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Green Shoots and April Showers - The Week Ahead

FICC Podcasts April 05, 2021
FICC Podcasts April 05, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of April 5th, 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 114, Green Shoots and April Showers presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring your thoughts from the trading desk for the upcoming week of April 5th. As spring gets underway and allergy season kicks off in earnest, we are truly looking forward to the weary glances and quickly offered defense of, "It's just allergies."

Speaker 3:

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

Ian Lyngen:

In the week just passed, the Treasury market highlight was the better than expected nonfarm payrolls print which when combined with the revisions from the prior two months, brought payroll's growth to over a million jobs, an impressive measure by any means. We also saw an as expected decrease in the unemployment rate to 6%, which was accompanied by a modest one tenth of a percent increase in deep labor market participation rate.

Ian Lyngen:

Overall very good numbers, particularly given that the bulk of the growth was centered in the service providing sector. In the run-up before jobs, it was actually when we saw the most notable price action, however. We saw 10 year yields reach as high as 177. Now ,that was before we saw the April 1st bid, which retraced the market and brought things back closer to 167. Now a 10 bp range in this environment isn't anything dramatic had it not been a reversal off of the high yield mark of the pandemic. Now complicating matters even further was the fact that the selloff occurred on the 31st of March, i.e. quarter end, also Japanese fiscal year end. The Japanese fiscal New Year opened with a bid. And while it's too early to truly expect to see flows from the region materialize, the price action did have the feel of a market attempting to get in front in what is expected to be a significant shift in investor behavior from one of the regions that has traditionally been a big sponsor of Treasuries.

Ian Lyngen:

These all occurred in the context of record high equity prices yet again, and as we look forward, the amount of fiscal stimulus that's in the system should continue to keep expectations high, at least through the April and May data series, and it won't be until we get into the summer months where more material questions will arise about the sustainability of the pace of growth that the U.S. economy appears poised to demonstrate through the first half.

Ian Lyngen:

Other data highlights of the week just past included a better than expected consumer confidence print, as well as the highest ISM manufacturing read since 1983. So it's very consistent with the continued performance inequities and risk assets, as well as the strength in the manufacturing and goods producing sector. Within the details of ISM we did see a pretty significant increase in prices paid. And this triggers the obvious question of how long before the higher input costs on the manufacturing side are ultimately realized in core inflation? On one level, it follows intuitively that goods producers are going to attempt to pass through the increase in costs to the end-user. The underlying question is, how willing will the consumer be to pay up for goods and therefore contribute to the overall pricing pressures in the economy? There's no uncertainty that this will be an issue that's closely followed over the course of the next several months and we'll be keeping an eye on the April 13th core CPI print for the month of March as the next potential inflection point.

Ben Jeffery:

Great, well, it was an unquestionably strong NFP print. We've got over a million jobs added in February and March, but to me, really, the question is how much of that was already reflected in pricing?

Ian Lyngen:

And I think that given the price action that followed the non-farm payrolls print, we can safely say that a fair amount of it was already built in. Immediately after the release, we saw the Treasury market sell off one, maybe two basis points. Now it was a low liquidity event because of the recommended early close at noon, as well as the fact that overseas markets were largely closed, which really left the market to absorb and trade the information in effectively 30 to 45 minutes before the established trend took hold and we've seen rates drift slightly higher from there.

Ian Lyngen:

My biggest takeaway from the entire process was that the market is eager to look beyond what we are seeing in terms of the reopening data and start to consider what the new normal will ultimately comprise. We've been on about this idea that we spent as a market, a fair amount of time projecting how long it will take to get to the new normal, but remarkably little time in contemplating exactly what the new normal will look like and how some of the newly established patterns of consumption during the pandemic might ultimately prove more permanent.

Ben Jeffery:

And within the details of NFP, we did see one of the hardest hit sectors, which is leisure and hospitality put in another solid month of gains. But using this as an example for what you're getting at, Ian, there's still 3.1 million fewer jobs in that sector of the economy than where we were before the pandemic. While there's undoubtedly been an impressive tick up in hiring, not just in that sector, but in the economy as a whole, as we move further from the darkest days of the pandemic, each incremental job gain is only going to get more difficult. That gets to exactly your point about how long it will ultimately take for firms to adapt to this new normal and business after COVID-19 to take shape, which then will allow hiring decisions to be made. But that's going to be a much longer process than just the next several months. That will take quarters, if not years.

Ian Lyngen:

And that sets us up for the next big question in the market and that is, how long can elevated inflation expectations persist without confirmation from the realized data. On April 13th, we see the March CPI print and expectations are for an impressive year-over-year figure if nothing else, because of the base effects. But also that the stimulus that's currently running through the system and the fact that the economy appears to be reopening, will lead to service sector inflation. That's one of the biggest unknowns. And as the second quarter comes into focus, clearly this could serve as an inflection point for the overall direction of rates. We did see 10 year yields reach as high as 177. Now ,that occurred at a point when the long bond was well off of its recent highs of 251. There's a meaningful dynamic at play between the belly of the curve and the 30 year sector, specifically 530 is flattening.

Ian Lyngen:

Now, the reason it's flattening, it has to do with where the market believes we ultimately are in the rate cycle. As the economy improves, liftoff expectations have been brought forward and that has weighed on the 5, 7 and 10 year sector disproportionately, while the assumption is that the sooner the fed starts to back away from an uber accommodative monetary policy, the more of a headwind that will ultimately provide for longer-term growth. Said differently, we've seen a lot of stimulus put into the system throughout the pandemic, but very few people anticipate that will ultimately change growth potential in the U.S. So, if growth potential is what it was prior to the pandemic and it will take us still a while to get back to those levels, then it follows intuitively that we should see the longer into the curve contained.

Ben Jeffery:

And thinking about normalization expectations, it's also worth mentioning that in our pre NFP survey this month, consensus seems to be centered around an early, not late 2023 timeline for the Fed to get rates off the effective lower bound. That roughly lines up with what we're seeing in the Euro dollars market. But it does come in stark contrast to the Fed's own projections, which we saw confirmed at the March FOMC and showed policy rates at zero through the end of 2023. Clearly the dot plot will be revised as more information becomes available on the pace of the recovery, but it seems that at this point, sometime in 2023 may be when the FOMC is ultimately able to get rates off zero.

Ian Lyngen:

On the topic of bringing forward expectations, one of the concerns that I continue to have as we see these impressive jobs numbers is, what if the accelerated progress on the vaccination front is bringing forward the reopening in a way that is leading investors to assume this trajectory is going to remain in place throughout the balance of the year, when in effect, we might find ourselves by the end of the second quarter, as the summer approaches, with the bulk of the sidelined service sector employees back into the market and investors will be left to look for the next growth impetus.

Ben Jeffery:

So effectively what you're saying is a steeper and faster climb in terms of hiring that ultimately leaves us at a slightly lower outright level than could be assumed if these gains were extrapolated over the entire year.

Ian Lyngen:

Exactly. And further to the point, that also implies a fair amount of the inflation will be condensed into the first half of the year. If we look at the March average hourly earnings data, we saw an unexpected decline of one tenth of a percent month over month versus the consensus for an increase of one tenth of a percent. Now this can be easily attributed to compositional issues and I'm content to do that for now. But once we have another two or three million workers brought back into the labor force, it will be telling to see how wage growth develops.

Ben Jeffery:

And on this topic of what might be a market that's left looking for the next impetus of growth, I think we'd be remiss not to discuss President Biden's infrastructure plan that we learned about in more detail this past week. Now for the time being the longer term growth positive impact of the bill seems to be overshadowing the potential for a corporate tax hike, but this push and pull as the bill is debated in Washington and maybe ultimately makes it onto the floor of Congress, will be a major theme over the next several months. Fair to say?

Ian Lyngen:

I think that's an apt characterization. However I would offer the caveat that a major infrastructure initiative has a decidedly different character than direct stimulus. Direct stimulus contributes almost immediately to real GDP via consumption, whereas these longer term infrastructure rebuild projects, not only trickle into the economy over an extended period of time, I think that the current proposal is an eight year program, but in doing so, leads to a relatively muted response in the Treasury market.

Ben Jeffery:

And on the issue of corporates and corporate taxes, we also reached a milestone in the domestic equity market this week. The S&P 500 crossed 4,000 for the first time ever. And we're once again at record highs. Now we've been talking a lot about the ability of the economic data to keep up with lofty expectations and what that means for the Treasury market, but we also are quickly approaching Q1 earnings season, which offers something of a similar dynamic on the corporate side. So almost regardless of the sector in the equity market, it's going to be especially telling to see the degree to which the reopenings and restriction rollbacks we've seen in the first quarter have been able to reinforce some of the realized equity gains we've seen via realized strong earnings prints.

Ian Lyngen:

Well, that certainly does bode well for a Fed that appears content to remain on hold and to a large extent has been ignoring or content with some of the recent increases in rates, both on the nominal and real side. Ongoing equity gains have suppressed equity vol and have contributed to ever easing financial conditions. This leaves the Fed lacking any urgency in terms of a WAM extension or a version of an operation twist of some type, while at the same time it does keep the prospects for tapering QE on the table at the end of this year and that implies that the setup for that will occur during the second half, presumably the third quarter. This obviously brings up the concern of how much of that is already priced in and does the Fed risk a taper tantrum once it becomes abundantly clear that Powell will follow through with scaling back QE.

Ben Jeffery:

And the March meeting was almost certainly too early to begin that discussion, but on Wednesday we do get the minutes of the March meeting and any discussion about how willing policy makers are to step back from some of this accommodation, will definitely be a point of focus. Remember, while the median Fed funds forecast at the end of 2023 stayed at zero, we did see a greater number of committee members lift their projections off the zero bound. So there's clearly building optimism in the Central Bank that the recovery will progress to such a degree to allow normalization to more material enter the discussion. Given the Fed speak we've heard both leading into and now coming out of the March meeting, it still seems that the party line is bond buying in its current form remains appropriate, but to avoid another taper tantrum, if nothing else, it's reasonable to assume that the committee is going to want to lay the groundwork for tapering well in advance of its execution to avoid any undue market tightening, which in turn could translate to an erosion of financial conditions.

Ian Lyngen:

So on a wonkier note, there does seem to be some Fed action in the very front end of the curve at a time when we've seen one month bill yields drop below zero. That's pretty notable.

Ben Jeffery:

And in addition to negative bill yields, we've also seen a significant pickup in the usage of the Fed's reverse repo facility. Remember at the March meeting, the Fed did decide to up the counter party limits from $30 billion to $80 billion for the usage of that facility and given the enormous amount of cash that continues to flow through to the front end as a function of not only an environment with bill pay downs, but also a declining TGA. So thus far, it seems the committee has been willing to leave any technical adjustment to IOER as a future problem, and instead have preferred to lean on the RRP facility, but it's certainly reasonable to expect that we see an increased usage of this sort of pressure release valve in the front end, given that repo rates are likely to remain under pressure. And for those investors who are able to, it's better to put overnight cash at zero at the Fed, then take a negative market-based overnight rate.

Ian Lyngen:

So the takeaway here is that zero is better than negative.

Ben Jeffery:

Wait, I thought you wanted to test negative.

Ian Lyngen:

Oh, pandemic humor. Still too soon.

Ian Lyngen:

In the week ahead, the Treasury market will receive a few fundamental data inputs, including ISM services, which while not particularly useful in so far as projecting non-farm payrolls, which is typically a key input. It will be telling to see how March is shaping up from the perspective of the service sector, which is key at this point in the recovery. We also hear from a variety of Fed speakers, including Powell, Bullard, Kaplan, and Evans. More importantly are the March FOMC minutes. Now we know that there was very little in terms of a shift in monetary policy that occurred at the March meeting. The statement was relatively unchanged, and we did see an update of the SEP and the dot plot. What will be interesting is the discussion around the run-up in rates and any sense that the Fed might be close to responding to what is effectively the market tightening while the Fed is attempting to maintain an extremely accommodative monetary policy stance.

Ian Lyngen:

In terms of levels to watch in the market 10-year yields at 177 appear, at least for the time being, to represent the upper bound in terms of what one might expect in the event of a sell-off. On the flip side, a push towards 150 over the course of the month of April, certainly isn't off the table, especially if we find ourselves in a situation where the core CPI numbers don't perform as well as the market is anticipating.

Ian Lyngen:

Now we do know that the year over year print is going to be impacted by the base effects and that's something that Powell, as well as a variety of Fed speakers have reinforced as a risk that we'll offer some distortion as to how the market is perceiving the true inflationary environment. The Fed has also actively coached financial markets to focus on the three month annualized rate of inflation and the February print for core CPI in those terms was an uninspired at seven tenths of a percent increase. So given that backdrop, we're open to yet another disappointment on the inflation front with the caveat that as we have already seen, there can remain a significant divergence between inflation expectations and the data itself. There will, at some point need to be a convergence between the two, however, it's not going to be the month of April and we wouldn't be surprised if this divergence persists well into the second half of 2021.

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 as we press submit for our NFT action bid, we cannot help but remember old man William's sage advice about accepting wooden nickels. Also non fungible in their own right, like snowflakes and just as valuable. Banana? Check. Duct tape? Check. Blank wall? Check. Deep, deep confusion regarding the nature of value? Check.

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 his 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:

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 suggestion that any investment or strategy referenced herein may be suitable for you.

Speaker 3:

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Speaker 3:

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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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