 10s or into 30s, we would use that as an opportunity for better placement for a core flattening position. It's difficult to even ponder the outright level of yields outside of the elevated geopolitical tensions. The Treasury market had a very strong bid on Friday into the weekend and the degree to which that can extend over the course of the coming week will be very telling, and we'd look for a breach of 1.68% in 10-year yields to clear the path for an even more significant rally, although if we did make it to 1.50 in 10s, we would be a seller there.

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. In a world with so much uncertainty and a dearth of levity at the moment, we will offer the laughable fact that we've managed to record 161 episodes of Macro Horizons without endangering a single pun. 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.

Speaker 2:

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Speaker 2:

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. 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 elected herein. BMO and its affiliates may have positions long or short and affect transactions or make markets in securities 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 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

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