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The Fall Stumble - The Week Ahead

FICC Podcasts September 09, 2021
FICC Podcasts September 09, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of September 13th, 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 137, the fall stumble, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of September 13th. That's right, Monday the 13th. Possibly even more troubling because at least Friday has Friday going for it.

Speaker 2:

The views expressed here are those of the participants and not those of the BMO Capital Markets, its affiliates or subsidiaries.

Ian Lyngen:

Each week, we offer an updated view on the U.S. 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 had a very specific reaction to a series of economic data releases that has brought into question the forward path of rates, specifically the weaker than expected August NonFarm Payrolls print on the Friday before Labor Day weekend triggered a bear steepening that was carried through to Tuesday. What's notable, however, is that buying interest eventually emerged before 10-year yields got above the 138 to 140 range. That was subsequently then furthered at the 10-year reopening auction with a notably strong 1.4 basis points stop through as well as outpaced demand from the indirect bidding subcategory.

Ian Lyngen:

Now, while this doesn't necessarily translate through to overseas interests, per se, we won't have that information for a couple of weeks. The assumption is that the strong demand for the 10-year auction was a function of overseas interest at this moment. This speaks to the idea that, at least in part, what is setting the outright level for Treasury yields has to do with the pace of the global recovery and foreign demand for Treasuries as opposed to simply the domestic performance as the real economy works its way out of the pandemic.

Ian Lyngen:

Our stance has long been that the outright level of Treasury yields is far less about supply and demand and more a function of the macro narrative. This was reinforced via the strong 10-year auction, but also in the performance of the Treasury market in the wake of the pandemic. If we were having this discussion in the '80s or '90s, we would make the point that it's less about the Treasury's borrowing needs per se than it is the domestic growth and inflation outlook that really sets the tone for 10 and 30-year yields. Today, in 2021, it has become increasingly evident that not only does Treasury issuance and net supply take a distant second seat to the macro narrative, but the focus of the macro narrative has expanded from being simply U.S. or domestically focused to now encompassing the global outlook. This is due in part to decades of globalization of the real economy, but it can also be attributed to globalization of ownership of Treasuries. When we deconstruct who the largest outright owners of Treasuries are, the top three remain the Fed, Japan and China.

Ian Lyngen:

Trade flows, as well as the expectation for comparative economic performance continue to be instrumental in trading Treasuries as does the uncertainty created by the pandemic.

Ben Jeffery:

Well Ian, coming into this week we saw what was a pretty meaningful extension of that post-NFP bear steepening. It was counterintuitive on Friday afternoon and even more counterintuitive on Tuesday morning coming back from the long weekend.

Ian Lyngen:

Well, it's only counter-intuitive in so far as one simply wouldn't expect a 500,000 [inaudible 00:04:29] miss in NonFarm Payrolls to translate through to a bear steepening in the Treasury market. However, if we think about the way that the market has behaved over the course of 2021, we have a variety of episodes that we can point to where the economic data hasn't been tradable in the traditional fashion. Q1 is an obvious example. Regardless of how the data was printing, we continued to push forward with a cheaper and steeper narrative that managed to run its course into the second quarter when we saw even strong data met by a drift lower in rates as overseas investors, particularly Japanese, returned to Treasuries. And that started a bull flattening that ran throughout the bulk of the quarter.

Ian Lyngen:

The next inflection point came following the June FOMC meeting when the market's perception of the Fed's commitment to the new framework was questioned following the increase in the 2023 dots. Fast forward to the August NonFarm Payroll print, and what we saw was a disappointing jobs number that will make it very difficult for the Fed to pull forward the lift-off rate hike while at the same time, a higher than expected average hourly earnings print, which will keep the Fed largely on track to taper by the end of the year.

Ben Jeffery:

And this gets at a dynamic that we've seen before, which is a little bit of that bad news is good in so far as it implies the Fed is going to be more patient on the journey towards normalization. We heard from [Bostik 00:06:09] over this past week stating explicitly that, that the incoming data has been underwhelming enough as to maybe warrant the Fed rethinking its timeline on tapering. Now that certainly doesn't mean an acceleration, but it is a critical aspect to consider in contemplating when the Fed will ultimately announce tapering. The August jobs report makes a September announcement much less likely and really now leaves the focus on November or December.

Ian Lyngen:

And when we contemplate whether or not the Fed will be willing to move forward with tapering at the November meeting, it's worth noting that in the interim, the Fed will only have a one more employment report, and while we'll see updates on the inflation front, jobs just became a greater question mark in the wake of NonFarm Payrolls.

Ben Jeffery:

And this brings up the question of what really would it take on the jobs front for the Fed to announce or not announce tapering at the November meeting. It's fair to say that another disappointment on the scale that we saw in August would be sufficient to inspire a fairly serious conversation on the committee about whether it's warranted to begin pulling back on bond buying just yet. And getting back to that bad news is good dynamic, another big miss on jobs will likely manifest in a repeat performance of that bear steepener we saw late last week and early this week.

Ian Lyngen:

That's an interesting point, Ben. It's not entirely clear to me that it would be a repeat of the bear steepener if for no other reason than the bear steepening that followed the August NonFarm Payroll print was really relatively short-lived. We only got 10-year yields back close to 140, a bit shy actually, and then we subsequently rallied into the 10-year auction, which stopped through with strong, indirect bidding. And if nothing else can be taken away from the experience is that the range trading momentum remains very strong in the Treasury market.

Ben Jeffery:

And especially in this current environment, the influence of more short-term factors like supply have been instrumental in determining the scale of the reactions we've seen to some of the economic fundamentals. We've been talking about this idea that rates have entered this regime where the data is mattering less than it once did, but that doesn't mean it doesn't matter at all. And this past week was a great example of the knee-jerk move, being inspired by the jobs data, but then it was ultimately the 10-year reopening that saw that price action extended until once again dip buyers stepped in at marginally higher yields. Demand emerging at levels below 140 tens suggests to me at least that it's going to be unlikely we rechallenge that 177 yield high before the end of the year.

Ian Lyngen:

At this point, there does seem to be very little question that we're going to be in a lower rate range for much longer than the market was anticipating at the beginning of the year. And I think that this is only reinforced by not only the Fed teeing up tapering in the fourth quarter, but also the ECB following through with their planned reduction of bond purchases. Still, we find ourselves in an environment where 10-year real yields are extremely negative, the breakeven curve shows that there is plenty of reflation already priced into the market and the real economy continues to struggle to move past the pandemic.

Ben Jeffery:

And that brings us to the main event this week, which is Tuesday CPI data. The August inflation report is going to be especially intriguing following the jobs numbers, if only given the rising concern about stagflation risk, and that higher prices are eroding confidence and eroding a willingness to consume, which in turn is dragging on the recovery. Within the details of CPI, clearly auto prices are going to be an area of focus, in addition to those pandemic specific pockets of rising prices and airfares and things like lodging away from home. But remember within the August NonFarm Payroll series, we saw flat hiring in leisure and hospitality. So that begs the question of whether that was a function of diminished demand in those categories or if prices there are still on the rise.

 

Ian Lyngen:

Let us also not forget that within the core CPI series, OER, or owner's equivalent to rent, is expected to be trending higher in the second half of this year primarily because of the run-up in housing prices seen during the pandemic. The passing of the reflationary baton from transitory factors to shelter costs is largely assumed at this point and I suspect that its actualization won't be a tradable event, at least not in so far as perpetuating a bear steepener in Treasuries. It might contribute to the upward pressure that we have seen in breakevens, which again puts downward pressure on real yields because implicitly it has become a growth story at this point in the cycle.

Ben Jeffery:

So does that suggest that if we are going to see 10-year yields move beyond that 142 level back toward 160 by the end of the year, that's going to have to be a growth story, not an inflation one?

Ian Lyngen:

If for no other reason then it's clear that any further inflation from here is going to undermine the prospects for consumption and function more as a tax on spending rather than be the type of organically driven inflation that the Fed would characterize as a sign of a healthy and potentially overheating economy.

Ian Lyngen:

When we think about the wage pressures already seen in the U.S. economy, what remains as a primary unknown is what happens during the month of September after the enhanced unemployment benefits expire and workers need to adjust to reduced income either by slowing consumption, spending down savings or going back to work.

Ben Jeffery:

And in addition to CPI, we also get August retail sales data on Thursday, which is going to be especially informative on exactly that dynamic, how willing have domestic households been to continue spending in an environment where we've seen reasonable wage gains? And more importantly, what did spending look like as we reached the point when the pandemic-related unemployment benefits began to expire? We often talk about the departure point mattering and yield terms, but I also think it applies to the spending landscape as well.

Ian Lyngen:

You're certainly right in that regard, Ben. And as we have seen a variety of forecasts for growth in the third quarter, continue to be revised lower and lower, it does bring into question, will the U.S. economy be able to meet the Fed's objective of 7% growth in 2021? It's difficult at this point to suggest that it's a foregone conclusion that the Fed's objective will be reached. More nuance to the discussion, as we think about how this applies to U.S. rates, is what happens if growth undershoots? It's been communicated that the Fed really wants to get out of perpetual QE and commence tapering, level off the balance sheet and move forward to a discussion around the liftoff rate hike. But in the event of a disappointing second half in terms of growth and presumably employment as well, if nothing else that should push out the first rate hike well into the middle of 2023.

 

Ben Jeffery:

And clearly the tapering discussion is going to be significant at the September meeting, but we also do get a revised SEP and dot plot on the Fed's formal projections about where they see policy rates in 2022, 2023 and for the first time, 2024. Remember, in June, that 50 basis points of policy tightening in 2023 was a bit of a surprise. But since then, we've now seen the Delta variant come in as a meaningful headwind to the recovery, in addition to some fiscal stimulus beginning to run its course. So to me that suggests that the bar for another "hawkish surprise" in the SEP is quite high, but it will nonetheless be interesting to see how committee members' expectations on policy rates have shifted over the past several months.

Ian Lyngen:

On the political front, we also recently heard from Secretary Yellen about the prospects were the Treasury Department to run out of cash by the end of October, give or take, we all know that this is a moving target with a number of different factors, not least of which being tax receipts, nonetheless, by reminding Congress of the urgency in terms of the Federal coffers. It has placed the debt ceiling issue back on the radar of market participants.

Ben Jeffery:

And if history is any guide, the most likely scenario is going to be that a technical default is avoided, but that's not going to prevent Congress from waiting until the 11th hour to either suspend or raise the debt ceiling. So in practical terms, that's going to continue to put downward pressure on funding costs and bill yields, while also keeping usage at the RRP facility very elevated. Over $1 trillion in cash a day being parked at the Fed receiving five basis points has now definitively become the new normal. And even after bill issuance can normalize once the debt ceiling issue is behind us, it's certainly not a foregone conclusion that we'll see a meaningful retracement there just given the massive amount of cash that remains in the system.

Ian Lyngen:

That's a very fair point, Ben. And you also make the observation about the 11th hour in Washington and that really does beg the question, why does everything wait until the 11th hour in Washington? Is it because they want to get it done right before lunch?

Ian Lyngen:

In the week ahead, the Treasury market has three primary influences to drive the direction of rates. First will be the CPI number with the headline expected to increase four tenths of a percent month over month in August and core seen up three tenths of a percent. The second primary influence will be the retail sales numbers for the month of August that will be released on Thursday morning and in the interim. The third and arguably more impactful influence will be the price action itself. And while this might sound needlessly glib, the fact of the matter is that the U.S. rates market remains in a period of consolidation and as investors recalibrate expectations for the final few months of the year, we anticipate that the 112 to 142 range will continue to hold in 10-year yields as uncertainty regarding jobs growth, as well as the overall health of the economy, continues to dominate the macro narrative.

 

 

Ian Lyngen:

As we consider the balance of 2021, we're retaining our year end target for 10-year yields in a range of 125 to 135. That isn't remarkably different from where the market's trading at the moment. And given the current trading dynamic, it also allows for another attempt to push toward that 150 or even 160 level in 10-year rates. But we maintain that both the upper bound and the lower bound for 2021 have now been established.

Ian Lyngen:

One of the more surprising developments in the Treasury market from our perspective is how the five-year sector has performed. We came into this year with a target for 10-year yields at 125 by year end, but five-year yields remaining subdued and closer to 35 basis points. What we see now is that the expression of bond bearish events during the second half of this year has triggered belly-led sell offs, which have brought five-year yields back to that 80 to 85 basis point range.

Ian Lyngen:

We're targeting a 90 to 95 basis point range for fives by year end, and this is simply a reflection of the fact that once tapering has been announced, the market will move even further into the mode of trading the liftoff rate hike. And if nothing else, another four months of progress through the pandemic will put the Fed's first rate hike that much closer assuming that the Delta variant and the risk of future variants doesn't materially derail the recovery or the medium term outlook.

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 NFL season now underway, it strikes us that free agents always seem to be so expensive.

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:

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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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