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Falling Back - The Week Ahead

FICC Podcasts Podcasts November 04, 2022
FICC Podcasts Podcasts November 04, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of November 7th, 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 196, Falling Back, 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 November 7th. Despite the Senate unanimously passing legislation in March that would make daylight savings time permanent, thanks to the House, the clocks will fall back at 2:00 a.m. on Sunday morning. As for the gifted extra hour, we plan to use it contemplating the branding of the Sunshine Protection Act. Perhaps it would've been more successful as the Clock Setter's Liberation Act. Just a thought.

Each week we offer an updated view on the U.S. 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 passed, the Treasury market received an array of tradable fundamentals to guide the overall direction of U.S. rates. The biggest input was the FOMC meeting. The FOMC increased the target rate by 75 basis points, matching market expectations and bringing the upper bound to 4%. When we add in the effect of the balance sheet runoff, this gets policy rates to, let's call it, 475, certainly well into tightening territory, but Powell made it very clear that they're not done yet.

Expectations are now for another 50 basis point rate hike in December, followed by 50 basis points in February, and capped by 25 basis points in March. We'll make the observation that there is a lot of economic data between now and February. We'll have not only the inputs from the Consumer Price Series, but we'll also have better context for the overall pace of real GDP growth in the fourth quarter. Recall that while Q3 headline GDP printed at 2.6%, which is a solid showing, the bulk of that was a function of the contribution from positive net exports. And when we drill down to the final sales to domestic purchasers, which is essentially a version of core GDP, for lack of a better phrase, what we saw was a very benign half a percent increase on a three month annualized basis. So something to be concerned about as we contemplate the health of the overall consumer and the pace of consumption as the fourth quarter unfolds.

We also saw the October non-farm payrolls figures. Headline NFP increased 261,000. This was comfortably above the consensus, which was 200,000. We also saw average hourly earnings gain four-tenths of a percent on a month over month basis, and that was slightly above the three-tenths of a percent consensus. However, the year over year numbers decelerated from 5% in September to 4.7% in October. This was as forecast. More notably, however, we did see a decline in the Household Survey number of jobs. The Household Survey saw a reduction of 328,000 jobs. Now, we've only seen three negative household jobs prints since the pandemic hit the data in the middle of 2020. Now all three of those have been this year, and historically when there is a divergence between the establishment survey, ie. headline NFP, and the Household Survey, that tends to mark an inflection point for the overall health of the labor market.

That said, labor force participation is notably low this cycle and the unemployment rate, while it did increase from 3.5% to 3.7%, is still very low by historic standards. Our biggest takeaway from Friday's BLS data was that nothing contained within the Employment Situation Report would influence the Fed in either direction. This means the Fed will retain flexibility between now and the December meeting as it relates to the 50 or 75 basis point rate hike debate. Moreover, at the end of the day, it comes down to the direction of inflation and whether or not there's a more material contraction in the overall pace of growth.

Ben Jeffery:

Well, going into the Fed meeting, the market was unquestionably looking for Powell's pivot, an acknowledgement that the Committee has delivered a massive amount of tightening and the time has arrived to take a step back and evaluate the tightening that's already been delivered. Powell pivoted but he pivoted more hawkishly, and while the FOMC statement acknowledged the cumulative and lagged impact of monetary policy action, Powell's press conference said that, based off the data they've received, the FOMC may need to go to an even higher terminal rate. That pushed yields across the curve higher and the curve flatter with 2s-10s setting new inverted extremes and dropping to its most negative territory since the 1980s.

Ian Lyngen:

One of the most surprising aspects of the Fed this week was the fact that within the details of the statement the overall Committee signaled that they are focused on the cumulative tightening and the lagged impact of monetary policy action. That was a clear signal that the Fed is going to transition from 75 basis point rate hikes being the go-to to 50 basis points in December. And I think that that is very consistent with the messaging that we have already received from the Fed, either indirectly or directly, and it sets the market up, as you pointed out, Ben, to debate, how many more rate hikes will we see to get to Powell's updated version of terminal? Now, stepping back from supersized rate hikes might have otherwise been interpreted as a mini pivot, if nothing else. The fact that the market has so quickly refocused on the debate of where terminal should be in this cycle is very telling.

And in the wake of an ostensibly stronger than expected Non-Farm Payrolls Report, it follows intuitively that we continue to see rates grinding higher. We remain decidedly in a go with mode as it relates to the sell-off. Higher rates driven by monetary policy expectations have proven the path of least resistance, and this isn't an environment in which we see any upside in fighting the trend, at least not yet. Eventually, we anticipate the buy-in interest will come in and that rates will ultimately trend lower. But for the time being, Effective Fed Funds, which are now at 3.83%, will serve as a floor for U.S. rates at least until we get to the December meeting and the presumed half point hike.

Ben Jeffery:

And while the meeting wasn't a dovish pivot, we have nonetheless reached a relevant inflection point in terms of what seems to be a shift in the Fed's reaction function. Powell went as far to say, as you highlighted, Ian, that the next meeting could very well be the one that the Committee delivers a smaller hike, and while clearly there's going to be a greater reluctance to keep delivering 75 basis points, Powell has firmly opened the door to an even higher terminal rate. So as whereas over the last several months the hawkish impulse that we had seen was additional 75 basis point moves, at this stage, depending on how the data plays out, it's not unreasonable to assume that the next leg of the hawkish trade is not going to be more 75 basis point hikes sooner, but rather additional 50 or 25 basis point hikes later.

So, from our perspective, and based on the Fed Funds Futures Market, that means that a March and or May rate hike in 2023 should now probably be on the table. So really what this means is, assuming the DOT plot in December is revised to reflect the 525 upper bound that's currently in the market, that means that a 50 basis point rate hike in December, another 50 basis point rate hike in February, and then a final 25 basis point move in March would bring monetary policy to where the market is currently expecting it will go.

Ian Lyngen:

I'll make the observation that not only does the week ahead contain a CPI print that could challenge the market's assumption of the Fed's agenda, but there are five CPI Reports between now and March, which is a meeting that the market has already effectively fully priced in a rate hike. So when we think about the balance of risks between now and terminal, it should be noted that while the Jobs Report might provide the Fed the flexibility to achieve a higher terminal rate than previously assumed, it won't in and of itself be the driver. The driver will, of course, be the direction of inflation. Expectations currently stand for a half a percent increase in the core CPI numbers on Thursday. We'd bias that a bit lower as a function of used auto prices and the assumption that OER and, to a lesser extent, rents are due for moderation into the end of the year.

Ben Jeffery:

And in this discussion of another high CPI read, maybe a meaningfully higher terminal assumption, it's worth acknowledging what we've seen historically in terms of the behavior of 10 yields versus Effective Fed Funds. Ian, you touched on the fact that effective funds would serve as a floor for 10 year yields over the next six weeks or so, and that's certainly consistent with what we've seen during previous hiking cycles. Generally speaking, 10 year yields do not trade below Effective Fed Funds until the Fed has either arrived at or is very close to terminal. So in practical terms what this means is that we probably have some greater bearishness in the long end of the curve to be realized if the inflation data, both next week but also the print we get before the December Fed meeting, shows that this higher terminal rate assumption is going to be justified by the data.

Now, as with so many aspects of this cycle, the one nuance that makes this time different during history is just how fast everything has played out, and this means that the economic data runs the risk of deteriorating even more quickly, which in terms of the discussion on the Funds/10s inversion means that it could happen earlier this cycle than we would have seen historically.

Ian Lyngen:

I'm actually targeting the 14th of December as the first inflection point to test that hypothesis. That's when we get the extra 50 basis points that we've been discussing in policy rates and that would put Effective Fed Funds at 4.33. Now, thus far at least, the cycle high for 10 year yields has been 4.34, so there's a reasonable debate about whether or not 2s will trade below Funds by the end of the year. Historically, as you point out, it isn't until the Fed reaches terminal and holds it for some period of time that the market begins to look forward to the next leg of the cycle and pushes rates below Effective Fed Funds. It will be very interesting to see where we end this year in terms of outright yield levels versus what the Fed has managed to accomplish.

Now, the Fed and the market as a result remains very much in a data dependent mode. Now, in part for that reason, as we make the rounds and talk to clients, one of the biggest takeaways is that people are not necessarily apathetic to the direction of the market, but they're not as engaged as they might otherwise be in terms of having positions on. People have cash on the sidelines waiting for the right moment to add duration. Certainly, this year's performance in fixed income has resulted in many investors being much more comfortable sidelined at the moment as opposed to taking any strong positions. And this isn't limited to simply outright duration, but also the shape of the curve. We've heard a lot of conceptual pushback against our call for 2s-10s to invert as far as negative 100 basis points. I think a fair amount of that comes down to the idea that the Fed is still very much in play and if the Fed is going to continue hiking rates, the curve can stay inverted, but outright rates will continue to be brought higher with the two year sector leading the move.

Ben Jeffery:

And while the Fed and payrolls were the main events of the week, we also did get the November refunding announcement, which confirmed the expectation that coupon auction sizes are going to remain unchanged for the coming quarter, which will leave next week's 10 and 30 year auctions at 35 billion and 21 billion respectively. But also, more importantly, it was what we didn't learn on the issue of buybacks that actually triggered the largest market reaction in off the run space, most specifically in 20s. The under performance of the off the run 20 year sector suggested that there were some in the market anticipating Yellen would offer more clarity on the size, scope, and timing of a potential buyback program. But all investors received was an acknowledgement that the issue of buybacks is going to continue to be studied, and we're probably going to need to wait at least until the February refunding announcement before we get any greater clarity on the issue.

Given that the debt ceiling is going to become topical once again right around the new year, I suspect that Washington will want to wait until it's borrowing capabilities are free and clear of the debt ceiling to really start messaging anything explicit as it relates to the buyback program. But as our Pre-NFP Survey showed this week, 65% of respondents are of the opinion that the Treasury will implement a buyback program and it will likely be at some point in the first half of next year.

Ian Lyngen:

There's an argument to be made that there would be a bigger liquidity benefit for the year in turn if the Treasury Department were to announce the buyback program sooner rather than later. However, Ben, as you point out, given that the Treasury Department didn't choose to signal that it is moving forward with the program via the November refunding statement, odds are low that we'll actually see it by year end.

Ben Jeffery:

And this, of course, brings us to the auctions themselves this week on Wednesday and Thursday before Friday's market closure where we're expecting all of the events that we've been discussing will likely necessitate a bit larger concession for supply than would otherwise be expected. As has been thematic this year, Treasury auctions generally have been a bit lackluster, and especially following Powell's hawkishness, it's not unreasonable to assume that we're going to need to see some larger discount to take down the supply itself. The steepening of the curve immediately following payrolls on Friday I also think adds a little bit of weight to this idea that a relative concession is already starting to make its way into valuations, and especially given the fact that the Fed hasn't pivoted, the dollar remains strong, and cross currency volatility is still very high, it's still probably too soon to expect that foreign buyers are going to reemerge in any material way to take advantage of the liquidity point.

That will be an inflection to keep an eye out for in the first half of next year, presumably as the Fed arrives to terminal and the dollar puts in its peaks. But as for the November refunding announcement, we certainly wouldn't fade a larger bearish set up into the auctions.

Ian Lyngen:

On the topic of overseas demand, it is notable that we've seen at the Fed some increases in swap line utilization. So this is effectively overseas central banks utilizing the Fed to access liquidity in dollars. We know that throughout this year there's been a scarcity of dollars as the Fed has ramped up its process of shrinking the balance sheet. And while we don't see any clear signs of stress or any indication that this is the beginning of something more problematic, it is worth keeping this on the radar, especially as we move forward into year end, and tighter monetary policy globally will continue to reveal pockets of stress throughout the overall financial system.

Ben Jeffery:

And on the issue of stress, November's begun and the holiday season is quickly approaching.

Ian Lyngen:

Ben, my experience has been that with enough eggnog, most problems solve themselves. In the week ahead, the Treasury market will continue to digest the implications from Powell's press conference in which he outlined the case for a higher terminal rate. The FOMC was successful in communicating the potential for a downshift to a 50 basis point rate hiking cadence at the December meeting, but the Chair managed to leave investors focused on how high rates will go and, more importantly, how long the Fed will be able to retain an elevated policy rate during this cycle. The week ahead also contains three key auctions of note, the $40 billion three year on Tuesday, followed by the $35 billion 10 year on Wednesday, and capped by the $21 billion long bond auction on Thursday. Now, these are refunding auctions, so slightly larger than the re-openings, and as such, we see a strong case to be made that either a pre-auction concession or a concession versus the 1:00 p.m. when issue rates will be required to take down supply.

There's also a wide variety of Fed speakers, including Collins and Mester on Monday, both are voters, Williams on Wednesday, who's also a voter, and then Mester and George again on Thursday. We don't anticipate a great deal of divergence from the FOMC's statement nor the messaging that Powell left the market with. That said, these could produce tradable headlines as monetary policy makers attempt to provide greater detail and nuance on their present thinking about the pace of hikes, the ultimate end goal, and, of course, any shifting reaction function to the incoming economic data. Without question, the highlight of the week ahead will be Thursday's CPI print. Expectations are for a seven-tenths of a percent gain in headline CPI for the month of October. On the core side, the average forecast is up 0.5% month over month. We are biased slightly lower simply because measures of used auto prices have been trending lower, and that hasn't come to fruition in the data as of yet.

And due to the lagged impact of the housing market on the shelter series via OER and rent, we're looking for a moderation, albeit not a reversal of some of the recent gains. To be fair, this is not dissimilar from the bias that we have brought in to the last several inflation prints, and to a large extent, given the reaction of the market and the Fed, we take solace in knowing that we hadn't been alone in that scale. 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 while we might not be staying up until 2:00 a.m. on Sunday morning to watch the hour drop, we look forward to celebrating it with a good night's sleep this weekend, especially after the week just passed.

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 3:

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