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Fed-Tastic - The Week Ahead

FICC Podcasts June 17, 2022
FICC Podcasts June 17, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of June 21st, 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 176. Fed-Tastic. 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 June 21st. And as we head into the long holiday weekend, we cannot help but reflect on the timeless insight from the genre classic. You got to know when to walk away. You got to know when to run. If you need us, we'll be Forrest Gumping it.

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, 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 lot of fundamental inputs with which to contend, the most significant of which was the FOMC's rate decision. The Fed delivered a 75 basis point rate hike that is arguably higher than what was anticipated. Although in the wake of the CPI data, there was a clear and concerted effort on the part of monetary policy makers to convey to the market that their intention was to put 75 basis points on the table.

Ian Lyngen:

So the fact of the matter is that The Fed ultimately did follow through with 75 basis points and the shock and awe value of that was limited to some extent. Now, as a point of clarification, the FOMC is not in the shock and awe business as it were so it wasn't all that surprising to see a well communicated increase in the target policy rate and The Fed layout expectations for yet another 75 basis point move in July. By looking at the SEP, which were also updated, our expectations are for 75 in July, 50 in September, 25 in November and 25 in December. Nothing particularly dramatic there but if we learned anything from the FOMC meeting in the week just passed, it was that Powell is willing to deliver in terms of surprising the market hawkishly.

Ian Lyngen:

At the end of the day however, the price action in Treasuries was the most remarkable aspect of the week. We had a massive selloff in the very beginning of the week, 10 Year Yields got as high as effectively, 3.50, just slightly below and then subsequently staged a rally back to end of the week, for all intents and purposes, where it was started. In the shorter dated maturities however, it was a different story. What we saw in the very front end of the curve was a significant enough of a selloff that twos, tens has once again inverted. Now we're ending the weak in slightly positive territory for twos, tens but the reality is it was a very sharp move midweek. Fives, thirties on the other hand continue to be inverted. And that's a trend that we expect will remain in place for some time. When we think about the extent to which fives, thirties can invert, it's important to offer the context that the last time that the fives, thirties curve was as inverted as we have seen this year was back in 2000.

Ian Lyngen:

And in 2000, it was an entirely different dynamic driving the inversion. Recall that during that period, The Federal Government was running a surplus and paying down the deficit and in the process retired the 30 year benchmark Treasury. Now that's almost unimaginable in the current environment but the fact of the matter is that was the context for the depths of the inversions, comparable to what we are seeing at this point. This isn't to imply that what is currently underway is a function of the supply and demand dynamic but rather just an acknowledgement of how extreme the move has been and I think more importantly, where we might ultimately find a limit to the inversion in fives, thirties. So that negative 15 to negative 20 basis point level is going to be a line in the sand and it's going to be a line in the sand that's relevant as the market continues to contemplate the probability that The Fed's aggressiveness on the inflation side is ultimately going to effectively hike the US economy into a recession.

Ian Lyngen:

The narrative of The Fed hiking the economy into a recession certainly isn't a new one and it's one that is evident in risk asset performance. It's notable that we had a significant selloff in US equities and as such, and it follows intuitively, we've seen financial conditions end up much tighter as a result. Now this brings us back to one of our core tenants and that is that at this point in the cycle, the market is doing a great deal of the heavy lifting for The Fed. Which implies that while The Fed might ultimately have designs on a notably higher terminal rate in practice, it could prove to be much more challenging. This isn't to suggest that we'd skew the terminal rate below the 3.75 to 4% range that's currently implied by both the SEP and The Fed Funds Futures Market but rather the road to terminal, we suspect will be a much bumpier ride and involve more downside risk in risk assets.

Ben Jeffery:

So this last week was always going to be very important. We had the market at something of a precarious position right up against some critical technical levels that we'd been watching for weeks, if not months, frankly. And all these factors came to a head with Wednesday's Fed meeting, Powell delivered a 75 basis point rate hike. And while just a few weeks ago, that was something widely viewed as off the table, the speed with which sentiment shifted toward the action that The Fed needed to take meant that going into Wednesday, a 75 basis point hike was expected and priced into the market. Add to this, a rate hike from the BOE, a surprise move from the Swiss National Bank. And really Ian, it was a week that was defined by, dare I say it, exciting monetary policy.

Ian Lyngen:

To be fair Ben, it's very rare that monetary policy is exciting, certainly not in the context of what we have seen this week. But the reality is that the central banks globally are playing catch up with inflation. I've heard that notion for several months now and at the risk of being needlessly glib, the fact of the matter is May's inflation numbers were high enough and outperformed expectations to a significant enough degree as to get monetary policy makers even more concerned about where we are in terms of the realized inflation data.

Ian Lyngen:

On the flip side, when we look at inflation expectations, the compression of breakevens, I think, tells a very important story. We have 10 year breakevens back toward that 255 level, we even have the 5-year, 5-year Forward compressing. All of this is a strong vote of confidence in the market's belief that The Fed is going to be able to do everything that is needed to contain realized inflation going forward. Now it's worth noting however, that those are just market based measures of inflation expectations. If we look at consumer confidence and some of the survey based measures, what we've very quickly come to realize is that consumers are still very concerned about inflation and the inflation anchor for the average consumer is still very much in peril at this stage.

Ben Jeffery:

And as we and frankly the market debated the likelihood that The Fed would ultimately decide to deliver a 75 basis point hike, one of the most convincing arguments in favor of 50 was that of The Fed's credibility. Remember at his press conference at the May Fed meeting, Powell went as far as to pre-commit to two more 50 bp rate hikes. That meant June and July were both going to see the target band increased by half a percentage point. And even more recently in that interview with the Wall Street Journal in the middle of May, we also heard Powell reiterate that 50 basis points was on the table for June with no mention of a 75 basis point rate hike. So one of the criticisms we heard against the idea of a 75 basis point hike was that if in fact The Fed delivered more than 50 basis points as they had communicated, that would shake the market's trust in The Fed delivering on what they previously communicated.

Ben Jeffery:

Obviously that was a trade off Powell was willing to make, giving us 75 and opening the door for another 75 basis point move in July. And what this means to us is that in this context, credibility means that The Fed is able to respond to the realized data and how developments have shifted over the inter-meeting period, even if those take place during the pre-meeting communication moratorium period. So while yes, the committee went back on their word about a 50 bp rate hike in June, what they did show they were credible in is acting appropriately, given how quickly both the market and the economy are shifting in the current environment. Looking forward, it is worth mentioning that Powell said 75 basis point moves are not going to be common, but did say that 50 or 75 is the most likely outcome of the July meeting.

Ben Jeffery:

So as we think about how many rate hikes and how large they will be, that will ultimately get us to that terminal level that The Fed penciled in the SEP at 3.75, so call that 3.50 to 4%. What the press conference showed is that probably we're going to get another 75 basis points, maybe a couple 50s and then slowing to a 25 basis point cadence seems to be the path of least resistance. And of course this assumes that inflation will react in a way that The Fed is anticipating. And it's also worth mentioning that if The Dots are to be believed, most of this cycle's tightening will have taken place this year. We only had another 25 basis point rate hike or two penciled into the Dot Plot for 2023 before we see that the median FOMC member actually expects lower policy rates in 2024 than in 2023.

Ian Lyngen:

So Ben, I think you make a great point and at its core, what you're effectively saying is a credibility of credibility argument. And while that's a great turn of phrase, it also implies that during the run up to the July FOMC meeting, the consensus expectation might ultimately be 75 but it almost goes without saying that the market's going to price in some non-zero probability of a 100 basis point rate hike. And I think that that was always one of the concerns on the FOMC. And one of the reasons that in the past it was difficult, if not prohibitive for The Fed to want to forward commit to a series of rate hikes. Now, I won't make the argument that perhaps there was a lesson learned by Powell in mentioning 50 basis points for the June and July meeting. However, I will be intrigued to see if we continue to see that level of specificity once we get past July.

Ian Lyngen:

I think that there's a lot of monetary policy communication risks built in there and for that reason, I think greater uncertainty as it relates to the path of Fed Funds going forward might ultimately be the story in the second half of the year. I'd also add that within the SEP, we got a few important updates that were overshadowed by the 75 basis point rate hike, but I'd like to highlight. One is GDP at the beginning of this year by The Fed was assumed to be 4%, we're now down to 1.7%. And that's even below The Fed's long run average of 1.8%. So a weak economic performance in 2022 has all of a sudden become The Fed’s go-to stance.

Ian Lyngen:

And I think that to a large extent, this has contributed to the flattening of the yield curve and more importantly, the fact that the macro narrative is now shifting to the possibility of a recession. When we think about the second quarter performance, what we see now is that the Atlanta Fed's GDPNow tracker is at zero for Q2; that in the wake of Q1's negative 1.5% print suggests that we actually should have a recession in the near term on the radar. Whether that comes to fruition or not is almost a moot point because the fact of the matter is that engineering a soft landing just became much more challenging for The Fed.

Ben Jeffery:

And turning for the moment away from monetary policy and towards the price action we saw in the Treasury Market. Ian, I would say it's those recessionary fears and those worries that are becoming more and more serious, not just among market participants but I would say among everybody globally, that contributed to the impressive moves in rates we've seen. A 30 basis point intraday range in 2-Year Yields and a 30 intraday basis point range in 10-Year Yields is hardly a traditional trading environment and shows just how uncertain yes, the path of monetary policy is but also the cross currents that are facing the economy and inflation. After breaching that 3.26 level that we've been watching in 10- Year Yields, we saw a challenge of that 3.45 level from April 2011 that held on the first attempt but then ultimately gave way to one last leg of the selling pressure that brought 10-Year Yields right up against that psychologically important 3.50 level that held twice.

Ben Jeffery:

And then it's these recessionary worries and a more concerted risk off tone that brought tens all the way back to the level that we started this trading week at. So to look at the week over week change, one might be excused for thinking it was just another summer trading week in Treasuries, but in actuality, we've now seen 10-Year Yields move back to over 11 year highs. And it's not just Treasuries that are responding to this volatility but obviously we've entered a troubling milestone in equities as well with the S&P 500 formally entering a bear market and continuing to respond in a negative fashion to not just hawkish central banking, but also these growth concerns that we've been discussing and that are moving increasingly from the realm of risks to consider to realities.

Ben Jeffery:

Ian, you and I have talked about several times, the nuance that higher inflation has now reached a point that firms can no longer pass loftier input prices onto the consumer. And that combined with negative sentiment resulting from inflation, remember last week we saw the U Michigan Measure of Consumer Sentiment fall to a record low, all points to, on the corporate side, narrowing profit margins with what that means for an ability to hire or retain workers. And on the consumer side, confidence that is eroding very quickly in an environment when an increasing share of disposable income is needing to be spent on things like gas and food. We have gas prices in the US at a record high and it doesn't seem to be the case that there's going to be any reprieve in the near term. Which is going to be especially punitive during the summer months and the time in the calendar that's most closely associated with higher demand for gas, just given the travel that typically takes place domestically between Memorial Day and Labor Day.

Ian Lyngen:

And we've made it this far in the conversation without mentioning the fact that mortgage rates are now at the highest that they have been in 14 years. And while we talk about the potential impact from the wealth effects perspective, when we see equities sell off by 20%, 30%, there's also a meaningful impact in the same dynamic resulting from a slowing in the real estate market. While prices certainly haven't reversed, a deceleration of the gains is going to begin to undermine people's expectations in terms of how much upside can ultimately be realized.

Ben Jeffery:

And Ian, I'm glad you touched on mortgage rates because we're already starting to see the implications from both higher borrowing costs but also higher home prices within the data itself. This past week, the month over month change in housing starts was its most negative since April 2020, which was obviously a pretty dismal economic environment. And when looking at the combination of the year over year change in home prices plus the average mortgage rate, we're at, effectively, the highest that proxy has ever been. So this is a clear indication of the impact that The Fed is having on housing and equity valuations, which exactly as you point out Ian, matter most for the wealth effect. And crashing the real estate market while maybe a bit hyperbolic is certainly a valid criticism to levy against Powell. But considering this share of core inflation that shelter occupies, if The Fed wants to bring down inflation, they almost by definition have to bring down or at least dramatically slow the appreciation that we've been seeing in real estate prices.

Ian Lyngen:

So is this what Bob Dylan meant when he said, give me shelter from the storm?

Ben Jeffery:

Wasn't that The Rolling Stones?

Ian Lyngen:

In the week ahead, the Treasury Market will have an array of new information to provide trading direction. The most obvious will be however, the price action itself. We're watching that 3.50 level in 10- Years but we're also watching the Zero Lower Bound for 2s/10s and with 5s/30s back and forth between inverted and not inverted, the shape of the yield curve is going to continue to be a focal point for investors as we contemplate where we are in the cycle and the ultimate fallout that we could see from The Fed’s efforts to normalize monetary policy at this point in the recovery. The clear takeaway from The Fed, the ECB, the Bank of England and now the Swiss National Bank has been a coincident, not coordinated effort to hike rates in pursuit of keeping inflation expectations duly anchored.

Ian Lyngen:

Now this is very consistent with what was perceived to be The Fed's monetary policy stance as the first quarter developed but the new information that we've seen over the course of the last several weeks has been a series of other central banks now joining in the effort. The notable exception is the Bank of Japan, which came out and is going to continue to target zero 10-Year JGB Yields and left rates in negative territory at negative 10 basis points. Their primary concern at the moment has to do with the economic fallout from COVID. And as we watch the yen continue to depreciate, there will certainly be an increased question about competitiveness of exports and how that ultimately circles back to the global inflationary environment. It's also in keeping with a theme of dollar strength, which has come to a large extent to define 2022.

Ian Lyngen:

From a macroeconomic perspective, a stronger dollar is consistent with The Fed's efforts to contain inflation expectations. And for dollar traded commodities such as oil, it does set up a situation where the US economy could see a counter force to the inflationary pressures that remain so prevalent across a variety of different sectors in the US economy. We remain impressed by how quickly The Fed was willing to pivot to 75 basis points from the previously communicated 50 basis point level. We're also interpreting this as a clear signal that The Fed is willing to be more flexible going forward.

Ian Lyngen:

And in this context, at least for the moment, being more flexible translates into being more hawkish. Now, not to belabor the point, but this ultimately brings us back to our core flattening position and the idea that over the course of 2022 rates will converge on one level across the curve. Now this is arguably somewhat intuitive given what we have seen play out already in the Treasury Market but when we came into the year, we thought that point of convergence might have been lower than it's ultimately ended up being. But for the time being, there's a very strong argument that all roads lead to 3.25. That's the case in 2-Year Yields, it appears to be increasingly the case in tens and thirties, twenties have become the outlier without question.

Ian Lyngen:

Now the bigger issue that we're contemplating is, what happens over the course of the summer if and when we do see the labor markets start to show signs of weakness and we see rates recalibrate lower? Is the curve going to invert to depths that we haven't seen in quite some time? That certainly appears to be the path of least resistance. On the flip side, there's an argument to be made that even though The Fed is going to have policy rates north of 3%, if not 4%, that we could still see 2-Year Yields and the 24 month window reflected on a rolling basis, incorporate rate cuts, which would for all intents and purposes, put a ceiling on the extent to which yields could back up. This is important in context, especially when one contemplates whether or not The Fed has effectively created a floor in 2-Year Yields.

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 in a week defined by monetary policy excitement, we're left to consider other oxymorons, premium economy class, sports sedan, same difference, deafening silence, tragic comedy or our personal favorite, macro insight.

Ian Lyngen:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com\macro horizons. 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:

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 a representation that any investment or strategy is suitable or appropriate to your unique circumstances or otherwise it 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 swap advisor to you or in your best interests in you, to the extent applicable, will rely solely on advice from your qualified independent representative in 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 herein 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 its affiliates that is not reflected herein. BMO and its affiliates may have positions, long or shorts, and effect transactions or make markets, in securities mentioned herein, or provided advice or loans to or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMO's trading desks 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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