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Bullish Inflection - The Week Ahead

FICC Podcasts June 18, 2021
FICC Podcasts June 18, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of June 21st, 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 125 Bullish Inflection presented by BMO Capital markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts on the trading desk for the upcoming week of June 21st. And with 10-year yields solidly below 150, despite taper talk and higher 2023 dots, we're reminded that one can only call it a conundrum once, and Greenspan beat us to it.

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, 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.

In the week just past, the Treasury market had a great deal of fundamental information to trade off. The highlight was the FOMC meeting. There were two main takeaways from the FOMC meeting. The first was an increase to the 2023 dot plot. The Fed introduced an additional 50 basis points worth of tightening. Presumably, that's bringing tightening forward from 2024, given that the longer run estimate was unchanged. Powell also started the conversation about tapering bond purchases. Now, unlike in 2013, the market has a reasonably good idea of what to expect from here. The consensus tapering timeline is that we will get an official announcement either in November or December, and the implementation of tapering will begin in Q1 2022.

Ian Lyngen:

Presumably, it runs the bulk of the year and from that point will transition from balance sheet expanding bond buying to simply maintenance bond buying of maturities that are coming out of the SOMA portfolio. Now, the Fed will still be buying bonds in an outright basis, both in Treasuries and mortgages, presumably, but it will just be at a level to maintain the amount of excess reserves currently in the system. Another key piece of information was a disappointing retail sales print for May. Now it wasn't enough to recast expectations for Q2 real GDP.

Ian Lyngen:

However, the pace of consumption will remain in focus over the course of the next several months, especially given the backdrop of an employment market that while continues to grow is not expanding at the pace that one might have otherwise wanted to see given the accelerated timeline of reopenings in the US. It's also worth noting that there was an increase in jobless claims for the June non-farm payroll survey week. Now we're still several weeks away from actually seeing the BLS data that will be on July 2nd.

Ian Lyngen:

But as the market continues to refine expectations for the next stage of the recovery, it goes without saying that progress to reengage sidelined workers and push up wages and increase real average hourly earnings will remain a focus. In terms of the next stage of the bullish repricing and Treasuries, we're of the mind that we're entering a consolidation period with 10-year yields around 150, the sell off that has occurred in the front end of the market that hasn't been reversed is unlikely to be reversed because that's simply a function of the market pricing in the new dot plot landscape.

Ian Lyngen:

So this implies a continued flattening, particularly in 5s/30s as the Fed's willingness to potentially address inflationary upside should it prove not transitory ultimately caps the degree to which 10 and 30-year yields can increase here.

Ben Jeffery:

So we get rate hikes in 2023, talking about talking about tapering and a sell off in Treasuries until Thursday, that is.

Ian Lyngen:

Then we got a pretty significant rally and the curve bull flattened. I think it's safe to say that the second leg of that trade was a bit of a conundrum for the market, as it were, at least based on the number of questions that we received in regards to positioning the seasonals and all the other influences that might actually be driving yields lower when the Fed just told us that they are going to have to hike more in 2023 than initially assumed. And the groundwork has been clearly established for tapering later this year

Ben Jeffery:

And going into the meeting, it was pretty broadly expected, I think, that the median 2023 dot would show one rate hike, but 50 basis points of tightening was something of an outside risk. Add to that the fact that Powell acknowledged this was the "talking about talking about tapering meeting" and the fact that we saw 530s flattened 20 basis points in just two sessions while break evens fell sharply and real yields picked up was revealing as to the current bias of Treasury market investors at this stage in the cycle.

Ian Lyngen:

As a point of clarification, though, when the Fed hikes, we tend to see inflation expectations moderate. So I'll argue that it was a pretty textbook hawkish monetary policy response to sea break evens off, but the surprising aspect of move frankly, was that 10 and 30-year yields declined at an outright basis relatively significantly. Look at 30s, for example, Ben, you have 2% 30 year yields as possibility. I think perhaps we got as low as 205, which is the lowest since February when the market was pricing in the more optimistic reopening, optimistic reflationary scenario that really characterize the first quarter.

Ian Lyngen:

Speaking of textbook price action.

Ben Jeffery:

And the non-zero chance of a WAM extension.

Ian Lyngen:

Oh, WAM, WAM on the door. And in keeping with the textbook theme, we'd be remiss not to acknowledge the fact that the seasonals are playing out pretty much as anticipated. So we brought in a fair amount of optimism at the beginning of the year, we saw reflation as a primary theme, we saw reopening as a primary theme. That got 10-year yields to 177 as the realities of the economic data cycle kicked in and we saw that NFP growth was good, but not great. We saw the market then started to moderate some of those ambitions, not that inflation isn't back in the system. It's just currently being characterized as transitory.

Ian Lyngen:

Not that jobs aren't being created, they're just not being created at a million jobs per month pace. And that's what led to the consolidation that occurred in the Treasury market during the second quarter. And now we're at a bit of a bullish inflection where the path of least resistance will most likely end up being a grind toward lower yields. The question in my mind, aside from what I'll be shopping for on Prime Day, is how far can this bullish price action ultimately run?

Ben Jeffery:

So assuming that 10-year yields go into the June NFP release on July 2nd, roughly between 140 and 150, and keeping with those seasonal patterns, it's realistic to assume that we'll see rates grind, if not necessarily plunge lower over July, August, and as we get into September. And this gets at a question we fielded a few times this week, which is okay, the market's now repricing to a less accommodative Fed backdrop in the near to medium term, which helps explain the rally and duration and flattening of the curve.

Ben Jeffery:

So as we get into September, which is historically the seasonal point when yields bottom, and we start to see enhanced unemployment benefits roll off, in-person learning resume and we move into October, November, December, and start to get the economic data for the early autumn, it's at that point, I think, when we'll have a much clearer picture of the undistorted pace of the recovery. And that suggests again that we'll see some upward pressure on rates into the end of 2021 and early 2022 as once again, optimism and greater clarity on the rebound materialize.

Ian Lyngen:

One of my issues with that analysis is it assumes that we'll see a re-basing higher in rates simply because we're returning to "normal." If the fact of the matter is what we're seeing is the Fed backtrack somewhat on their new framework, that would imply that term premium shouldn't be as high and that inflation while it might run hot, it won't run as high as perhaps a market had previously assumed. I think that's one of the things capping rates in this current environment.

Ben Jeffery:

And that's a really important point on this latest "hawkish" surprise. The Fed is still classifying inflation as transitory, but yet they're starting to take steps to normalize monetary policy. They're choosing to focus on progress on vaccinations, ongoing hiring, albeit not at the pace one would ultimately like to see. It's those dynamics and very easy financial conditions that are giving them cover to begin the conversation about tapering. But based off what we heard from Powell, the Fed is still of the mind that inflation will be transitory, which is why rates are forecasted to still be at zero through the end of 2022.

Ben Jeffery:

So on the one hand, the recovery is moving along well enough to justify tapering, but on the other inflation is presumed to be transitory and thus, we still have policy in very accommodative territory, if not necessarily with the backing of a QE program.

Ian Lyngen:

I think it's worth emphasizing the financial conditions aspect of what's going on in the market. Financial conditions are super easy. Equities are near all time records. Equity volatility is low. Credit spreads are tight. We have seen the fact that the Treasury market came out of this most recent round of policy revelations lower in yields speaks to a Fed that has plenty of room or cover to proceed with tapering and eventually start the process of normalizing rates. Had Powell's comments about talking about talking about tapering had been met with a sustainable selloff in Treasuries and equities, then financial conditions could have easily tightened to the point that the Fed would need to walk back some of that timing.

Ian Lyngen:

But as it stands, there's little question that this was a successful transition on the part of monetary policymakers to the next stage of the rate cycle.

Ben Jeffery:

So in terms of a rough timeline for the balance of the year, a lot of focus is going to be on the Jackson Hole Symposium in late August for Powell to more formally lay the groundwork for tapering to likely be confirmed in the formal statement at some point in the fourth quarter, maybe the November or December meeting.

Ian Lyngen:

Won't be October.

Ben Jeffery:

With the actual tapering process to begin early in 2022, run for call it 10 to 12 months and then stop completely before the Fed and investors focus will shift to calibrating liftoff estimates on timing and outright scale.

Ian Lyngen:

It's also worth noting that while the consensus expectation is that Powell will be reappointed for another term and accept, it would nonetheless be a tidy end to 2021 for the Fed to formerly announce tapering. So regardless of what happens on the political/monetary policy leadership side, the gears will already be in motion to wind down true balance sheet expanding QE. Another quick note on the change to the dot plot, the market has been focused on two or three hikes now being priced in.` The reality is that the Fed added 50 basis points of tightening. It doesn't have to occur in quarter point increments.

Ian Lyngen:

And in fact, if one believes the Fed is really committed to allowing inflation to run hot and using a framework that looks back over the last year on average at a core calculation the Fed has yet to commit itself to, then it's very reasonable to think that the Fed might actually have to move more than 25 basis points at a time, particularly in the beginning. Now it's far too early for that to be a call, certainly not our call, but it's something worth keeping in mind as the market attempts to price in the forward path of policy rates.

Ben Jeffery:

And during Thursday's rally, we saw evidence within the price action itself supporting exactly that dynamic. Ian, you mentioned 30-year yields got back to within striking distance of 2% 30-year yields, not 10-year yields.

Ian Lyngen:

Do you think that will satisfy those in the market who were calling for 2% Treasuries?

Ben Jeffery:

Never said which Treasuries. But all kidding aside, while we saw that take place in the long end of the curve, the three and five-year sector retained essentially all of their selloff that we saw following the Fed announcement and dot plot adjustment. So that substantial bull flattening we saw was a function of outperforming duration and less so and underperforming belly of the curve, given the fact that the front end and the belly are now starting to be beholden to lift off that will likely take place at some point within the next two, two and a half years.

Ben Jeffery:

And aside from the Fed funds forecast, I was also at least mildly surprised that the Fed increased their outlook for overall growth in 2021, up to 7% from six and a half percent, which again gets back to this idea that the recovery is progressing enough to begin the conversation on tapering. Clearly, an environment with 7% GDP doesn't warrant a QE program, which puts a significant onus on the second half to see the rebound accelerate. Remember in the first quarter, we only saw 6.4% expansion on an annualized basis.

Ian Lyngen:

It was surprising to me as well, particularly in an environment where higher inflation, whether transitory or not, has become a reality. And in the context of how we view GDP, for the same amount of nominal GDP, the higher the price deflator, the lower the real number. So it's with this context that the second and third quarters' real GDP print will be scrutinized for the ability of the recovery to keep up with the Fed's expectations.

Ben Jeffery:

Speaking of expectations, now's probably a good time as any for my mid-year review.

Ian Lyngen:

Oh, for sure. Let's put it this way. There is a lot of opportunity here.

Ian Lyngen:

In the week ahead, the Treasury market will continue to digest the information that came out of the FOMC and the subsequent price action that has occurred. The combination of a reasonably sharp sell-off followed by a largely counter-intuitive bull flattener has left the market prime for a period of consolidation. Now, volumes were particularly high last week, but in the week ahead, there's very little on the calendar that should suggest that we will see another definitive breakout. We have a variety of Fed speakers, some voters, some non voters that should add incrementally, at least, to the Fed's message.

Ian Lyngen:

However, it's very difficult to imagine anyone going off script at this point. We're now in the middle of June, summer is officially starting. The auction calendar is focused on twos, fives and sevens. All of this creates a background where one would expect that the only material challenges that would occur to the broader trend in Treasury yields would be of a technical nature. Now, typically following a move of the magnitude that we saw on Thursday, one would assume that the momentum profile had reached extremes, i.e. well into overbought territory.

Ian Lyngen:

The fact of the matter, however, is that stochastics remain out of overbought conditions, which suggests that there's still room for a steady grind lower in 10 and 30-year yields. This would fit very well with the traditional seasonal patterns, which are constructive between here and the middle of September with the caveat that there's very little that's likely to occur from an economic perspective between now and the autumn that would trigger the type of repricing that either put 125 10-year yields on the table, or 2% 10s back on the market's radar.

Ian Lyngen:

After all, the market is expecting inflation to peak sometime this summer with a year-over-year rate trending lower as the school year begins and in person learning once again becomes the norm. The rebound and the employment sector will obviously be an important backdrop. However, given our sense that investors have essentially put on hold further refinements of the recovery expectations and how we're past the summer months, any meaningful attempts at higher or lower yields on an outright basis should ultimately prove an opportunity to fade the move.

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 with Prime Day quickly approaching, we look forward to celebrating the usefulness of two, three, five, seven, 11, 13, 17, 19.

Ben Jeffery:

Oh, I get it. You had to Google that, didn't you?

Ian Lyngen:

Obviously.

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.

Speaker 2:

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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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