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End of the Quarter As We Know It - The Week Ahead

FICC Podcasts October 01, 2021
FICC Podcasts October 01, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of October 4th, 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 140. End of the quarter as we know it, presented by BMO Capital Markets and we feel fine. I'm your host, Ian Lyngen here with Ben Jeffrey to bring your thoughts from the trading desk for the upcoming week of October 4th. And as the post-season gets underway, at least Kaplan will have more time to dedicate to his baseball franchise.

Speaker 2:

The views expressed here are those of the participants and not those are the 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 in each show with our musings on the week ahead. Please feel free to reach out on Bloomberg or email me 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 new fundamental information to incorporate into pricing. The biggest driver, however, was a continuation of the post FOMC sell off in the Treasury market. Now 10 year yields have successfully retraced to that 155 to 160 zone that we've been targeting. The big question then becomes whether or not we can take another leg higher in rates that targets something closer to 165 or 170.

Ian Lyngen:

As it stands now, we continue to see upward pressure on rates and acknowledge that the dip buying goalposts have been lowered since the beginning of this year when 10 year yields got as high as 177. Now our baseline assumption is that we don't see 10 year rates back above 177 between now and the end of the year. However, and being intellectually honest, that's not our highest conviction call. Our highest conviction call was that we did retrace to 125 and see a meaningful sell off as the fourth quarter of got underway. All else being equal however, the fact that the market selling pressure has stalled out in the 155 to 160 zone does reinforce the underlying notion that it's going to be very difficult to effectively retread the same fundamentals that we were trading in Q1 in Q4 with a different outcome and higher rates. One of the most fascinating aspects of the recent price action has been the shape of the curve.

Ian Lyngen:

If given the information that the market would have interpreted the September FOMC meeting as hawkish, we would expect that to have resulted in a higher probability of rate hikes sooner, which if we look at the Euro dollars market that's precisely what happened. However, this steepening nature of the sell-off has in effect led the five-year sector to outperform tens and thirties. This is a bit counter-intuitive because the sooner the Fed's starts tightening monetary policy, the more likely they are to take the edge off of growth and inflation expectations. Given that so much of the sell-off was driven by the 15 basis point increase in 10 year real yields, we'd like to simply attribute that to an improved economic outlook. With the one caveat that the Fed's QE program has disproportionately impacted the comparatively low liquidity tips market. So, in the obvious progress towards tapering, as seen at the September meeting should lead to a baseline increase in real rates. It's that underlying dynamic that leaves us cautious that we might be seeing a false positive as it were, in terms of improving growth expectations in a year ahead.

Ben Jeffery:

So, it was really a week about the follow-through from the FOMC. And while we did see 10-year yields get to that 155 to 160 zone that we've been targeting, at this stage it appears that we're going to need to see another impulse to trigger the next round of a bearish repricing.

Ian Lyngen:

Well that's a reasonable baseline assumption given the fundamentals as we head into the September nonfarm payrolls report, that it's a holiday week in China, which implies a respite of baseline buy-in from the region if nothing else. Now while that doesn't necessitate a backup in yields, if we look historically, there is an identifiable trend that US Treasury yields tend to edge a bit higher during the Chinese holiday week.

Ben Jeffery:

And using that as a frame of reference with 10-year yields at let's call it 150, that could easily put levels just below 160 on the table during the week ahead. I would also add, Ian, you mentioned September's NFP data, which on the margin could limit trading conviction. But given the fact that the backdrop at this stage is a Fed that's still committed to tapering almost regardless of what we see in terms of NFP and the market continuing to refine estimates on when we'll see the cycles first rate hike, it's fair to say that while the sell-off could bring 10's to 160, I don't think we're going to see 175 in the week ahead.

Ian Lyngen:

Certainly not in the week ahead, but it should be on the radar given the bearish steepening seasonals that tend to take hold in the month of October and let us not forget with declining COVID case counts, reopening optimism has once again become thematic in financial markets. One of the big risks in Q4 is that higher treasury yields ultimately lead to a recalibration of valuations in risk assets. We saw a mini episode of that in the wake of the Fed, where higher rates on Monday and Tuesday led to wobbles in the equity market and subsequently stalled the degree to which yields were able to backup.

Ben Jeffery:

And even after taking into account this latest period of weakness in domestic equities, we still see the S&P 500 up over 15% year to date. And while I completely agree with you, Ian, that this feedback loop will limit the extent to which we see interest rates move meaningfully higher, it is worth acknowledging how the price action in the equity market may impact the timing of future Fed actions. And what I mean by this is that given the influence that equity volatility and the VIX plays on overall financial conditions, in the event we see a material correction in stocks that triggers a surge in equity of all and ultimately financial conditions that could lead the Fed to Telegraph a bit more patients on their normalization timeline. I don't think that changes tapering, but it could make lift off in 2023 versus 2022 marginally more likely.

Ian Lyngen:

That does bring up the question, what would change the Fed's timing on tapering? And to your point, Ben, I expect that the bar is extremely high for the Fed not to follow through with a November announcement that gets implemented in December. The one potentially conceivable outcome that would give the Fed pause would be a negative nonfarm payrolls print. Now we've seen a steady increase in initial jobless claims throughout the month of September, including for nonfarm payroll survey week. So, if anything that adds a little bit of caution around the consensus for September's NFP data, which is roughly 500,000. A repeat of what we saw in August would be troubling, but again not enough for the Fed to change course on what will be an extremely well telegraphed tapering.

Ben Jeffery:

And we also heard from Powell several times this week and once again, while he reiterated his expectation that higher inflation will ultimately abate as some of the supply chain issues and bottlenecks work themselves out, he made essentially no efforts to further demarcate the tapering process from the liftoff rate hike. And this brings up an interesting debate that's currently playing out in the market, which is the degree of the Fed's commitment to their new operating framework. We've now seen a period with core inflation substantially above target and even though the framework shift would all else equal imply a comfort with these sorts of numbers, clearly the rhetoric from the Fed is showing some concern that the central bank will need to act in order to offset materially higher prices.

Ian Lyngen:

Oh, there is a debate about whether or not the drama unfolding in Washington surrounding the debt ceiling would provide a disincentive for the Fed to follow through with tapering. My baseline assumption is that even if we don't have complete resolution and we simply get a stop gap measure that pushes the decision later in the year, that the Fed won't view that as a material inhibition to the next phase of monetary policy. Also on the political front, Powell's renomination remains very topical. It was assumed a given that Powell would be renominated for a second term at the Fed until the last week or so. Given some of the disclosures around personal trading and the questions that has raised from lawmakers, the politics around Powell's renomination just got a lot more complicated.

Ben Jeffery:

And there's also the question of who's going to fill the Vice Chair for Supervision seat, currently occupied by Randall Quarles. In conversations we've been having with clients, it seems at this point that's something of a happy medium from the White House's perspective would be appointing Brainard to fill that supervision seat and appeal to the more progressive members of Congress while keeping Powell on for another term as Chair, given the bipartisan support that he seems to have garnered from Congress.

Ian Lyngen:

If we do find ourselves in a situation where Powell doesn't get renominated, it's safe to assume that anyone the Biden administration would want to bring in would ideally for the administration, err on the side of being more stimulative, which means more dovish, which implies a further commitment to the Fed's new framework. And in that context, I'd actually expect to see yields move a bit higher in tens and thirties because that gets us back to a similar dynamic that we saw in Q1 of 2021, which is unrequited inflation expectations, repricing rates to a higher yield plateau. Again, not our baseline assumption but nonetheless, something worth pondering as we think about the fourth quarter.

Ben Jeffery:

And while the price response in that vein would likely be principally a breakevens move as inflation expectations move higher, if the repricing over the last week is any indication, the next leg in Treasuries is going to be primarily a real yield move. Given the optimism on growth and the less accommodative Fed that all odds equal implies higher, I.E less negative. Real yields.

Ian Lyngen:

Optically I would agree with that, but one of my concerns in this regard, Ben is we've heard so many times that QE and the tips market has been much more distortive than it has in for example, nominal treasuries. And so, the 15 basis point backup in real tenure yield seen after the Fed could very well simply be a mini tantrum in response to the upcoming Fed taper. And if that's the case, then I would worry that what we're interpreting as economic optimism being priced into the market as the third quarter came to an end, is in fact simply an anticipatory unwinding of particularly accommodative monetary policy.

Ben Jeffery:

And this again leaves me somewhat skeptical that we're going to be able to see, say two handle tens before the end of the year. in the event, that real yields move higher either as a function of the Fed's participation in the tips market, economic optimism, or some combination of the two that's mechanically going to have an offsetting effect on inflation expectations. Less accommodative policy translating to a more moderate pace of growth and rising consumer prices. So, if as it currently stands, tenure breakevens are at roughly 240 basis points. It's challenging for me to envision a situation where 10 year real yields make it all the way to negative 40 basis points without that sharp correction in risk assets that we mentioned earlier. And in the event that ultimately transpires that would once again, trigger more buying interest in treasury simply as a flight to quality impulse and limit the degree to which nominal tenure yields will ultimately be able to rise.

Ian Lyngen:

I would note that while I agree with the potential feedback loop over the course of the next several months, if we take the same logic and extend it over the course of 2022, it won't hold as well. So, said differently, we can see a steady grind higher in real rates that doesn't derail the equity market. If for no other reason, then the assumption would be that it's not an unwind of the distortions caused by QE, but rather a reflection of the fact that the global growth profile will presumably be improving in the year ahead. So, at the risk of trying to put too fine a point on it, the vulnerability of risk assets is highest when there's a very sharp move, as opposed to a gradual trend.

Ben Jeffery:

And bringing the conversation back to the happenings in Washington, we did hear from secretary Yellen this week that the Treasury Department expects it will be out of cash by October 18th. So, call that the new drop dead day in determining Congress's deadline to raise or once again, suspend the debt ceiling. While we remain in the camp that a technical default is extremely unlikely, if the price action in the bill market is any indication, there is some angst that treasury may be late in delivering some payments. Bills maturing in late October are trading at discount, albeit just a few basis points. And while Congress still presumably has three weeks to address this issue, in addition to the September jobs report, this promises to be a theme that continues to garner a great deal of investors focus, especially in the front end.

 

Ian Lyngen:

Attention. Wait, what were we talking about? In the week ahead the primary event in the Treasury market will be Friday's nonfarm payrolls report. As it currently stands, the consensus is calling for roughly 500,000 additional jobs created in the month of September. Now well this certainly wouldn't be the highest pace seen thus far in the recovery, it is well off of the disappointing August levels. Recall that ADP was particularly useful in predicting last month's BLS numbers. And as a result, we'd expect that Wednesday's release of the private payrolls figure will set the tone for market expectations into the official data. With the backdrop of the Chinese holiday week, all else being equal, we'd lean a bit more bearishly on the Treasury market within the confines of the range that's already been established. In the event that we see a more significant breakout we'd reference the trading parameters that were in place before the pandemic, specifically the August to December 2019 trading range, which in tenure yields was 143 to 197.

Ian Lyngen:

So, that implies that in the event of a more significant breakout, ultimately pushing tenure yields above 2% will be extremely challenging in the near term. Nonetheless, looking forward to 2022, we do anticipate that further progress out of the pandemic will ultimately lead to higher rates as the real economy continues to expand. While we don't expect a repeat of the impressive growth seen during the first half of 2021, a solid above trend three to three and a half percent seems very consensus at this point and that will effectively put in a floor for 10 and 30 year Treasury yields regardless of how we see the rest of the global economy performing on the tail end of the pandemic. We'd be remiss not to at least acknowledge the drama playing out in Washington between the debt ceiling debate, the budget, and the infrastructure deal. We expect that the market will be susceptible to headlines associated with the progress, although ultimately the outright level of yields in the Treasury market will not be defined by these events. Nonetheless, the front end of the market, bills in particular, will be vulnerable to any risk of an actual delayed payment.

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 as we watched the drama heat up in Washington and contentious negotiations extend, we cannot help but ask ourselves why so much Yellen. Get it? 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 suggestion that any investment or strategy referenced herein maybe suitable for you.

Speaker 2:

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 interest in you to the extent applicable. We will rely solely on advice from your qualified, independent representative making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.

Speaker 2:

You should conduct your own independent analysis of the matters referred to here in 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 it's affiliates that is not reflected herein. BMO and it's 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 [inaudible 00:19:45] 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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