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Geopolitical Containment - The Week Ahead

FICC Podcasts February 25, 2022
FICC Podcasts February 25, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of February 28th, 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 160. Geopolitical containment 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 February 28th.

Ian Lyngen:

And as concerns regarding COVID recede only to be overtaken by tensions in Eastern Europe, the one constant has been contagion risk. Nope, no such thing is too soon.

Speaker 2:

The views expressed here are those of the participants and not those of 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 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 biggest news was Russia's decision to move forward with the invasion of the Ukraine. Now, this was initially traded as a bond bullish event with Treasury yields dropping dramatically at the beginning of the week. However, eventually it turned into a somewhat bearish event, insofar as the issue appears to be contained to the Ukraine.

Ian Lyngen:

Now in the event that Russia's ambitions don't stop at Kiev, then the involvement of NATO countries might become a more realistic scenario, but for the time being, at least, the market seems to be content to assume that the Eastern European issues will largely not impact the US economy. That said, it should contain the extent to which 10 and 30 year yields ultimately back up, if for no other reason than this certainly undermines the global growth outlook, at least on the margin.

Ian Lyngen:

The impact in the energy sector was initially rather dramatic with the front month WTI contract trading of $100 a barrel, but this too eventually faded as it appears that sanctions are going to be focused on the financial aspects of Russia, as opposed to the commodity production side.

Ian Lyngen:

So where does that leave us from a Treasury market perspective? Well, we continue to expect that the Fed will deliver a 25 basis point rate hike at the March meeting. There's been enough chatter about the potential for a 50 basis point liftoff that one can't completely take the discussion off the table, but at the end of the day, we expect that 25 basis points will be the path of least resistance. The logic here being, if the Fed were to lift off with 50 basis points, the market would simply assume that each subsequent hike would be 50 basis points. That would lead to a dramatic spike in front end yields, and almost immediately invert the curve.

Ian Lyngen:

Now, the Fed has made it abundantly clear in prior cycles, as well as this one, that a flatter curve doesn't necessarily have the same implications for a looming recession. Nonetheless, curve compression is not ideal from the perspective of monetary policy makers. And so if a gradual and predictable hiking cycle can be delivered, and the long end of the Treasury curve doesn't rally on an outright basis, the Fed would be content to deliver such a scenario.

Ian Lyngen:

The week just passed also contained a couple of data points of note. We did have stronger than expected personal spending data and the core PCE number increased as expected, but still at a 5.2% year over year rate. There were also upward revisions to the inflation data contained within the Q4 GDP report. It was striking that consumption was revised lower while the headline price deflator was revised up.

Ian Lyngen:

The revisions also highlighted that a good portion of Q4's GDP growth was a function of an inventory rebuild. To a large extent, this makes sense given what we have seen in terms of supply chain issues, but nonetheless, it is a doubling down on the bet that the consumer is going to come roaring back in the first quarter. So this inventory overhang does present a material headwind to growth as 2022 gets underway.

Ben Jeffery:

Well, for those expecting that this was the week the market was going to get a breather, fairly pedestrian auction of twos, fives, and sevens, it did not end up being that week.

Ian Lyngen:

Not at all, Ben. There were so many developments in the geopolitical sphere that it was difficult for the market to take a breather. In fact, we did see a rather dramatic sequence of price action, including what followed intuitively as a very strong bid for treasuries on the news that Russia was invading the Ukraine, only to be offset with the most durable price action being of course, the flattening of the curve.

Ben Jeffery:

And in keeping with the theme of the dramatic moves, not just in rates, but commodities, equities, on Thursday after the world learned that Russia was moving beyond just the separatist regions of Eastern Ukraine and mounting a full scale invasion of the country, we saw the NASDAQ open down 3% to close the session up 3%, and oil begin the session north of $100 a barrel, only to make a complete round trip and close the day in the low $90 a barrel range.

Ben Jeffery:

In addition to the conflict itself, there was also the nuance of what we're continuing to learn about the West's sanctions on Russia in an effort to inflict economic damage, given that at this point, it's become very clear that there is effectively no appetite for a direct military conflict. Of course, assuming that the invasion does not spread beyond Ukraine's borders.

Ian Lyngen:

And that's what it really comes down to. It's an Article 5 of NATO issue. Is the US going to be called upon to defend NATO countries, whether it's Poland or another country that is neighboring the Ukraine? As it currently stands, the market is assuming that Putin's ambitions end with the Ukraine. In the event that there's more saber-rattling in the weeks to come, surely there will be questions about whether or not boots on the ground will be warranted.

Ian Lyngen:

Nonetheless, we're operating under the assumption that the crisis will be contained to the Ukraine, and as we have seen by the sanctions imposed by the West thus far, there's also a notable lack of interest in tampering with the energy flowing out of Russia.

Ben Jeffery:

And politics of the issue aside, this is simply a result of the construction of the global energy market. Germany gets 55% of its natural gas from Russia, and even the US is an importer of Russian oil. So while yes, in terms of economic damage, targeting the oil and gas sector in Russia would be very damaging to their economy.

Ben Jeffery:

For better or worse on a global scale, the economy needs energy coming out of Russia, and this fact is not wasted on the EU or the US, which goes a meaningful distance in helping explain why at this point, the sanctions are very financial focused. Russian banks, restrictions on individuals, and really an effort to limit Russia's access to global capital markets and currencies outside of the ruble, which did reach its all-time low versus the dollar as news began to hit the tape that the Russian military was moving more completely into Ukraine.

Ian Lyngen:

Bringing it back to the US rates market, the implications for monetary policy are less obvious. At the beginning of the process, we were trading this from an inflationary perspective. So during several sessions, we saw a push flatter in the curve and upward pressure on front end yields. The idea there being that elevated energy prices would flow through to the US economy and contribute to an already rapid pace of consumer price inflation.

Ian Lyngen:

The fact that oil has retreated from the $100 a barrel level does speak to this containment notion, and also leaves the market to focus on the broader geopolitical concerns that arise when one contemplates what other potentially contested regions could come into focus over the balance of the year.

Ben Jeffery:

And the follow-up notion that's been making the rounds this week is, does this increase tensions in the Taiwan Strait? Obviously Taiwan's relationship with mainland China is going to continue to be an area of focus on the geopolitical stage, as well as how Beijing is viewing the latest escalation in Ukraine within their broader aspirations on the international stage.

Ben Jeffery:

At this point, it doesn't seem that there's any indication this is more than just another geopolitical discussion point, but in a world that's now more uncertain than it was coming into 2022, this will almost certainly continue to occupy at least a portion of the market's discussion.

Ian Lyngen:

And let us not forget about the cyber-attack angle. A lot has been made about any potential escalation to go global insofar as vulnerabilities of banking and infrastructure systems. Now we certainly have no insight to offer in that regard other than to observe that it will be a background risk over the next several months.

Ben Jeffery:

In this part of the discussion, Ian helps explain why the market has treated the latest leg of the conflict as more of a risk off impulse and a dovish monetary policy one, as opposed to the inflation side. We saw the April Fed fund's futures contract move from trading with an implied yield of 44 basis points to as low as 35 basis points in just one session.

Ben Jeffery:

And in practical terms, what that points to is that investors are interpreting the invasion as inspiring a bit more patience by the FOMC. We did hear from Governor Waller that he thinks there's a strong case to be made for a 50 bit left off, but in a similar fashion the Bullard, that really isn't keeping with his more hawkish tendencies.

Ian Lyngen:

So on net, the last week has reinforced our baseline assumption that on March 16th, the FOMC will increase policy rates by 25 basis points and signal that a quarter point cadence will be the norm for this cycle.

Ian Lyngen:

Now we also continue to believe that the backbone of the hiking cycle will be quarterly moves. However, we're certainly open to a move in May as well to really kickstart the process of rate normalization before the balance sheet runoff is subsequently announced in July.

Ben Jeffery:

And that blueprint is probably pretty well-priced into the market at this point, if only given the sponsorship that we saw for twos, fives and even sevens at their auctions over this past week. Twos and fives both showed record non-dealer allocations and an indication that given the amount of hawkishness that's been priced in so far this year, the increase in Treasury yields in the sector is most beholden to Fed policy, has now reached a point to bring in fairly significant dip buying interest. After all, it's been a very dramatic move to begin the year as we transitioned from the December SEP forecasting just three rate hikes to now the debate centering on five or six.

Ian Lyngen:

And to be fair, there is a debate that we might see more than five or six rate hikes, even though at this point, the Fed funds futures market is pricing in slightly more than six 25 basis point moves for 2022. It will be interesting to see how the Fed chooses to adjust its projections. The perception that the Fed is going to need to aggressively respond to inflation does bring into question what that will do to real GDP in the coming years.

Ian Lyngen:

Now, as it currently stands, the assumption is that price stability will help hiring, and it won't come at the expense of real consumption. Now obviously, if the Fed takes the edge off of inflation in real terms, spending should improve for the same amount of nominal growth.

Ian Lyngen:

That said, another key debate that will surely be in focus come 16th March will be whether or not the Fed is comfortable increasing its guidance related to the terminal policy rate. As it presently stands right now, the long run Fed funds futures projection is 2.5%. There's a strong argument that should be higher, although whether the Fed would ultimately be able to achieve that level is another story altogether.

Ben Jeffery:

And this week is the final opportunity for FOMC members to offer their opinion before we get into the radio silence period ahead of the meeting. We've heard from Governor Waller, we've heard from New York Fed President Williams, but this week carrying the greatest weight will be Powell's Humphrey-Hawkins testimony to both the House and the Senate, where he will weigh in on the 25 versus 50 debate. And just how aggressive the Fed will be in running down Soma Holdings.

Ben Jeffery:

We're still in this camp expecting that balance sheet normalization will be announced in July, but there is certainly the risk that the Chair indicates he would favor beginning that process before the end of the first half of the year.

Ian Lyngen:

And Powell will certainly also receive questions on how the situation in the Ukraine impacts the economic outlook. While the market seems to be comfortable trading it from the inflation side, I suspect that at the end of the day, the Fed will be more concerned about the global growth outlook if we continue to see geopolitical tensions increase.

Ben Jeffery:

But at this point, it's safe to say that these concerns may moderate the aggressiveness with which the Fed and frankly other central banks are going to normalize policy, but it has not taken rate hikes or QT off the table.

Ben Jeffery:

So in terms of what it means for the shape of the curve, this will continue to set a floor for front end yields, twos through fives, while conversely the growth and inflation outlook is going to serve as a drag on the longer end. That doesn't take another shot at that 206 level and 10 year yields off the table. But over the longer term, it will likely keep the curve persistently in this flatter range that we're quickly becoming accustomed to.

Ian Lyngen:

And flatter to the point of inversion in twos, tens in particular. We did get as low as 33 basis points in twos, tens, and we expect that once the hiking process is officially underway, that that pressure will once again re-emerge with an initial target being 25 basis points from here.

Ben Jeffery:

So despite not even seeing the first rate hike of the cycle yet, at this point, not fighting the Fed is otherwise said as not fading the flattener.

Ian Lyngen:

In the week ahead, there are several factors that will be driving the direction of US rates. The most obvious being the ongoing developments in Eastern Europe, as Russia continues to push through the Ukraine, and concerns about approaching the borders of NATO countries remain, we expect that this will provide at least a degree of underlying bond bullishness.

Ian Lyngen:

In terms of real economic data, Friday's non-farm payrolls is expected to show a 400,000 job increase in the month of February, and the unemployment rate is expected to print at just 3.9%. Below 4% at this point in the cycle is encouraging, although we will highlight at that the labor force participation rate remains stubbornly low at this point in the cycle. And a lot of that has to do with the 55 and older cohort leaving the labor force and presumably bringing forward retirement plans.

Ian Lyngen:

That said, the labor force participation in the 34 to 44 year old cohort continues to be lower than it was prior to the pandemic. And a lot of that we suspect ultimately comes down to in-person learning and the availability and accessibility of childcare. So as we continue to see pandemic restrictions eased, and the market look forward to a post-COVID world, we would, all else being equal, anticipate the labor force participation will continue to rise.

Ian Lyngen:

Also contained in the week ahead will be the ISM manufacturing and service sector prints. Here, we will continue to anticipate optimism on both fronts with special attention paid to the service sector, given that the real economy is now transitioning to the point where we would expect a rotation out of goods consumption and into service spending to accelerate as those pandemic restrictions continue to ease.

Ian Lyngen:

Let us not forget that we do hear from Powell who will be giving his semi-annual congressional testimony, both to the House and the Senate with a variety of questions, certain to bring up concerns regarding whether or not the Ukraine will have a more meaningful impact on the US economy. Trade between the US and the Ukraine and Russia for that matter is relatively limited, and so there'll be less of an immediate hit in terms of growth.

Ian Lyngen:

The more tangible concerns will likely be related to investor sentiment, the potential fallout in terms of the wealth effect, and of course, any implications for the energy complex. At present, the upward pressure on oil prices seems to have run its course for the time being, but that's not to imply that we can't see another surge higher in oil and natural gas prices in the event that sanctions either become more sector specific, or that there are other regions that begin to suffer from increased geopolitical tensions.

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 with March coming in like a lion, we are reminded that the 74th day of the Roman calendar, not only marks the Empire's deadline for settling debts and the notorious assassination of Julius Caesar.

Ben Jeffery:

Best salad ever.

Ian Lyngen:

This year, it corresponds to the beginning of the FOMC meeting in which liftoff is a foregone conclusion. Et tu, Jerome?

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.

Ian Lyngen:

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 thick macro strategy group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

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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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