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Focused on Flattening - The Week Ahead

FICC Podcasts November 12, 2021
FICC Podcasts November 12, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of November 15th, 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 146, focused on flattening. Presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with birthday boy, Ben Jeffrey, to bring you our thoughts from the trading desk for the upcoming week of November 15th. As the holiday shopping season quickly approaches and supply chain concerns abound, we are happy to have pre-ordered our Inflation Me Elmo doll, but we overpaid.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates for subsidiaries.

Ian Lyngen:

Each week, we offer an update 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 ian.lyngen@bmo.com with questions for future episodes. We value your input and hope to keep the show as interactive as possible. That being said, let's get started.

Ian Lyngen:

In the week just past, the choppy price action in the treasury market has contributed further to the evolving macro narrative. We brought in a reasonably strong bid at the beginning of the week with 10-Year yields, as low as 141. Now this was just six basis points above our target range for tens at the end of the year, which is at 125-135 zone.

Ian Lyngen:

The fact of the matter is, however, that the market wasn't able to retain that bid and yields quickly backed up, that was aided by the significant tail at the 30 year auction, as well as a 1.1 basis point tail at the 10-Year auction. More importantly for the macro narrative, however, was the stronger than expected headline and core CPI print. Inflation is now running at the highest levels that it has both on the headline and the core series since the early 1990s.

Ian Lyngen:

Now, this is very consistent with one of the biggest trades for 2021, which has been the reflationary story. When we look at the breakdown of the inflation itself, what we see is that there is arguably a broadening of the categories of upward pressure on consumer prices. Energy was a big contributor in October, but even within the core series, we see that new and used auto prices continue to support inflation expectations. We also now have the contribution of higher than expected OER or owner's equivalent rent.

Ian Lyngen:

All of this intuitively brings into question the Fed's expectations for prices to eventually moderate and also leaves the market focused on the pace of tapering. As it presently stands, expectations are for the first two months of tapering to be at 15 billion dollars a month, but as we move into 2022, there is an increasingly compelling argument that the Fed will need to accelerate the decrease of bond buying, which will create the needed flexibility for the Fed to bring forward the liftoff rate hike into the middle of 2022. As it presently stands, we continue to look toward Q4 of 2022 as a most likely period for the Fed to deliver the first rate hike of the cycle. Expectation from there will be a quarterly cadence with a nod to the fact that if inflation continues to come in above expectations, it follows intuitively that the Fed would then choose to deliver the first hike in the third quarter.

Ian Lyngen:

This debate is the primary one among market participants at the moment, simply whether or not the October inflation print warrants recalibrating Fed expectations for the year ahead. Our take is that the October data certainly puts Q4 2021 on a reflationary trajectory. However, there will be plenty of data between now and the point where the Fed actually needs to make the decision on liftoff.

Ben Jeffery:

It's been an unquestionably exciting week. Ian, I'm going to pose a question to you that has been posed to us several times over the course of the last few days. How has the October inflation data changed what we're thinking about the market?

Ian Lyngen:

Well, one of the primary ways in which it has reinforced some of our core tenants in the treasury market, is it fits extremely well with the notion that the big trade in 2022 is going to be the, "Surprise flattening of the curve," which is really just a way of changing the paradigm around the under performance of the belly of the curve.

Ian Lyngen:

The flattening of the fives thirties curve, I expect will continue to be thematic. This week, we saw this benchmark spread reach as low as 63 basis points. It's very conceivable that in the new year, we will see a return to the 2018 range, which was effectively 20 to 40 basis points. Now this is notable, because such a flattening has historically been a late cycle development, not what one would expect when the Fed has yet to follow through with the first rate hike. As we think about the debate playing out in the market moment, there has been, and will continue to be, a lot of focus on the fact that while 5-Year yields have breached 125, 10-Year yields are still in a range below 160.

Ben Jeffery:

As part of this discussion, there's also the critical component of the details within the CPI release. This past week was somewhat different, in that the upside surprise was not solely a function of some pandemic specific increases in prices. Think things like airfares, lodging away from home, subcategories simply related to the lifting of restrictions and reengaging in some version of a normal economy. Rather, we saw both food and energy somewhat intuitively up sharply.

Ben Jeffery:

Another round of increases in auto prices and probably most noteworthy, a sharp 0.44% month over month increase in OER. Now this is not necessarily a surprise, given what we've seen in the real estate market over the last 12/18 months, but the fact that it's now flowing through with a meaningful effect on the core CPI series, has to raise some questions on the FOMC, just giving the sensitivity of the housing market to borrowing costs and ultimately the Fed funds rate.

Ian Lyngen:

Well, it's interesting that Powell has come out in the past and said that the Fed is not worried about the run up that we have seen in home price appreciation. Now, that isn't to suggest that there's no chance that the Fed would ultimately feel compelled to respond to inflation, even if it was driven in part by the recent acceleration in home prices, as evidenced by OER. What we will be looking for is how the Fed introduces the conversation about OER and housing costs in the inflation complex.

Ian Lyngen:

There's a very compelling argument that what drove the increase in home prices was 100% the pandemic and the Fed's response. Now that's slightly less obvious as pointing to travel related costs and saying, "This is the natural result of reopenings and the new normal coming back online." It's a bit more nuanced. It's effectively saying that the Fed's policy response, i.e., much lower rates combined with the exodus from densely populated urban centers to first and second ring suburbs is what's truly driven home prices higher. Perhaps there's an argument to be made that that's a temporary impact or transitory.

Ben Jeffery:

Given what we heard from Powell at the November FOMC and this upcoming week's heavy slate of Fed speak, it's going to be very interesting to see the degree to which other monetary policy makers stick to that transitory characterization. The fact that the chair went as far as to explicitly layout next year in Q2 or Q3 as the timeframe that the committee is expecting, we see some of these transitory dislocations begin to wane. Means that as we get closer to that point in the cycle, any earlier tone shift from either Powell or frankly anyone else on the committee could potentially be a signal that monetary policy makers are thinking about either A accelerating, the pace of tapering or B pondering maybe bringing the lift off rate hike forward, or making the first rate hike by more than 25 basis points.

Ian Lyngen:

To your point, Ben, the week ahead contains a lot of high profile voting members who we expect will weigh in on the recent higher than expected inflation print. At the end of the day, this will bring into question the two rate hikes that are currently priced in for 2022. At least from our perspective, all else being equal, we'd expect the Fed to continue to reinforce the transitory narrative. This implies that investors will soon turn their focus to the December FOMC meeting, where we get an update of the beloved dot plot.

Ben Jeffery:

In thinking about the dot plot and also what we saw immediately following CPI, we feel that a very interesting question on why the very front end of the curve did not flatten more sharply as the two year sector underperformed, presumably as the timing of liftoff was brought forward. Really the best explanation for this, is that what we're seeing on the inflation front also has implications for the terminal rate.

Ben Jeffery:

While yes, the two year sector did underperform initially, the fact that the belly of the curve was able to keep pace with that down trade, implies that maybe the latest reads on prices mean that the Fed is going to need to ultimately bring rates to a higher level than maybe was presumed initially. From that perspective, not only is the 2022 dot going to be in focus, but the shape of the dot plot thereafter, is also going to be especially relevant simply to gauge how the Fed is envisioning the path of the hiking cycle beyond liftoff.

Ian Lyngen:

There's also an argument to be made, that the parallel shift in the twos fives curve rather than a flattening, simply implies that there is a higher probability that the Fed achieves what is assumed to be their terminal rate. Now, whether that is 175 or 250 really remains to be seen. But the fact of the matter is, that the market continues to price in fairly lofty inflation expectations. One of the more interesting nuances within the breakeven space that we've seen over the course of the last week has been the steady state or grind somewhat higher in 10-Year break evens as well as 5-Year break evens.

Ian Lyngen:

However, this has occurred with an important divergence. The 5-Year 5-Year Forward, however has drifted lower. Our interpretation of this price action is that the market has a reasonable amount of faith, not only in the Fed's ability, but also willingness to address higher realized inflation at some point, and that it will ultimately keep forward inflation expectations contained.

Ben Jeffery:

Ian, that's a really good point, because the last time we saw 10-Year break even so significantly higher than the 5-year 5-Year Forward measure, was in the early 2000s. Frankly didn't persist for all that long. As that spread normalized, what we saw was rather than 5-Year 5-Year Forwards increasing sharply to meet 10-Year break evens, it was actually a decline in outright inflation expectations that flowed through to a compression and the spread between those two measures. Which reinforces exactly your point, which is that given the Fed's demonstrated track record and fighting runaway inflation over the longer term. The second part of that 5-Year 5-Year Forward, there still is faith that tighter monetary policy will be able to offset spiraling prices.

Ian Lyngen:

Let us not forget that the market's confidence in the Fed's ability to fight inflation is part of what has been keeping longer dated yields contained. Particularly tens and thirties. If we think about the evolution of monetary policy making and the increase in transparency that has occurred over the last 30 plus years, global central bankers, particularly the Fed, have become incredibly transparent and in doing so, investors have a reasonably good understanding of the Fed's reaction function to higher inflation. What made this particular cycle so unique, was the Fed's shift in the framework. Recall that in 2020, the Fed introduced this average inflation targeting notion as well as maximum versus full employment.

Ian Lyngen:

All of which implied, that the Fed wouldn't respond to inflation in the same way that they had in the past. What we have seen in 2021, is that investors to a large extent have lost faith in the Fed's commitment to the new framework. Now I'll argue that's not necessarily fair, simply because the magnitude of the upside surprises on the inflation front had put Powell in a very difficult situation. Even if the Fed did want to allow inflation to run hotter than it has in prior cycles, the US economy is simply faced with too much inflation at the moment for the Fed to stand idly by.

 

Ben Jeffery:

This brings us to what were the other meaningful events of this past week? Namely the tailed 10-Year refunding and very weak 30-Year refunding that showed its largest tail since August, 2011, but on thirties, given the fact that the auction was coming right after that upside surprise and CPI, and that in outright terms, rates are still fairly significantly off the local peaks. To me, the auction result suggested more of a reluctance to catch the proverbial knife than any real broader rethink of the appropriate level of long end yields at this stage. The fact that immediately following the auction itself, we saw long-end yields drift lower. I think we enforces that idea somewhat.

Ben Jeffery:

If anything, given these refundings were the first set of smaller auctions following last week's refunding announcement, the fact that smaller auctions resulted in larger tails really once again, gets at the fact that given Treasury's unique position in financial markets, it's much less of a supply-demand flow driven dynamic than it is about the macro fundamentals, such as CPI.

Ian Lyngen:

On the topic of refunding auction performance, a question that we received recently from a client was, "Why do foreign market participants tend to take a larger share of refunding auctions as opposed to reopenings?"

Ben Jeffery:

In addition to the new and shiny bond argument, there's also a component of the variety of investment that say large foreign official accounts participate in the Treasury market. What I mean by that is, that given some large foreign holders of treasuries have meaningful exposure to the long end of the curve that needs to be adjusted, but likely broadly maintained. The fact that a lot of those holdings mature in refunding months, means that this investor class has a greater reinvestment need in refunding months than reopening months. Rather than wait to allocate that cash over refundings, and then the subsequent to reopenings, clearly there's a preference to simply bid a bit more aggressively at refundings and align those positional until the next quarter.

Ian Lyngen:

That also resonates when one thinks about the objective of reserve managers, and that is to have access to liquidity. The on the run is going to be the most liquid bond in any particular sector. Paying a bit of a premium for the liquidity certainly does resonate.

Ben Jeffery:

Speaking of on the run, what was your marathon time, Ian?

Ian Lyngen:

You know, Ben, it was exactly what it was last year.

Ben Jeffery:

And the year before that.

 

Ian Lyngen:

And probably next year. In the week ahead, the Treasury market will continue to digest the implications from the stronger than expected October inflation print. We have the October retail sales figures on Tuesday. The consensus is currently for a four tenths of a percent increase in retail sales. Now, we're reminded that this is not an inflation adjusted series. When we put it in the context of the six tenths of a percent and headline CPI, we start to get increasingly concerned about real growth and the implications for the forward path of the real economy.

Ian Lyngen:

Now, the recent increases in wages, particularly for some of the low wage earners have contributed to expectations for inflation over the course of the next year to become self-perpetuating. We are cautious against assuming that this is a given at this point in the cycle, if for no other reason, then real spending capacity continues to be undermined by higher prices.

Ian Lyngen:

Yes, inflation will be self-perpetuating to some extent, but eventually demand will be undermined. When we think about the potential response by policymakers, we are reminded that central bankers do not have the best track record of engineering soft landings, In effect, that's precisely what the Fed will need to do to keep the real economy from slipping into a recession. Specifically, monetary policy makers will need to thread the proverbial needle of tightening monetary policy enough to contain prices and forward price expectations on consumer goods and services, while remaining stimulative enough to keep the recovery on track.

Ian Lyngen:

It goes without saying that this is an unenviable position for Powell and company to be in at the moment, especially with the lingering uncertainties regarding who will get nominated to be chair of the FOMC in 2022. Our baseline assumption remains that there's a 75-80% probability that Powell gets the official nod. The second most likely candidate will be Brainard. Some of the recent price action confirms the notion that Brainard would be interpreted as a more dovish outcome for the FOMC. We saw that recently following reports that the White House had interviewed Brainard for the potential chair role.

Ian Lyngen:

We find ourselves very sympathetic to the idea that any sitting president would want the easiest monetary policy possible, given the implications for the employment market and the potential for reelection or legacy, if nothing else. That said, the upward pressure on consumer prices has complicated the calculus for Biden and the administration insofar as being seen as turning a blind eye to higher living costs, has political implications going forward as well. It's within that context that we'll be looking at this week's supply events, namely the $32 billion 20-Year on Wednesday, and the $14 billion tips reopening given how 10-Year real yields just hit a record low of negative 1.25%. We struggle to imagine that demand won't be high for the inflation protected securities in the 10-Year sector. Although it's being equal, we'll be watching that auction take down for further evidence of apprehension around the inflationary situation going forward.

 

 

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. As the holidays offer a time for reflection and to refocus on what's truly important, we are reminded of old man Lyngen's sage wisdom, "The key to happiness is lowering expectations and forecasts."

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. Please email me directly with any feedback, ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple podcast 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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