Delay Replay - Monthly Roundtable

Margaret Kerins:

This is Macro Horizon's, monthly episode 36 Delay Replay, presented by BMO Capital Markets. I'm your host, Margaret Kerins, here with Ian Lyngen, Ben Reitzes, Greg Anderson, Steven Gallo, Dan Krieter, Dan Belton and Ben Jeffery from our FICC macro strategy team to bring you our outlook for US and Canadian rates, high quality spreads in foreign exchange and the main narratives driving our forecasts as we kick off the new year.

Margaret Kerins:

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, it's affiliates or subsidiaries.

Margaret Kerins:

The new year has started with a bearish impulse in Treasuries in the backdrop of record COVID infections, delayed return to the office, renewed shutdowns in some nations that once again are prolonging the pandemic timeline and hindering expectations for supply chain resolution and its implication for inflation. The market is looking past this latest wave and betting on continued economic resiliency.

Margaret Kerins:

That said the renewed restrictions are dampening expectations for Q1 GDP. At the same time, fiscal and monetary policy tailwinds are subsiding forcing the economy to stand on its own, and its first test is of course the Fed's transition from accommodation to tightening. The market continues to price three Fed hikes this year, beginning in midyear at quarterly cadence. 10 year yields at 165 are over the 30 basis points higher than early December levels, and about 25 basis points lower than the December, 2019 highs.

Margaret Kerins:

In addition, two year yields reached an intraday high of 80 basis points yesterday, the first trading day of the year, which is the highest level since March, 2020. So, let's kick it off with Ian. Ian, how does the bearish impulse in Treasuries play into your expectations for the first half of the year in the backdrop of the latest surging COVID wave?

Ian Lyngen:

Well, Margaret, I think that the year has started off very much in line with our expectations. We had been leaning more bearishly on the Treasury market in Q1 than we had throughout much of 2021. And this is a reflection of the realities of a strong underlying economy with increasing evidence that there's going to continue to be a period of sustainably higher inflation. So, it follows intuitively that in such an environment, yield should be higher.

Ian Lyngen:

What I find fascinating about at least the initial part of the move is that it has occurred while Fed expectations continue to increase, in terms of the amount of rate hikes priced in, in 2022, but break evens, while incrementally higher, have been far more subdued than the backup in real rates. And the real rates are telling us a pro-growth story and renewed optimism associated with reopening and reengaging of the real economy.

Ian Lyngen:

This, as you point out Margaret, with the backdrop of record high COVID case counts in the US, is very telling. And our takeaway, at least, is that it's less a question about the outright number of cases and more an issue of timing. The market is expecting that the holidays will be, unfortunately, accompanied by an increase in case count that should peak some time in the middle or latter part of January. So, as long as we see a cresting of the cases by the end of this month, that will conform with the market's broader expectations for the current wave to behave, not dissimilar to waves in the past.

Ian Lyngen:

When accompanied by the fact that the associated symptoms appear to be more mild, investors have extracted a fair amount of confidence and optimism that this will pass and reopenings, as a theme, will once again emerge toward the end of the second quarter. Now, clearly, there's a fair amount of optimism reflected in that outlook, but nonetheless, that's what the market is trading at the moment.

Margaret Kerins:

So, Ian, I think you mentioned a couple of really interesting points. We have seen this market reaction before, where we're looking past the COVID infections into the reopening trade. You had mentioned the market pricing in increased expectations for additional rate hikes. Now that we know that the Fed has increased the speed of tapering, because they would like to be ready to raise rates earlier, if needed, do you think that a March hike is on the table?

Ian Lyngen:

Well, I would say that one would be remiss not to at least concede that a March hike is on the table. The same thing applies for June as well. While June has a much higher probability from our perspective, there is a chance that the Fed decides to go in March. The market is currently saying that there's a 68% probability that the Fed moves in March. But that also assumes something that I think is key when framing the Fed's decision.

Ian Lyngen:

And that is that the Fed came into this process focused on the base effects created by the higher than expected second quarter data in 2021. The assumption is that in April, May and June, those numbers will start to decline, at least on a year over year basis. So, if the Fed were to move in March, they would effectively be signaling that they're comfortable starting the rate normalization process, regardless of whether inflation ultimately conforms with those moderating expectations. It's for that reason that I think that there's a good case to be made for June, assuming that inflation doesn't actually conform in the second quarter.

Ben Jeffery:

And Ian, as the new year gets underway, and the fact that we're even having this conversation about the potential for a March liftoff, it's really important to consider the positional backdrop and some of the seasonality that we've tended to see play out in the Treasury market. Remember during 2021, that being short bonds was one of the most popular to trades we saw. Whether it be in some of the survey based data or the CFTC data we saw it was readily apparent that the market as a whole was fairly bearish on the long end.

Ben Jeffery:

Now, obviously, as we got toward the calendar turn and trading books started to be closed, positions squared, and balance sheets aligned for reporting, some of that conviction may have rated slightly. With just two trading days in 2022 thus far, we've already seen that bias reemerge, and I think it's going to be very telling to see the degree to which some of those positional metrics extend even further in favor of being short Treasuries. Not to mention the seasonal dynamic that usually plays out in the first half of the year, as optimism is brought into valuations to the detriment of Treasuries. So, with that backdrop, a Fed that's committed to begin the process of rate normalization, coupled with those behavioral aspects creates a fairly compelling bearish case for Treasuries, at least over the next several months.

Dan Krieter:

It's a similar story in credit, Ben. I think technicals are going to play an extremely important role here in the next couple weeks, because from a high level, I'm with you guys on the macro side. We're at a very uncertain point. There are certainly some strong tailwinds for credit. You guys talked a bit about the most recent variant of COVID and how, with each variant, we're seeing increasing evidence that the economy will continue to grow through those variants. There's less fear out there, and we shouldn't see too much of a threat to consumption from variants going forward if we continue to see potentially less severe outcomes from the Omicron variant.

Dan Krieter:

And as a result, we should see consumption stay very strong, all tailwinds for credit. But at the same time, there are some headwinds as well, to potentially cancel out those tailwinds. And you talked about some of the headwinds as well, just higher Treasury yields for one, the Fed's response to it quite a bit more exposed to that. And ultimately what will probably be the defining characteristic for credit spreads this year is how well will corporations be able to pass along the higher cost of inputs along to final consumers? We don't know that yet, and it's going to take a lot of time to figure that out.

Dan Krieter:

So, while we have this sort of neutral macro outlook on credit, where we have headwinds and tailwinds canceling out, I think technicals are going to be extremely important. Also the time of year is just another reason to think. So, obviously, the most amount of supply in the entire year comes in January and February. So, on the technical outlook, Dan, what's your view for technicals in the credit market going forward?

Dan Belton:

So we're expecting heavy corporate supply throughout 2022. And that's going to start in January, and already has to some extent. We had $11.25 billion price yesterday, which is noteworthy considering that many jurisdictions were still closed for the new year's holiday. Today, we have 18 deals in the market, which is a total that we haven't seen in about four months. And so, given the strong start and the fact that we're expecting heavy supply to continue throughout the year, we view the risk to January supplies actually lying upside from the consensus estimate of about 140 billion, which is garnered from a survey of syndicate banks.

Dan Belton:

But even if the supply does come in heavier than the 140 billion estimate, it should still be very well digested by investors who typically anticipate and set up for strong supply at the beginning of every year. To this point, despite January typically being, as you said, one of the couple heaviest months of issuance of the year, it's also the second or third most seasonally supportive time for credit from the standpoint of spreads and excess returns. So, if you couple that with the fact that spreads and all in yields are now more attractive than they've been for the better part of the past year, we think that there's ample reason to expect that demand is going to show up to absorb this supply that we get in the early part of 2022. And that underpins our at least near term bullish stance on credit. But of course this strong demand is going to be contingent on strong global risk appetite.

Stephen Gallo:

Well, thanks for that, Dan. I think that's a good segue to transition to the international sphere. And you mentioned a couple of important themes that you're watching for the credit markets. I think if we switch gears from the North American picture, the inflation story is going to be a very important theme during the first few months of the year globally. That is the outlook for price developments.

Stephen Gallo:

So, I'll cover that all first by just pointing out for Europe, for the Euro area, there is an outlier risk for the Euro and credit markets if we don't get a clear and meaningful cresting of inflation pressures at some point this year, which forces the ECB into a sort of QE cliff edge, due to pressure from the more hawkish Northern Euro area countries. And that tension could come to a head for a number of reasons. One of them being that it's a French presidential election year. So, that's something to keep in mind. But I'll just get that out of the way first by saying the ECB cliff edge scenario is not our base case, but it's an important outlier to watch for the Euro, for Euro area credit markets, as we look at price developments during the year.

Stephen Gallo:

Another important issue is the geopolitical risk element. And that's most notably in relation to Russia and Ukraine. In terms of where we are now, there will be, and there have been, bilateral talks between Russia and the US. They're scheduled to resume, I think, on the 10th and the 11th of January. And then all other NATO members will get involved from the 12th. But if you read between the lines of what's happened already, the statements that have been made by the US and Russian sides already, it seems to me as if it's very much in Russia's interests, or at least this is what it's doing, to keep the tension high, to extract as many concessions as possible because of a combination of the fact that perhaps it feels the threat of sanctions is a bluff, or it can ride most of the sanctions out. Or because Putin really holds a lot of the important cards in the form of the flow of natural gas to Europe or the flow of migrants through Belarus, which could become an issue again in the spring when the weather improves.

Stephen Gallo:

In terms of the way Russia has negotiated so far, it's not even leaving the issue of security guarantees regarding eastward expansion of NATO on the table for negotiation. It's completely off the table. So a very hard line stance from Russia. Where do we go from here? Look, I don't think we need to make a full scale invasion of Ukraine or into Eastern Ukraine by Russia as our base case. But I think the key unresolved question for markets is how will the US and the rest of NATO respond if Putin continues to quietly encroach in Eastern Ukraine, which is what it looks like he's setting himself up to do?

Stephen Gallo:

And if the west does impose sanctions on Russia, then at the current levels in Euro dollar, we're probably not priced for the risk that Putin uses one or more of his so called ACE cards. That key one being the flow of natural gas to large parts of Europe. So, the current environment is likely to remain quite a challenging one for the Euro for the time being. That would be my main point.

Greg Anderson:

Stephen, great point about sanctions and from what the Biden administration has said thus far, said they would basically impose the most onerous sanctions yet on Russia. And Putin has responded to that with the threat of some type of technical military response, presumably cyber warfare or something of the sorts.

Greg Anderson:

How this plays out, probably, where we can't predict exactly the actions of each participant, I think we can pretty accurately predict that it would lead to a higher US dollar almost across the board, but particularly against the Euro. And if energy prices spike, I'll point out it's not just Europe that's vulnerable. So, another currency that would be particularly vulnerable is the Japanese yen. We've already seen dollar yen push through the Q4 cycle high just earlier today, and looks like it's headed towards $1.20.

Greg Anderson:

There's sort of twin influences there. First, there is the rise in energy prices, which is a clear negative for the yen. And then, on top of that, it's rising yields in the US and both of those influences look like they will twin up, so to speak, and push dollar yen at least through $1.18 in the first half of the year.

Greg Anderson:

For most of the developed countries, they're energy importers. The one exception to that, obviously, is Canada, as an exporter. And in December, particularly the back half of the month, we saw a nice little loony rally on the back of the post Omicron recovery in crude oil. I think that move has a little bit of legs left, particularly on crosses. So, you can easily see Canadian dollar reaching new highs against the yen, new highs against the Euro. Whether it can continue to rally against the US dollar, that's a tougher question with the Fed rate hikes that Ian had mentioned.

Greg Anderson:

And also point out as just another little background issue, arguably more important for foreign exchange than hikes, it's quantitative tightening. And if the Fed were to go that route alongside of rate hikes, that would be really positive for the US dollar. And it would probably push dollar Canada higher, no matter what the bank of Canada does.

Ben Reitzes:

Speaking of the bank of Canada, the Canadian dollar probably doesn't factor into things that much at the moment, given current levels. It just isn't strong enough or weak enough to really move the needle at this point. What is the bigger concern right now for the bank are the renewed pandemic restrictions put in place through much of Canada.

Ben Reitzes:

Ontario is back in lockdown, more or less. Same with Quebec. So, the two biggest problems are going to see a pretty weak economic picture through the month of January. Expectations had been building for a potential rate hiking, maybe as soon as January. Those expectations were dampened notably in December, but no one really ruled out a move. But at this point it does look as though a January move is all but out of the question.

Ben Reitzes:

That doesn't really change the picture for the rest of the year, though. Expectations are still for this wave to fade as all the others have in the past, and the economy to rebound similar to what we've seen in the past as well. And so, it still looks as though the bank is on pace to raise rates, for sure by the spring. I think April is our base case call right now, but there's a decent chance they open the door for potential move in March if you get higher than expected inflation over the next couple months. And if the economy rebounds a little bit quicker than expected, if this COVID wave does subside maybe a little faster than prior waves had.

Ben Reitzes:

We are still looking for overnight rates to move higher through course of the year, starting in the spring. Things are maybe a little bit different, looking at the Canada curve. Canada has outperformed pretty noticeably through December relative to the US. We're expecting that to reverse, to some extent, through the first few weeks of January. The issuance machine from the provinces is going to ramp back up. That will likely weigh, at least to some extent, at cross market on Canada, on the 10 year sector. And the 30 year sector, and so even though you're getting this wave of restrictions and likely weakness on the macro side. That may not have as much of an impact as it seems on the surface, when looking at the Canadian rates market.

Margaret Kerins:

So, Ben, I think you raised some interesting points, especially about the response in Canada to the latest wave. And I think there's some hope in the marketplace that this is the final wave. And we end up in this situation where it's actually endemic and no longer a pandemic. But I'd like to go back to the discussion from Steven and Greg, and the heightened geopolitical risk due to the Russia-Ukraine situation. And Ian, I want to pass this to you. How do you think that could impact your call for 10, say, in the first quarter?

Ian Lyngen:

Yeah, I think that, if the situation on the geopolitical front heats up, that would be an obvious flight to quality support for Treasuries. The observation that I would make is that there has been some underlying degree of geopolitical uncertainty throughout the course of the last several years. While the topic and the region might change, the Treasury market has proven itself relatively resilient in moving beyond some of those omnipresent risks that have become a reality of the global environment.

Ian Lyngen:

So, it's difficult to say with a straight face that we shouldn't keep an eye on some of the geopolitical concerns as a potential flight to quality for Treasuries, but we are not alone in the idea that it's not going to be a 50 or 75 basis point move. If anything, it would be 15 to 20, as the market gets a better understanding of what the true risks are and how that ultimately will play out. Barring, of course, a much more severe escalation than I think anyone in the market is expecting at this point.

Margaret Kerins:

So, basically, a knee jerk reaction to the ticker bomb, but ultimately not something as severe as what could possibly be expected. In terms of this geopolitical risk, do you think it's enough to derail the Fed in their tightening cycle?

Ian Lyngen:

What I have found really fascinating about this cycle is the perception that because of the way that different economies have fared during the pandemic, that the Fed is really primarily focused, as arguably, they should be, only on what's going on in the US economy. Far more so than we saw following the financial crisis, which I think is telling, insofar as it implies that as long as what's going on overseas isn't having a dampening impact on inflation or materially derailing the recovery, then the Fed will continue a pace with their rate normalization plans.

Margaret Kerins:

Yeah. And any flight to quality would actually give them some cover as it would ease financial conditions. And that's a wrap. Thank you to all of our BMO experts, and thank you for listening. This concludes Macro Horizons, monthly episode 36 Delay Replay. As always, please reach out to us with feedback and any ideas on topics you'd like us to tackle.

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