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Closing Out the First Quarter - The Week Ahead

FICC Podcasts March 25, 2022
FICC Podcasts March 25, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of March 28th, 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 164: Closing Out the First Quarter, 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 28th. And with March coming to an end, April showers at hand, and seasonal sniffles looming, we can already hear the echoes. "It's allergies, not COVID," or a variant thereof.

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, 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 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 sold off in a rather dramatic fashion with the 10-year yield reaching as high as 241 and a half. The week also saw a rather dramatic flattening of the yield curve in keeping with the notion that the bulk of the bearish expression in Treasuries this year is going to be focused in the front end of the curve.

Ian Lyngen:

We saw a selloff in 2s, 3s, and 5s as well. And that was accompanied by moments in which the outright level of 10 and 30 year yields actually declined. The strong reception to the 20 year auction speaks to the attractiveness of what was the highest yielding new 20 year on record, as well as the idea that we, as a market, have now priced to a more aggressive policy rate normalization path, as well as the realities of the balance sheet runoff, which is expected to be announced as early as the May FOMC meeting. The next question becomes, well, what will be the incremental trading impulse from here? One of the aspects of financial markets that has struck us as particularly notable is how well equities have managed to hold in in such an environment. All else being equal, we would've expected Powell's hints at a 50 basis point hike in May to have had a much more meaningful impact on stocks.

Ian Lyngen:

The fact that the S&P 500 returned to 4,500 does reflect a great deal of investor optimism, and I think that this investor optimism is worth exploring in a little bit of detail. Part of the traditional narrative is anything that monetary policy makers do to curtail inflation comes at the expense of growth and eventually the jobs market. Now, the Fed has its dual mandate of price, stability and full employment. So, this created a unique set of challenges for the Fed during this particular cycle. What Powell has done is he's reframed the impact of inflation on the employment market. Specifically, the Fed's mantra now is that price stability is key for continued hiring.

Ian Lyngen:

So. By effectively recalibrating market participants' expectations for what a, quote-unquote, "good policy response would be," the FOMC has created a trading environment in the equity market in which everything that is hawkish ends up being risk-on simply because Powell and the Fed are now aggressively fighting what has been identified as the biggest risk to the real economy. That doesn't mean that tighter monetary policy won't ultimately curtail growth, however, but for the time being the equity market is trading it as such. Said differently, it appears that equity investors are saying that if Powell can get inflation under control, then there's more up-side for the real economy in the near and medium term.

Ben Jeffery:

Are we there yet?

Ian Lyngen:

I think we might have passed it.

Ben Jeffery:

And by it, we're talking about inversion.

Ian Lyngen:

Yes. We have seen a couple key benchmark curves in the Treasury market invert, notably the 5s 10s dipped below zero for the first time in the cycle. This is relevant because it's very consistent with what we're seeing, broadly speaking, in terms of the flattening of the yield curve. We saw 2s 10s below 20 basis points and 5s 30s the flattest that it's been since 2007, right up against 11 basis points. Now, for context, one of our core calls for this year has been a flattening of the yield curve to the point of inversion in 2s 10s. Now, our baseline assumption is that 2s 10s inverts sometime between now and the May FOMC meeting. If and when this occurs, the bigger question quickly becomes, how far can 2s 10s invert given that it's occurring much earlier in the cycle than we would have otherwise expected? The lower bound historically has been roughly -20 basis points.

Ben Jeffery:

And along with the price action itself, most notably the flattening, Ian, but also the bearishness further out the curve, we saw an impressive market reaction to Powell's Monday morning speech in which he more resolutely laid out the case for a 50 basis point rate hike in May and maybe even in June as well. That was really the significant fundamental impetus that triggered the latest leg of what had already been a very impressive steepening run in 2s 10s, in 5s 30s, in 5s 10s, which as you mentioned, Ian, has already dipped below zero. And when the Chair was asked, "What could prevent the committee from going 50 in May?" he gave a very clear answer in, "Nothing."

Ian Lyngen:

And I think that that's an important departure point when we consider how the balance of the first half of the year is going to play out. Assume that the Fed does follow through with a 50 basis point rate hike in May, as well as an announcement about the organic runoff of the balance sheet. All else being equal, one has to assume that this will accelerate the flattening of the curve even further. Because if we get a 50 basis point hike in May, we're certainly going to price in a 50 basis point hike in June. This has complicated the process of determining what fair value is in the two year sector. Now, obviously it's going to be extremely policy path dependent in terms of the number of hikes we see this year. And more importantly, at least as we think about what's priced in versus where we'll end the year, what does the market assume is going to occur in 2023? We've already seen some significant flattening in the Euro dollars market. Effectively investors are saying, "The more dramatic the rate hikes are now, the sooner the Fed is going to have to cut later."

Ben Jeffery:

And as we've seen, historically the Fed has struggled to leave rates steady when they're not at the effective lower bound. Remember we got the final rate hike of the last cycle in December of 2019, and the committee was only able to keep rates on hold into the summer of 2019 before we saw those three fine-tuning 25 basis point rate cuts. That's not a phenomenon just limited to last cycle, but also looking back historically, following hiking cycles the Fed is seldom able to keep rates steady well off zero before the realities of economic performance necessitate rate cuts, fine tuning or otherwise. And more relevant to this discussion, Ian, is the market pricing of exactly that dynamic. We very rarely see the front end, whether that be in bills, two year yields, Euro dollars, or Fed funds futures, price stagnant policy. Almost as soon as the Fed signals that they're done tightening, we start to see rate cuts priced in, and that will be even more topical during this cycle, given what's already shaping up to be a not so good growth outlook.

Ian Lyngen:

And let us not forget, when we think about the shape of the yield curve and what it implies for the performance of the real economy, the market investors tend to focus on the 2s 10 spread, but the Fed research supports the idea that the most relevant curve is three month bills versus 10-year yields, which currently stands at roughly 188 basis points. So, there's plenty of flattening to be done. The caveat there being that three month bill yields tend to move lockstep with policy rate. So, if we do see 50 basis point rate hikes in May and June, that will get that spread to 88 basis points, to say nothing of the fact when the Fed starts to unwind SOMA, the go-to issuance sector for the Treasury Department initially will be the bill market. And unlike further out the curve, the supply and demand dynamic is particularly strong in bills. So, the incremental supply will push rates even higher, contributing to further flattening in three month bills versus 10s.

Ben Jeffery:

And that assumes that we see 10-year yields hold at roughly their current levels around, call it 240. But if we've learned anything from the year so far, there is a lot that can play out over the course of the next several quarters that could benefit the long end of the Treasury curve, whether that be flight to quality resulting from whatever happens next in Ukraine, or more immediately relevant, the beginning of the fiscal new year in Japan and the alleviation of some balance sheet constraints that are likely influencing investor behavior in the country that is the largest foreign holder of Treasuries.

Ian Lyngen:

It's notable that even with the assumption that Japanese investors are on the sidelines into their fiscal year end, we still saw a remarkably strong auction in the 20-year sector on Wednesday. A 1.1 basis point stop through for 16 billion 20 years speaks to the notion that US rates are in the process of price discovery and we will find the new equilibrium. The question is whether that is with 10-year yields at 240, 250 or 225.

Ben Jeffery:

And along with 20s, we also did get the 10-year TIPS reopening, which tailed 1.8 basis points, but with underlying bidding statistics that were on the strong side of average. For a TIPS auction, a 1.8 bid tail is fair to characterize as decent, probably. And the demand for inflation protection at this point in the cycle is especially interesting given, not only the increasingly hawkish Fed backdrop that we've been discussing already, Ian, but also the type of inflation that will not be responding to tighter Fed policy. Obviously a higher Fed funds target band is going to do little to alleviate the pressure we're seeing in the oil market, with crude trading right around $115 a barrel, or the upside in food prices that are resulting from the disruptions in Europe and the role that Ukraine plays in global food supply chains.

Ben Jeffery:

So, even if the Fed is able to effectively combat rising core inflation, it's not unreasonable to assume that we're going to see higher headline inflation for a little bit longer timeframe. Ian, you and I have talked about this idea of the divergence between headline and core that could potential materialize over the summer. And in this context, given the fact that TIPS are linked to headline CPI, it was telling to me that we saw good auction demand, despite a Fed that is clearly committed to do what it can to contain higher consumer prices.

Ian Lyngen:

Well, to your point, Ben, the Fed is committed to do what it can to contain higher prices, but the Fed doesn't pump oil and the Fed doesn't grow grain. What they can do is they can take the edge off demand in the US. And this brings us to the overarching risk of the Fed attempting to engineer a soft landing for the real economy. Historically, as you pointed out, Ben, one of the reasons that monetary policy only reaches the terminal rate for a temporary and relatively short period of time is because there's a long history of overshooting on the tightening side and the Fed needing to take some of that back.

Ben Jeffery:

And one of the places to watch for that overshoot is obviously going to be the labor market. It's been sometime since the damage done to jobs by COVID has been repaired to a sufficient degree that the Fed has felt comfortable to put forward with normalization. Obviously now inflation is in the driver's seat in that regard. And even though employment is a lagging economic indicator, as we think about what could change in the broader macro landscape to really inspire a more cautious tone from the Fed, it's going to be critical to watch some of the higher frequency employment figures such as jobless claims. Remember over this past week, we saw initial jobless claims come in at just 187,000, which is the lowest since 1969. So, jobless claims at over a half century low at this point has given Powell the green light to be very aggressive. I would point to that and also what we saw domestic equities do this week.

Ian Lyngen:

The other eventuality that could lead to derailing the Feds hiking ambitions comes in the form of the potential for tighter financial conditions. Now, as it stands, the equity market has performed remarkably well, all things considered. There's a war in Eastern Europe. We have the Fed tightening monetary policy. Balance sheet runoff is expected to be announced. There's certainly increasing energy prices associated with sanctions against Russia. And still the S&P 500 managed to make it back above 4,500 in the week just passed. What I find striking about this is that there seems to be a collective buy-in to the narrative of monetary policy makers, that the biggest risk to the economy at the moment is inflation. Yes, that is clearly the biggest risk. However, combating inflation isn't necessarily good for growth. There's a lot of things that need to go right for that to happen. Now, what the Fed is in effect saying, I'll suggest, is that the risks of runaway inflation or the Fed losing its credibility as an inflation fighter are far more meaningful over the next 30 or 40 years than risking the post-pandemic recovery that's already been pretty strong.

Ben Jeffery:

So, what you're saying is that a hawkish Fed is actually good for risk assets?

Ian Lyngen:

It's good for risk assets until it's not. And I think it's that inflection point that we will be watching for, because it will come in the form of either declining consumption in real terms or in inflection in the jobs market, as you pointed out, Ben.

Ben Jeffery:

And that brings us to Friday's payrolls report that will show the state of hiring in March and will be the last official BLS update before the May FOMC meeting. So, we have one more jobs report and one more CPI report until the Fed convenes in May and makes the decision on whether or not they're going to hike by 50 basis points. And thinking about what that means for the price action over this coming week, the proximity to the event risk, I think, coupled with the magnitude of the repricing we've seen this week so far will lend itself to a bit of a period of consolidation for investors to catch their proverbial breath. That certainly doesn't mean a rally back to 2% 10s is going to take place over the next few days, but I don't think it's going to be a straight shot to 275.

Ian Lyngen:

I would tend to agree with that. And there's no question that next week is going to be an exciting week in the Treasury market. Ben, do you have any big plans for April Fool's Day?

Ben Jeffery:

Well, Ian, after the time we've spent together, I think you and I both know we do not limit the fool to just April 1st.

Ian Lyngen:

You can fool early, you can fool often, and you can always fool us. In the week ahead, the Treasury market will have another set of top tier economic data to help guide trading. We're coming into this week with a remarkably flat yield curve and continued geopolitical uncertainties. There's little to suggest that there will be any near-term resolution to the war in Ukraine and as such, elevated energy prices will continue to reinforce the Fed's more hawkish stance. The highlight of this week's economic data will be the March non-farm payrolls print. The consensus currently stands at plus 400,000 jobs with average hourly earnings seen increasing 4/10ths of a percent in March. In addition, the unemployment rate is expected to decline to just 3.7%. Within the details, we'll be eager to see how the labor force participation rate has improved and what that implies for the sustainability of upward pressure on wages. Now, keep in mind, real wages are still negative, certainly on a year-over-year basis, and that will serve to further undermine consumer's real spending power.

Ian Lyngen:

This is particularly relevant given that the Atlanta Fed's GDPNow tracker shows that Q1 growth is running at just 9/10ths of a percent, a far cry from the 2.8% that the Fed is projecting 2022 will see in terms of real growth. This isn't to imply that we're on the precipice of a recession or anything so dramatic. In fact, a lot of what we're going to see in Q1 real GDP is a giveback of the inventory rebuild that we saw in Q4. So, in practical terms, while it might appear that there is less urgency on the growth side, Powell has made it abundantly clear that he believes the economy is on strong enough footing to absorb a much more aggressive rate hiking campaign than was previously signaled. We're certainly on board with the idea of a 50 basis point move in May as well as another one in June, with the caveat that the spread between the May and June meeting may contain enough uncertainty to bring into question the prudence of a second 50 basis point move.

Ian Lyngen:

Clearly a lot has changed over the course of 2022 thus far, and we're only three months into it. We continue to lean bearishly on the front of the market. One of our core calls for the year has been an earlier curve inversion than in prior cycles, and we're holding onto this for the time being. There's an argument that once the 2s 10s curve inverts far enough, that the Fed could choose to use its balance sheet to re-steepen the curve. Now, we do think the balance sheet runoff is coming sooner rather than later, but we do not expect the Fed to engage in an operation reverse twist where they attempt to sell Treasuries directly out of SOMA. Instead, given the fact that over the next three years there's $2.2 trillion of maturities coming out of SOMA in the Treasury space, we expect, if anything, the Fed will err on the side of reaching the runoff caps sooner and setting those caps higher than it did during the last cycle.

Ian Lyngen:

We've reached a 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 the March payrolls report scheduled for release on April Fool's day, we cannot shake the image of Charlie Brown, Lucy Van Pelt, and the football. Like they say, you can't make humor out of happiness. Sometimes the bond market is just so funny.

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.

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:

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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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