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Half Point Habituation - The Week Ahead

FICC Podcasts June 03, 2022
FICC Podcasts June 03, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of June 6th, 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 174: Half Point Habituation 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 June 6th. And with the Queen's celebration in full swing, we just learned that we have yet another thing in common with Kim Kardashian, no entrance to the Platinum Jubilee official party. It's called a royal snub. Not to worry, we'll be re-watching Hamilton.

Announcer:

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 U.S. 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 I-A-N.L-Y-N-G-E-N@bmo.com with questions for future episodes. We value your input and hope to keep the show as interactive as possible.

Ian Lyngen:

So that being said, let's get started. In the week just passed, the Treasury market put in a remarkably choppy performance after having ended the final full week of May on a decidedly bullish tone, we saw rates back up with 3% 10 years once again coming on the radar. Now taking a step back, the price action can be best characterized as an extended period of consolidation. We make this observation primarily because the bulk of the price action has been remarkably in range, and it's been associated with the extreme momentum measures working their way out of overbought territory in the Treasury market.

Ian Lyngen:

Now, with these extremes alleviated to some extent, investors will be left to contemplate how the Fed will shift monetary policy over the course of the summer months. We're now into the Fed's radio silence period and expectations for the June 15th FOMC meeting are for another 50 basis point rate hike, this to be followed by 50 basis points in July and then at the September 21st meeting, another 50 basis points has increasingly become the consensus outlook.

Ian Lyngen:

Now, you'll recall that in the week just passed the Bank of Canada increased rates 50 basis points, but it was accompanied by language suggesting that a 75 basis point rate hike might be on the table soon. We don't anticipate a scenario in which the Fed will need to move 75 basis points. However, additional 50 basis point moves later in the year should be a consideration albeit not the base case scenario once we get past the September meeting.

Ian Lyngen:

We've long lamented that during this cycle, it's notable how political inflation has become. We've heard that both from the White House, as well as a variety of members of Congress. In addition, increasingly hearing issues from the politicians on the state and local level. So what this suggests is it's going to be an issue that remains relevant through at least the midterm elections, which implies that every meeting through November we'll see a rate hike of some magnitude.

Ian Lyngen:

The fact certainly isn't lost on us; however, that a lot of the inflation that is hitting the consumer the hardest has to do with supply shocks and not on the demand side. Sure, undermining demand sufficiently will eventually curtail inflation, but it increases the risk that the Fed overshoots the mark and we ultimately find ourselves in a slower growth environment than monetary policymakers would ideally have liked to have engineered.

Ben Jeffery:

So last week we got a rally, 10-year yields down to 2.70, but this week were short A, but B was bearish. We got 10-year yields back within striking distance of 3% and a jobs report that was meh.

Ian Lyngen:

Yeah, I think that's a fair characterization. It was a remarkably consensus non-farm payrolls report. We saw a slightly higher than expected headline print, but the private NFP numbers were pretty much in line with expectations. The one aspect of the report that I will note stood out was the fact that average hourly earnings undershot expectations increasing three-tenths of a percent month over month in May effectively matching what we saw in April, and that left the year over year figures to decline to 5.2% from 5.5%.

Ian Lyngen:

Now, this is obviously consistent with the peak inflation narrative, but more importantly, it is a reminder that in real terms, wages continue to decline and that will potentially serve to undermine consumers purchasing power as the summer months unfold. Nonetheless, the post-payrolls knee-jerk response was toward higher rates. This is at least in part a function of the fact that we have $33 billion 10-year notes auctioned on Wednesday and $29 billion in 30s auctioned on Thursday.

Ben Jeffery:

And along with an early setup for the June reopening auctions of 10s and 30s, it's also worth acknowledging that along with the increase in outright yields, we did see a slight steepening of the curve, which reinforces that auction concession idea. And I would argue is also a function of the lower than expected monthly gain in average hourly earnings, and at least one data point that suggests the peak of wage growth and thus, inflation is behind us for this cycle.

Ben Jeffery:

From a monetary policy perspective, this means that the Fed will continue with at least two more 50 bp hikes, but in the event that wages start to moderate and the risk of a wage inflation spiral lessens, they might not need to be as extremely hawkish as what otherwise have been the case.

Ian Lyngen:

Now, this brings us to the obvious question, how do they address the September meeting? Brainard left open the possibility of another 50 basis point rate hike, making an aggregate of four consecutive 50 basis point rate hikes and a total of 225 basis points in rate normalization.

Ian Lyngen:

Without question, that would put monetary policy into the zone of neutral, if not through, with the broader issue isn't one of defining where neutral is during this particular cycle, but rather the extent to which the real economy can handle higher borrowing costs and continue to see a reasonable performance in risk assets.

Ben Jeffery:

And on the performance of risk assets, it's been very relevant to see the past two weeks price action shows that the moves in the S&P 500 has tracked very closely to the price action we've seen in 10-year real rates. Higher inflation-adjusted borrowing costs comes at the expense of equity valuations. Meanwhile, drops in real yields have been viewed as a positive through the lens of stock valuations.

Ben Jeffery:

Recall back in early May, we saw 10-year real rates get as high as positive 36 basis points. We then saw a bid for TIPS bring that measure back down to the mid-teens, which is still in positive territory, but not so high as to trigger that feedback loop with stocks. And now that we've settled into this range right around 25 basis points, it seems that equities have been able to find their footing or at the very least not continue to drop sharply.

Ian Lyngen:

The direction of the yield curve in here is a pretty big unknown when we think about how the Fed is transitioning to running off their balance sheet this month. The first date of relevance will be the maturities on the 15th of June. Now recall the Fed hasn't been buying securities outright in the Treasury market for some time. So what this means in practical terms is that there will be smaller add-ons at the upcoming auction. We've made the point before, but it warrants reiterating. The bigger question isn't the smaller auction add-ons, but rather how Yellen and the Treasury Department choose to make up any funding shortfall.

Ian Lyngen:

One of the defining characteristics of this year so far has been higher than expected tax receipts at the federal level, which means that borrowing needs will be less dramatic as we contemplate the balance of 2022. So this implies that there is plenty of borrowing capacity in the bill market to absorb any funding shortfall that results from the Fed's marginally smaller participation. And let us not forget, the Fed is going to let a meaningful amount of bills mature from SOMA over the course of the next eight to 12 months.

Ben Jeffery:

And from what the Treasury Department has told us, they would prefer that bills comprised somewhere between 15 to 20% of total debt outstanding. And that figure currently stands at roughly 12, 13%, which to your point, Ian, leaves room for the bill market to grow and should afford Yellen patience in needing to once again start to increase coupon auction sizes, also looking at valuations in the very front end of the curve, there's clearly very significant demand for the shorter stated Treasuries with bills and even short coupons trading well through OIS and in a more traditional environment would be considered very, very rich.

Ben Jeffery:

But we've seen that dynamic persist so durably given that we're still in a net negative bill issuance environment, that it certainly makes sense the Treasury Department will be very comfortable increasing bill auction sizes, which should help rationalize demand and presumably pull some of the $2 trillion that remains in the RRP program out of that system and into the "longer parts of the market" by which I mean just not overnight.

Ian Lyngen:

And I think that your observation about RRP really does go a distance to answer the question, who's going to pick up the bills?

Ben Jeffery:

Well, it's not going to be Powell at least not until the recession happens and they need to start buying bonds again.

Ian Lyngen:

Give it time.

Ben Jeffery:

But in all seriousness, we also have been seeing an increasing number of headlines surrounding hiring freezes at large corporations, some news around rightsizing workforces and coming layoffs. And this is something that is obviously more closely associated with late cycle dynamics only two years after we exited the last recession. But somewhat counterintuitively, I'm not so sure that even a modest increase in the unemployment rate would be enough to get the Fed to pause, maybe slow their hiking pace to 25 basis points every meeting or 25 basis points a quarter.

Ben Jeffery:

But in some ways a higher unemployment rate that's closer to some version of sustainable would be in keeping with the labor market side of the Fed's dual mandate, but also help take some of the upward pressure off wages and ultimately inflation. Within our pre-NFP survey this month, we saw that the general consensus in terms of timing to see core CPI drop below 3% on a year over year basis is the third quarter of 2023. A timeline that certainly resonates with the lagged impact of monetary policy. And when it is that we would expect this year's rate hikes to more observably start impacting the real economy.

Ian Lyngen:

That isn't to suggest that the market isn't going to attempt to trade that dynamic ahead of the fact. And the fact of the matter is I'll argue that's precisely what we saw over the course of the last several weeks. Now, the reversal seems to be implying that there's some buy-in with the Fed's narrative that the real economy can withstand higher rates.

Ian Lyngen:

And for all intents and purposes, if risk assets can withstand higher rates and financial conditions remain as tight as they have been, that is something of a Goldilocks scenario for the Fed and is consistent with, if not, actually proof of concept of a soft landing.

Ben Jeffery:

But something else that took place over this past week that gave us a bit more apprehension around the prospects for a soft landing, not that we needed anything more in that front was the renewed rally in oil and a WTI contract that closed back in on $120 a barrel. Now, a lot of the weakness we've seen in crude over the past month or so has been a function of the fact that a lot of China has still been locked down. And as demand for oil from China starts to pick up again, it's certainly not unreasonable to expect that we're going to see continued upward pressure on oil prices with everything that implies for input costs, gas prices, and the overall tax on consumption argument.

Ben Jeffery:

Ian, as you and I have discussed several times, the Fed can't do anything directly to address the price of oil, but what they can do is temper demand sufficiently to keep core inflation low even if energy prices are going to remain high. In a very interesting client conversation this week, we heard the lament that at this point the Fed is just fighting gas prices and that's not a fight that Powell is likely going to be able to win.

Ian Lyngen:

That's a fair point, Ben. And I'd also note that the administration has been getting involved with the ongoing release of oil from the strategic petroleum reserves and OPEC+ has committed to increasing production, although most analysts suggest that there might be an enforceability issue in that regard.

Ben Jeffery:

And there's another late cycle dynamic that's attracting an increasing amount of attention, both from the market, but also from the Fed. That is what is becoming increasingly clear in the housing market and what is starting to look like the turn in the real estate cycle. Now, this, of course, has to do with the fact that mortgage rates are back at levels we haven't seen since 2009. And it's also one of the implied objectives that the Fed set out to accomplish when they began hiking rates so aggressively.

Ben Jeffery:

Both from a wealth effect perspective, but also just the composition of the inflation data, taking the edge off of housing would be an acceptable or even encouraging outcome from the perspective of the FOMC. We heard from Vice Chair Brainard this week that while housing is cooling, she doesn't expect a dramatic move lower, but rather a slow recalibration of prices and overall activity to higher borrowing costs in one of the most interest rate-sensitive subsets of the economy.

Ian Lyngen:

And that brings us to the classic wealth effect argument. Is the Fed going to be successful in taking the upside edge out of home prices, which would contribute to a lower inflation profile? And at the same time, reduce the overall wealth effect, leading consumers to be a bit more cautious with their outlays. That's one of the primary risks that the Fed now faces in its effort to engineer that all too elusive soft landing.

Ben Jeffery:

Ah, sorry, your flight's been canceled, but we can rebook you in four to six days.

Ian Lyngen:

That's fine. I'll be here waiting. Still waiting. No, no, yeah, no, I'm just waiting.

Ian Lyngen:

In the week ahead, the Treasury market will be tasked with taking down three auctions. First will be the $44 billion three-year note on Tuesday, followed by 10s at 33 billion on Wednesday, and capped with 19 billion long bonds on Thursday. The primary economic data event of the week will be CPI. Headline CPI is seen increasing seven-tenths of a percent month over month and the core figures are seen up four-tenths of a percent. Now, these numbers are consistent with this notion that there will continue to be a divergence between headline and core consumer prices, particularly as the summer months play out.

Ian Lyngen:

Now, this starts to become increasingly problematic as we get further into driving season and higher gasoline prices undermine spendable dollars for other non-necessities on the household level. This isn't a new notion, i.e., inflation functioning as a tax on consumption. But up until this point in the cycle, headline inflation has been the only inflation that matters. We did hear from Brainard that the inflation numbers that really matter are core inflation and that offers some context for what might be a transition after we get through the summer months to a Fed that is a bit more cautious and less hurried in their endeavor to normalize monetary policy.

Ian Lyngen:

Although, frankly, once we get past September, Fed funds will be close enough to the zone of neutral for government bond work as it were. In the context of the overall direction of the market, we are on board with a continued and/or extended period of consolidation with 10-year yields trending below 3%. And our focus will increasingly be on the shape of the yield curve as the summer unfolds. The front end remains clearly anchored to monetary policy expectations and that implies that twos, threes, and fives have an effective floor in terms of yields for the moment.

Ian Lyngen:

Further out the curve; however, 10s and 30s, once we get through the needed concession for the re-openings, we anticipate that the path of least resistance will ultimately be toward lower rates. Now, part of this has to do with where we are in the cycle. Part of it has to do with the fact that there have been many sideline market participants who've been waiting for a dip to buy. We did get 10s back up to 3.20, but that's a level that is increasingly appearing as though it's going to mark the upper bound for yields in the 10-year sector for the time being.

Ian Lyngen:

What will be pivotal in defining the extent to which the long end of the curve can outperform will ultimately come down to risk assets. Now, as May ended and June began, there appeared to be a collective sense of stabilization in equity markets. Our take is that this period of relative calm has a limited shelf life. And once we get greater clarity on the inflation and growth front, we will see an attempt to revisit valuations in equities, which will have obvious implications for realized volatility and that translates through to financial conditions. And ultimately the feedback with higher real yields will provide a tangible headwind to risk assets.

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 contemplate a summer road trip in the context of the national average gasoline price surpassing $4.75 a gallon, all we can say is yabba dabba doo.

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@ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider.

Ian Lyngen:

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.

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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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