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Checking the Taper - The Week Ahead

FICC Podcasts July 23, 2021
FICC Podcasts July 23, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of July 26h, 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 130, Checking The Taper, 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 July 26th. And as trading volumes decline and summer vacations beckon, we're reminded to make sure to unplug the Peloton before hitting the road, as if it's functioning as anything other than a clothing rack at this point.

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 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 underwent a pretty meaningful transition in terms of price action and what it implies going forward. What we've seen over the course of the last several weeks is a defined bull flattener. Now the bull flattening has been associated with 10 year real yields declining as low as -112 basis points, and it has also largely been a function of a dimmer economic outlook based on the risks associated with the Delta variant. What we saw at the beginning of the week just passed was a transition from it being entirely a growth story to it becoming a monetary policy uncertainty. In yield movement terms, that translated from a bull flattener to a belly led rally. So the five-year sector is now pricing expectations for a later lift-off rate hike than previously. Recall that the June FOMC meeting was an important inflection point of market participants' understanding of the Fed's new reaction function to higher than expected inflation in the new framework.

Ian Lyngen:

Now, while there might have been concerns about the Fed's commitment to the new framework following the increase in the 2023 Dot Plot, those have long since been forgotten as monetary policy officials are now expected to be focused on the risks associated with an extended runway out of the global pandemic.

Ian Lyngen:

It would also be remiss not to mention the take down of the 20 year auction. A $24 billion supply event that tailed 1.2 basis points might otherwise have been interpreted as a net negative for the outlook for the Treasury market, but point in fact, it was simply a supply concession that was ultimately absorbed. Similarly, the demand for new 10-year TIPS, which stopped through 2.1 basis points, was very consistent with investor's interest in buying inflation protection at this point in the cycle.

Ian Lyngen:

We continue to be impressed with how well inflation expectations have remained intact would send your breakeven solidly above 225, we expect that the biggest drama between now and the end of the summer will play out in real yield space. In the event that the macro narrative begins to focus on the downside risks associated with the COVID variants, then we would look to that -112 level and its key resistance in 10-year TIPS on the way to a more sustainable repricing.

Ben Jeffery:

So Ian, I think it's fair to say that really the narrative in the market has become just how concerned investors and, frankly the world, should be about the rising number of Delta variant cases we're seeing both domestically and abroad.

Ian Lyngen:

That certainly has been the focus of investors over the course of the last couple weeks, and there has been a reasonable amount of pushback against the relevance of the Delta variant, particularly as 10 year yields dipped as low as 112 and seem to be stabilizing in a range of 125 to 130. All else being equal, a single variant to which the mRNA vaccines are effective, at least in so far as preventing hospitalizations and severe cases, it shouldn't be an issue that derails the outlook for the global recovery. However, part of the story is that we knew that there were going to be variants, we knew that the variants could potentially extend the timeline out of the pandemic, but what was the greatest unknown was the extent to which the vaccine would have been fully embraced. And if we look at the vaccination rates even in the US, we're not to a point where we can assume that future mutations of the virus will be covered by the existing immunizations.

Ben Jeffery:

But in terms of the strictly economic impact of the rise in cases, I do think it is worth emphasizing that this instance is much different than the early days of the pandemic. A, the medical community has a much better understanding of the coronavirus and not only how to prevent it, but also how to treat it, which should all else equal keep hospitalizations down. B, there are now several highly effective vaccines that are widely available, at least in the US. And C, and I think maybe most importantly, is the fact that there's clearly a dramatically reduced political will to reimplement some of the types of restrictions we saw in 2020.

Ben Jeffery:

There have been several political figures who have said mask mandates are off the table for now, businesses are not going to be reclosed, and if in fact there are segments of the population that are worried about the Delta variant, the best way to receive protection is getting a vaccine. So from that perspective, I think we certainly could see more targeted policies in terms of stemming the spread of the Delta variant, but wholesale business closures like we saw last year seem unlikely, at least at this stage.

Ian Lyngen:

I don't disagree, but I will make the argument that if one hasn't already received the vaccine or isn't scheduled to get it in the US, that there's very little that's likely to occur between now and the end of the year that changes the mind of that subset of the population. So the logical extension of that then becomes, while we might not see wholesale business closures, what we could see is self-imposed restrictions. And by that, I simply mean people being less willing to re-engage in the employment market come the fall when unemployment benefits run out, people being less willing to venture out and embrace in-person commerce again.

Ian Lyngen:

We were always operating under the assumption that there would be a very strong initial wave once the restrictions lifted and the economy was reopened, people who wanted to get back out there, embrace indoor dining, engage with the in-person retail shopping experience, and then the trajectory would start to moderate somewhat, although still be net positive. The risks raised by the focus on the variants is we have the initial wave of people coming back into the economy, and then that simply stagnates. And that will lengthen the time it will take the US to make it all the way out of the pandemic. And it also has implications for the inflation complex. On the one hand, higher prices have already led to sticker shock, which will presumably curtail consumption, but on the other hand, the pockets of labor scarcity that are evident via anecdotes and the JOLTS data, for example, suggests that upper pressure on wages is unavoidable for the next several months.

Ben Jeffery:

And what remains to be seen is how durable that upward pressure on wages becomes once we get into a more traditional labor market environment in the later part of Autumn. Ian, you've made this point before, and that is a very unique characteristic of this latest recession has been the influence on the participation rate. Even though we've seen very robust headline job gains over the past several months, the overall participation rate remains troublingly low. And as a more meaningful benchmark of the overall health of the labor market, I think watching the participation rate will be very important and I would argue the newly introduced risk around the Delta variant is only going to serve as a headwind in getting more people engaged in the search for employment and driving that participation rate up.

Ian Lyngen:

Precisely, and I think that that is the big unknown. And as we contemplate how that will ultimately work through the economic data, we have the competing factor of goods producers being compelled to push through higher costs associated with raw inputs, with higher transportation costs, as well as potentially a labor component. The issue is that none of this suggests that we're seeing a traditional heating up of the real economy that leads to a tight labor market and subsequently sustainably higher rates of inflation. Instead what the global economy is facing is a series of significant dislocations in terms of supply chains, in terms of consumption patterns, in terms of prospective employers, in terms of labor availability, and as Chair Powell has pointed out, we're in a very unique period, especially on the inflation front.

Ian Lyngen:

I continue to side with the Fed in so far as the inflation upside is transitory, at least for the time being. One of the most frequently asked questions we've been receiving is, what would it take to transition from transitory to non transitory? My baseline assumption remains that the Fed owns the definition of the transitory, and so in practical terms, as long as the Fed says it's transitory, then monetary policy will be based on that characterization. It's only when policymakers signal that something has changed that investors should refocus on the inflation issue. This implies that the best that market participants can hope for is to get ahead of any potential shift on the part of policymakers. So what does that look like? Perhaps it is a broadening of the buckets where we have seen inflation, so outside of used and new auto prices, travel-related costs, and potentially OER, if we start to see sustainable increases throughout the inflation complex, that's when the Fed would need to revisit the issue.

Ben Jeffery:

And Ian, I think you and I would agree that that's an issue that's unlikely to be resolved at Wednesday's policy meeting. Everything we've heard from Chair Powell and those more dovishly inclined on the FOMC so far points to an ongoing commitment to the transitory narrative. There is the Delta risk and what that might suggest for the trajectory of monetary policy, but to this point, it seems that while that headwind is insufficient to move the timeline on tapering, that is a formal announcement sometime in the fourth quarter to begin in the first quarter of 2022, what it may do is embolden those monetary policy makers that are advocating for the liftoff rate hike later rather than sooner. I would argue that while that consensus timeline on tapering is well intact, expectations on the timeline of liftoff are still being refined, which certainly contributed to the price action we saw in rates over this past week.

Ian Lyngen:

And in contemplating the degree to which tapering has been priced into the Treasury market, I've been of the mine that we've moved on, and to your point, Ben, that we're now debating liftoff rate hike, and that's the most relevant in terms of price action. Another perspective, however, would be to say, we traded it for the upside in terms of what it might mean for Treasury yields, but we haven't yet fully traded the economic downside risks posed by the Fed beginning the process of scaling out of QE. So said differently, once tapering is fully realized, we might actually see a repricing to a slower growth impulse. In practical terms, that would more likely be a bull flattener as opposed to the belly-led price action we've seen recently.

Ben Jeffery:

And in outright yield terms, at the risk of sounding like a broken record, we have once again seen the range in Treasury yields redefined. Ian, you touched on it earlier, but 10 year yields got as low as 1.12% and the subsequent bearish retracement has now left the benchmark rate in a 120 to 130 zone, as once again, positions are likely being reset and the process of building a volume bulge from which to incorporate the next fundamental input is underway.

Ben Jeffery:

And in looking at the latest move in 10s, it hasn't been that dissimilar from the first break we saw of 125. Remember in that instance, 10-year yields dip below 125 very briefly before backing up just beyond 140 and then the next leg of the repricing got us to 112, and now we've seen a backup to just beyond 130. So it's this trading pattern that has emerged as very topical over the summer and it will be especially intriguing to see if it repeats itself in the wake of the FOMC. There is still that opening gap from 109 to 110 that will be a relevant technical level, if nothing else, as August approaches.

Ian Lyngen:

One of the other notable aspects of the recent price action is that it has, up until the end of this week just passed, occurred on unseasonably high volume levels. We haven't seen the traditional summer doldrum set in, although on Thursday and Friday the volume profiles started to notably decline. I expect that that would be the case over the course of the bulk of August, but that does imply that the week ahead will see a reasonable amount of activity in the Treasury market.

Ben Jeffery:

And in addition to the more traditional month-end considerations around the end of July, remember that the suspension of the debt limit also expires next week with still more room to go for the Treasury department to bring down its cash balance before enacting extraordinary accounting measures. Now, this will almost certainly be an issue that's limited to the front end, and what I mean by that is more cash entering the system as bills are paid down. We've received the question quite frequently of just how long the extraordinary accounting measures can last, and given the uncertainty around outlays and tax receipts, really the best way to frame a consensus around that issue is what we've heard from the Treasury department itself.

Ben Jeffery:

Secretary Yellen has said that she expects the extraordinary measures can last into late August. And while there's little reason to question that analysis, I would just add that if anything, she would probably like to convey a bit sooner rather than later drop dead date, if only to inspire a bit of urgency on the part of Congress to once again resolve the issue and allow the Treasury department to return its cash balance to where they would ideally like it.

Ian Lyngen:

So with bill supply likely to decline, that will presumably put a fair amount of upward pressure on the RRP program, correct?

Ben Jeffery:

Yeah, absolutely. We've already seen some more upward pressure associated with the GSE cash reinvestment period and given balance sheet needs around the calendar turn, it was always going to be very likely that we saw a pickup in the RRP facility usage, debt limit issue aside. So while, yes, these are very large amounts of cash that are being put at the Fed overnight receiving five basis points, really the facility is functioning exactly as it was designed, to absorb excess cash in the system and preserve the integrity of the Fed's lower bound. So while there has been concern around the scale of the uptake, so far it seems that the Fed is very comfortable continuing to lean on the RRP facility in order to keep money markets stable.

Ian Lyngen:

Well, it's nice to have stability in some regard.

Ben Jeffery:

Certainly not on the Macro horizon.

Ian Lyngen:

In the week ahead the Treasury market will have a variety of economic data to inform trading direction, but ultimately we expect that the FOMC meeting on Wednesday will set the tone for monetary policy expectations going forward. We don't expect any taper announcement or even any clarity in so far as whether it will be mortgages first, then Treasuries, or a simultaneous taper. That conversation will most likely occur at Jackson Hole. Instead, what market participants will be focused on is the Fed's characterization of the risks to the global outlook associated with the Delta and other variants.

Ian Lyngen:

Engaging the market's response in this regard will be focused on the five-year sector. Now the logic here is that, to a large extent, the market has priced in the presumed taper timeline for the time being, which means that anything that might lead to a challenge of those expectations would be a tradable event. However, the process of debating the timing of the liftoff rate hike doesn't fall into that category. So instead, anything that comes out of the Fed will be first expressed in the five-year sector, a less dovish tone than expected will be a flattener of 5s/30s, and we suspect lead to outright higher rates in the front end, but lower rates in the long end.

Ian Lyngen:

Now, this is a typical and very consistent with an inflection point. Generally, we tend to see rates in outright terms move the same direction and the curve shape be the real story. To have the two sides of the curve performing different in outright terms is unique and reflects the underlying macroeconomic debate that's currently at play. In the event that the Fed takes the lead of the price action and focuses on the Delta variant concerns, then that will lead the five-year sector to outright lower yields and have the opposite impact on the longer end of the curve. So a net steeper, particularly in 5s/30s.

Ian Lyngen:

All of this price action will be in place before Thursday's real GDP print. Now if the market's performance in 2021 is any guide, we assume that US rates will not trade a strong real GDP print in the traditional manner. If anything, we would expect a stronger print to be more easily dismissed than any downside surprise, but on that we expect GDP to come and go with little net impact, as the market starts to focus on month end, the debt limit suspension and summer trading conditions. 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 all eyes on Tokyo, we continue to lament the fact that there is no Olympic level punning. We'll take solace in the trophy on our mantel. Participant is Greek for first place, right?

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 FIC 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 suggestion that any investment or strategy referenced here in may be suitable for you. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment, legal, accounting, or tax advice, or representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures, contracts, and commodity options or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the US Commodity Exchange Act. BMO is not undertaking to act as a swab advisor to you or in your best interests in you to the extent applicable will rely solely on advice from your qualified, independent representative making, hedging, or trading decisions.

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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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